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HOVNANIAN ENTERPRISES INC

2018-12-20

2018-10-31

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Hovnanian Enterprises, Inc. (“HEI”) conducts all of its homebuilding and financial services operations through its subsidiaries (references herein to the “Company,” “we,” “us” or “our” refer to HEI and its consolidated subsidiaries and should be understood to reflect the consolidated business of HEI’s subsidiaries). Overview As discussed in previous quarters, we were limited in our ability to invest in land purchases in fiscal 2016 and 2017 due to significant debt maturities that we were unable to refinance and therefore had to pay at maturity. This reduction of investment has led to a decrease in community count and revenues, which impacts our overall profitability. Our total number of lots controlled increased in the quarter ended October 31, 2018, as compared to the same period of the prior year, which is the fourth consecutive quarter for which we have experienced a year-over-year quarterly increase. We believe continued growth in lots controlled should ultimately lead to community count growth and our fiscal 2017 and 2018 financing transactions have provided us with the long term capital needed to implement our investment strategy to grow our business. However, there is typically a significant time lag from when we first control lots until the time that we open a community for sale. Our cash position in fiscal 2018 allowed us to spend $566.8 million on land purchases and land development during fiscal 2018, along with using $211.4 million of cash to pay down debt, and still have $187.9 million of homebuilding cash and cash equivalents as of October 31, 2018. We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices and sales pace and plan to continue actively pursuing such land acquisitions. New land purchases at pricing that we believe will generate appropriate investment returns and drive greater operating efficiencies are needed to return to sustained profitability. The factors discussed above for fiscal 2016 and 2017 led to a decrease in our community count from 130 at October 31, 2017 to 123 at October 31, 2018, and as a result, for the year ended October 31, 2018 we experienced mixed operating results compared to the prior year. More specifically: ● Net contracts per average active selling community increased slightly to 35.9 for the year ended October 31, 2018 compared to 35.1 in the prior year. ● Active selling communities decreased 5.4% over last year, and our average active selling communities decreased by 12.2% over last year. Net contracts decreased 10.1% for the year ended October 31, 2018, compared to the prior year. ● For the year ended October 31, 2018, sale of homes revenues decreased 18.5% as compared to the prior year, as a result of a 13.5% decrease in deliveries, primarily due to our decreased community count. ● Gross margin percentage increased from 13.2% for the year ended October 31, 2017 to 15.2% for the year ended October 31, 2018. Gross margin percentage, before cost of sales interest expense and land charges, increased from 17.2% for the year ended October 31, 2017 to 18.4% for the year ended October 31, 2018. The improvements in both gross margin percentage and gross margin percentage, before cost of sales interest expense and land charges, are primarily the result of the mix of communities delivering, as well as the benefit of a one-time $6.3 million credit related to a land development reimbursement from a municipality in California. ● Selling, general and administrative costs (including corporate general and administrative expenses) decreased $26.9 million for the year ended October 31, 2018 as compared to the prior year. As a percentage of total revenue, such costs increased from 10.4% for the year ended October 31, 2017 to 11.5% for the year ended October 31, 2018. The dollar decrease for year ended October 31, 2018 was primarily due to the reduction of our warranty reserves, as a result of our annual actuarial analysis, along with an adjustment to our insurance reserves in the third quarter of fiscal 2018, resulting from a recent legal settlement. There was also an increase in management fees received from our joint ventures, due to increased unconsolidated joint venture deliveries during the period, and $12.5 million of additional reserves recorded in fiscal 2017 related to the Grandview litigation discussed in Note 18 to the Consolidated Financial Statements. Partially offsetting the decrease for the year ended October 31, 2018, were higher stock compensation costs and legal (including litigation) fees incurred related to our fiscal 2018 financing transactions. We received insurance coverage, less the deductible, for these litigation costs. Also offsetting the decreased costs for the year ended October 31, 2018 was rent expense related to (i) the sale and leaseback of our former corporate headquarters building for the period from November 2017 to February 2018 and (ii) rent on our new headquarters building. The increase in selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenue for the year ended October 31, 2018 was mainly due to the decrease in total revenues for fiscal 2018 as compared to the prior year. When comparing sequentially from the third quarter of fiscal 2018 to the fourth quarter of fiscal 2018, our gross margin percentage increased from 15.4% to 16.5% and our gross margin percentage, before cost of sales interest expense and land charges, increased from 18.4% to 19.2%. Our gross margin percentage, and gross margin percentage, before cost of sales interest expense and land charges, increased primarily as a result of product mix, as well as the benefit of a one-time $6.3 million credit related to a land development reimbursement from a municipality in California. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenues decreased from 11.8% to 8.3%, as compared to the third quarter of fiscal 2018 primarily due to a $10.2 million reduction in our construction defect reserves in the fourth quarter of fiscal 2018, as a result of our annual actuarial analysis, along with an increase in management fees received from our joint ventures, due to increased unconsolidated joint venture deliveries during the period. Partially offsetting the decrease was an adjustment to our insurance reserves in the third quarter of fiscal 2018, resulting from a recent legal settlement. Improving the efficiency of our selling, general and administrative expenses will continue to be a significant area of focus. We had 1,826 homes in backlog with a dollar value of $745.6 million at October 31, 2018 (a decrease of 7.7% in dollar value compared to the prior year). As expected, due to our use of cash for significant debt repayments in prior fiscal years as discussed above, our community count decreased during fiscal 2018. Further, our net contracts per community declined in the fourth quarter of fiscal 2018 compared to the fourth quarter of fiscal 2017 consistent with data for the overall housing market. In light of these results, we remain cautious and are carefully evaluating market conditions when evaluating new land acquisitions. As discussed above, we have invested $566.8 million in land purchases and land development during fiscal 2018, which along with continued land acquisitions, is expected to lead to future community count growth. However, there is typically a significant time lag from when we first control lots until the time that we open a community for sale. This timeline can vary significantly from a few months (in a market such as Houston) to three to five plus years (in a market such as New Jersey). We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices and sales paces and plan to continue actively pursuing such land acquisitions. Given the mix of land that we currently control and the land investment we currently anticipate, we currently believe that our community count growth will begin in the first half of fiscal 2019. Ultimately, community count growth, absent adverse market factors, should lead to delivery and revenue growth in the future. Subsequent to our fiscal year-end, there have been significant wildfires throughout Southern California. While none of our communities have been directly affected, we could experience labor shortages, construction delays or utility company delays, which in turn could impact our fiscal 2019 results. Critical Accounting Policies Management believes that the following critical accounting policies require its most significant judgments and estimates used in the preparation of the consolidated financial statements: Income Recognition from Mortgage Loans - Our Financial Services segment originates mortgages, primarily for our homebuilding customers. We use mandatory investor commitments and forward sales of mortgage backed securities (“MBS”) to hedge our mortgage-related interest rate exposure on agency and government loans. We elected the fair value option for our mortgage loans held for sale in accordance with Accounting Standards Codification (“ASC”) 825, “Financial Instruments,” which permits us to measure our loans held for sale at fair value. Management believes that the election of the fair value option for loans held for sale improves financial reporting by mitigating volatility in reported earnings caused by measuring the fair value of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. Substantially all of the mortgage loans originated are sold within a short period of time in the secondary mortgage market on a servicing released, nonrecourse basis, although the Company remains liable for certain limited representations, such as fraud, and warranties related to loan sales. Mortgage investors could seek to have us buy back loans or compensate them for losses incurred on mortgages we have sold based on claims that we breached our limited representations and warranties. We have established reserves for probable losses. While we believe these reserves are adequate for known losses and projected repurchase requests, given the volatility in the mortgage industry and the uncertainty regarding the ultimate resolution of these claims, if either actual repurchases or the losses incurred resolving those repurchases exceed our expectations, additional expense may be incurred. Inventories - Inventories consist of land, land development, home construction costs, capitalized interest, construction overhead and property taxes. Construction costs are accumulated during the period of construction and charged to cost of sales under specific identification methods. Land, land development and common facility costs are allocated based on buildable acres to product types within each community, then charged to cost of sales equally based upon the number of homes to be constructed in each product type. We record inventories in our consolidated balance sheets at cost unless the inventory is determined to be impaired, in which case the inventory is written down to its fair value. Our inventories consist of the following three components: (1) sold and unsold homes and lots under development, which includes all construction, land, capitalized interest and land development costs related to started homes and land under development in our active communities; (2) land and land options held for future development or sale, which includes all costs related to land in our communities in planning or mothballed communities; and (3) consolidated inventory not owned, which includes all costs related to specific performance options, variable interest entities and other options, which consists primarily of model homes financed with an investor and inventory related to land banking arrangements accounted for as financings. We decide to mothball (or stop development on) certain communities when we determine that the current performance does not justify further investment at the time. When we decide to mothball a community, the inventory is reclassified on our Consolidated Balance Sheets from “Sold and unsold homes and lots under development” to “Land and land options held for future development or sale.” As of October 31, 2018, the net book value associated with our 18 mothballed communities was $24.5 million, net of impairment charges recorded in prior periods of $186.1 million. We regularly review communities to determine if mothballing is appropriate. During fiscal 2018, we did not mothball any communities, but we sold two previously mothballed communities and re-activated two previously mothballed communities. From time to time we enter into option agreements that include specific performance requirements, whereby we are required to purchase a minimum number of lots. Because of our obligation to purchase these lots, for accounting purposes in accordance with ASC 360-20-40-38, we are required to record this inventory on our Consolidated Balance Sheets. As of October 31, 2018, we had no specific performance options recorded on our Consolidated Balance Sheets. Consolidated inventory not owned also consists of other options that were included on our Consolidated Balance Sheets in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). We sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 360-20-40-38, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheets, at October 31, 2018, inventory of $50.5 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $43.9 million recorded to “Liabilities from inventory not owned.” We have land banking arrangements, whereby we sell our land parcels to the land banker and they provide us an option to purchase back finished lots on a quarterly basis. Because of our options to repurchase these parcels, for accounting purposes, in accordance with ASC 360-20-40-38, these transactions are considered financings rather than sales. For purposes of our Consolidated Balance Sheets, at October 31, 2018, inventory of $37.4 million was recorded as “Consolidated inventory not owned,” with a corresponding amount of $19.5 million recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. The recoverability of inventories and other long-lived assets is assessed in accordance with the provisions of ASC 360-10, “Property, Plant and Equipment − Overall” (“ASC 360-10”). ASC 360-10 requires long-lived assets, including inventories, held for development to be evaluated for impairment based on undiscounted future cash flows of the assets at the lowest level for which there are identifiable cash flows. As such, we evaluate inventories for impairment at the individual community level, the lowest level of discrete cash flows that we measure. We evaluate inventories of communities under development and held for future development for impairment when indicators of potential impairment are present. Indicators of impairment include, but are not limited to, decreases in local housing market values, decreases in gross margins or sales absorption rates, decreases in net sales prices (base sales price net of sales incentives), or actual or projected operating or cash flow losses. The assessment of communities for indication of impairment is performed quarterly. As part of this process, we prepare detailed budgets for all of our communities at least semi-annually and identify those communities with a projected operating loss. For those communities with projected losses, we estimate the remaining undiscounted future cash flows and compare those to the carrying value of the community, to determine if the carrying value of the asset is recoverable. The projected operating profits, losses, or cash flows of each community can be significantly impacted by our estimates of the following: ● future base selling prices; ● future home sales incentives; ● future home construction and land development costs; and ● future sales absorption pace and cancellation rates. These estimates are dependent upon specific market conditions for each community. While we consider available information to determine what we believe to be our best estimates as of the end of a quarterly reporting period, these estimates are subject to change in future reporting periods as facts and circumstances change. Local market-specific conditions that may impact our estimates for a community include: ● the intensity of competition within a market, including available home sales prices and home sales incentives offered by our competitors; ● the current sales absorption pace for both our communities and competitor communities; ● community specific attributes, such as location, availability of lots in the market, desirability and uniqueness of our community, and the size and style of homes currently being offered; ● potential for alternative product offerings to respond to local market conditions; ● changes by management in the sales strategy of the community; ● current local market economic and demographic conditions and related trends of forecasts; and ● existing home inventory supplies, including foreclosures and short sales. These and other local market-specific conditions that may be present are considered by management in preparing projection assumptions for each community. The sales objectives can differ between our communities, even within a given market. For example, facts and circumstances in a given community may lead us to price our homes with the objective of yielding a higher sales absorption pace, while facts and circumstances in another community may lead us to price our homes to minimize deterioration in our gross margins, although it may result in a slower sales absorption pace. In addition, the key assumptions included in our estimate of future undiscounted cash flows may be interrelated. For example, a decrease in estimated base sales price or an increase in homes sales incentives may result in a corresponding increase in sales absorption pace. Additionally, a decrease in the average sales price of homes to be sold and closed in future reporting periods for one community that has not been generating what management believes to be an adequate sales absorption pace may impact the estimated cash flow assumptions of a nearby community. Changes in our key assumptions, including estimated construction and development costs, absorption pace and selling strategies, could materially impact future cash flow and fair-value estimates. Due to the number of possible scenarios that would result from various changes in these factors, we do not believe it is possible to develop a sensitivity analysis with a level of precision that would be meaningful to an investor. If the undiscounted cash flows are more than the carrying value of the community, then the carrying amount is recoverable, and no impairment adjustment is required. However, if the undiscounted cash flows are less than the carrying amount, then the community is deemed impaired and is written down to its fair value. We determine the estimated fair value of each community by determining the present value of its estimated future cash flows at a discount rate commensurate with the risk of the respective community, or in limited circumstances, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale), and recent bona fide offers received from outside third parties. Our discount rates used for all impairments recorded from October 31, 2016 to October 31, 2018 ranged from 16.8% to 19.8%. The estimated future cash flow assumptions are virtually the same for both our recoverability and fair value assessments. Should the estimates or expectations used in determining estimated cash flows or fair value, including discount rates, decrease or differ from current estimates in the future, we may be required to recognize additional impairments related to current and future communities. The impairment of a community is allocated to each lot on a relative fair value basis. From time to time, we write off deposits and approval, engineering and capitalized interest costs when we determine that it is no longer probable that we will exercise options to buy land in specific locations or when we redesign communities and/or abandon certain engineering costs. In deciding not to exercise a land option, we take into consideration changes in market conditions, the timing of required land takedowns, the willingness of land sellers to modify terms of the land option contract (including timing of land takedowns), and the availability and best use of our capital, among other factors. The write-off is recorded in the period it is deemed not probable that the optioned property will be acquired. In certain instances, we have been able to recover deposits and other pre-acquisition costs that were previously written off. These recoveries have not been significant in comparison to the total costs written off. Inventories held for sale are land parcels ready for sale in their current condition, where we have decided not to build homes but are instead actively marketing for sale. These land parcels represented $6.4 million and $23.6 million of our total inventories at October 31, 2018 and 2017, respectively, and are reported at the lower of carrying amount or fair value less costs to sell. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. Unconsolidated Homebuilding and Land Development Joint Ventures - Investments in unconsolidated homebuilding and land development joint ventures are accounted for under the equity method of accounting. Under the equity method, we recognize our proportionate share of earnings and losses earned by the joint venture upon the delivery of lots or homes to third parties. Our ownership interests in the joint ventures vary but our voting interests are generally 50% or less. In determining whether or not we must consolidate joint ventures where we are the managing member of the joint venture, we assess whether the other partners have specific rights to overcome the presumption of control by us as the manager of the joint venture. In most cases, the presumption is overcome because the joint venture agreements require that both partners agree on establishing the significant operating and capital decisions of the partnership, including budgets, in the ordinary course of business. The evaluation of whether or not we control a venture can require significant judgment. In accordance with ASC 323-10, “Investments - Equity Method and Joint Ventures - Overall,” we assess our investments in unconsolidated joint ventures for recoverability, and if it is determined that a loss in value of the investment below its carrying amount is other than temporary, we write down the investment to its fair value. We evaluate our equity investments for impairment based on the joint venture’s projected cash flows. This process requires significant management judgment and estimates. During fiscal 2017, we wrote down certain joint venture investments by $2.8 million. There were no write-downs in fiscal 2018 or 2016. Post-Development Completion, Warranty Costs and Insurance Deductible Reserves - In those instances where a development is substantially completed and sold and we have additional construction work to be incurred, an estimated liability is provided to cover the cost of such work. We accrue for warranty costs that are covered under our existing general liability and construction defect policy as part of our general liability insurance deductible. This accrual is expensed as selling, general, and administrative costs. For homes delivered in fiscal 2018 and 2017, our deductible under our general liability insurance is a $20 million aggregate for construction defect and warranty claims. For bodily injury claims, our deductible per occurrence in fiscal 2018 and 2017 is $0.25 million, up to a $5 million limit. Our aggregate retention for construction defect, warranty and bodily injury claims is $20 million for fiscal 2018 and $21 million for fiscal 2017. We do not have a deductible on our worker's compensation insurance. Reserves for estimated losses for construction defects, warranty and bodily injury claims have been established using the assistance of a third-party actuary. We engage a third-party actuary that uses our historical warranty and construction defect data to assist our management in estimating our unpaid claims, claim adjustment expenses and incurred but not reported claims reserves for the risks that we are assuming under the general liability and construction defect programs. The estimates include provisions for inflation, claims handling and legal fees. These estimates are subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products we build, claim settlement patterns, insurance industry practices and legal interpretations, among others. Because of the high degree of judgment required in determining these estimated liability amounts, actual future costs could differ significantly from our currently estimated amounts. In addition, we establish a warranty accrual for lower cost-related issues to cover home repairs, community amenities and land development infrastructure that are not covered under our general liability and construction defect policy. We accrue an estimate for these warranty costs as part of cost of sales at the time each home is closed and title and possession have been transferred to the homebuyer. See Note 16 to the Consolidated Financial Statements for additional information on the amount of warranty costs recognized in cost of goods sold and administrative expenses. Recent Accounting Pronouncements See Note 3 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. Capital Resources and Liquidity Our operations consist primarily of residential housing development and sales in the Northeast (New Jersey and Pennsylvania), the Mid-Atlantic (Delaware, Maryland, Virginia, Washington D.C. and West Virginia), the Midwest (Illinois and Ohio), the Southeast (Florida, Georgia and South Carolina), the Southwest (Arizona and Texas) and the West (California). In addition, we provide certain financial services to our homebuilding customers. We have historically funded our homebuilding and financial services operations with cash flows from operating activities, borrowings under our credit facilities, the issuance of new debt and equity securities and other financing activities. Due to covenant restrictions in our debt instruments, we are currently limited in the amount of debt we can incur that does not qualify as refinancing indebtedness with certain maturity requirements (a limitation that we expect to continue for the foreseeable future), even if market conditions would otherwise be favorable, which could also impact our ability to grow our business. In fiscal 2017, we transferred four communities to an existing joint venture, which resulted in $11.2 million of net cash proceeds to us during the period. During fiscal 2018, we completed a wind down of our operations in the San Francisco Bay area in Northern California and in Tampa, Florida. Any liquidity-enhancing or other capital raising/refinancing transaction will depend on identifying counterparties, negotiation of documentation and applicable closing conditions and any required approvals. Operating, Investing and Financing Activities - Overview Our homebuilding cash balance, including $12.7 million of cash collateralizing our letter of credit agreements, at October 31, 2018 was $200.6 million, a decrease of $264.8 million from October 31, 2017. However, as of October 31, 2018 we have $125.0 million of borrowing capacity under our Secured Credit Facility (defined below), and therefore, our total liquidity at October 31, 2018 was $325.6 million, which is above our target liquidity range of $170.0 million to $245.0 million. In addition to using cash to pay down debt during fiscal 2018, we spent $566.8 million on land and land development. After considering this land and land development and all other operating activities, including revenue received from deliveries, we used $66.8 million of cash in operations. During fiscal 2018, cash provided by investing activities was $35.5 million, primarily related to the sale of our former corporate headquarters building, along with distributions from joint ventures, partially offset by investments in new and existing joint ventures. Cash used in financing activities was $229.4 million during fiscal 2018, which included net payments of $211.4 million for debt repayments and $27.5 million used for model finance and land banking programs. We intend to continue to use nonrecourse mortgage financings, model sale leaseback, joint ventures, and, subject to covenant restrictions in our debt instruments, land banking programs as our business needs dictate. Our cash uses during the year ended October 31, 2018 and 2017 were for operating expenses, land purchases, land deposits, land development, construction spending, debt payments, state income taxes, interest payments, litigation matters and investments in joint ventures. During these periods, we provided for our cash requirements from available cash on hand, housing and land sales, financing transactions, model sale leasebacks, land banking transactions, joint ventures, financial service revenues and other revenues. We believe that these sources of cash together with our Secured Credit Facility will be sufficient through fiscal 2019 to finance our working capital requirements. Our net income (loss) historically does not approximate cash flow from operating activities. The difference between net income (loss) and cash flow from operating activities is primarily caused by changes in inventory levels together with changes in receivables, prepaid and other assets, mortgage loans held for sale, interest and other accrued liabilities, deferred income taxes, accounts payable and other liabilities, and noncash charges relating to depreciation, stock compensation awards and impairment losses for inventory. When we are expanding our operations, inventory levels, prepaids and other assets increase causing cash flow from operating activities to decrease. Certain liabilities also increase as operations expand and partially offset the negative effect on cash flow from operations caused by the increase in inventory levels, prepaids and other assets. Similarly, as our mortgage operations expand, net income from these operations increases, but for cash flow purposes net income is partially offset by the net change in mortgage assets and liabilities. The opposite is true as our investment in new land purchases and development of new communities decrease, causing us to generate positive cash flow from operations. In fiscal 2017, with spending on land purchases and land development relatively flat as compared to fiscal 2016, we continued to generate cash from operations. As we continue to increase spending on land purchases and land development, cash flow from operations will decrease. As we continue to actively seek land investment opportunities, we will also remain focused on liquidity. See “Inventory Activities” below for a detailed discussion of our inventory position. Debt Transactions As of October 31, 2018, we had $1,111.0 million of outstanding senior secured notes ($1,093.4 million, net of discount and debt issuance costs), comprised of $53.2 million 2.0% 2021 Notes (defined below), $141.8 million 5.0% 2021 Notes (defined below), $75.0 million 9.5% 2020 Notes (defined below), $440.0 million 10.0% Senior Secured Notes due 2022 and $400.0 million 10.5% Senior Secured Notes due 2024. As of October 31, 2018, we also had $180.7 million of outstanding senior notes ($144.4 million net of discount, premium and debt issuance costs), comprised of $90.1 million 5.0% Senior Notes due 2040 and $90.6 million 13.5% Senior Notes due 2026 ($26.0 million of 8.0% Senior Notes due 2019 are owned by a wholly-owned consolidated subsidiary of HEI and therefore, in accordance with GAAP, such notes are not reflected on the Consolidated Balance Sheets of HEI). In addition, as of October 31, 2018, there were $202.5 million ($201.4 million net of debt issuance costs) of borrowings under our senior unsecured term loan facility (“Term Loan Facility”). Except for K. Hovnanian, the issuer of the notes and borrower under the Credit Facilities, (as defined below) our home mortgage subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures and certain of our title insurance subsidiaries, we and each of our subsidiaries are guarantors of the Credit Facilities, the senior secured notes and senior notes outstanding at October 31, 2018 (collectively, the “Notes Guarantors”). In addition to the Notes Guarantors, the 5.0% Senior Secured Notes due 2021 (the “5.0% 2021 Notes”), the 2.0% Senior Secured Notes due 2021 (the “2.0% 2021 Notes” and together with the 5.0% 2021 Notes, the “2021 Notes”) and the 9.50% Senior Secured Notes due 2020 (the “9.50% 2020 Notes” and collectively with the 2021 Notes, the “JV Holdings Secured Group Notes”) are guaranteed by K. Hovnanian JV Holdings, L.L.C. and its subsidiaries, except for certain joint ventures and joint venture holding companies (collectively, the “JV Holdings Secured Group”). Members of the JV Holdings Secured Group do not guarantee K. Hovnanian's other indebtedness. The credit agreements governing the Credit Facilities and the indentures governing the notes (together, the “Debt Instruments”) outstanding at October 31, 2018 do not contain any financial maintenance covenants, but do contain restrictive covenants that limit, among other things, the Company’s ability and that of certain of its subsidiaries, including K. Hovnanian, to incur additional indebtedness (other than nonrecourse indebtedness, certain permitted indebtedness and refinancing indebtedness (under the 9.50% 2020 Notes, any new or refinancing indebtedness may not be scheduled to mature earlier than January 15, 2021 (so long as no member of the JV Holdings Secured Group is an obligor thereon), or February 15, 2021 (if otherwise), and under the 10.0% Senior Secured Notes due 2022 (the “10.0% 2022 Notes”), any refinancing indebtedness of the 7.0% Senior Notes due 2019 (the “7.0% Notes”) (which includes the Term Loans (as defined below)) and 8.0% Senior Notes due 2019 (the “8.0% Notes” and together with the 7.0% Notes, the “2019 Notes”) (which includes the New Notes (as defined below) and the Term Loans) may not be scheduled to mature earlier than July 16, 2024 (such restrictive covenant in respect of the 10.5% Senior Secured Notes due 2024 (the “10.5% 2024 Notes”) was eliminated as described below)), pay dividends and make distributions on common and preferred stock, repurchase subordinated indebtedness and common and preferred stock, make other restricted payments, including investments, sell certain assets (including in certain land banking transactions), incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all assets, enter into certain transactions with affiliates and make cash repayments of the 2019 Notes and refinancing indebtedness in respect thereof (with respect to the 10.0% 2022 Notes). The Debt Instruments also contain events of default which would permit the lenders or holders thereof to exercise remedies with respect to the collateral (as applicable), declare the loans made under the Term Loan Facility (defined below) (the “Term Loans”) and loans made under the Secured Credit Facility (as defined below) (the “Secured Revolving Loans”) or notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the Term Loans, Secured Revolving Loans or notes or other material indebtedness, cross default to other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy and insolvency, with respect to the Term Loans and Secured Revolving Loans, material inaccuracy of representations and warranties and with respect to the Term Loans and Secured Revolving Loans, a change of control, and, with respect to the Secured Revolving Loans and senior secured notes, the failure of the documents granting security for the Secured Revolving Loans and senior secured notes to be in full force and effect, and the failure of the liens on any material portion of the collateral securing the Secured Revolving Loans and senior secured notes to be valid and perfected. As of October 31, 2018, we believe we were in compliance with the covenants of the Debt Instruments. If our consolidated fixed charge coverage ratio, as defined in the agreements governing our debt instruments, is less than 2.0 to 1.0, we are restricted from making certain payments, including dividends, and from incurring indebtedness other than certain permitted indebtedness, refinancing indebtedness and nonrecourse indebtedness. As a result of this ratio restriction, we are currently restricted from paying dividends, which are not cumulative, on our 7.625% Series A Preferred Stock. We anticipate that we will continue to be restricted from paying dividends for the foreseeable future. Our inability to pay dividends is in accordance with covenant restrictions and will not result in a default under our debt instruments or otherwise affect compliance with any of the covenants contained in our debt instruments. Under the terms of our Debt Instruments, we have the right to make certain redemptions and prepayments and, depending on market conditions and covenant restrictions, may do so from time to time. We also continue to evaluate our capital structure and may also continue to make debt purchases and/or exchanges for debt or equity from time to time through tender offers, open market purchases, private transactions, or otherwise, or seek to raise additional debt or equity capital, depending on market conditions and covenant restrictions. On December 1, 2017, our 6.0% Senior Exchangeable Note Units were paid in full, which units consisted of $53.9 million principal amount of our Senior Exchangeable Notes that matured and the final installment payment of $2.1 million on our 11.0% Senior Amortizing Notes. On December 28, 2017, the Company and K. Hovnanian announced that they had entered into a commitment letter (the “Commitment Letter”) in respect of certain financing transactions with GSO Capital Partners LP (“GSO”) on its own behalf and on behalf of one or more funds managed, advised or sub-advised by GSO (collectively, the “GSO Entities”), and had commenced a private offer to exchange with respect to the 8.0% Notes (the “Exchange Offer”). Pursuant to the Commitment Letter, the GSO Entities agreed to, among other things, provide the principal amount of the following: (i) a senior unsecured term loan credit facility (the “Term Loan Facility”) to be borrowed by K. Hovnanian and guaranteed by the Company and the Notes Guarantors, pursuant to which the GSO Entities committed to lend K. Hovnanian Term Loans consisting of $132.5 million of initial term loans (the “Initial Term Loans”) on the settlement date of the Exchange Offer for purposes of refinancing K. Hovnanian’s 7.0% Notes, and up to $80.0 million of delayed draw term loans (the “Delayed Draw Term Loans”) for purposes of refinancing certain of K. Hovnanian’s 8.0% Notes, in each case, upon the terms and subject to the conditions set forth therein, and (ii) a senior secured first lien credit facility (the “Secured Credit Facility” and together with the Term Loan Facility, the “Credit Facilities”) to be borrowed by K. Hovnanian and guaranteed by the Notes Guarantors, pursuant to which the GSO Entities committed to lend to K. Hovnanian the Secured Revolving Loans, consisting of up to $125.0 million of senior secured first priority loans to fund the repayment of K. Hovnanian’s then outstanding secured term loans (the “Secured Term Loans”) and for general corporate purposes, upon the terms and subject to the conditions set forth therein. In addition, pursuant to the Commitment Letter, the GSO Entities have committed to purchase, and K. Hovnanian has agreed to issue and sell, on January 15, 2019 (or such later date within five business days as mutually agreed by the parties working in good faith), $25.0 million in aggregate principal amount of additional 10.5% 2024 Notes (the “Additional 10.5% 2024 Notes”) at a purchase price, for each $1,000 principal amount of Additional 10.5% 2024 Notes, that would imply a yield to maturity equal to (a) the volume weighted average yield to maturity (calculated based on the yield to maturity during the 30 calendar day period ending on one business day prior to the settlement date of the Additional 10.5% 2024 Notes, which is expected to be January 15, 2019) for the 10.5% 2024 Notes, minus (b) 0.50%, upon the terms and subject to conditions set forth therein. On January 29, 2018, K. Hovnanian, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent, and the GSO Entities entered into the Term Loan Facility. K. Hovnanian borrowed the Initial Term Loans on February 1, 2018 to fund, together with cash on hand, the redemption on February 1, 2018 of all $132.5 million aggregate principal amount of 7.0% Notes, which resulted in a loss on extinguishment of debt of $0.5 million. On May 29, 2018, K. Hovnanian completed the redemption of $65.7 million aggregate principal amount of the 8.0% Notes (representing all of the outstanding 8.0% Notes, excluding the $26 million of 8% Notes held by the Subsidiary Purchaser (as defined below)) with approximately $70.0 million in borrowings on the Delayed Draw Term Loans under the Term Loan Facility (with the completion of this redemption, the remaining committed amounts under the Delayed Draw Term Loans may not be borrowed). This transaction resulted in a loss on extinguishment of debt of $4.3 million for year ended October 31, 2018. The Term Loans bear interest at a rate equal to 5.0% per annum and interest is payable in arrears, on the last business day of each fiscal quarter. The Term Loans will mature on February 1, 2027, which is the ninth anniversary of the first closing date of the Term Loan Facility. On January 29, 2018, K. Hovnanian, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent, and the GSO Entities entered into the Secured Credit Facility. Availability under the Secured Credit Facility will terminate on December 28, 2019 and any outstanding Secured Revolving Loans on such date shall convert to secured term loans maturing on December 28, 2022. On September 10, 2018, K. Hovnanian borrowed $35.0 million of Secured Revolving Loans under the Secured Credit Facility and used $41.0 million of cash on hand to repay the Secured Term Loans in full, plus unpaid interest and closing costs (in the fourth quarter of fiscal 2018, K. Hovnanian repaid the borrowed Secured Revolving Loans and as of October 31, 2018 there were no amounts outstanding under the Secured Credit Facility). This transaction resulted in a loss on extinguishment of debt of $1.8 million for the year ended October 31, 2018. The Secured Revolving Loans and the guarantees thereof are secured (subject to perfection requirements under the terms of the Secured Credit Facility) by substantially all of the assets owned by K. Hovnanian and the Notes Guarantors, subject to permitted liens and certain exceptions, on a first lien basis relative to the liens securing K. Hovnanian’s 10.0% 2022 Notes and 10.5% 2024 Notes pursuant to an intercreditor agreement. The collateral securing the Secured Revolving Loans will be the same as that securing the 10.0% 2022 Notes and the 10.5% 2024 Notes. The Secured Revolving Loans bear interest at a rate equal to 10.0% per annum, and interest is payable in arrears, on the last business day of each fiscal quarter. On February 1, 2018, K. Hovnanian accepted all of the $170.2 million aggregate principal amount of 8.0% Notes validly tendered and not validly withdrawn in the Exchange Offer (representing 72.14% of the aggregate principal amount of 8.0% Notes outstanding prior to the Exchange Offer), and in connection therewith, K. Hovnanian issued $90.6 million aggregate principal amount of its 13.5% Senior Notes due 2026 (the “New 2026 Notes”) and $90.1 million aggregate principal amount of its 5.0% Senior Notes due 2040 (the “New 2040 Notes” and together with the New 2026 Notes, the “New Notes”) under a new indenture. Also, as part of the Exchange Offer, K. Hovnanian at Sunrise Trail III, LLC, a wholly-owned subsidiary of the Company (the “Subsidiary Purchaser”), purchased for $26.5 million in cash an aggregate of $26.0 million in principal amount of the 8.0% Notes (the “Purchased 8.0% Notes”). The New Notes were issued by K. Hovnanian and guaranteed by the Notes Guarantors, except the Subsidiary Purchaser, which does not guarantee the New Notes. The New 2026 Notes bear interest at 13.5% per annum and mature on February 1, 2026. The New 2040 Notes bear interest at 5.0% per annum and mature on February 1, 2040. Interest on the New Notes is payable semi-annually on February 1 and August 1 of each year to holders of record at the close of business on January 15 or July 15, as the case may be, immediately preceding each such interest payment date. The Exchange Offer was treated as a substantial modification of debt. The New Notes were recorded at fair value (based on management's estimate using available trades for similar debt instruments) on the date of the issuance of the New Notes, which equaled $103.0 million for the New 2026 Notes and $44.0 million for the New 2040 Notes, resulting in a premium on the New 2026 Notes and a discount on the New 2040 Notes, and a loss on extinguishment of debt of $0.9 million for the year ended October 31, 2018. On May 30, 2018, K. Hovnanian, the Notes Guarantors and Wilmington Trust, National Association, as Trustee, executed the Second Supplemental Indenture, dated as of May 30, 2018 (the “Supplemental Indenture”), to the Indenture governing the New Notes. The Supplemental Indenture eliminated the covenant restricting certain actions with respect to the Purchased 8.0% Notes, which covenant had included requirements that (A) K. Hovnanian and the guarantors of the New Notes would not, (i) prior to June 6, 2018, redeem, cancel or otherwise retire, purchase or acquire any Purchased 8.0% Notes or (ii) make any interest payments on the Purchased 8.0% Notes prior to their stated maturity, and (B) K. Hovnanian and the guarantors of the New Notes would not, and would not permit any of their subsidiaries to (i) sell, transfer, convey, lease or otherwise dispose of any Purchased 8.0% Notes other than to any subsidiary of the Company that is not K. Hovnanian or a guarantor of the New Notes or (ii) amend, supplement or otherwise modify the Purchased 8.0% Notes or the indenture under which they were issued with respect to the Purchased 8.0% Notes, subject to certain exceptions. In addition, the Supplemental Indenture eliminated events of default related to the eliminated covenant. On May 30, 2018, K. Hovnanian paid the overdue interest on the Purchased 8.0% Notes that was originally due on May 1, 2018 and as a result of such payment, the “Default” under the Indenture governing the 8.0% Notes was cured. On January 16, 2018, K. Hovnanian, the Notes Guarantors and Wilmington Trust, National Association, as Trustee and Collateral Agent, executed the Second Supplemental Indenture, dated as of January 16, 2018, to the indenture governing the 10.0% 2022 Notes and 10.5% 2024 Notes, dated as of July 27, 2017 (as supplemented, amended or otherwise modified), among K. Hovnanian, the Notes Guarantors and Wilmington Trust, National Association, as Trustee and Collateral Agent, giving effect to the proposed amendments to such indenture solely with respect to the 10.5% 2024 Notes, which were obtained in a consent solicitation of the holders of the 10.5% 2024 Notes, and which eliminated the restrictions on K. Hovnanian’s ability to purchase, repurchase, redeem, acquire or retire for value the 2019 Notes and refinancing or replacement indebtedness in respect thereof. See Note 9 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for a further discussion of K. Hovnanian’s Credit Facilities, senior secured notes and senior notes. Mortgages and Notes Payable We have nonrecourse mortgage loans for certain communities totaling $95.6 million and $64.5 million (net of debt issuance costs) at October 31, 2018 and October 31, 2017, respectively, which are secured by the related real property, including any improvements, with an aggregate book value of $241.9 million and $157.8 million, respectively. The weighted-average interest rate on these obligations was 6.1% and 5.3% at October 31, 2018 and October 31, 2017, respectively, and the mortgage loan payments on each community primarily correspond to home deliveries. We also had nonrecourse mortgage loans on our former corporate headquarters totaling $13.0 million at October 31, 2017. On November 1, 2017, these loans were paid in full in connection with the sale of this corporate headquarters building. Our wholly owned mortgage banking subsidiary, K. Hovnanian American Mortgage, LLC (“K. Hovnanian Mortgage”), originates mortgage loans primarily from the sale of our homes. Such mortgage loans and related servicing rights are sold in the secondary mortgage market within a short period of time. In certain instances, we retain the servicing rights for a small amount of loans. The loans are secured by the mortgages held for sale and repaid when we sell the underlying mortgage loans to permanent investors. As of October 31, 2018 and October 31, 2017, we had an aggregate of $113.2 million and $114.6 million, respectively, outstanding under several of K. Hovnanian Mortgage’s short-term borrowing facilities. See Note 8 to the Consolidated Financial Statements for a discussion of these agreements and facilities. Equity On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 4 million shares of Class A Common Stock. We did not repurchase any shares under this program during fiscal 2018 or 2017. As of October 31, 2018, the maximum number of shares of Class A Common Stock that may yet be purchased under this program is 0.5 million. (See Part II, Item 5 for information on equity purchases). On July 12, 2005, we issued 5,600 shares of 7.625% Series A Preferred Stock, with a liquidation preference of $25,000 per share. Dividends on the Series A Preferred Stock are not cumulative and are payable at an annual rate of 7.625%. The Series A Preferred Stock is not convertible into the Company’s common stock and is redeemable in whole or in part at our option at the liquidation preference of the shares. The Series A Preferred Stock is traded as depositary shares, with each depositary share representing 1/1000th of a share of Series A Preferred Stock. The depositary shares are listed on the NASDAQ Global Market under the symbol “HOVNP.” In fiscal 2018, 2017 and 2016, we did not make any dividend payments on the Series A Preferred Stock as a result of covenant restrictions in our debt instruments. Certain debt instruments to which we are a party contain restrictions on the payment of cash dividends. As a result of the most restrictive of these provisions, we are not currently able to pay any cash dividends. We have never paid a cash dividend to common stockholders. We anticipate that we will continue to be restricted from paying dividends, which are not cumulative, for the foreseeable future. Inventory Activities Total inventory, excluding consolidated inventory not owned, increased $105.2 million during the year ended October 31, 2018 from October 31, 2017. Total inventory, excluding consolidated inventory not owned, increased in the Mid-Atlantic by $15.8 million, in the Midwest by $5.8 million, in the Southwest by $38.8 million and in the West by $57.9 million. These increases were partially offset by decreases in the Northeast of $10.7 million and in the Southeast of $2.4 million. These inventory fluctuations were primarily attributable to home deliveries and land sales during the period, partially offset by new land purchases and land development. During the year ended October 31, 2018, we had aggregate impairments in the amount of $2.1 million. We wrote-off costs in the amount of $1.4 million during the year ended October 31, 2018 related to land options that expired or that we terminated, as the communities’ forecasted profitability was not projected to produce adequate returns on investment commensurate with the risk. In the last few years, we have been able to acquire new land parcels at prices that we believe will generate reasonable returns under current homebuilding market conditions. There can be no assurances that this trend will continue in the near term. Substantially all homes under construction or completed and included in inventory at October 31, 2018 are expected to be closed during the next six to nine months. Consolidated inventory not owned decreased $36.9 million. Consolidated inventory not owned consists of options related to land banking and model financing transactions that were added to our Consolidated Balance Sheets in accordance with US GAAP. The decrease from October 31, 2017 to October 31, 2018 was primarily due to a decrease in land banking transactions along with a decrease in the sale and leaseback of certain model homes during the period. We have land banking arrangements, whereby we sell land parcels to the land bankers and they provide us an option to purchase back finished lots on a predetermined schedule. Because of our options to repurchase these parcels, for accounting purposes in accordance with ASC 360-20-40-38, these transactions are considered a financing rather than a sale. For purposes of our Consolidated Balance Sheet, at October 31, 2018, inventory of $50.5 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $43.9 million (net of debt issuance costs) recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. In addition, we sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 360-20-40-38, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheet, at October 31, 2018, inventory of $37.4 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $19.5 million (net of debt issuance costs) recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. When possible, we option property for development prior to acquisition. By optioning property, we are only subject to the loss of the cost of the option and predevelopment costs if we choose not to exercise the option (other than with respect to specific performance options discussed above). As a result, our commitment for major land acquisitions is reduced. The costs associated with optioned properties are included in “Land and land options held for future development or sale” on the Consolidated Balance Sheets. Also included in “Land and land options held for future development or sale” are amounts associated with inventory in mothballed communities. We mothball (or stop development on) certain communities when we determine the current performance does not justify further investment at the time. That is, we believe we will generate higher returns if we decide against spending money to improve land today and save the raw land until such time as the markets improve or we determine to sell the property. As of October 31, 2018, we had mothballed land in 18 communities. The book value associated with these communities at October 31, 2018 was $24.5 million, which was net of impairment charges recorded in prior periods of $186.1 million. We continually review communities to determine if mothballing is appropriate. During fiscal 2018, we did not mothball any additional communities, but we sold two previously mothballed communities and re-activated two previously mothballed communities. Inventories held for sale, which are land parcels where we have decided not to build homes, represented $6.4 million and $23.6 million, respectively, of our total inventories at October 31, 2018 and October 31, 2017, and are reported at the lower of carrying amount or fair value less costs to sell. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. The following tables summarize home sites included in our total residential real estate. The increase in remaining home sites available at October 31, 2018 compared to October 31, 2017 was primarily attributable to our ability to control new land during fiscal 2018. As previously discussed, we expect to continue to actively seek new land investment opportunities in fiscal 2019. The following table summarizes our started or completed unsold homes and models, excluding unconsolidated joint ventures, in active and substantially completed communities. The decrease in the total homes from October 31, 2017 to October 31, 2018 is due to the decrease in community count during the period. (1) Active selling communities (which are communities that are open for sale with ten or more home sites available) were 123 and 130 at October 31, 2018 and 2017, respectively. Ratio does not include substantially completed communities, which are communities with less than ten home sites available. Other Balance Sheet Activities Homebuilding - Restricted cash and cash equivalents increased $10.7 million from October 31, 2017 to $12.8 million at October 31, 2018. The increase was primarily due to cash collateral required to collateralize certain of our letters of credit under our stand alone letter of credit facilities which had been previously issued under and collateralized by our unsecured revolving credit facility that had a final maturity in September 2018. Investments in and advances to unconsolidated joint ventures increased $8.6 million during the fiscal year ended October 31, 2018 compared to October 31, 2017. The increase was primarily due to recording our share of income in excess of distributions and additional capital contributions on several existing joint ventures during the period, along with an increase for an investment in a new joint venture in the third quarter of fiscal 2018. These increases were partially offset by decreases related to the acquisition of the remaining assets of one of our joint ventures in the first quarter of fiscal 2018, along with partner distributions on another joint venture during the period. As of October 31, 2018 and October 31, 2017, we had investments in nine and ten homebuilding joint ventures, respectively, and one land development joint venture for both periods. We have no guarantees associated with our unconsolidated joint ventures, other than guarantees limited only to performance and completion of development, environmental indemnification and standard warranty and representation against fraud, misrepresentation and similar actions, including a voluntary bankruptcy. Receivables, deposits and notes, net decreased $23.0 million from October 31, 2017 to $35.2 million at October 31, 2018. The decrease was primarily due to funds received in the third quarter of fiscal 2018 for receivables related to land sales in the fourth quarter of fiscal 2017 and the second quarter of fiscal 2018. Property, Plant, and Equipment decreased $32.6 million from October 31, 2017 to October 31, 2018. The decrease was primarily due to the sale of our former corporate headquarters building on November 1, 2017, totaling $34.7 million, net of accumulated depreciation. The decrease was slightly offset by an increase for software costs capitalized during the period. Prepaid expenses and other assets were as follows as of: Prepaid insurance increased due to the timing of premium payments. These costs are amortized over the life of the associated insurance policy, which can be one to three years. Prepaid project costs consist of community specific expenditures that are used over the life of the community. Such prepaids are expensed as homes are delivered and therefore have declined as our community count has declined. Other prepaids increased primarily due to costs related to our Term Loan Facility, along with new premiums for the renewal of certain software and related services during the period, partially offset by amortization of these costs. Financial services assets consist primarily of residential mortgages receivable held for sale of which $129.0 million and $131.5 million at October 31, 2018 and 2017, respectively, were being temporarily warehoused and are awaiting sale in the secondary mortgage market. The slight decrease in mortgage loans held for sale from October 31, 2017 was related to a decrease in the volume of loans originated during the fourth quarter of 2018 compared to the fourth quarter of 2017, partially offset by an increase in the average loan value. Nonrecourse mortgages increased to $95.6 million at October 31, 2018, from $64.5 million at October 31, 2017. The increase was primarily due to new mortgages for communities in all segments obtained during the fiscal 2018, along with additional loan draws on existing mortgages, partially offset by the payment of existing mortgages, including a mortgage on a community which was transferred to a joint venture. Accounts payable and other liabilities are as follows as of: Reserves decreased during the period as payments for construction defect claims exceeded new accruals primarily due to litigation settlements, along with a reduction in our warranty reserves based on our annual assessment. Accrued expenses increased due to the timing of various accruals primarily related to legal and marketing services during the fourth quarter of fiscal 2018 as compared to the fourth quarter of fiscal 2017. The increase in accrued compensation was primarily due to accrued bonuses being higher in fiscal 2018 as compared to fiscal 2017 as a result of financial performance in 2018. Other liabilities decreased primarily due to deferred income recognized during the period for home closings that had been previously delayed in connection with the remediation of the Weyerhaeuser-manufacture I-joist issue as previously disclosed in our Form 10-K for the fiscal year ended October 31, 2017. Customers’ deposits decreased $3.7 million from October 31, 2017 to $30.1 million at October 31, 2018. The decrease was primarily related to the decrease in backlog during the year. Nonrecourse mortgages secured by operating properties decreased $13.0 million from October 31, 2017 to October 31, 2018. The decrease was due to the payoff of our mortgage loans on our former corporate headquarters building, which was sold on November 1, 2017. Liabilities from inventory not owned decreased $27.7 million to $63.4 million at October 31, 2018. The decrease was due a decrease in land banking transactions during the period, along with a decrease in the sale and leaseback of certain model homes, both of which are accounted for as financing transactions as described above. Accrued interest decreased $6.2 million to $35.6 million at October 31, 2018. The decrease was primarily due to a combination of the timing of interest payments on our senior notes issued in fiscal 2018 as compared to our senior notes that were refinanced in fiscal 2018. Results of Operations Total Revenues Compared to the prior period, revenues increased (decreased) as follows: Homebuilding Sale of homes revenues decreased $433.8 million, or 18.5%, for the year ended October 31, 2018, decreased $260.8 million, or 10.0%, for the year ended October 31, 2017, and increased $512.7 million, or 24.6%, for the year ended October 31, 2016 as compared to the same period of the prior year. The decreased revenues in fiscal 2018 were primarily due to the number of home deliveries decreasing 13.5%, and the average price per home decreasing to $393,280 in fiscal 2018 from $417,714 in fiscal 2017. The decrease in deliveries in fiscal 2018 was primarily the result of a reduction in community count in fiscal 2018 by 5.4%. The decreased revenues in fiscal 2017 were primarily due to the number of home deliveries decreasing 13.3%, partially offset by the average price per home increasing to $417,714 in fiscal 2017 from $402,350 in fiscal 2016. The decrease in fiscal 2017 deliveries was primarily the result of a reduction in community count by 22.2%. The increased revenues in fiscal 2016 were primarily due to the 17.4% increase in deliveries, as well as the average price per home increasing to $402,350 in fiscal 2016 from $379,177 in fiscal 2015. For fiscal 2018, the fluctuations in average prices were primarily the result of geographic and community mix of our deliveries and home price decreases (which we increase or decrease in communities depending on the respective community’s performance), partially offset by price increases in some communities primarily in the West. For fiscal 2017, the fluctuations in average prices were primarily the result of the geographic and community mix of our deliveries, along with our ability to raise home prices in certain communities. For fiscal 2016, the fluctuations in average prices were primarily a result of the geographic and community mix of our deliveries, as opposed to home price increases. For further detail on changes in segment revenues see “Homebuilding Operations by Segment” below. For further detail on land sales and other revenue, see the section titled “Land Sales and Other Revenues” below. Information on homes delivered by segment is set forth below: (1) Represents housing revenue and home deliveries for our unconsolidated homebuilding joint ventures for the period. We provide this data as a supplement to our consolidated results as an indicator of the volume managed in our unconsolidated joint ventures. See Note 20 to the Consolidated Financial Statements for a further discussion of our joint ventures. The decrease in housing revenues during year ended October 31, 2018, as compared to year ended October 31, 2017, was primarily attributed to our decreased deliveries, as our community count has decreased year over year, and by the decrease in average sales price. Housing revenues in fiscal 2018 decreased in all of our homebuilding segments combined by 18.5%, and average sales price decreased by 5.8%, excluding unconsolidated joint ventures. In our homebuilding segments, homes delivered decreased in fiscal 2018 as compared to fiscal 2017 by 49.3%, 21.5%, 2.9% and 20.5% in the Northeast, Mid-Atlantic, Southeast and Southwest, respectively, and increased by 3.4% and 10.5% in the Midwest and West, respectively. Overall in fiscal 2018 as compared to fiscal 2017 homes delivered decreased 13.5% across all our segments, excluding unconsolidated joint ventures. The decrease in housing revenues during year ended October 31, 2017, as compared to year ended October 31, 2016, was primarily attributed to our decreased deliveries, partially offset by an increase in average sales price. Housing revenues in fiscal 2017 decreased in all of our homebuilding segments combined by 10.0%, while average sales price increased by 3.8%, excluding joint ventures. In our homebuilding segments, homes delivered decreased in fiscal 2017 as compared to fiscal 2016 by 37.0%, 10.8%, 30.5% and 14.3% in the Northeast, Mid-Atlantic, Midwest and Southwest, respectively, and increased by 5.7% and 12.8% in the Southeast and West, respectively. Overall in fiscal 2017 as compared to fiscal 2016 homes delivered decreased 13.3% across all our segments, excluding unconsolidated joint ventures. Quarterly housing revenues and net sales contracts by segment, excluding unconsolidated joint ventures, for the years ended October 31, 2018, 2017 and 2016 are set forth below (Net contracts are defined as new contracts executed during the period for the purchase of homes, less cancellations of contracts in the same period): (1) The Midwest net contracts include $1.9 million, $7.1 million and $18.4 million, respectively, for the quarters ended July 31, 2016, April 30, 2016 and January 31, 2016, from Minneapolis, Minnesota. (2) The Southeast net contracts include $9.9 million and $21.7 million, respectively, for the quarters ended April 30, 2016 and January 31, 2016, from Raleigh, North Carolina. Contracts per average active selling community in fiscal 2018 were 35.9 compared to fiscal 2017 of 35.1. Our reported level of sales contracts (net of cancellations) has been impacted by a slight increase in the pace of sales in most of the Company’s segments during fiscal 2018. Cancellation rates represent the number of cancelled contracts in the quarter divided by the number of gross sales contracts executed in the quarter. For comparison, the following are historical cancellation rates, excluding unconsolidated joint ventures: Another common and meaningful way to analyze our cancellation trends is to compare the number of contract cancellations as a percentage of the beginning backlog. The following table provides this historical comparison, excluding unconsolidated joint ventures. Most cancellations occur within the legal rescission period, which varies by state but is generally less than two weeks after the signing of the contract. Cancellations also occur as a result of a buyer's failure to qualify for a mortgage, which generally occurs during the first few weeks after signing. As shown in the tables above, the contract cancellations over the past several years have been within what we believe to be a normal range. However, market conditions remain uncertain and it is difficult to predict what cancellation rates will be in the future. An important indicator of our future results is recently signed contracts and our home contract backlog for future deliveries. Our consolidated contract backlog, excluding unconsolidated joint ventures, by segment is set forth below: (1) The Midwest contract backlog as of October 31, 2016 reflects the reduction of 64 homes and $24.1 million related to the sale of our land portfolio in Minneapolis, Minnesota. (2) The Southeast contract backlog as of October 31, 2016 reflects the reduction of 67 homes and $33.7 million related to the sale of our land portfolio in Raleigh, North Carolina. (3) Contract backlog as of October 31, 2016 excluded 9 homes that were sold to one of our joint ventures at the time of the joint venture formation. Contract backlog dollars decreased 7.7% as of October 31, 2018 compared to October 31, 2017, and the number of homes in backlog decreased 7.9% for the same period. The decrease in backlog was driven by a 10.1% decrease in net contracts and the decrease in community count for the year ended October 31, 2018 compared to the prior fiscal year. In the month of November 2018, excluding unconsolidated joint ventures, we signed an additional 285 net contracts amounting to $112.4 million in contract value. Total cost of sales on our Consolidated Statements of Operations includes expenses for consolidated housing and land and lot sales, including inventory impairment loss and land option write-offs (defined as “land charges” in the tables below). A breakout of such expenses for housing sales and homebuilding gross margin is set forth below. Homebuilding gross margin before cost of sales interest expense and land charges is a non-GAAP financial measure. This measure should not be considered as an alternative to homebuilding gross margin determined in accordance with GAAP as an indicator of operating performance. Management believes this non-GAAP measure provides investors another way to understand our operating performance. This measure is also useful internally, helping management evaluate our operating results on a consolidated basis and relative to other companies in our industry. In particular, the magnitude and volatility of land charges for the Company, and for other homebuilders, have been significant and, as such, have made financial analysis of our industry more difficult. Homebuilding metrics excluding land charges, as well as interest amortized to cost of sales, and other similar presentations prepared by analysts and other companies are frequently used to assist investors in understanding and comparing the operating characteristics of homebuilding activities by eliminating many of the differences in companies’ respective level of impairments and levels of debt. Cost of sales expenses as a percentage of consolidated home sales revenues are presented below: We sell a variety of home types in various communities, each yielding a different gross margin. As a result, depending on the mix of communities delivering homes, consolidated gross margin may fluctuate up or down. Total homebuilding gross margin percentage increased to 15.2% for the year ended October 31, 2018 compared to 13.2% for the same period last year. This increase was primarily due to the mix of communities delivering homes and the reduction of our warranty reserves, as a result of our annual analysis performed in the fourth quarter of each year, along with a $6.3 million benefit from a one-time credit related to a land development reimbursement from a municipality in California. Total homebuilding gross margin percentage increased to 13.2% for the year ended October 31, 2017 compared to 12.2% for the year ended October 31, 2016. This increase was primarily attributed to the mix of communities delivering homes, and the reduction of our warranty reserves, as the result of our annual analysis. Additionally, there was a decrease in land charges compared to the prior year because of the impairments recorded in the prior year, which related to the sale of our land portfolio in Minneapolis, Minnesota. For the years ended October 31, 2018, 2017 and 2016, gross margin was favorably impacted by the reversal of prior period inventory impairments of $51.7 million, $74.4 million and $57.9 million, respectively, which represented 2.7%, 3.2% and 2.2%, respectively, of “Sale of homes” revenue. Reflected as inventory impairment loss and land option write-offs in cost of sales (“land charges”), we have written off or written down certain inventories totaling $3.5 million, $17.8 million and $33.4 million during the years ended October 31, 2018, 2017 and 2016, respectively, to their estimated fair value. See Note 12 to the Consolidated Financial Statements for an additional discussion. During the years ended October 31, 2018, 2017 and 2016, we wrote off residential land options and approval and engineering costs totaling $1.4 million, $2.7 million and $8.9 million, respectively, which are included in the total land charges mentioned above. Option, approval and engineering costs are written off when a community’s pro forma profitability is not projected to produce adequate returns on the investment commensurate with the risk and when we believe it is probable we will cancel the option, or when a community is redesigned engineering costs related to the initial design are written off. Such write-offs were located in all segments in fiscal 2018, 2017 and 2016. The inventory impairments amounted to $2.1 million, $15.1 million and $24.5 million for the years ended October 31, 2018, 2017 and 2016, respectively. It is difficult to predict impairment levels, and should it become necessary or desirable to have additional land sales, further lower prices, or should the estimates or expectations used in determining estimated cash flows or fair value decrease or differ from current estimates in the future, we may need to recognize additional impairments. Below is a breakdown of our lot option walk-aways and impairments by segment for fiscal 2018. In fiscal 2018, we walked away from 13.6% of all the lots we controlled under option contracts. The remaining 86.4% of our option lots are in communities that we believe remain economically feasible. The following table represents lot option walk-aways by segment for the year ended October 31, 2018: (1) Includes lots optioned at October 31, 2018 and lots optioned that the Company walked away from in the year ended October 31, 2018. The following table represents impairments by segment for the year ended October 31, 2018: (1) Represents carrying value, net of prior period impairments, if any, at the time of recording the applicable period’s impairments. Land Sales and Other Revenues Land sales and other revenues consist primarily of land and lot sales. A breakout of land and lot sales is set forth below: Land sales are ancillary to our residential homebuilding operations and are expected to continue in the future but may significantly fluctuate up or down. Although we budget land sales, they are often dependent upon receiving approvals and entitlements, the timing of which can be uncertain. As a result, projecting the amount and timing of land sales is difficult. There were four land sales in the year ended October 31, 2018, compared to ten in the same period of the prior year, resulting in a $24.3 million decrease in land sales revenue. There were ten land sales in the year ended October 31, 2017, compared to 26 in the same period of the prior year, resulting in a $27.4 million decrease in land sales revenue. This decrease was primarily due to the sale of six land parcels in the Midwest and ten land parcels in the Southeast in the third quarter of fiscal 2016 in connection with our previously discussed strategy to exit the Minneapolis, Minnesota and Raleigh, North Carolina markets. Land sales and other revenues decreased $21.2 million for the year ended October 31, 2018 and decreased $26.0 million for the year ended October 31, 2017 compared to the same periods in the prior year. Other revenues include income from contract cancellations where the deposit has been forfeited due to contract terminations, interest income, cash discounts and miscellaneous one-time receipts. The decrease from fiscal 2017 to fiscal 2018 and the decrease from fiscal 2016 to fiscal 2017 was mainly due to the fluctuations in land sales revenue noted above. Slightly offsetting the decrease from fiscal 2017 to fiscal 2018 was the gain recognized from the sale of our former corporate headquarters building in the first quarter of fiscal 2018. Homebuilding Selling, General and Administrative Homebuilding selling, general and administrative (“SGA”) expenses decreased $37.1 million to $159.2 million for the year ended October 31, 2018 as compared to the year ended October 31, 2017. The decrease was primarily related to a $10.2 million reduction in our construction defect reserves based on our annual actuarial analysis, along with a $2.3 million reduction for a litigation settlement, and $12.5 million of additional reserves recorded in fiscal 2017 related to the Grandview II litigation. The remaining decrease is due to the reduction of our community count, a decrease in insurance costs and the increase of joint venture management fees received, which offset general and administrative expenses, as a result of more joint venture deliveries. SGA increased $3.4 million to $196.3 million for the year ended October 31, 2017 as compared to the year ended October 31, 2016. The increase was primarily due to a $12.5 million adjustment in the fourth quarter of fiscal 2017 in our construction defect reserves related to litigation. Excluding this adjustment, SGA expenses decreased $9.1 million to $183.8 million for the year ended October 31, 2017 as compared to the year ended October 31, 2016. The decrease was mainly due to our decision to exit four markets during 2016, the reduction of our community count and the increase of joint venture management fees received, which offset general and administrative expenses, as a result of more joint venture deliveries. Homebuilding Operations by Segment Financial information relating to the Company’s operations was as follows: Segment Analysis (Dollars in thousands, except average sales price) Homebuilding Results by Segment Northeast - Homebuilding revenues decreased 44.5% in fiscal 2018 compared to fiscal 2017 primarily due to a 49.3% decrease in homes delivered, partially offset by a 13.5% increase in average selling price. The increase in average sales price was the result of some new communities delivering higher priced single family homes in higher-end submarkets of the segment in fiscal 2018 compared to some communities that are no longer delivering that had lower priced single family homes in similar submarkets of the segment in fiscal 2017. Also impacting the increase in average sales price was higher option revenue and location premiums and the result of our ability to raise prices in fiscal 2018 in certain communities that were delivering homes during both periods. Income before income taxes increased $18.6 million to $20.9 million, which was mainly due a $24.6 million improvement in loss from unconsolidated joint ventures to income, along with a $10.6 million decrease in selling, general and administrative costs and a $2.8 million decrease in inventory impairment loss and land option write-offs. The increase was partially offset by the decrease in homebuilding revenues discussed above and the decrease in gross margin percentage before interest expense for fiscal 2018 compared to fiscal 2017. Homebuilding revenues decreased 24.6% in fiscal 2017 compared to fiscal 2016 primarily due to a 37.0% decrease in homes delivered and a 3.5% decrease in average selling price. The decrease in average sales price was the result of new communities delivering lower priced townhomes and single family homes in lower-end submarkets of the segment in fiscal 2017 compared to some communities that are no longer delivering that had higher priced townhomes and single family homes in higher-end submarkets of the segment in fiscal 2016. Loss before income taxes decreased $6.2 million to income of $2.3 million, which was mainly due a $38.9 million increase in land sales and other revenue, a $7.3 million decrease in inventory impairment loss and land option write-offs and a $4.5 million decrease in selling, general and administrative costs, partially offset by the decrease in homebuilding revenues discussed above. Additionally, the gross margin percentage before interest expense was flat for fiscal 2017 compared to fiscal 2016. Mid-Atlantic - Homebuilding revenues decreased 23.6% in fiscal 2018 compared to fiscal 2017 primarily due to a 21.5% decrease in homes delivered and a 2.6% decrease in average sales price. The decrease in average sales price was the result of new communities delivering lower priced, smaller single family homes in lower-end submarkets of the segment in fiscal 2018 compared to some communities delivering in fiscal 2017 that are no longer delivering and which had higher priced, larger single family homes in higher-end submarkets of the segment. Income before income taxes increased $1.6 million to $18.8 million, due mainly to a $2.3 million decrease in selling, general and administrative costs and a $1.9 million decrease in inventory impairment loss and land option write-offs and a slight increase in gross margin percentage before interest expense for fiscal 2018 compared to fiscal 2017. Homebuilding revenues increased 1.2% in fiscal 2017 compared to fiscal 2016 primarily due to a 13.5% increase in average sales price, partially offset by a 10.8% decrease in homes delivered. The increase in average sales price was the result of new communities delivering higher priced, larger single family homes in higher-end submarkets of the segment in fiscal 2017 compared to some communities that are no longer delivering that had lower priced, entry-level single family homes in lower-end submarkets of the segment in fiscal 2016. The increase in average sales price was also impacted by our ability to raise prices in fiscal 2017 in certain communities that were delivering homes during both periods. This increase had a minimal impact on our gross margin percentage as it was partially offset by higher construction costs we experienced during the same period. Income before income taxes decreased $0.3 million to $17.2 million, due mainly to a $0.8 million increase in selling, general and administrative costs and a $1.3 million increase in inventory impairment loss and land option write-offs, partially offset by the increase in homebuilding revenues discussed above and a $1.2 million increase in income from unconsolidated joint ventures. Additionally, the gross margin percentage before interest expense was flat for fiscal 2017 compared to fiscal 2016. Midwest - Homebuilding revenues decreased 1.6% in fiscal 2018 compared to fiscal 2017. There was a 4.6% decrease in average sales price, partially offset by a 3.4% increase in homes delivered. The decrease in average sales price was the result of new communities delivering lower priced, smaller single family homes in lower-end submarkets of the segment in fiscal 2018 compared to some communities that are no longer delivering and which had higher priced, larger single family homes in higher-end submarkets of the segment in fiscal 2017. Loss before income taxes improved $2.7 million to income of $1.5 million. The improvement was primarily due to a $2.7 million decrease in selling, general and administrative costs and the $0.6 million decrease in loss from unconsolidated joint ventures, partially offset by a slight decrease in gross margin percentage before interest expense. Homebuilding revenues decreased 35.8% in fiscal 2017 compared to fiscal 2016. There was a 30.5% decrease in homes delivered and a 0.4% decrease in average sales price. The decrease in average sales price was the result of less deliveries and home sales revenue for the segment due to our decision to exit the Minneapolis, Minnesota market in fiscal 2016, which had higher priced, single family homes delivering compared to the lower priced, single family homes delivering for the remaining markets in the segment. Also impacting the decrease was a $23.1 million decrease in land sales and other revenue due to the sale of our land portfolio in our Minneapolis, Minnesota division in fiscal 2016. Loss before income taxes decreased $10.3 million to a loss of $1.2 million. The decrease in loss was primarily due to a $14.3 million decrease in inventory impairment loss and land option write-offs relating to our land portfolio sold in our Minneapolis, Minnesota division, a $5.7 million decrease in selling, general and administrative costs and a slight increase in gross margin percentage before interest expense. Southeast - Homebuilding revenues decreased 7.2% in fiscal 2018 compared to fiscal 2017. The decrease was primarily due to a 2.9% decrease in homes delivered and a 4.6% decrease in average sales price. The decrease in average sales price was the result of new communities delivering lower priced, single family homes and townhomes in lower-end submarkets of the segment in fiscal 2018 compared to some communities that are no longer delivering and which had higher priced, larger single family homes and townhomes in higher-end submarkets of the segment in fiscal 2017. Loss before income taxes increased $3.7 million to a loss of $9.9 million due to the decrease in homebuilding revenue discussed above, a $1.6 million increase in selling, general and administrative costs and a $2.9 million decrease in income from unconsolidated joint ventures to a loss, partially offset by a $7.3 million decrease in inventory impairment loss and land option write-offs. Additionally, the gross margin percentage before interest expense was flat for fiscal 2018 compared to fiscal 2017. Homebuilding revenues decreased 0.1% in fiscal 2017 compared to fiscal 2016. The decrease was primarily due to a $42.7 million decrease in land sales and other revenue due to the sale of our land portfolio in our Raleigh, North Carolina division during fiscal 2016, partially offset by 13.4% increase in average sales price and a 5.7% increase in homes delivered. The increase in average sales price was the result of new communities delivering higher priced, larger single family homes in higher-end submarkets of the segment in fiscal 2017 compared to some communities that are no longer delivering that had lower priced, townhomes and single family homes in lower-end and submarkets of the segment in fiscal 2016. The increase in average sales price was also impacted by our ability to raise prices in fiscal 2017 in certain communities that were delivering homes during both periods. This increase had a minimal impact on our gross margin percentage as it was partially offset by higher construction costs we experienced during the same period. Loss before income taxes decreased $11.6 million to a loss of $6.2 million due to a $6.8 million decrease in selling, general and administrative costs and a $2.6 million increase in income from unconsolidated joint ventures, while gross margin percentage before interest expense remained flat. This decrease in loss was partially offset by the decrease in land sales and other revenue noted above and a $5.6 million increase in inventory impairment loss and land option write-offs. Southwest - Homebuilding revenues decreased 22.9% in fiscal 2018 compared to fiscal 2017 primarily due to a 20.5% decrease in homes delivered and a 2.9% decrease in average sales price. The decrease in average sales price was the result of new communities delivering lower priced, smaller single family homes in lower-end submarkets of the segment in fiscal 2018 compared to some communities that are no longer delivering and which had higher priced, larger single family homes and townhomes in higher-end submarkets of the segment in fiscal 2017. Income before income taxes decreased $21.7 million to $49.9 million in fiscal 2018 mainly due to the decrease in homebuilding revenues discussed above, partially offset by a $5.5 million increase in income from unconsolidated joint ventures. Additionally, the gross margin percentage before interest expense was flat for fiscal 2018 compared to fiscal 2017. Homebuilding revenues decreased 19.5% in fiscal 2017 compared to fiscal 2016 primarily due to a 14.3% decrease in homes delivered, a 5.9% decrease in average sales price and a $3.0 million decrease in land sales and other revenue. The decrease in average sales price was the result of new communities delivering lower priced, single family homes in lower-end submarkets of the segment in fiscal 2017 compared to some communities that are no longer delivering that had higher priced, single family homes in higher-end submarkets of the segment in fiscal 2016. The decrease in average sales price was partially offset our ability to raise prices in fiscal 2017 in certain communities that were delivering homes during both periods. This increase had a minimal impact on our gross margin percentage as it was partially offset by higher construction costs we have been experienced during the same period. Income before income taxes decreased $12.9 million to $71.5 million in fiscal 2017 mainly due to the decrease in homebuilding revenues discussed above, partially offset by a $1.5 million decrease in selling, general and administrative costs and a $2.8 million decrease in inventory impairment loss and land option write-offs. Additionally, the gross margin percentage before interest expense was flat for fiscal 2017 compared to fiscal 2016. West - Homebuilding revenues decreased 10.7% in fiscal 2018 compared to fiscal 2017 primarily due to an 18.6% decrease in average sales price and a $2.6 million decrease in land sales and other revenue, partially offset by 10.5% increase in homes delivered. The decrease in average sales price was the result of new communities delivering lower priced, single family homes in lower-end submarkets of the segment in fiscal 2018 compared to some communities that are no longer delivering and which had higher priced, single family homes in higher-end submarkets of the segment in fiscal 2017. Partially offsetting the decrease in average sales price was the impact of price increases in certain communities within the segment. Income before income taxes increased $28.4 million to $48.0 million in fiscal 2018 due mainly to an increase in gross margin percentage before interest expense, along with a $3.6 million increase in income from unconsolidated joint ventures and a $1.8 million decrease in inventory impairment loss and land option write-offs. This increase in income was partially offset by a $4.7 million increase in selling, general and administrative costs. Homebuilding revenues increased 25.7% in fiscal 2017 compared to fiscal 2016 primarily due to a 12.8% increase in homes delivered and a 10.7% increase in average sales price. The increase in average sales price was the result of our ability to raise prices in fiscal 2017 in certain communities that were delivering homes during both periods. In addition, there was a $2.9 million increase in land sales and other revenue for fiscal 2017 compares to fiscal 2016. Income before income taxes increased $16.2 million to $19.6 million in fiscal 2017 due mainly to the increase in homebuilding revenues discussed above, a $2.9 million decrease in selling, general and administrative costs and a slight increase in gross margin percentage before interest expense. This increase in income was partially offset by a $4.4 million decrease in income from unconsolidated joint ventures and a $1.9 million increase in inventory impairment loss and land option write-offs. Financial Services Financial services consist primarily of originating mortgages from our home-buyers, selling such mortgages in the secondary market, and title insurance activities. We use mandatory investor commitments and forward sales of MBS to hedge our mortgage-related interest rate exposure on agency and government loans. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk associated with MBS forward commitments and loan sales transactions is managed by limiting our counterparties to investment banks, federally regulated bank affiliates and other investors meeting our credit standards. Our risk, in the event of default by the purchaser, is the difference between the contract price and fair value of the MBS forward commitments. For the years ended October 31, 2018, 2017 and 2016, FHA/VA loans represented 24.6%, 25.1%, and 25.5%, respectively, of our total loans. The origination of FHA/VA loans have decreased over the last three fiscal years and our conforming conventional loan originations as a percentage of our total loans also decreased slightly from 69.6% for fiscal 2016 to 69.0% for fiscal 2017, but increased slightly to 69.8% for fiscal 2018. The remaining 5.6%, 5.9% and 4.9% of our loan originations represent jumbo and/or USDA loans. Profits and losses relating to the sale of mortgage loans are recognized when legal control passes to the buyer of the mortgage and the sales price is collected. During the years ended October 31, 2018, 2017, and 2016, financial services provided a $18.2 million, $26.4 million and $35.5 million pretax profit, respectively. In fiscal 2018, financial services pretax profit decreased $8.2 million due to the decrease in the homebuilding deliveries, and the decrease in the basis point spread between the loans originated and the implied rate from the sale of the loans as a result of the competitive financial services market and recent increases in mortgage rates. In fiscal 2017, financial services pretax profit decreased $9.1 million compared to fiscal 2016 due to the decrease in homebuilding deliveries, along with a decrease in the average price of loans settled. In the market areas served by our wholly owned mortgage banking subsidiaries, 72.4%, 67.8%, and 67.3% of our noncash home buyers obtained mortgages originated by these subsidiaries during the years ended October 31, 2018, 2017, and 2016, respectively. Corporate General and Administrative Corporate general and administrative expenses include the operations at our headquarters in New Jersey. These expenses include payroll, stock compensation, legal expenses, rent and facility costs and other costs associated with our executive offices, information services, human resources, corporate accounting, training, treasury, process redesign, internal audit, construction services and administration of insurance, quality and safety. Corporate general and administrative expenses increased $10.3 million for the year ended October 31, 2018 compared to the year ended October 31, 2017, and decreased $0.8 million for the year ended October 31, 2017 compared to the year ended October 31, 2016. The increase in expense for fiscal 2018 was primarily due to increased legal (including litigation) fees related to our fiscal 2018 financing transactions and higher costs for ongoing litigations involving the Company. Also contributing to the increase in corporate general and administrative expenses was rent expense incurred during the year ended October 31, 2018, related to (i) the sale and leaseback of our former corporate headquarters building for the period from November 2017 to February 2018, and (ii) our new corporate headquarters building which we moved into in February 2018. Additionally impacting the increase was an increase in stock compensation expense in fiscal 2018, as a result of lower expense in fiscal 2017, resulting from the forfeiture of compensation under our long-term incentive plan due to the retirement of a senior executive, along with the cancelation of certain stock awards that did not meet their performance criteria. The minor decrease in expense for fiscal 2017 compared to fiscal 2016 was due mainly to the reversal of previously recognized expense for certain performance based stock compensation plans for which certain requirements are not expected to be satisfied, partially offset by the increase from an adjustment to reserves for self-insured medical claims that were reduced based on claim estimates that occurred in the prior year and which did not recur in 2017. Other Interest Other interest increased $6.0 million to $103.3 million for the year ended October 31, 2018 compared to October 31, 2017 and increased $6.3 million to $97.3 million for the year ended October 31, 2017 compared to October 31, 2016. Our assets that qualify for interest capitalization (inventory under development) are less than our debt, and therefore a portion of interest not covered by qualifying assets must be directly expensed. In fiscal 2018, the increase was attributed to more interest incurred as a result of the senior secured notes issued in July 2017 that have a higher interest rate than the senior secured notes which they refinanced and additional amounts outstanding under the term loan facility in fiscal 2018 compared to fiscal 2017. In fiscal 2017, our qualifying assets for interest capitalization decreased by more than our debt, therefore directly expensed interest increased for the year ended October 31, 2017 compared to the year ended October 31, 2016. Also contributing to the increase was the higher interest rate on our secured debt that was refinanced in July 2017. Loss on Extinguishment of Debt We incurred a $7.5 million loss on extinguishment of debt during the year ended October 31, 2018 due to (i) borrowings of the Initial Term Loans in the amount of $132.5 million under the Term Loan Facility, and proceeds of such Initial Term Loans, together with cash on hand, were used to redeem all of K. Hovnanian’s outstanding $132.5 million aggregate principal amount of 7.0% Notes (upon redemption, all 7.0% Notes were cancelled); and (ii) the exchange of all of the $170.2 million aggregate principal amount of 8.0% Notes validly tendered and not validly withdrawn in the Exchange Offer (representing 72.14% of the aggregate principal amount of 8.0% Notes outstanding prior to the exchange offer), and the issuance of $90.6 million aggregate principal amount of New 2026 Notes and $90.1 million aggregate principal amount of New 2040 Notes, and as part of the Exchange Offer, the Subsidiary Purchaser, purchased for $26.5 million in cash the Purchased 8.0% Notes. These transactions resulted in a loss on extinguishment of debt of $1.4 million. In addition, on May 29, 2018, K. Hovnanian completed the redemption of $65.7 million aggregate principal amount of the 8.0% Notes (upon redemption, such 8.0% Notes were cancelled) with approximately $70.0 million in borrowings on the Delayed Draw Term Loans under the Term Loan Facility. This transaction resulted in a loss on extinguishment of debt of $4.3 million. Third, on September 10, 2018, K. Hovnanian drew $35.0 million on the Secured Credit Facility and used $41.0 million of cash on hand to repay the secured term loans in full, plus unpaid interest and closing costs. This transaction resulted in a loss on extinguishment of debt of $1.8 million for the year ended October 31, 2018. We incurred a $34.9 million loss on extinguishment of debt during the year ended October 31, 2017. This was due to three items that occurred during fiscal 2017. First, we repurchased in open market transactions $17.5 million aggregate principal amount of 7.0% Notes, $14.0 million aggregate principal amount of 8.0% Notes and 6,925 senior exchangeable note units representing $6.9 million stated amount of senior exchangeable note units. The aggregate purchase price for these transactions was $30.8 million, plus accrued and unpaid interest. These transactions resulted in a gain on extinguishment of debt of $7.8 million. Second, we incurred $0.4 million of costs associated with the 9.50% 2020 Notes issued during the fourth quarter of fiscal 2016. Third, we issued $440.0 million aggregate principal amount of 10.0% 2022 Notes and $400.0 million aggregate principal amount of 10.5% 2024 Notes. The net proceeds from these issuances together with available cash were used to (i) purchase $575,912,000 principal amount of 7.25% First Lien Notes, $87,321,000 principal amount of 9.125% Second Lien Notes and all $75,000,000 principal amount of 10.0% Second Lien Notes that were tendered and accepted for purchase pursuant to the Tender Offers and to pay related tender premiums and accrued and unpaid interest thereon to the date of purchase and (ii) satisfy and discharge all obligations (and cause the release of the liens on the collateral securing such indebtedness) under the indentures under which the 7.25% First Lien Notes, the 9.125% Second Lien Notes and the 10.0% Second Lien Notes were issued and in connection therewith to call for redemption on October 15, 2017 and on November 15, 2017 all remaining $1,088,000 principal amount of 7.25% First Lien Notes and all remaining $57,679,000 principal amount of 9.125% Second Lien Notes, respectively, that were not validly tendered and purchased in the applicable Tender Offer in accordance with the redemption provisions of the indentures governing the 2020 Secured Notes. These transactions resulted in a loss on extinguishment of debt of $42.3 million. We incurred a $3.2 million loss on extinguishment of debt for the year ended October 31, 2016, due to the redemption of the remaining outstanding principal amount of our 8.625% Senior Notes due 2017 and the exchange of a portion of our Existing Second Lien Notes for Exchange Notes. These losses were slightly offset by a gain from the purchase of 20,823 6.0% Exchangeable Note Units due December 2017. We did not incur any loss on the extinguishment of debt for the year ended October 31, 2015. Income (Loss) from Unconsolidated Joint Ventures Income (loss) from unconsolidated joint ventures consists of our share of the earnings or losses of our joint ventures. Income (loss) from unconsolidated joint ventures increased $31.0 million for the year ended October 31, 2018 from a loss of $7.0 million for the year ended October 31, 2017 to income of $24.0 million. The increase is due to the recognition of our share of income from certain of our joint ventures delivering more homes and increased profits in the current fiscal year as compared to the prior fiscal year when they reported losses primarily due to startup costs. Loss from unconsolidated joint ventures increased $2.7 million for the year ended October 31, 2017 from a loss of $4.3 million for the year ended October 31, 2016 to a loss of $7.0 million. The increase in loss was due to the recognition of our share of losses on our newly formed joint ventures, some of which had not delivered any homes, and the write-off of our investment on a joint venture that delivered its last home during fiscal 2017 and we have determined that we will not receive any future distributions. Total Taxes The total income tax expense of $3.6 million for the year ended October 31, 2018 was primarily related to state tax expense from income generated that was not offset by tax benefits in states where we fully reserve the tax benefit from net operating losses. The total income tax expense of $286.9 million for the year ended October 31, 2017 was primarily due to increasing our valuation allowance to fully reserve against our deferred tax assets (“DTAs”). In addition, this period was also impacted by state tax expense from income generated in some states, which was not offset by tax benefits in other states that had losses for which we fully reserve the net operating losses. The total income tax expense of $5.3 million for the year ended October 31, 2016 was primarily due to current state taxes and permanent differences related to stock compensation, partially offset by a federal tax benefit related to receiving a specified liability loss refund of taxes paid in fiscal year 2002. Deferred federal and state income tax assets primarily represent the deferred tax benefits arising from net operating loss carryforwards and temporary differences between book and tax income which will be recognized in future years as an offset against future taxable income. If the combination of future years’ income (or loss) and the reversal of the timing differences results in a loss, such losses can be carried forward to future years. In accordance with ASC 740, we evaluate our deferred tax assets quarterly to determine if valuation allowances are required. ASC 740 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a “more likely than not” standard. As of October 31, 2018, we considered all available positive and negative evidence to determine whether, based on the weight of that evidence, our valuation allowance for our DTAs was appropriate in accordance with ASC 740. As listed in Note 11 to the Consolidated Financial Statements, in order of the weighting of each factor, is the available positive and negative evidence that we considered in determining that it is more likely than not that all of our DTAs will not be realized. In analyzing these factors, overall the negative evidence, both objective and subjective, outweighed the positive evidence. Based on this analysis, we determined that the current valuation allowance for deferred taxes of $638.2 million as of October 31, 2018, which fully reserves for our DTAs, is appropriate. Off-Balance Sheet Financing In the ordinary course of business, we enter into land and lot option purchase contracts in order to procure land or lots for the construction of homes. Lot option contracts enable us to control significant lot positions with a minimal capital investment and substantially reduce the risks associated with land ownership and development. At October 31, 2018, we had $59.0 million in option deposits in cash to purchase land and lots with a total purchase price of $1.2 billion. Our financial exposure is generally limited to forfeiture of the nonrefundable deposits, letters of credit and other nonrefundable amounts incurred. We have no material third-party guarantees. Contractual Obligations The following summarizes our aggregate contractual commitments at October 31, 2018. (1) Total contractual obligations exclude our accrual for uncertain tax positions of $1.5 million recorded for financial reporting purposes as of October 31, 2018 because we were unable to make reasonable estimates as to the period of cash settlement with the respective taxing authorities. (2) Represents our senior unsecured term loan credit facility, senior secured and senior notes and other notes payable and $716.0 million of related interest payments for the life of such debt. (3) Does not include $95.6 million of nonrecourse mortgages secured by inventory. These mortgages have various maturities spread over the next two to three years and are paid off as homes are delivered. (4) Does not include the mortgage warehouse lines of credit made under our Master Repurchase Agreements. See“- Capital Resources and Liquidity.” Also does not include our $125.0 million Secured Credit Facility under which there were no borrowings outstanding as of October 31, 2018. (5) Represents obligations under option contracts with specific performance provisions, net of cash deposits. We had outstanding letters of credit and performance bonds of $12.5 million and $192.5 million, respectively, at October 31, 2018, related principally to our obligations to local governments to construct roads and other improvements in various developments. We do not believe that any such letters of credit or bonds are likely to be drawn upon. Inflation Inflation has a long-term effect, because increasing costs of land, materials and labor result in increasing sale prices of our homes. In general, these price increases have been commensurate with the general rate of inflation in our housing markets and have not had a significant adverse effect on the sale of our homes. A significant risk faced by the housing industry generally is that rising house construction costs, including land and interest costs, will substantially outpace increases in the income of potential purchasers and therefore limit our ability to raise home sale prices, which may result in lower gross margins. Inflation has a lesser short-term effect, because we generally negotiate fixed-price contracts with many, but not all, of our subcontractors and material suppliers for the construction of our homes. These prices usually are applicable for a specified number of residential buildings or for a time period of between three to twelve months. We also have certain national contracts whereby the prices are applicable for time periods ranging from one to three years. Construction costs for residential buildings represent approximately 55% of our homebuilding cost of sales for fiscal 2018. Safe Harbor Statement All statements in this Annual Report on Form 10-K that are not historical facts should be considered as “Forward-Looking Statements” within the meaning of the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such forward-looking statements include but are not limited to statements related to the Company's goals and expectations with respect to its financial results for future financial periods. Although we believe that our plans, intentions and expectations reflected in, or suggested by, such forward-looking statements are reasonable, we can give no assurance that such plans, intentions or expectations will be achieved. By their nature, forward-looking statements: (i) speak only as of the date they are made, (ii) are not guarantees of future performance or results and (iii) are subject to risks, uncertainties and assumptions that are difficult to predict or quantify. Therefore, actual results could differ materially and adversely from those forward-looking statements as result of a variety of factors. Such risks, uncertainties and other factors include, but are not limited to: ● Changes in general and local economic, industry and business conditions and impacts of a significant homebuilding downturn; ● Adverse weather and other environmental conditions and natural disasters; ● High leverage and restrictions on the Company’s operations and activities imposed by the agreements governing the Company’s outstanding indebtedness; ● Availability and terms of financing to the Company; ● The Company’s sources of liquidity; ● Changes in credit ratings; ● The seasonality of the Company’s business; ● The availability and cost of suitable land and improved lots and sufficient liquidity to invest in such land and lots; ● Shortages in, and price fluctuations of, raw materials and labor; ● Reliance on, and the performance of, subcontractors; ● Regional and local economic factors, including dependency on certain sectors of the economy, and employment levels affecting home prices and sales activity in the markets where the Company builds homes; ● Fluctuations in interest rates and the availability of mortgage financing; ● Increases in cancellations of agreements of sale; ● Changes in tax laws affecting the after-tax costs of owning a home; ● Operations through unconsolidated joint ventures with third parties; ● Government regulation, including regulations concerning development of land, the home building, sales and customer financing processes, tax laws and the environment; ● Legal claims brought against us and not resolved in our favor, such as product liability litigation, warranty claims and claims made by mortgage investors; ● Levels of competition; ● Successful identification and integration of acquisitions; ● Significant influence of the Company’s controlling stockholders; ● Availability of net operating loss carryforwards; ● Utility shortages and outages or rate fluctuations; ● Geopolitical risks, terrorist acts and other acts of war; ● Loss of key management personnel or failure to attract qualified personnel; ● Information technology failures and data security breaches; and ● Negative publicity. Certain risks, uncertainties and other factors are described in detail in Part I, Item 1 “Business” and Part I, Item 1A “Risk Factors” in this Annual Report on Form 10-K as updated by our subsequent filings with the SEC. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason after the date of this Annual Report on Form 10-K.

<s>[INST] Hovnanian Enterprises, Inc. (“HEI”) conducts all of its homebuilding and financial services operations through its subsidiaries (references herein to the “Company,” “we,” “us” or “our” refer to HEI and its consolidated subsidiaries and should be understood to reflect the consolidated business of HEI’s subsidiaries). Overview As discussed in previous quarters, we were limited in our ability to invest in land purchases in fiscal 2016 and 2017 due to significant debt maturities that we were unable to refinance and therefore had to pay at maturity. This reduction of investment has led to a decrease in community count and revenues, which impacts our overall profitability. Our total number of lots controlled increased in the quarter ended October 31, 2018, as compared to the same period of the prior year, which is the fourth consecutive quarter for which we have experienced a yearoveryear quarterly increase. We believe continued growth in lots controlled should ultimately lead to community count growth and our fiscal 2017 and 2018 financing transactions have provided us with the long term capital needed to implement our investment strategy to grow our business. However, there is typically a significant time lag from when we first control lots until the time that we open a community for sale. Our cash position in fiscal 2018 allowed us to spend $566.8 million on land purchases and land development during fiscal 2018, along with using $211.4 million of cash to pay down debt, and still have $187.9 million of homebuilding cash and cash equivalents as of October 31, 2018. We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices and sales pace and plan to continue actively pursuing such land acquisitions. New land purchases at pricing that we believe will generate appropriate investment returns and drive greater operating efficiencies are needed to return to sustained profitability. The factors discussed above for fiscal 2016 and 2017 led to a decrease in our community count from 130 at October 31, 2017 to 123 at October 31, 2018, and as a result, for the year ended October 31, 2018 we experienced mixed operating results compared to the prior year. More specifically: Net contracts per average active selling community increased slightly to 35.9 for the year ended October 31, 2018 compared to 35.1 in the prior year. Active selling communities decreased 5.4% over last year, and our average active selling communities decreased by 12.2% over last year. Net contracts decreased 10.1% for the year ended October 31, 2018, compared to the prior year. For the year ended October 31, 2018, sale of homes revenues decreased 18.5% as compared to the prior year, as a result of a 13.5% decrease in deliveries, primarily due to our decreased community count. Gross margin percentage increased from 13.2% for the year ended October 31, 2017 to 15.2% for the year ended October 31, 2018. Gross margin percentage, before cost of sales interest expense and land charges, increased from 17.2% for the year ended October 31, 2017 to 18.4% for the year ended October 31, 2018. The improvements in both gross margin percentage and gross margin percentage, before cost of sales interest expense and land charges, are primarily the result of the mix of communities delivering, as well as the benefit of a onetime $6.3 million credit related to a land development reimbursement from a municipality in California. Selling, general and administrative costs (including corporate general and administrative expenses) decreased $26.9 million for the year ended October 31, 2018 as compared to the prior year. As a percentage of total revenue, such costs increased from 10.4% for the year ended October 31, 2017 to 11.5% for the year ended October 31, 2018. The [/INST] Negative. </s>

HOVNANIAN ENTERPRISES INC

2019-12-19

2019-10-31

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Hovnanian Enterprises, Inc. (“HEI”) conducts all of its homebuilding and financial services operations through its subsidiaries (references herein to the “Company,” “we,” “us” or “our” refer to HEI and its consolidated subsidiaries and should be understood to reflect the consolidated business of HEI’s subsidiaries). Overview Our community count increased 14.6% from 123 communities at October 31, 2018 to 141 at October 31, 2019. For seven consecutive quarters through the third quarter of fiscal 2019, our total number of lots controlled increased as compared to the same period of the prior year. Although there was a slight decrease in total lots controlled of 3.2% as of October 31, 2019 as compared to October 31, 2018, the growth in lots controlled in previous quarters has led to the year-over-year community count growth. Our strategy has been to grow through increased open for sale communities. As our recently opened communities begin delivering homes, we believe it should lead to additional delivery and revenue growth, and in turn profitability in future periods, absent adverse market factors. Our cash position has allowed us to spend $562.8 million on land purchases and land development during fiscal 2019, and still have total liquidity of $275.9 million, including $131.0 million of homebuilding cash and cash equivalents as of October 31, 2019. We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices, sales pace and construction costs and plan to continue actively pursuing such land acquisitions. New land purchases at pricing that we believe will generate appropriate investment returns and drive greater operating efficiencies are needed to return to sustained profitability; however, we remain cautious and are carefully evaluating market conditions when pursuing new land acquisitions. Additional results for the year ended October 31, 2019 were as follows: ● For the year ended October 31, 2019, sale of homes revenues increased 2.3% as compared to the prior year, as a result of a 2.0% increase in deliveries, primarily due to our increased community count. ● Gross margin percentage decreased from 15.2% for the year ended October 31, 2018 to 14.2% for the year ended October 31, 2019. This decrease was primarily due to the increase in cost of sales interest as a result of changes in estimates of interest per home for deliveries during fiscal 2019 in connection with our semi-annual community life planning process, along with a decrease due to the mix of communities delivering in each period. During this planning process, the duration of communities and timing of spending thereon could change, resulting in changes in total estimated community life capitalized interest. Estimated community life capitalized interest is written-off with each delivery. Gross margin percentage, before cost of sales interest expense and land charges, decreased slightly from 18.4% for the year ended October 31, 2018 to 18.1% for the year ended October 31, 2019, primarily due to the mix of communities delivering. ● Selling, general and administrative costs (including corporate general and administrative expenses) increased $4.3 million for the year ended October 31, 2019 as compared to the prior year, primarily as a result of our increased community count, along with a lower adjustment to our warranty reserves (as a result of our annual actuarial analysis) in fiscal 2019 as compared to fiscal 2018. However, as a percentage of total revenue, such costs remained relatively flat at 11.6% for the year ended October 31, 2019 compared to 11.5% for the year ended October 31, 2018. ● Active selling communities at October 31, 2019 increased 14.6% over last year, and our average active selling communities increased by 5.4% over last year. Net contracts increased 14.3% for the year ended October 31, 2019, compared to the prior year. ● Net contracts per average active selling community increased to 39.0 for the year ended October 31, 2019 compared to 35.9 in the prior year. ● Contract backlog increased from 1,826 homes at October 31, 2018 to 2,191 homes at October 31, 2019, with a dollar value of $880.1 million, representing a 18.0% increase in dollar value compared to the prior year. When comparing sequentially from the third quarter of fiscal 2019 to the fourth quarter of fiscal 2019, our gross margin percentage increased slightly from 14.0% to 14.5% and our gross margin percentage, before cost of sales interest expense and land charges, also increased slightly from 18.4% to 18.9%, both primarily as a result of product mix, as well as a minor increase due to the increase in delivery volume. Selling, general and administrative costs (including corporate general and administrative expenses) as a percentage of total revenues decreased from 12.1% to 7.6%, as compared to the third quarter of fiscal 2019, primarily due to the increase in delivery volume. Critical Accounting Policies Management believes that the following critical accounting policies require its most significant judgments and estimates used in the preparation of the consolidated financial statements: Income Recognition from Mortgage Loans - Our Financial Services segment originates mortgages, primarily for our homebuilding customers. We use mandatory investor commitments and forward sales of mortgage backed securities (“MBS”) to hedge our mortgage-related interest rate exposure on agency and government loans. We elected the fair value option for our mortgage loans held for sale in accordance with Accounting Standards Codification (“ASC”) 825, “Financial Instruments,” which permits us to measure our loans held for sale at fair value. Management believes that the election of the fair value option for loans held for sale improves financial reporting by mitigating volatility in reported earnings caused by measuring the fair value of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. Substantially all of the mortgage loans originated are sold within a short period of time in the secondary mortgage market on a servicing released, nonrecourse basis, although the Company remains liable for certain limited representations, such as fraud, and warranties related to loan sales. Mortgage investors could seek to have us buy back loans or compensate them for losses incurred on mortgages we have sold based on claims that we breached our limited representations and warranties. We have established reserves for probable losses. While we believe these reserves are adequate for known losses and projected repurchase requests, given the volatility in the mortgage industry and the uncertainty regarding the ultimate resolution of these claims, if either actual repurchases or the losses incurred resolving those repurchases exceed our expectations, additional expense may be incurred. Inventories - Inventories consist of land, land development, home construction costs, capitalized interest, construction overhead and property taxes. Construction costs are accumulated during the period of construction and charged to cost of sales under specific identification methods. Land, land development and common facility costs are allocated based on buildable acres to product types within each community, then charged to cost of sales equally based upon the number of homes to be constructed in each product type. We record inventories in our consolidated balance sheets at cost unless the inventory is determined to be impaired, in which case the inventory is written down to its fair value. Our inventories consist of the following three components: (1) sold and unsold homes and lots under development, which includes all construction, land, capitalized interest and land development costs related to started homes and land under development in our active communities; (2) land and land options held for future development or sale, which includes all costs related to land in our communities in planning or mothballed communities; and (3) consolidated inventory not owned, which includes all costs related to variable interest entities and other options, which consists primarily of model homes financed with an investor and inventory related to land banking arrangements accounted for as financings. We decide to mothball (or stop development on) certain communities when we determine that the current performance does not justify further investment at the time. When we decide to mothball a community, the inventory is reclassified on our Consolidated Balance Sheets from “Sold and unsold homes and lots under development” to “Land and land options held for future development or sale.” As of October 31, 2019, the net book value associated with our 13 mothballed communities was $13.8 million, net of impairment charges recorded in prior periods of $138.1 million. We regularly review communities to determine if mothballing is appropriate. During fiscal 2019, we did not mothball any communities, but we sold two previously mothballed communities and re-activated three previously mothballed communities. We sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 606-10-55-68, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheets, at October 31, 2019, inventory of $54.2 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $51.2 million recorded to “Liabilities from inventory not owned.” We have land banking arrangements, whereby we sell our land parcels to the land banker and they provide us an option to purchase back finished lots on a quarterly basis. Because of our options to repurchase these parcels, for accounting purposes, in accordance with ASC 606-10-55-70, these transactions are considered financings rather than sales. For purposes of our Consolidated Balance Sheets, at October 31, 2019, inventory of $136.1 million was recorded as “Consolidated inventory not owned,” with a corresponding amount of $89.8 million recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. The recoverability of inventories and other long-lived assets is assessed in accordance with the provisions of ASC 360-10, “Property, Plant and Equipment − Overall” (“ASC 360-10”). ASC 360-10 requires long-lived assets, including inventories, held for development to be evaluated for impairment based on undiscounted future cash flows of the assets at the lowest level for which there are identifiable cash flows. As such, we evaluate inventories for impairment at the individual community level, the lowest level of discrete cash flows that we measure. We evaluate inventories of communities under development and held for future development for impairment when indicators of potential impairment are present. Indicators of impairment include, but are not limited to, decreases in local housing market values, decreases in gross margins or sales absorption rates, decreases in net sales prices (base sales price net of sales incentives), or actual or projected operating or cash flow losses. The assessment of communities for indication of impairment is performed quarterly. As part of this process, we prepare detailed budgets for all of our communities at least semi-annually and identify those communities with a projected operating loss. For those communities with projected losses, we estimate the remaining undiscounted future cash flows and compare those to the carrying value of the community, to determine if the carrying value of the asset is recoverable. The projected operating profits, losses, or cash flows of each community can be significantly impacted by our estimates of the following: ● future base selling prices; ● future home sales incentives; ● future home construction and land development costs; and ● future sales absorption pace and cancellation rates. These estimates are dependent upon specific market conditions for each community. While we consider available information to determine what we believe to be our best estimates as of the end of a quarterly reporting period, these estimates are subject to change in future reporting periods as facts and circumstances change. Local market-specific conditions that may impact our estimates for a community include: ● the intensity of competition within a market, including available home sales prices and home sales incentives offered by our competitors; ● the current sales absorption pace for both our communities and competitor communities; ● community specific attributes, such as location, availability of lots in the market, desirability and uniqueness of our community, and the size and style of homes currently being offered; ● potential for alternative product offerings to respond to local market conditions; ● changes by management in the sales strategy of the community; ● current local market economic and demographic conditions and related trends of forecasts; and ● existing home inventory supplies, including foreclosures and short sales. These and other local market-specific conditions that may be present are considered by management in preparing projection assumptions for each community. The sales objectives can differ between our communities, even within a given market. For example, facts and circumstances in a given community may lead us to price our homes with the objective of yielding a higher sales absorption pace, while facts and circumstances in another community may lead us to price our homes to minimize deterioration in our gross margins, although it may result in a slower sales absorption pace. In addition, the key assumptions included in our estimate of future undiscounted cash flows may be interrelated. For example, a decrease in estimated base sales price or an increase in homes sales incentives may result in a corresponding increase in sales absorption pace. Additionally, a decrease in the average sales price of homes to be sold and closed in future reporting periods for one community that has not been generating what management believes to be an adequate sales absorption pace may impact the estimated cash flow assumptions of a nearby community. Changes in our key assumptions, including estimated construction and development costs, absorption pace and selling strategies, could materially impact future cash flow and fair-value estimates. Due to the number of possible scenarios that would result from various changes in these factors, we do not believe it is possible to develop a sensitivity analysis with a level of precision that would be meaningful to an investor. If the undiscounted cash flows are more than the carrying value of the community, then the carrying amount is recoverable, and no impairment adjustment is required. However, if the undiscounted cash flows are less than the carrying amount, then the community is deemed impaired and is written down to its fair value. We determine the estimated fair value of each community by determining the present value of its estimated future cash flows at a discount rate commensurate with the risk of the respective community, or in limited circumstances, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale), and recent bona fide offers received from outside third parties. Our discount rates used for all impairments recorded from October 31, 2017 to October 31, 2019 ranged from 16.8% to 19.8%. The estimated future cash flow assumptions are virtually the same for both our recoverability and fair value assessments. Should the estimates or expectations used in determining estimated cash flows or fair value, including discount rates, decrease or differ from current estimates in the future, we may be required to recognize additional impairments related to current and future communities. The impairment of a community is allocated to each lot on a relative fair value basis. From time to time, we write off deposits and approval, engineering and capitalized interest costs when we determine that it is no longer probable that we will exercise options to buy land in specific locations or when we redesign communities and/or abandon certain engineering costs. In deciding not to exercise a land option, we take into consideration changes in market conditions, the timing of required land takedowns, the willingness of land sellers to modify terms of the land option contract (including timing of land takedowns), and the availability and best use of our capital, among other factors. The write-off is recorded in the period it is deemed not probable that the optioned property will be acquired. In certain instances, we have been able to recover deposits and other pre-acquisition costs that were previously written off. These recoveries have not been significant in comparison to the total costs written off. Inventories held for sale are land parcels ready for sale in their current condition, where we have decided not to build homes but are instead actively marketing for sale. These land parcels represented $6.4 million of our total inventories at October 31, 2018, and are reported at the lower of carrying amount or fair value less costs to sell. There were no inventories held for sale at October 31, 2019. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. Unconsolidated Homebuilding and Land Development Joint Ventures - Investments in unconsolidated homebuilding and land development joint ventures are accounted for under the equity method of accounting. Under the equity method, we recognize our proportionate share of earnings and losses earned by the joint venture upon the delivery of lots or homes to third parties. Our ownership interests in the joint ventures vary but our voting interests are generally 50% or less. In determining whether or not we must consolidate joint ventures where we are the managing member of the joint venture, we assess whether the other partners have specific rights to overcome the presumption of control by us as the manager of the joint venture. In most cases, the presumption is overcome because the joint venture agreements require that both partners agree on establishing the significant operating and capital decisions of the partnership, including budgets, in the ordinary course of business. The evaluation of whether or not we control a venture can require significant judgment. In accordance with ASC 323-10, “Investments - Equity Method and Joint Ventures - Overall,” we assess our investments in unconsolidated joint ventures for recoverability, and if it is determined that a loss in value of the investment below its carrying amount is other than temporary, we write down the investment to its fair value. We evaluate our equity investments for impairment based on the joint venture’s projected cash flows. This process requires significant management judgment and estimates. During fiscal 2019 and fiscal 2017, we wrote down certain joint venture investments by $0.9 million and $2.8 million, respectively. There were no write-downs in fiscal 2018. Warranty Costs and Construction Defect Reserves - We accrue for warranty costs that are covered under our existing general liability and construction defect policy as part of our general liability insurance deductible. This accrual is expensed as selling, general, and administrative costs. For homes delivered in fiscal 2019 and 2018, our deductible under our general liability insurance is a $20 million aggregate for construction defect and warranty claims. For bodily injury claims, our deductible per occurrence in fiscal 2019 and 2018 is $0.25 million, up to a $5 million limit. Our aggregate retention for construction defect, warranty and bodily injury claims is $20 million for fiscal 2019 and 2018. We do not have a deductible on our worker's compensation insurance. Reserves for estimated losses for construction defects, warranty and bodily injury claims have been established using the assistance of a third-party actuary. We engage a third-party actuary that uses our historical warranty and construction defect data to assist our management in estimating our unpaid claims, claim adjustment expenses and incurred but not reported claims reserves for the risks that we are assuming under the general liability and construction defect programs. The estimates include provisions for inflation, claims handling and legal fees. These estimates are subject to a high degree of variability due to uncertainties such as trends in construction defect claims relative to our markets and the types of products we build, claim settlement patterns, insurance industry practices and legal interpretations, among others. Because of the high degree of judgment required in determining these estimated liability amounts, actual future costs could differ significantly from our currently estimated amounts. In addition, we establish a warranty accrual for lower cost-related issues to cover home repairs, community amenities and land development infrastructure that are not covered under our general liability and construction defect policy. We accrue an estimate for these warranty costs as part of cost of sales at the time each home is closed and title and possession have been transferred to the homebuyer. See Note 16 to the Consolidated Financial Statements for additional information on the amount of warranty costs recognized in cost of goods sold and administrative expenses. Recent Accounting Pronouncements See Note 3 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K. Capital Resources and Liquidity Our operations consist primarily of residential housing development and sales in the Northeast (New Jersey and Pennsylvania), the Mid-Atlantic (Delaware, Maryland, Virginia, Washington D.C. and West Virginia), the Midwest (Illinois and Ohio), the Southeast (Florida, Georgia and South Carolina), the Southwest (Arizona and Texas) and the West (California). In addition, we provide certain financial services to our homebuilding customers. We have historically funded our homebuilding and financial services operations with cash flows from operating activities, borrowings under our credit facilities, the issuance of new debt and equity securities and other financing activities. Due to covenant restrictions in our debt instruments, we are currently limited in the amount of debt we can incur that does not qualify as refinancing indebtedness (a limitation that we expect to continue for the foreseeable future), even if market conditions would otherwise be favorable, which could also impact our ability to grow our business. Operating, Investing and Financing Activities - Overview Our homebuilding cash balance at October 31, 2019 decreased $56.9 million from October 31, 2018. We spent $562.8 million on land and land development during the period. After considering this land and land development and all other operating activities, including revenue received from deliveries, we used $249.1 million of cash from operations. However, as of October 31, 2019, we had $125.0 million of borrowing capacity under our Secured Credit Agreement (defined below), and therefore, our total liquidity at October 31, 2019 was $275.9 million, which is above our target liquidity range of $170.0 to $245.0 million. During fiscal 2019, we used $8.3 million of cash for investing activities, primarily for investments in joint ventures, partially offset by distributions from joint ventures. Cash provided by financing activities was $206.7 million during fiscal 2019, which included net proceeds of $8.2 million from debt issuances, $78.5 million from land banking and model sale leaseback programs, $109.0 million of net proceeds from nonrecourse mortgages and $27.1 million from in mortgage warehouse lines of credit. Subject to covenant restrictions in our debt instruments, we intend to continue to use nonrecourse mortgage financings, model sale leaseback, joint ventures, and land banking programs as our business needs dictate. Our cash uses during the years ended October 31, 2019 and 2018 were for operating expenses, land purchases, land deposits, land development, construction spending, debt refinancings and payments, state income taxes, interest payments, litigation matters and investments in joint ventures. During these periods, we provided for our cash requirements from available cash on hand, housing and land sales, financing transactions, model sale leasebacks, land banking transactions, joint ventures, financial service revenues and other revenues. We believe that these sources of cash together with available borrowings under our senior secured revolving credit facility will be sufficient through fiscal 2020 to finance our working capital requirements. Our net income (loss) historically does not approximate cash flow from operating activities. The difference between net income (loss) and cash flow from operating activities is primarily caused by changes in inventory levels together with changes in receivables, prepaid and other assets, mortgage loans held for sale, interest and other accrued liabilities, deferred income taxes, accounts payable and other liabilities, and noncash charges relating to depreciation, stock compensation awards and impairment losses for inventory. When we are expanding our operations, inventory levels, prepaids and other assets increase causing cash flow from operating activities to decrease. Certain liabilities also increase as operations expand and partially offset the negative effect on cash flow from operations caused by the increase in inventory levels, prepaids and other assets. Similarly, as our mortgage operations expand, net income from these operations increases, but for cash flow purposes net income is partially offset by the net change in mortgage assets and liabilities. The opposite is true as our investment in new land purchases and development of new communities decrease, causing us to generate positive cash flow from operations. In fiscal 2019 and 2018, with continued spending on land purchases and land development, we used cash in operations. As we continue to actively seek land investment opportunities, we will also remain focused on liquidity. See “Inventory Activities” below for a detailed discussion of our inventory position. Debt Transactions Senior notes and credit facilities balances as of October 31, 2019 and October 31, 2018, were as follows: (1) “ Notes payable” on our Consolidated Balance Sheets as of October 31, 2019 and 2018 consists of the total senior secured and senior notes shown above, as well as accrued interest of $19.1 million and $35.6 million, respectively. (2) $26.0 million of 8.0% Senior Notes due 2019 are owned by a wholly-owned consolidated subsidiary of HEI. Therefore, in accordance with GAAP, such notes are not reflected on the Consolidated Balance sheets of HEI. On November 1, 2019, the maturity of the 8.0% Senior Notes was extended to November 1, 2027. (3) At October 31, 2019, provides for up to $125.0 million in aggregate amount of senior secured first lien revolving loans. Availability thereunder will terminate on December 28, 2022. Except for K. Hovnanian, the issuer of the notes and borrower under the senior unsecured term loan facility (the “Term Loan Facility”) and under our $125.0 million senior secured revolving credit facility (the “Secured Credit Facility” and together with the term loan facility, the “Credit Facilities”), our home mortgage subsidiaries, certain of our title insurance subsidiaries, joint ventures and subsidiaries holding interests in our joint ventures, we and each of our subsidiaries are guarantors of the Credit Facilities, the senior secured notes and senior notes outstanding at October 31, 2019 (collectively, the “Notes Guarantors”), which include the subsidiaries that had guaranteed (collectively, the “Former New Secured Group Guarantors”) K. Hovnanian’s 9.50% Notes, 2.000% Notes and 5.000% Notes (each as defined under below). As a result of the 2019 Transactions (as defined in and described under below), K. Hovnanian’s obligations under the Credit Facilities, the senior secured notes and senior notes are guaranteed by the Notes Guarantors (including the Former New Secured Group Guarantors) and, in the case of the Secured Credit Facility and the senior secured notes, will be secured in accordance with the terms of the applicable Debt Instrument by substantially all of the assets owned by K. Hovnanian and the Notes Guarantors (including the assets owned by the Former New Secured Group Guarantors), subject to permitted liens and certain exceptions. The credit agreements governing the Credit Facilities and the indentures governing the senior secured and senior notes (together, the “Debt Instruments”) outstanding at October 31, 2019 do not contain any financial maintenance covenants, but do contain restrictive covenants that limit, among other things, the Company’s ability and that of certain of its subsidiaries, including K. Hovnanian, to incur additional indebtedness (other than non-recourse indebtedness, certain permitted indebtedness and refinancing indebtedness), pay dividends and make distributions on common and preferred stock, repay certain indebtedness prior to its respective stated maturity, repurchase common and preferred stock, make other restricted payments (including investments), sell certain assets (including in certain land banking transactions), incur liens, consolidate, merge, sell or otherwise dispose of all or substantially all of their assets and enter into certain transactions with affiliates. The Debt Instruments also contain customary events of default which would permit the lenders or holders thereof to exercise remedies with respect to the collateral (as applicable), declare the loans made under the Term Loan Facility (defined below) (the “Term Loans”) and loans made under the Secured Credit Agreement (as defined below) (the “Secured Revolving Loans”) or notes to be immediately due and payable if not cured within applicable grace periods, including the failure to make timely payments on the Term Loans, Secured Revolving Loans or notes or other material indebtedness, cross default to other material indebtedness, the failure to comply with agreements and covenants and specified events of bankruptcy and insolvency, with respect to the Term Loans and Secured Revolving Loans, material inaccuracy of representations and warranties and with respect to the Term Loans and Secured Revolving Loans, a change of control, and, with respect to the Secured Revolving Loans and senior secured notes, the failure of the documents granting security for the Secured Revolving Loans and senior secured notes to be in full force and effect, and the failure of the liens on any material portion of the collateral securing the Secured Revolving Loans and senior secured notes to be valid and perfected. As of October 31, 2019, we believe we were in compliance with the covenants of the Debt Instruments. If our consolidated fixed charge coverage ratio is less than 2.0 to 1.0, as defined in the applicable Debt Instrument, we are restricted from making certain payments, including dividends, and from incurring indebtedness other than certain permitted indebtedness, refinancing indebtedness and nonrecourse indebtedness. As a result of this ratio restriction, we are currently restricted from paying dividends (in the case of the payment of dividends on preferred stock, our secured debt leverage ratio must also be less than 4.0 to 1.0), which are not cumulative, on our 7.625% Series A Preferred Stock. We anticipate that we will continue to be restricted from paying dividends for the foreseeable future. Our inability to pay dividends is in accordance with covenant restrictions and will not result in a default under our Debt Instruments or otherwise affect compliance with any of the covenants contained in our Debt Instruments. Under the terms of our Debt Instruments, we have the right to make certain redemptions and prepayments and, depending on market conditions and covenant restrictions, may do so from time to time. We also continue to actively analyze and evaluate our capital structure and explore transactions to simplify our capital structure and to strengthen our balance sheet, including those that reduce leverage and/or extend maturities, and will seek to do so with the right opportunity. We may also continue to make debt purchases and/or exchanges for debt or equity from time to time through tender offers, exchange offers, open market purchases, private transactions, or otherwise, or seek to raise additional debt or equity capital, depending on market conditions and covenant restrictions. On January 15, 2019, pursuant to a Commitment Letter, the Company issued $25.0 million in aggregate principal amount of the Additional 10.5% 2024 Notes to certain funds managed, advised or sub-advised by GSO at a discount for a purchase price of $21.3 million in cash. The Additional 10.5% 2024 Notes were issued as additional notes of the same series as the 10.5% 2024 Notes. On October 31, 2019, K. Hovnanian, the Company, the Notes Guarantors, Wilmington Trust, National Association, as administrative agent, and affiliates of certain investment managers (the “Investors”), as lenders, entered into a credit agreement (the “Secured Credit Agreement”) providing for up to $125.0 million in aggregate amount of Secured Revolving Loans to be used for general corporate purposes, upon the terms and subject to the conditions set forth therein. Secured Revolving Loans are to be borrowed by K. Hovnanian and guaranteed by the Notes Guarantors. Availability under the Secured Credit Agreement will terminate on December 28, 2022 and the Secured Revolving Loans will bear interest at a rate per annum equal to 7.75%, and interest will be payable in arrears, on the last business day of each fiscal quarter. In connection with the entering into of the Secured Credit Agreement, K. Hovnanian terminated its then existing Secured Credit Facility. On October 31, 2019, K. Hovnanian completed private placements of senior secured notes as follows: (i) K. Hovnanian issued an aggregate of $350.0 million of 7.75% Senior Secured 1.125 Lien Notes due 2026 (the “1.125 Lien Notes”) in part pursuant to a Note Purchase Agreement, dated October 31, 2019, among K. Hovnanian, the Notes Guarantors and certain Investors as purchasers thereof (the “1.125 Lien Notes Purchase Agreement”) and in part pursuant to the Exchange Agreement (as defined below), with the proceeds from the sale of 1.125 Lien Notes under the 1.125 Lien Notes Purchase Agreement used to fund the cash payments to certain Exchanging Holders (as defined below) under the Exchange Agreement; and (ii) K. Hovnanian issued an aggregate of $282.3 million of 10.5% Senior Secured 1.25 Lien Notes due 2026 (the “1.25 Lien Notes”), pursuant to a Note Purchase Agreement (the “1.25 Lien Notes Purchase Agreement”), dated October 31, 2019, among K. Hovnanian, the Notes Guarantors and certain Investors as purchasers thereof (the “1.25 Lien Notes Purchasers”), the proceeds of which were used to fund the Satisfaction and Discharge (as defined below). In addition, on October 31, 2019, K. Hovnanian completed private exchanges of (i) approximately $221.0 million aggregate principal amount of its 10.0% Senior Secured Notes due 2022 (the “10.0% 2022 Notes”) and approximately $114.0 million aggregate principal amount of its 10.5% Senior Secured Notes due 2024 (the “10.5% 2024 Notes” and, together with the 10.0% 2022 Notes, the “Second Lien Notes”) held by certain participating bondholders (the “Exchanging Holders”) for a portion of the $350.0 million aggregate principal amount of 1.125 Lien Notes described above and/or cash, and (ii) approximately $99.6 million aggregate principal amount of its 10.5% 2024 Notes held by certain of the Exchanging Holders for approximately $103.1 million aggregate principal amount of 11.25% Senior Secured 1.5 Lien Notes due 2026 (the “1.5 Lien Notes” and, together with the 1.125 Lien Notes and the 1.25 Lien Notes, the “New Secured Notes”), pursuant to an Exchange Agreement, dated October 30, 2019 (the “Exchange Agreement”), among K. Hovnanian, the Notes Guarantors and the Exchanging Holders. On October 31, 2019, K. Hovnanian issued notices of redemption for all of its outstanding 9.50% Senior Secured Notes due 2020 (the “9.50% Notes”), 2.000% Senior Secured Notes due 2021 (the “2.000% Notes”) and 5.000% Senior Secured Notes due 2021 (the “5.000% Notes”) and deposited with Wilmington Trust, National Association, as trustee under the indenture (the “9.50% Notes Indenture”) governing the 9.50% Notes and as trustee under the indenture (the “5.000%/2.000% Notes Indenture”) governing the 5.000% Notes and the 2.000% Notes sufficient funds to satisfy and discharge (collectively, the “Satisfaction and Discharge”) (i) the 9.50% Indenture and to fund the redemption of all outstanding 9.50% Notes and to pay accrued and unpaid interest on the redeemed notes to, but not including, the November 10, 2019 redemption date and (ii) the 5.000%/2.000% Indenture and to fund the redemption of all outstanding 5.000% Notes and 2.000% Notes and to pay accrued and unpaid interest on the redeemed notes to, but not including, the November 30, 2019 redemption date. Proceeds from the issuance of the 1.25 Lien Notes together with cash on hand were used to fund the Satisfaction and Discharge. Upon the Satisfaction and Discharge of the 9.50% Notes Indenture, all of the collateral securing the 9.50% Notes was released and the restrictive covenants and events of default contained therein ceased to have effect and upon the Satisfaction and Discharge of the 5.000%/2.000% Notes Indenture, all of the collateral securing the 5.000% Notes and the 2.000% Notes was released and the restrictive covenants and events of default contained therein ceased to have effect as to both such series of Notes. The Company and K. Hovnanian obtained the consent of certain lenders/holders under its existing debt instruments to amend such debt instruments in connection with the issuance of the New Secured Notes and the execution of the indentures governing the New Secured Notes and the Secured Credit Agreement. The Company, K. Hovnanian and the guarantors also amended such debt instruments to add the Former New Secured Group Guarantors as guarantors thereunder and, in the case of the Second Lien Notes, to add the Former New Secured Group Guarantors as pledgors and grantors of their assets (subject to permitted liens and certain exceptions) to secure such Second Lien Notes. The transactions that were consummated on October 31, 2019, as described, are collectively referred to herein as the “2019 Transactions.” The 2019 Transactions resulted in a loss in extinguishment of debt of $42.4 million for the year ended October 31, 2019 which is included as “Loss on Extinguishment of Debt” on the Consolidated Statement of Operations. See Note 9 to the Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for a further discussion of K. Hovnanian’s Credit Facilities, senior secured notes and senior notes. Mortgages and Notes Payable We have nonrecourse mortgage loans for certain communities totaling $203.6 million and $95.6 million (net of debt issuance costs) at October 31, 2019 and October 31, 2018, respectively, which are secured by the related real property, including any improvements, with an aggregate book value of $410.2 million and $241.9 million, respectively. The weighted-average interest rate on these obligations was 8.3% and 6.1% at October 31, 2019 and October 31, 2018, respectively, and the mortgage loan payments on each community primarily correspond to home deliveries. Our wholly owned mortgage banking subsidiary, K. Hovnanian American Mortgage, LLC (“K. Hovnanian Mortgage”), originates mortgage loans primarily from the sale of our homes. Such mortgage loans and related servicing rights are sold in the secondary mortgage market within a short period of time. In certain instances, we retain the servicing rights for a small amount of loans. The loans are secured by the mortgages held for sale and repaid when we sell the underlying mortgage loans to permanent investors. As of October 31, 2019 and 2018, we had an aggregate of $140.2 million and $113.2 million, respectively, outstanding under several of K. Hovnanian Mortgage’s short-term borrowing facilities. See Note 8 to the Consolidated Financial Statements for a discussion of these agreements and facilities. Equity On July 3, 2001, our Board of Directors authorized a stock repurchase program to purchase up to 0.2 million shares of Class A Common Stock. We did not repurchase any shares under this program during fiscal 2019 or 2018. As of October 31, 2019, the maximum number of shares of Class A Common Stock that may yet be purchased under this program is 22 thousand. (See Part II, Item 5 for information on equity purchases). On July 12, 2005, we issued 5,600 shares of 7.625% Series A Preferred Stock, with a liquidation preference of $25,000 per share. Dividends on the Series A Preferred Stock are not cumulative and are payable at an annual rate of 7.625%. The Series A Preferred Stock is not convertible into the Company’s common stock and is redeemable in whole or in part at our option at the liquidation preference of the shares. The Series A Preferred Stock is traded as depositary shares, with each depositary share representing 1/1000th of a share of Series A Preferred Stock. The depositary shares are listed on the NASDAQ Global Market under the symbol “HOVNP.” In fiscal 2019, 2018 and 2017, we did not make any dividend payments on the Series A Preferred Stock as a result of covenant restrictions in our debt instruments. Certain debt instruments to which we are a party contain restrictions on the payment of cash dividends. As a result of the most restrictive of these provisions, we are not currently able to pay any cash dividends. We have never paid a cash dividend to common stockholders. We anticipate that we will continue to be restricted from paying dividends, which are not cumulative, for the foreseeable future. On October 31, 2019, in connection with the issuance of the 7.75% Senior Secured 1.25 Lien Notes due 2026, we issued and sold an aggregate of 178,427 shares of Class A Common Stock, par value $0.01 per share (and associated Preferred Stock Purchase Rights), to the purchasers of such Notes for an aggregate purchase price of $1,784.27. The issuance was exempt from registration under Section 4(a)(2) of the Securities Act of 1933. Inventory Activities Total inventory, excluding consolidated inventory not owned, increased $111.9 million during the year ended October 31, 2019 from October 31, 2018. Total inventory, excluding consolidated inventory not owned, increased in the Northeast by $12.6 million, in the Mid-Atlantic by $46.5 million, in the Midwest by $9.7 million, in the Southeast by $3.8 million, in the Southwest by $7.5 million and in the West by $31.8 million. These inventory fluctuations were primarily attributable to new land purchases and land development, partially offset by home deliveries and land sales during the period. During the year ended October 31, 2019, we had aggregate impairments in the amount of $2.7 million. We wrote-off costs in the aggregate amount of $3.6 million during the year ended October 31, 2019 related to land options that expired or that we terminated, as the communities’ forecasted profitability was not projected to produce adequate returns on investment commensurate with the risk. In the last few years, we have been able to acquire new land parcels at prices that we believe will generate reasonable returns under current homebuilding market conditions. There can be no assurances that this trend will continue in the near term. Substantially all homes under construction or completed and included in inventory at October 31, 2019 are expected to be closed during the next six to nine months. Consolidated inventory not owned increased $102.4 million. Consolidated inventory not owned consists of options related to land banking and model financing transactions that were added to our Consolidated Balance Sheets in accordance with US GAAP. The increase from October 31, 2018 to October 31, 2019 was primarily due to an increase in land banking transactions along with an increase in the sale and leaseback of certain model homes during the period. We have land banking arrangements, whereby we sell land parcels to the land bankers and they provide us an option to purchase back finished lots on a predetermined schedule. Because of our options to repurchase these parcels, for accounting purposes in accordance with ASC 606-10-55-70, these transactions are considered a financing rather than a sale. For purposes of our Consolidated Balance Sheet, at October 31, 2019, inventory of $136.1 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $89.8 million (net of debt issuance costs) recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. In addition, we sell and lease back certain of our model homes with the right to participate in the potential profit when each home is sold to a third party at the end of the respective lease. As a result of our continued involvement, for accounting purposes in accordance with ASC 606-10-55-68, these sale and leaseback transactions are considered a financing rather than a sale. Therefore, for purposes of our Consolidated Balance Sheet, at October 31, 2019, inventory of $54.2 million was recorded to “Consolidated inventory not owned,” with a corresponding amount of $51.2 million (net of debt issuance costs) recorded to “Liabilities from inventory not owned” for the amount of net cash received from the transactions. When possible, we option property for development prior to acquisition. By optioning property, we are only subject to the loss of the cost of the option and predevelopment costs if we choose not to exercise the option. As a result, our commitment for major land acquisitions is reduced. The costs associated with optioned properties are included in “Land and land options held for future development or sale” on the Consolidated Balance Sheets. Also included in “Land and land options held for future development or sale” are amounts associated with inventory in mothballed communities. We mothball (or stop development on) certain communities when we determine the current performance does not justify further investment at the time. That is, we believe we will generate higher returns if we decide against spending money to improve land today and save the raw land until such time as the markets improve or we determine to sell the property. As of October 31, 2019, we had mothballed land in 13 communities. The book value associated with these communities at October 31, 2019 was $13.8 million, which was net of impairment charges recorded in prior periods of $138.1 million. We continually review communities to determine if mothballing is appropriate. During fiscal 2019, we did not mothball any additional communities, but we sold two previously mothballed communities and re-activated three previously mothballed communities. Inventories held for sale, which are land parcels where we have decided not to build homes, and are actively marketing the land for sale, represented $6.4 million of our total inventories at October 31, 2018, and are reported at the lower of carrying amount or fair value less costs to sell. There were no inventories held for sale at October 31, 2019. In determining fair value for land held for sale, management considers, among other things, prices for land in recent comparable sale transactions, market analysis studies, which include the estimated price a willing buyer would pay for the land (other than in a forced liquidation sale) and recent bona fide offers received from outside third parties. The following tables summarize home sites included in our total residential real estate. The following table summarizes our started or completed unsold homes and models, excluding unconsolidated joint ventures, in active and substantially completed communities. The increase in the total homes from October 31, 2018 to October 31, 2019 is primarily due to the increase in community count during the period, along with a planned increase of additional unsold homes in certain markets to take advantage of increased sales pace. (1) Active selling communities (which are communities that are open for sale with ten or more home sites available) were 141 and 123 at October 31, 2019 and 2018, respectively. This ratio does not include substantially completed communities, which are communities with less than ten home sites available. Other Balance Sheet Activities Homebuilding - Restricted cash and cash equivalents increased $8.1 million from October 31, 2018 to $20.9 million at October 31, 2019. The increase was primarily due to cash collateral for new letters of credit issued during the period. Investments in and advances to unconsolidated joint ventures increased $3.3 million during the fiscal year ended October 31, 2019 compared to October 31, 2018. The increase was primarily due to the income from two of our joint ventures during fiscal 2019, along with new capital contributions for existing joint ventures and a new joint venture during fiscal 2019, partially offset by a note receivable from one of our joint ventures that was paid off the fourth quarter of fiscal 2019, along with partner distributions during the period. As of October 31, 2019 and October 31, 2018, we had investments in ten and nine unconsolidated homebuilding joint ventures, respectively, and one unconsolidated land development joint venture for both periods. We have no guarantees associated with our unconsolidated joint ventures, other than guarantees limited only to performance and completion of development, environmental indemnification and standard warranty and representation against fraud, misrepresentation and similar actions, including a voluntary bankruptcy. Receivables, deposits and notes, net increased $9.7 million from October 31, 2018 to $44.9 million at October 31, 2019. The increase was primarily due to an increase in receivables for reimbursements of expenditures in connection with certain structured lot option agreements, along with increased receivables related to the timing of home closings during the period, as well as a new insurance receivable for premium adjustments and a new receivable related to the funding of the Satisfaction and Discharge as described under “ - Capital Resources and Liquidity”. These increases were partially offset by a decrease related the return of a municipal receivable during the period. Prepaid expenses and other assets were as follows as of: Prepaid insurance decreased slightly due to the timing of premium payments. These costs are amortized over the life of the associated insurance policy, which can be one to three years. Prepaid project costs consist of community specific expenditures that are used over the life of the community. Such prepaids are expensed as homes are delivered, and therefore have increased as our community count has increased. Other prepaids increased primarily due to costs associated with the refinancing of our senior secured revolving credit facility in the fourth quarter of fiscal 2019. Financial services assets consist primarily of residential mortgages receivable held for sale of which $163.0 million and $129.0 million at October 31, 2019 and 2018, respectively, were being temporarily warehoused and are awaiting sale in the secondary mortgage market. The increase in mortgage loans held for sale from October 31, 2018 was primarily related to an increase in the volume of loans originated during the fourth quarter of 2019 compared to the fourth quarter of 2018, partially offset by a decrease in the average loan value. Nonrecourse mortgages secured by inventory increased to $203.6 million at October 31, 2019, from $95.6 million at October 31, 2018. The increase was primarily due to a new mortgage on several communities that are part of a consolidated joint venture entered into in the second quarter of fiscal 2019, along with new mortgages for other communities in most of our segments obtained during fiscal 2019, as well as additional loan borrowings on existing mortgages, partially offset by the payment of existing mortgages during the period. Accounts payable and other liabilities are as follows as of: The increase in accounts payable was primarily due to the increase in deliveries in the fourth quarter of fiscal 2019 as compared to the fourth quarter of fiscal 2018. Reserves decreased during the period, primarily due to a reduction in our construction defect reserves in connection with our annual assessment as our loss experience has continued to improve over the past few years. Accrued expenses increased primarily due to accruals for legal fees associated with the 2019 Transactions (as previously defined). Other liabilities increased primarily due to several new municipal loans and bonds for land development issued during the period. Customers’ deposits increased $5.8 million from October 31, 2018 to $35.9 million at October 31, 2019. The increase was primarily related to the increase in backlog during the year. Liabilities from inventory not owned increased $77.6 million to $141.0 million at October 31, 2019. The increase was due an increase in land banking transactions during the period, along with an increase in the sale and leaseback of certain model homes, both of which are accounted for as financing transactions as described above. Accrued interest decreased $16.5 million to $19.1 million at October 31, 2019. The decrease was primarily due to interest payments made on debt in connection with the 2019 Transactions (as previously defined) during the fourth quarter of fiscal 2019. Financial Services (liabilities) increased $25.7 million from $143.4 million at October 31, 2018, to $169.1 million at October 31, 2019. The increase is primarily due to an increase in amounts outstanding under our mortgage warehouse lines of credit, and directly correlates to the increase in the volume of mortgage loans held for sale during the period. Results of Operations Total Revenues Compared to the prior period, revenues increased (decreased) as follows: Homebuilding Sale of homes revenues increased $43.5 million, or 2.3%, for the year ended October 31, 2019, decreased $433.8 million, or 18.5%, for the year ended October 31, 2018, and decreased $260.8 million, or 10.0%, for the year ended October 31, 2017 as compared to the same period of the prior year. The increased revenues in fiscal 2019 were primarily due to the number of home deliveries increasing 2.0%, and the average price per home increasing to $394,194 in fiscal 2019 from $393,280 in fiscal 2018. The increase in deliveries in fiscal 2019 were primarily due to the result of an increase in community count in fiscal 2019 as compared to fiscal 2018 of 14.6%. The decreased revenues in fiscal 2018 were primarily due to the number of home deliveries decreasing 13.5% and the average price per home decreasing to $393,280 in fiscal 2018 from $417,714 in fiscal 2017. The decreased revenues in fiscal 2017 were primarily due to the number of home deliveries decreasing 13.3%, partially offset by the average price per home increasing to $417,714 in fiscal 2017 from $402,350 in fiscal 2016. The decrease in fiscal 2018 and 2017 deliveries were primarily the result of a reduction in community count by 5.4% and 22.2%, respectively. The fluctuations in average prices for fiscal 2019, 2018, and 2017 were primarily the result of geographic and community mix of our deliveries. For fiscal 2018, there were also home price decreases (which we increase or decrease in communities depending on the respective community’s performance), partially offset by price increases in some communities primarily in the West. For fiscal 2017, we were also able to raise home prices in certain communities. For further detail on changes in segment revenues see “Homebuilding Operations by Segment” below. For further detail on land sales and other revenue, see the section titled “Land Sales and Other Revenues” below. Information on homes delivered by segment is set forth below: (1) Represents housing revenue and home deliveries for our unconsolidated homebuilding joint ventures for the period. We provide this data as a supplement to our consolidated results as an indicator of the volume managed in our unconsolidated joint ventures. See Note 20 to the Consolidated Financial Statements for a further discussion of our joint ventures. The increase in housing revenues during year ended October 31, 2019, as compared to year ended October 31, 2018, was primarily attributed to our increased deliveries, as our community count has increased year over year, and by the increase in average sales price. Housing revenues in fiscal 2019 increased in all of our homebuilding segments combined by 2.3%, and average sales price increased by 0.2%, excluding unconsolidated joint ventures. In our homebuilding segments, homes delivered increased in fiscal 2019 as compared to fiscal 2018 by 7.9%, 2.7% and 16.7% in the Northeast, Midwest and West, respectively, and decreased by 3.0%, 8.6% and 0.4% in the Mid-Atlantic, Southeast and Southwest, respectively. Overall in fiscal 2019 as compared to fiscal 2018 homes delivered increased 2.0% across all our segments, excluding unconsolidated joint ventures. The decrease in housing revenues during year ended October 31, 2018, as compared to year ended October 31, 2017, was primarily attributed to our decreased deliveries, as our community count decreased year over year, and by the decrease in average sales price. Housing revenues in fiscal 2018 decreased in all of our homebuilding segments combined by 18.5%, and average sales price decreased by 5.8%, excluding unconsolidated joint ventures. In our homebuilding segments, homes delivered decreased in fiscal 2018 as compared to fiscal 2017 by 49.3%, 21.5%, 2.9% and 20.5% in the Northeast, Mid-Atlantic, Southeast and Southwest, respectively, and increased by 3.4% and 10.5% in the Midwest and West, respectively. Overall in fiscal 2018 as compared to fiscal 2017 homes delivered decreased 13.5% across all our segments, excluding unconsolidated joint ventures. Quarterly housing revenues and net sales contracts by segment, excluding unconsolidated joint ventures, for the years ended October 31, 2019, 2018 and 2017 are set forth below (net contracts are defined as new contracts executed during the period for the purchase of homes, less cancellations of contracts in the same period): Contracts per average active selling community in fiscal 2019 were 39.0 compared to fiscal 2018 of 35.9. Our reported level of sales contracts (net of cancellations) has been positively impacted by an increase in community count, along with an increase in the pace of sales in most of the Company’s segments during fiscal 2019. Cancellation rates represent the number of cancelled contracts in the quarter divided by the number of gross sales contracts executed in the quarter. For comparison, the following are historical cancellation rates, excluding unconsolidated joint ventures: Another common and meaningful way to analyze our cancellation trends is to compare the number of contract cancellations as a percentage of the beginning backlog. The following table provides this historical comparison, excluding unconsolidated joint ventures. Most cancellations occur within the legal rescission period, which varies by state but is generally less than two weeks after the signing of the contract. Cancellations also occur as a result of a buyer's failure to qualify for a mortgage, which generally occurs during the first few weeks after signing. As shown in the tables above, the contract cancellations over the past several years have been within what we believe to be a normal range. However, market conditions remain uncertain and it is difficult to predict what cancellation rates will be in the future. An important indicator of our future results is recently signed contracts and our home contract backlog for future deliveries. Our consolidated contract backlog, excluding unconsolidated joint ventures, by segment is set forth below: (1) Contract backlog as of October 31, 2019 excludes 29 homes that were sold to one of our joint ventures at the time of the joint venture formation. Contract backlog dollars increased 18.0% as of October 31, 2019 compared to October 31, 2018, and the number of homes in backlog increased 20.0% for the same period. The increase in backlog was driven by a 14.3% increase in net contracts and the increase in community count for the year ended October 31, 2019 compared to the prior fiscal year. In the month of November 2019, excluding unconsolidated joint ventures, we signed an additional 404 net contracts amounting to $159.1 million in contract value. Total cost of sales on our Consolidated Statements of Operations includes expenses for consolidated housing and land and lot sales, including inventory impairment loss and land option write-offs (defined as “land charges” in the tables below). A breakout of such expenses for housing sales and homebuilding gross margin is set forth below. Homebuilding gross margin before cost of sales interest expense and land charges is a non-GAAP financial measure. This measure should not be considered as an alternative to homebuilding gross margin determined in accordance with GAAP as an indicator of operating performance. Management believes this non-GAAP measure enables investors to better understand our operating performance. This measure is also useful internally, helping management evaluate our operating results on a consolidated basis and relative to other companies in our industry. In particular, the magnitude and volatility of land charges for the Company, and for other homebuilders, have been significant and, as such, have made financial analysis of our industry more difficult. Homebuilding metrics excluding land charges, as well as interest amortized to cost of sales, and other similar presentations prepared by analysts and other companies are frequently used to assist investors in understanding and comparing the operating characteristics of homebuilding activities by eliminating many of the differences in companies’ respective level of impairments and levels of debt. Cost of sales expenses as a percentage of consolidated home sales revenues are presented below: We sell a variety of home types in various communities, each yielding a different gross margin. As a result, depending on the mix of communities delivering homes, consolidated gross margin may fluctuate up or down. Total homebuilding gross margin percentage decreased to 14.2% for the year ended October 31, 2019 compared to 15.2% for the same period last year. This decrease was primarily due to the increase in cost of sales interest as previously discussed in “ - Overview.” Also contributing to the decrease is the mix of communities delivering compared to the same period of the prior year, along with a slight increase in direct costs and financing concessions. Total homebuilding gross margin percentage increased to 15.2% for the year ended October 31, 2018 compared to 13.2% for the same period of the prior year. This increase was primarily due to the mix of communities delivering homes and the reduction of our warranty reserves, as a result of our annual analysis performed in the fourth quarter of each year, along with a $6.3 million benefit from a one-time credit related to a land development reimbursement from a municipality in California. For the years ended October 31, 2019, 2018 and 2017, gross margin was favorably impacted by the reversal of prior period inventory impairments of $37.7 million, $51.7 million and $74.4 million, respectively, which represented 1.9%, 2.7% and 3.2%, respectively, of “Sale of homes” revenue. Reflected as inventory impairment loss and land option write-offs in cost of sales (“land charges”), we have written off or written down certain inventories totaling $6.3 million, $3.5 million and $17.8 million during the years ended October 31, 2019, 2018 and 2017, respectively, to their estimated fair value. See Note 12 to the Consolidated Financial Statements for an additional discussion. During the years ended October 31, 2019, 2018 and 2017, we wrote off residential land options and approval and engineering costs totaling $3.6 million, $1.4 million and $2.7 million, respectively, which are included in the total land charges mentioned above. Option, approval and engineering costs are written off when a community’s pro forma profitability is not projected to produce adequate returns on the investment commensurate with the risk and when we believe it is probable we will cancel the option, or when a community is redesigned engineering costs related to the initial design are written off. Such write-offs were located in all segments in fiscal 2019, 2018 and 2017. The inventory impairments amounted to $2.7 million, $2.1 million and $15.1 million for the years ended October 31, 2019, 2018 and 2017, respectively. It is difficult to predict impairment levels, and should it become necessary or desirable to have additional land sales, further lower prices, or should the estimates or expectations used in determining estimated cash flows or fair value decrease or differ from current estimates in the future, we may need to recognize additional impairments. Below is a breakdown of our lot option walk-aways and impairments by segment for fiscal 2019. In fiscal 2019, we walked away from 22.3% of all the lots we controlled under option contracts. The remaining 77.7% of our option lots are in communities that we believe remain economically feasible. The following table represents lot option walk-aways by segment for the year ended October 31, 2019: (1) Includes lots optioned at October 31, 2019 and lots optioned that the Company walked away from in the year ended October 31, 2019. The following table represents impairments by segment for the year ended October 31, 2019: (1) Represents carrying value, net of prior period impairments, if any, at the time of recording the applicable period’s impairments. Land Sales and Other Revenues Land sales and other revenues consist primarily of land and lot sales. A breakout of land and lot sales is set forth below: Land sales are ancillary to our residential homebuilding operations and are expected to continue in the future but may significantly fluctuate up or down. Although we budget land sales, they are often dependent upon receiving approvals and entitlements, the timing of which can be uncertain. As a result, projecting the amount and timing of land sales is difficult. There were six land sales in the year ended October 31, 2019, compared to four in the same period of the prior year, resulting in a $15.1 million decrease in land sales revenue. Despite an increase in the number of land sales in fiscal 2019, there was a significant land sale in the Northeast segment in fiscal 2018 which resulted in the decrease in land sales revenue during fiscal 2019. There were four land sales in the year ended October 31, 2018, compared to ten in the same period of the prior year, resulting in a $24.3 million decrease in land sales revenue. Land sales and other revenues decreased $18.6 million for the year ended October 31, 2019 and decreased $21.2 million for the year ended October 31, 2018 compared to the same periods in the prior year. Other revenues include income from contract cancellations where the deposit has been forfeited due to contract terminations, interest income, cash discounts and miscellaneous one-time receipts. The decrease from fiscal 2018 to fiscal 2019 and the decrease from fiscal 2017 to fiscal 2018 was mainly due to the fluctuations in land sales revenue noted above. Slightly offsetting the decrease from fiscal 2017 to fiscal 2018 was the gain recognized from the sale of our former corporate headquarters building in the first quarter of fiscal 2018. Homebuilding Selling, General and Administrative Homebuilding selling, general and administrative (“SGA”) expenses increased $7.6 million to $166.8 million for the year ended October 31, 2019 as compared to the year ended October 31, 2018. The increase was primarily related to a decrease of joint venture management fees received of $4.2 million, which offset general and administrative expenses, as a result of less unconsolidated joint venture deliveries, and $3.3 million less of a reduction of our construction defect reserves (a $6.9 million reduction in fiscal 2019 as compared to $10.2 million reduction in fiscal 2018) based on our annual actuarial analysis. SGA decreased $37.1 million to $159.2 million for the year ended October 31, 2018 as compared to the year ended October 31, 2017. The decrease was primarily related to a $10.2 million reduction in our construction defect reserves based on our annual actuarial analysis, along with a $2.3 million reduction for a litigation settlement, and $12.5 million of additional reserves recorded in fiscal 2017 related to the Grandview II litigation. The remaining decrease is due to the reduction of our community count, a decrease in insurance costs and the increase of joint venture management fees received, which offset general and administrative expenses, as a result of more joint venture deliveries. Homebuilding Operations by Segment Financial information relating to the Company’s operations was as follows: Segment Analysis (Dollars in thousands, except average sales price) Homebuilding Results by Segment Northeast - Homebuilding revenues increased 6.9% in fiscal 2019 compared to fiscal 2018 primarily due to a 7.9% increase in homes delivered and a 12.9% increase in average selling price, partially offset by a $12.8 million decrease in land sales and other revenue. The increase in average sales price was the result of new communities delivering higher priced, larger single family homes and townhomes in higher-end submarkets of the segment in fiscal 2019 compared to certain communities delivering in fiscal 2018 that had lower priced, single family homes and townhomes in lower-end submarkets of the segment that are no longer delivering. Income before income taxes increased $0.1 million to $21.0 million, which was mainly due to the increase in homebuilding revenues discussed above and the increase in gross margin percentage before interest expense for fiscal 2019 compared to fiscal 2018. This increase was partially offset by a $1.0 million decrease in income from unconsolidated joint ventures and a $0.5 million increase in selling, general and administrative costs for fiscal 2019 compared to fiscal 2018. Homebuilding revenues decreased 44.5% in fiscal 2018 compared to fiscal 2017 primarily due to a 49.3% decrease in homes delivered, partially offset by a 13.5% increase in average selling price. The increase in average sales price was the result of some new communities delivering higher priced single family homes in higher-end submarkets of the segment in fiscal 2018 compared to certain communities delivering in fiscal 2017 that had lower priced single family homes in similar submarkets of the segment that are no longer delivering. Also impacting the increase in average sales price was higher option revenue and location premiums and the result of our ability to raise prices in fiscal 2018 in certain communities that were delivering homes during both periods. Income before income taxes increased $18.6 million to $20.9 million, which was mainly due a $24.6 million improvement in loss from unconsolidated joint ventures to income, along with a $10.6 million decrease in selling, general and administrative costs and a $2.8 million decrease in inventory impairment loss and land option write-offs. The increase was partially offset by the decrease in homebuilding revenues discussed above and the decrease in gross margin percentage before interest expense for fiscal 2018 compared to fiscal 2017. Mid-Atlantic - Homebuilding revenues increased 0.7% in fiscal 2019 compared to fiscal 2018 primarily due to a 3.8% increase in average sales price, partially offset by a 3.0% decrease in homes delivered. The increase in average sales price was the result of new communities delivering higher priced, larger single family homes in higher-end submarkets of the segment in fiscal 2019 compared to certain communities delivering in fiscal 2018 that had lower priced, single family homes and townhomes in mid to higher-end submarkets of the segment that are no longer delivering. Income before income taxes decreased $4.4 million to $14.3 million, due mainly to a $0.6 million increase in inventory impairment loss and land option write-offs and a slight decrease in gross margin percentage before interest expense for fiscal 2019 compared to fiscal 2018. Homebuilding revenues decreased 23.6% in fiscal 2018 compared to fiscal 2017 primarily due to a 21.5% decrease in homes delivered and a 2.6% decrease in average sales price. The decrease in average sales price was the result of new communities delivering lower priced, smaller single family homes in lower-end submarkets of the segment in fiscal 2018 compared to certain communities delivering in fiscal 2017 that had higher priced, larger single family homes in higher-end submarkets of the segment that are no longer delivering. Income before income taxes increased $1.6 million to $18.8 million, due mainly to a $2.3 million decrease in selling, general and administrative costs and a $1.9 million decrease in inventory impairment loss and land option write-offs and a slight increase in gross margin percentage before interest expense for fiscal 2018 compared to fiscal 2017. Midwest - Homebuilding revenues increased 4.0% in fiscal 2019 compared to fiscal 2018 primarily due to a 2.7% increase in homes delivered and a 1.0% increase in average sales price. The increase in average sales price was the result of new communities delivering higher priced, larger single family homes in higher-end submarkets of the segment in fiscal 2019 compared to certain communities delivering in fiscal 2018 that had lower priced, smaller single family homes in lower-end submarkets of the segment that are no longer delivering. Also impacting the increase in average sales price was higher option revenue in certain communities. Income before taxes decreased $2.2 million to a loss of $0.6 million. The decrease was primarily due to a $2.0 million increase in selling, general and administrative costs and a $2.1 million increase in inventory impairment loss and land option write-offs, while gross margin percentage before interest expense was flat for fiscal 2019 compared to fiscal 2018. Homebuilding revenues decreased 1.6% in fiscal 2018 compared to fiscal 2017. There was a 4.6% decrease in average sales price, partially offset by a 3.4% increase in homes delivered. The decrease in average sales price was the result of new communities delivering lower priced, smaller single family homes in lower-end submarkets of the segment in fiscal 2018 compared to certain communities delivering in fiscal 2017 that had higher priced, larger single family homes in higher-end submarkets of the segment that are no longer delivering. Loss before income taxes improved $2.7 million to income of $1.5 million. The improvement was primarily due to a $2.7 million decrease in selling, general and administrative costs and the $0.6 million decrease in loss from unconsolidated joint ventures, partially offset by a slight decrease in gross margin percentage before interest expense. Southeast - Homebuilding revenues decreased 8.9% in fiscal 2019 compared to fiscal 2018 primarily due to an 8.6% decrease in homes delivered, partially offset by a 1.0% increase in average sales price. The increase in average sales price was the result of new communities delivering higher priced, single family homes in higher-end submarkets of the segment in fiscal 2019 compared to certain communities delivering in fiscal 2018 that had lower priced, smaller single family homes and townhomes in lower-end submarkets of the segment that are no longer delivering. Also impacting the increase in average sales price was higher option revenue in certain communities. Loss before income taxes increased $0.1 million to a loss of $10.0 million due to the decrease in homebuilding revenue discussed above and a $1.2 million increase in selling, general and administrative costs, partially offset by a $0.6 million decrease in inventory impairment loss and land option write-offs, a $3.3 million improvement in loss from unconsolidated joint ventures to income and a slight increase in gross margin percentage before interest expense for fiscal 2019 compared to fiscal 2018. Homebuilding revenues decreased 7.2% in fiscal 2018 compared to fiscal 2017. The decrease was primarily due to a 2.9% decrease in homes delivered and a 4.6% decrease in average sales price. The decrease in average sales price was the result of new communities delivering lower priced, single family homes and townhomes in lower-end submarkets of the segment in fiscal 2018 compared to some communities delivering in fiscal 2017 that had higher priced, larger single family homes and townhomes in higher-end submarkets of the segment that are no longer delivering. Loss before income taxes increased $3.7 million to a loss of $9.9 million due to the decrease in homebuilding revenue discussed above, a $1.6 million increase in selling, general and administrative costs and a $2.9 million decrease in income from unconsolidated joint ventures to a loss, partially offset by a $7.3 million decrease in inventory impairment loss and land option write-offs. Additionally, the gross margin percentage before interest expense was flat for fiscal 2018 compared to fiscal 2017. Southwest - Homebuilding revenues decreased 1.4% in fiscal 2019 compared to fiscal 2018 primarily due to a 0.4% decrease in homes delivered and a 1.3% decrease in average sales price. The decrease in average sales price was the result of new communities delivering lower priced, smaller single family homes in lower-end submarkets of the segment in fiscal 2019 compared to some communities delivering in fiscal 2018 that had higher priced, larger single family homes in higher-end submarkets of the segment that are no longer delivering. Income before income taxes decreased $16.4 million to $33.5 million in fiscal 2019 mainly due to the decrease in homebuilding revenues discussed above and a decrease in gross margin percentage before interest expense for fiscal 2019 compared to fiscal 2018, partially offset by a $2.8 million increase in income from unconsolidated joint ventures and a $1.9 million decrease in selling, general and administrative costs. Homebuilding revenues decreased 22.9% in fiscal 2018 compared to fiscal 2017 primarily due to a 20.5% decrease in homes delivered and a 2.9% decrease in average sales price. The decrease in average sales price was the result of new communities delivering lower priced, smaller single family homes in lower-end submarkets of the segment in fiscal 2018 compared to some communities delivering in fiscal 2017 that had higher priced, larger single family homes and townhomes in higher-end submarkets of the segment that are no longer delivering. Income before income taxes decreased $21.7 million to $49.9 million in fiscal 2018 mainly due to the decrease in homebuilding revenues discussed above, partially offset by a $5.5 million increase in income from unconsolidated joint ventures. Additionally, the gross margin percentage before interest expense was flat for fiscal 2018 compared to fiscal 2017. West - Homebuilding revenues increased 10.6% in fiscal 2019 compared to fiscal 2018 primarily due to a 16.7% increase in homes delivered, partially offset by a 5.2% decrease in average sales price. The decrease in average sales price was the result of new communities delivering lower priced, smaller single family homes in lower-end submarkets of the segment in fiscal 2019 compared to some communities delivering in fiscal 2018 that had higher priced, larger single family homes in higher-end submarkets of the segment that are no longer delivering. Income before income taxes decreased $8.0 million to $40.0 million in fiscal 2019 due mainly to a $4.1 million increase in selling, general and administrative costs, a $3.2 million decrease in income from unconsolidated joint ventures to a loss and a slight decrease in gross margin percentage before interest expense. Homebuilding revenues decreased 10.7% in fiscal 2018 compared to fiscal 2017 primarily due to an 18.6% decrease in average sales price and a $2.6 million decrease in land sales and other revenue, partially offset by 10.5% increase in homes delivered. The decrease in average sales price was the result of new communities delivering lower priced, single family homes in lower-end submarkets of the segment in fiscal 2018 compared to some communities delivering in fiscal 2017 that had higher priced, single family homes in higher-end submarkets of the segment that are no longer delivering. Partially offsetting the decrease in average sales price was the impact of price increases in certain communities within the segment. Income before income taxes increased $28.4 million to $48.0 million in fiscal 2018 due mainly to an increase in gross margin percentage before interest expense, along with a $3.6 million increase in income from unconsolidated joint ventures and a $1.8 million decrease in inventory impairment loss and land option write-offs. This increase in income was partially offset by a $4.7 million increase in selling, general and administrative costs. Financial Services Financial services consist primarily of originating mortgages from our home buyers, selling such mortgages in the secondary market, and title insurance activities. We use mandatory investor commitments and forward sales of MBS to hedge our mortgage-related interest rate exposure on agency and government loans. These instruments involve, to varying degrees, elements of credit and interest rate risk. Credit risk associated with MBS forward commitments and loan sales transactions is managed by limiting our counterparties to investment banks, federally regulated bank affiliates and other investors meeting our credit standards. Our risk, in the event of default by the purchaser, is the difference between the contract price and fair value of the MBS forward commitments. For the years ended October 31, 2019, 2018 and 2017, our conforming conventional loan originations as a percentage of our total loans were 65.8%, 69.8% and 69.0%, respectively. FHA/VA loans represented 29.8%, 24.6%, and 25.1%, respectively, of our total loans. The remaining 4.4%, 5.6% and 5.9% of our loan originations represent jumbo and/or USDA loans. Profits and losses relating to the sale of mortgage loans are recognized when legal control passes to the buyer of the mortgage and the sales price is collected. During the years ended October 31, 2019, 2018, and 2017, financial services provided a $17.6 million, $18.2 million and $26.4 million pretax profit, respectively. In fiscal 2019, financial services pretax profit decreased $0.6 million primarily due to the geographic mix of title company activity within each period. In fiscal 2018, financial services pretax profit decreased $8.2 million compared to fiscal 2017 due to the decrease in homebuilding deliveries, and the decrease in the basis point spread between the loans originated and the implied rate from the sale of the loans as a result of the competitive financial services market and recent increases in mortgage rates. In the market areas served by our wholly owned mortgage banking subsidiaries, 70.9%, 72.4%, and 67.8% of our noncash home buyers obtained mortgages originated by these subsidiaries during the years ended October 31, 2019, 2018, and 2017, respectively. Corporate General and Administrative Corporate general and administrative expenses include the operations at our headquarters in New Jersey. These expenses include payroll, stock compensation, legal expenses, rent and facility costs and other costs associated with our executive offices, information services, human resources, corporate accounting, training, treasury, process redesign, internal audit, national and digital marketing, construction services and administration of insurance, quality and safety. Corporate general and administrative expenses decreased $3.3 million for the year ended October 31, 2019 compared to the year ended October 31, 2018, and increased $10.3 million for the year ended October 31, 2018 compared to the year ended October 31, 2017. The decrease in expense for fiscal 2019 was due to decreased legal fees (including litigation) related to financing transactions and higher costs for ongoing litigations involving the Company during fiscal 2018 which did not recur in fiscal 2019, along with a decrease in stock compensation expense, primarily due to the cancellation of certain stock awards that did not meet their performance criteria in fiscal 2019. Also impacting the decrease for fiscal 2019 is an increase in the adjustment to reserves for self-insured medical claims, which were reduced based on claim estimates. The increase in expense for fiscal 2018 was primarily due to increased legal (including litigation) fees related to our fiscal 2018 financing transactions and higher costs for ongoing litigations involving the Company. Also contributing to the increase in corporate general and administrative expenses was rent expense incurred during the year ended October 31, 2018, related to (i) the sale and leaseback of our former corporate headquarters building for the period from November 2017 to February 2018, and (ii) our new corporate headquarters building which we moved into in February 2018. Additionally impacting the increase was an increase in stock compensation expense in fiscal 2018, as a result of lower expense in fiscal 2017, resulting from the forfeiture of compensation under our long-term incentive plan due to the retirement of a senior executive, along with the cancellation of certain stock awards that did not meet their performance criteria. Other Interest Other interest decreased $13.2 million to $90.1 million for the year ended October 31, 2019 compared to October 31, 2018, and increased $6.0 million to $103.3 million for the year ended October 31, 2018 compared to October 31, 2017. Our assets that qualify for interest capitalization (inventory under development) are less than our debt, and therefore a portion of interest not covered by qualifying assets must be directly expensed. In fiscal 2019, the decrease was due to our assets that qualify for interest capitalization increasing by more than our debt, therefore the amount of directly expensed interest decreased. In fiscal 2018, the increase was attributed to more interest incurred as a result of the senior secured notes issued in July 2017 that have a higher interest rate than the senior secured notes which they refinanced and additional amounts outstanding under the term loan facility in fiscal 2018 compared to fiscal 2017. Loss on Extinguishment of Debt As a result of the 2019 Transactions we consummated on October 31, 2019 and discussed above under “- Capital Resources and Liquidity - Debt Transactions” and under Note 9 to the Consolidated Financial Statements. We incurred a $42.4 million loss on extinguishment of debt, a majority of which was non-cash. We incurred a $7.5 million loss on extinguishment of debt during the year ended October 31, 2018 due to several financing and refinancing transactions completed in fiscal 2018 as described in Note 9 to the Consolidated Financial Statements under “ - Fiscal 2018.” We incurred a $34.9 million loss on extinguishment of debt during the year ended October 31, 2017 due to three items that occurred during fiscal 2017. First, we repurchased in open market transactions $31.5 million aggregate principal amount of Senior Notes and 6,925 senior exchangeable note units representing $6.9 million stated amount of senior exchangeable note units. The aggregate purchase price for these transactions was $30.8 million, plus accrued and unpaid interest. These transactions resulted in a gain on extinguishment of debt of $7.8 million. Second, we incurred $0.4 million of costs associated with the Senior Secured Notes issued during the fourth quarter of fiscal 2016. Third, we completed certain refinancing transactions as described in Note 9 to the Consolidated Financial Statements under “ - Fiscal 2017,” which resulted in a loss on extinguishment of debt of $42.3 million. Income (Loss) from Unconsolidated Joint Ventures Income (loss) from unconsolidated joint ventures consists of our share of the earnings or losses of our joint ventures. Income (loss) from unconsolidated joint ventures increased $4.9 million for the year ended October 31, 2019 from income of $24.0 million for the year ended October 31, 2018 to income of $28.9 million. The increase is due to our share of income from certain of our joint ventures delivering more homes resulting in increased profits for fiscal 2019 compared to fiscal 2018. Income (loss) from unconsolidated joint ventures increased $31.0 million for the year ended October 31, 2018 from a loss of $7.0 million for the year ended October 31, 2017 to income of $24.0 million. The increase is due to the recognition of our share of income from certain of our joint ventures delivering more homes and increased profits in the current fiscal year as compared to the prior fiscal year when they reported losses primarily due to startup costs. Total Taxes The total income tax expense of $2.4 million and $3.6 million for the years ended October 31, 2019 and 2018 was primarily related to state tax expense from income generated that was not offset by tax benefits in states where we fully reserve the tax benefit from net operating losses. The total income tax expense of $286.9 million for the year ended October 31, 2017 was primarily due to increasing our valuation allowance to fully reserve against our deferred tax assets (“DTAs”). In addition, the same years were also impacted by state tax expense from income generated in some states, which was not offset by tax benefits in other states that had losses for which we fully reserve the net operating losses. Deferred federal and state income tax assets primarily represent the deferred tax benefits arising from net operating loss (“NOL”) carryforwards and temporary differences between book and tax income which will be recognized in future years as an offset against future taxable income. If the combination of future years’ income (or loss) and the reversal of the timing differences results in a loss, such losses can be carried forward to future years. In accordance with ASC 740, we evaluate our deferred tax assets (“DTAs”) quarterly to determine if valuation allowances are required. ASC 740 requires that companies assess whether valuation allowances should be established based on the consideration of all available evidence using a “more likely than not” standard. As of October 31, 2019, we considered all available positive and negative evidence to determine whether, based on the weight of that evidence, our valuation allowance for our DTAs was appropriate in accordance with ASC 740. As listed in Note 11 to the Consolidated Financial Statements, in order of the weighting of each factor, is the available positive and negative evidence that we considered in determining that it is more likely than not that all of our DTAs will not be realized. In analyzing these factors, overall the negative evidence, both objective and subjective, outweighed the positive evidence. Based on this analysis, we determined that the current valuation allowance for deferred taxes of $623.2 million as of October 31, 2019, which fully reserves for our DTAs, is appropriate. Off-Balance Sheet Financing In the ordinary course of business, we enter into land and lot option purchase contracts in order to procure land or lots for the construction of homes. Lot option contracts enable us to control significant lot positions with a minimal capital investment and substantially reduce the risks associated with land ownership and development. At October 31, 2019, we had $70.0 million in option deposits in cash and letters of credit to purchase land and lots with a total purchase price of $1.3 billion. Our financial exposure is generally limited to forfeiture of the nonrefundable deposits, letters of credit and other nonrefundable amounts incurred. We have no material third-party guarantees. Unconsolidated Joint Ventures As discussed in Note 20 - Investments in Unconsolidated Joint Ventures in the Notes to Consolidated Financial Statements, we have investments in unconsolidated joint ventures in various markets where our homebuilding operations are located. Our unconsolidated joint ventures had total combined assets of $539.7 million at October 31, 2019 and $602.0 million at October 31, 2018. Our investments in unconsolidated joint ventures totaled $127.0 million at October 31, 2019 and $123.7 million at October 31, 2018. As of October 31, 2019 and 2018, our unconsolidated joint ventures had outstanding debt totaling $186.9 and $236.7 million, respectively, under separate construction loan agreements with different third-party lenders and affiliates of certain investment partners to finance their respective land development activities, with the outstanding debt secured by the corresponding underlying property and related project assets and non-recourse to us. While we and our unconsolidated joint venture partners provide certain guarantees and indemnities to the lender, we do not have a guaranty or any other obligation to repay our outstanding debt or to support the value of the collateral underlying the outstanding debt. We do not believe that our existing exposure under our guaranty and indemnity obligations related to the outstanding debt is material to our consolidated financial statements. As discussed in Note 19 - Variable Interest Entities in the Notes to Consolidated Financial Statements. We determined that none of our joint ventures at October 31, 2019 and 2018 were a variable interest entity. All our unconsolidated joint ventures were accounted for under the equity method because we did not have a controlling financial interest. Contractual Obligations The following summarizes our aggregate contractual commitments at October 31, 2019. (1) Total contractual obligations exclude our accrual for uncertain tax positions of $1.3 million recorded for financial reporting purposes as of October 31, 2019 because we were unable to make reasonable estimates as to the period of cash settlement with the respective taxing authorities. (2) Represents our senior unsecured term loan credit facility, senior secured and senior notes and other notes payable and $839.5 million of related interest payments for the life of such debt. (3) Does not include $203.6 million of nonrecourse mortgages secured by inventory. These mortgages have various maturities spread over the next two to three years and are paid off as homes are delivered. (4) Does not include the mortgage warehouse lines of credit made under our Master Repurchase Agreements. See“- Capital Resources and Liquidity.” Also does not include our $125.0 million Secured Credit Facility under which there were no borrowings outstanding as of October 31, 2019. We had outstanding letters of credit and performance bonds of $19.2 million and $202.9 million, respectively, at October 31, 2019, related principally to our obligations to local governments to construct roads and other improvements in various developments. We do not believe that any such letters of credit or bonds are likely to be drawn upon. Inflation Inflation has a long-term effect, because increasing costs of land, materials and labor result in increasing sale prices of our homes. In general, these price increases have been commensurate with the general rate of inflation in our housing markets and have not had a significant adverse effect on the sale of our homes. A significant risk faced by the housing industry generally is that rising house construction costs, including land and interest costs, will substantially outpace increases in the income of potential purchasers and therefore limit our ability to raise home sale prices, which may result in lower gross margins. Inflation has a lesser short-term effect, because we generally negotiate fixed price contracts with many, but not all, of our subcontractors and material suppliers for the construction of our homes. These prices usually are applicable for a specified number of residential buildings or for a time period of between three to twelve months. Construction costs for residential buildings represent approximately 54.0% of our homebuilding cost of sales for fiscal 2019. Safe Harbor Statement All statements in this Annual Report on Form 10-K that are not historical facts should be considered as “Forward-Looking Statements” within the meaning of the “Safe Harbor” provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such forward-looking statements include but are not limited to statements related to the Company's goals and expectations with respect to its financial results for future financial periods. Although we believe that our plans, intentions and expectations reflected in, or suggested by, such forward-looking statements are reasonable, we can give no assurance that such plans, intentions or expectations will be achieved. By their nature, forward-looking statements: (i) speak only as of the date they are made, (ii) are not guarantees of future performance or results and (iii) are subject to risks, uncertainties and assumptions that are difficult to predict or quantify. Therefore, actual results could differ materially and adversely from those forward-looking statements as result of a variety of factors. Such risks, uncertainties and other factors include, but are not limited to: ● Changes in general and local economic, industry and business conditions and impacts of a significant homebuilding downturn; ● Adverse weather and other environmental conditions and natural disasters; ● High leverage and restrictions on the Company’s operations and activities imposed by the agreements governing the Company’s outstanding indebtedness; ● Availability and terms of financing to the Company; ● The Company’s sources of liquidity; ● Changes in credit ratings; ● The seasonality of the Company’s business; ● The availability and cost of suitable land and improved lots and sufficient liquidity to invest in such land and lots; ● Shortages in, and price fluctuations of, raw materials and labor, including due to changes in trade policies, including the imposition of tariffs and duties on homebuilding materials and products and related trade disputes with and retaliatory measures taken by other countries; ● Reliance on, and the performance of, subcontractors; ● Regional and local economic factors, including dependency on certain sectors of the economy, and employment levels affecting home prices and sales activity in the markets where the Company builds homes; ● Increases in cancellations of agreements of sale; ● Fluctuations in interest rates and the availability of mortgage financing; ● Changes in tax laws affecting the after-tax costs of owning a home; ● Operations through unconsolidated joint ventures with third parties; ● Government regulation, including regulations concerning development of land, the home building, sales and customer financing processes, tax laws and the environment; ● Legal claims brought against us and not resolved in our favor, such as product liability litigation, warranty claims and claims made by mortgage investors; ● Levels of competition; ● Successful identification and integration of acquisitions; ● Significant influence of the Company’s controlling stockholders; ● Availability of net operating loss carryforwards; ● Utility shortages and outages or rate fluctuations; ● Geopolitical risks, terrorist acts and other acts of war; ● Loss of key management personnel or failure to attract qualified personnel; ● Information technology failures and data security breaches; and ● Negative publicity. Certain risks, uncertainties and other factors are described in detail in Part I, Item 1 “Business” and Part I, Item 1A “Risk Factors” in this Annual Report on Form 10-K as updated by our subsequent filings with the SEC. Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason after the date of this Annual Report on Form 10-K.

<s>[INST] Hovnanian Enterprises, Inc. (“HEI”) conducts all of its homebuilding and financial services operations through its subsidiaries (references herein to the “Company,” “we,” “us” or “our” refer to HEI and its consolidated subsidiaries and should be understood to reflect the consolidated business of HEI’s subsidiaries). Overview Our community count increased 14.6% from 123 communities at October 31, 2018 to 141 at October 31, 2019. For seven consecutive quarters through the third quarter of fiscal 2019, our total number of lots controlled increased as compared to the same period of the prior year. Although there was a slight decrease in total lots controlled of 3.2% as of October 31, 2019 as compared to October 31, 2018, the growth in lots controlled in previous quarters has led to the yearoveryear community count growth. Our strategy has been to grow through increased open for sale communities. As our recently opened communities begin delivering homes, we believe it should lead to additional delivery and revenue growth, and in turn profitability in future periods, absent adverse market factors. Our cash position has allowed us to spend $562.8 million on land purchases and land development during fiscal 2019, and still have total liquidity of $275.9 million, including $131.0 million of homebuilding cash and cash equivalents as of October 31, 2019. We continue to see opportunities to purchase land at prices that make economic sense in light of our current sales prices, sales pace and construction costs and plan to continue actively pursuing such land acquisitions. New land purchases at pricing that we believe will generate appropriate investment returns and drive greater operating efficiencies are needed to return to sustained profitability; however, we remain cautious and are carefully evaluating market conditions when pursuing new land acquisitions. Additional results for the year ended October 31, 2019 were as follows: For the year ended October 31, 2019, sale of homes revenues increased 2.3% as compared to the prior year, as a result of a 2.0% increase in deliveries, primarily due to our increased community count. Gross margin percentage decreased from 15.2% for the year ended October 31, 2018 to 14.2% for the year ended October 31, 2019. This decrease was primarily due to the increase in cost of sales interest as a result of changes in estimates of interest per home for deliveries during fiscal 2019 in connection with our semiannual community life planning process, along with a decrease due to the mix of communities delivering in each period. During this planning process, the duration of communities and timing of spending thereon could change, resulting in changes in total estimated community life capitalized interest. Estimated community life capitalized interest is writtenoff with each delivery. Gross margin percentage, before cost of sales interest expense and land charges, decreased slightly from 18.4% for the year ended October 31, 2018 to 18.1% for the year ended October 31, 2019, primarily due to the mix of communities delivering. Selling, general and administrative costs (including corporate general and administrative expenses) increased $4.3 million for the year ended October 31, 2019 as compared to the prior year, primarily as a result of our increased community count, along with a lower adjustment to our warranty reserves (as a result of our annual actuarial analysis) in fiscal 2019 as compared to fiscal 2018. However, as a percentage of total revenue, such costs remained relatively flat at 11.6% for the year ended October 31, 2019 compared to 11.5% for the year ended October 31, 2018. Active selling communities at October 31, 2019 increased 14.6% over last year, and our average active selling communities increased by 5.4% over last year. Net contracts increased 14.3% for the year ended October 31, 2019, compared to the prior year. Net contracts per [/INST] Negative. </s>

APOGEE ENTERPRISES, INC.

2015-04-29

2015-02-28

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This discussion contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All forecasts and projections in this document are “forward-looking statements,” and are based on management's current expectations or beliefs of the Company's near-term results, based on current information available pertaining to the Company, including the risk factors noted under Item 1A in this Form 10-K. From time to time, we also may provide oral and written forward-looking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by the Company. Any or all of our forward-looking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forward-looking statements made by or on behalf of the Company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to, the risks and uncertainties set forth under Item 1A in this Form 10-K. We wish to caution investors that other factors might in the future prove to be important in affecting the Company's results of operations. New factors emerge from time to time; it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Overview We are a leader in certain technologies that provide distinctive solutions for enclosing commercial buildings and framing art. The Company's four reportable segments are: Architectural Glass, Architectural Services, Architectural Framing Systems and Large-Scale Optical (LSO). • Architectural Glass segment consists of Viracon, a fabricator of coated, high-performance architectural glass for global markets. • The Architectural Services segment consists of Harmon, one of the largest U.S. full-service building glass installation and renovation companies; it designs, engineers, fabricates and installs the walls of glass, windows and other curtainwall products making up the outside skin of commercial and institutional buildings. • The Architectural Framing Systems segment companies design, engineer, fabricate and finish the aluminum frames used in customized aluminum and glass window, curtainwall, storefront and entrance systems comprising the outside skin and entrances of commercial and institutional buildings. We have aggregated four operating segments into the Architectural Framing Systems reporting segment based upon their similar products, customers, distribution methods, production processes and economic characteristics: Wausau Window and Wall Systems, a manufacturer of standard and custom aluminum window systems and curtainwall for the North American commercial construction and historical renovation markets; Tubelite, a fabricator of aluminum storefront, entrance and curtainwall products for the U.S. commercial construction industry; Alumicor, a fabricator of aluminum storefront, entrance, curtainwall and window products for the Canadian commercial construction industry; and Linetec, a paint and anodize finisher of architectural aluminum and PVC shutters for U.S. markets. • LSO segment consists of Tru Vue, a manufacturer of value-added glass and acrylic for the custom picture framing and fine art markets. The following highlights the results for fiscal 2015: • Consolidated revenues increased 21 percent over fiscal 2014, or 17 percent excluding the impact of Alumicor, and operating income was up 58 percent over last year. All four segments grew revenue and earnings. • EPS was $1.72, including a $0.22 per share impact of a 48C tax credit. Excluding this item, adjusted EPS was $1.50, up 58 percent over the prior year. • Architectural Glass segment revenues improved 18 percent over fiscal 2014 and operating income improved to $16.4 million, as compared to $3.9 million in the prior year. • The Architectural Services segment revenues increased 13 percent over fiscal 2014 and operating income improved by 66 percent. • The Architectural Framing Systems segment net sales improved 38 percent compared to fiscal 2014, or 24 percent organic growth when adjusting out the impact of Alumicor, and operating income was up 46 percent. • The LSO segment revenues increased by 8 percent over fiscal 2014 while operating income grew slightly over prior-year levels. • Consolidated backlog was $490.8 million at February 28, 2015, up 49 percent over the fiscal 2014 level. Strategy Architectural Glass, Architectural Services and Architectural Framing Systems Segments These three segments serve the commercial construction market, which is highly cyclical. They participate in various phases of the value chain to design, engineer, manufacture and install customized aluminum and glass window, curtainwall, and storefront and entrance systems for commercial buildings - each with nationally recognized brands and leading positions in their target market segments. The window, curtainwall and storefront systems manufactured by our Architectural Framing Systems segment, as well as the glass products fabricated by our Architectural Glass segment, are sold to installers who enclose commercial buildings, such as offices, hospitals, educational facilities, government facilities, high-end multi-family buildings and retail centers. We believe general contractors and architects value our ability to reliably deliver quality, customized window and curtainwall solutions. Their customers - building owners and developers - value the distinctive look, energy efficiency, and hurricane and blast protection features of our window and curtainwall systems. These attributes can contribute to higher lease rates, lower operating costs due to the energy efficiency of our value-added glass and aluminum systems, a more comfortable environment for building occupants, and protection for buildings and occupants from hurricanes and blasts. Our Architectural Services segment fabricates and installs window and curtainwall systems on newly constructed commercial buildings, as well as providing large-scale retrofit services for the window and curtainwall systems on existing commercial buildings. We collaborate closely with our customers, the general contractors, to complete installation projects on time and on budget in order to minimize costly job-site labor overruns. We look at several market indicators, such as office space vacancy rates, architectural billing statistics, employment and other macroeconomic indicators, to gain insight into the commercial construction market. One of our primary indicators is U.S. non-residential construction market activity as documented by Dodge Data & Analytics (Dodge) (formerly McGraw-Hill Construction), a leading independent provider of construction industry analysis, forecasts and trends. We utilize the information for the building types that we typically serve (office towers, hotels, retail centers, education facilities and dormitories, health care facilities, government buildings and high-end multi-family buildings) and adjust this information (which is based on construction starts) to align with our fiscal year and the lag that is required to account for when our products and services typically are initiated in a construction project - approximately eight months after project start. From the Dodge data, we believe that our U.S. markets had a compound annual growth rate of eight percent over our past three fiscal years, while our combined compound annual organic growth rate for our three architectural segments was 13 percent over that same period. Our overall strategy in the Architectural Glass and Architectural Framing Systems segments is to deliver organic growth faster than our commercial construction markets. While our Architectural Services segment will continue to deliver organic growth, the strategy of this segment will be focused on project selection and improved project margins. We will grow through geographic expansion and entry into adjacent markets and product offerings, while remaining focused on distinctive solutions for enclosing commercial buildings. We draw upon our leading brands, energy-efficient products and reputation for high quality and service in pursuit of our strategies. We also aspire to lead our markets in the development of practical, energy-efficient products for new construction and renovation. We have introduced products and services designed to meet the growing demand for energy-efficient building materials. These products have included new energy-efficient glass coatings, thermally enhanced aluminum framing systems, and systems with a high percentage of recycled content. While each of our operating segments has the ability to grow through geographic expansion and product line extension, we regularly evaluate business development opportunities in complementary markets. This strategy can take the form of acquisition or strategic alliances. In recent years, we have increased our focus on the window and curtainwall retrofit and renovation market. We have seen increased interest from the non-residential and high-end multi-family building sectors in upgrading the façades and improving the energy efficiency of their buildings. We consider this to be a significant opportunity for Apogee in the coming years. Additionally, we are constantly working to improve the efficiency and productivity of our manufacturing and installation operations. During fiscal 2014, we completed the initial roll-out of lean manufacturing principles to all of our operating units. In fiscal 2015, we continued to see increasing maturity of many of the lean manufacturing disciplines. We expect this initiative to continue to deliver gross margin expansion into the foreseeable future. Lastly, we consistently evaluate capital investments to improve productivity and product development capabilities, as well as to provide appropriate manufacturing capacity to support growth. LSO segment Our basic strategy in this segment is to convert the custom picture framing market from clear uncoated glass and acrylic products to value-added products that protect art from UV damage while minimizing reflection from the glass, so that viewers see the art rather than the glass. We estimate that over 60 percent of the demand for U.S. custom picture framing glass has converted to value-added glass. Although we are finding it more difficult to further increase the use of value-added glass in the U.S. market, we continue to see conversion to value-added glass. We offer a variety of products with varying levels of reflection control and promote the benefits to consumers with point-of-purchase displays and other promotional materials. We also participate in the global fine art sector, which includes demand from museums and private art collections. This sector appreciates the conservation and anti-reflective properties of our products, primarily our acrylic products. Acrylic is a preferred material in the fine art sector because the product is light weight, which allows its use with art that is much larger and for which weight is an important consideration. We will continue to expand our presence in this sector through international expansion and product line extensions. Additionally, this is the third fiscal year where we have been executing on our strategy of increasing custom picture framing sales in selected geographies outside the U.S. We now have distributors in over 30 countries, mainly in Europe, that are serviced from our warehouse in the Netherlands and directly from the U.S. As we leverage our products and distribution network, we will grow at a faster pace internationally than in the U.S. Results of Operations Net Sales Fiscal 2015 Compared to Fiscal 2014 Sales increased to $933.9 million, up 21.1 percent over fiscal 2014 sales of $771.4 million. Organic growth was 16.9 percent, or $127.5 million, when excluding the sales generated by our Canadian storefront and entrance business, which was acquired in the third quarter of fiscal 2014. Organic growth came primarily from increased sales volume in our architectural-based segments due to increased commercial construction activity in the U.S. The Architectural Glass segment accounted for approximately 32 percent of the organic growth due to increased volumes and improved pricing. Increased volume in the U.S. window, storefront and finishing businesses in the Architectural Framing Systems segment accounted for approximately 30 percent of the growth. The remaining organic growth was attributable to volume growth in the Architectural Services business and an improved mix of value-added products in the LSO segment. Fiscal 2014 Compared to Fiscal 2013 Sales grew 10.2 percent in fiscal 2014 to $771.4 million compared to $700.2 million in fiscal 2013. The inclusion of Alumicor sales since the date of acquisition accounted for 2 percentage points of this increase. Improved product mix and pricing in the Architectural Glass segment drove approximately 4 percentage points of the increase. Volume growth in the Architectural Services segment favorably impacted fiscal 2014 by about 2 percentage points and the remainder of the increase resulted from improved volume in our Architectural Framing segment's U.S. storefront and finishing businesses. Performance The relationship between various components of operations, as a percentage of net sales, is illustrated below for the past three fiscal years. Fiscal 2015 Compared to Fiscal 2014 Gross profit improved 0.9 percentage points to 22.3 percent of sales in fiscal 2015 from 21.4 percent in fiscal 2014. The increase in gross margins was due to the impact of operating leverage on increased volume and improved pricing in the Architectural Glass segment, as well as operating leverage on increased volume in the window business within the Architectural Framing Systems segment. These positive items were partially offset by manufacturing cost overruns in the Architectural Services Segment, increased aluminum costs in the U.S. and Canadian storefront and entrance businesses within the Architectural Framing Systems segment, and costs to restart the Utah facility in our Architectural Glass segment. Selling, general and administrative (SG&A) spending for fiscal 2015 increased by $20.0 million over fiscal 2014, while SG&A as a percent of sales decreased to 15.5 percent in fiscal 2015 from 16.2 percent in fiscal 2014. The addition of our Canadian storefront and entrance business acquired in the third quarter of fiscal 2014 contributed approximately 30 percent of the increase in year-on-year spend. The remaining increase was due to increased incentive compensation on improved results, increased sales commissions from higher sales volumes and write-down of certain assets acquired in our window business in fiscal 2014. Other income was $1.4 million for fiscal 2015 compared to a small expense in the prior-year period, mainly due to the receipt of the final distribution in the first quarter of fiscal 2015 related to a European business that was discontinued over 15 years ago. Our effective tax rate for fiscal 2015 was 22.3 percent. The effective tax rate in fiscal 2015 includes a $6.4 million tax benefit from an energy-efficient investment credit under Section 48C of the Internal Revenue Code in the second quarter of this fiscal year, upon successful start-up and commercial production of coatings on our new architectural glass coater. The tax credit was awarded in 2011 by the U.S. Internal Revenue Service (IRS) in cooperation with the Department of Energy as part of the American Reinvestment and Recovery Act to incent energy-efficiency investments throughout the United States. Excluding this credit, our effective tax rate would have been 32.2% in fiscal 2015, slightly higher than 29.6% in fiscal 2014, due to a lesser net benefit from tax reserve adjustments in the current year. Fiscal 2014 Compared to Fiscal 2013 Gross profit improved as a percent of sales to 21.4 percent in fiscal 2014 from 20.8 percent in fiscal 2013. The improvement in gross margins was due to the margin impact of improved mix and pricing in the Architectural Glass segment, improved project margins in the Architectural Services segment and overall productivity improvements. These favorable items were partially offset by lower capacity utilization in the Architectural Framing System's window business related to an anticipated gap in the schedule for more complex projects. Selling, general and administrative spending increased by $6.7 million in fiscal 2014 over fiscal 2013, while SG&A as a percent of sales decreased to 16.2 percent in fiscal 2014 from 16.9 percent in fiscal 2013. The increase in spending was primarily due to increased salaries and related benefits to support sales growth and geographic expansion, as well as other costs related to geographic expansion and acquisitions during fiscal 2014. Segment Analysis Architectural Glass Fiscal 2015 Compared to Fiscal 2014. Fiscal 2015 net sales of $346.5 million increased $52.7 million, or 17.9 percent, over fiscal 2014. The increase for the year was primarily due to increased volume and some improvement in pricing. Operating income improved to $16.4 million in fiscal 2015, compared to $3.9 million in fiscal 2014, an improvement of $12.6 million. Operating margins improved to 4.7 percent in fiscal 2015 compared to 1.3 percent in fiscal 2014. As the commercial construction activity has increased, the Architectural Glass segment has benefited from operating leverage on volume growth and improved pricing. The segment also demonstrated positive manufacturing productivity that was partially offset by inefficiencies experienced as the business expanded its workforce to meet demand and costs incurred to restart the Utah facility. Fiscal 2014 Compared to Fiscal 2013. Fiscal 2014 net sales increased $27.4 million to $293.8 million, or 10.3 percent over fiscal 2013. Improved mix and pricing in our U.S. and Brazilian businesses accounted for most of the increase. The remainder was due to volume growth in both our U.S. and Brazilian businesses, partially offset by a decline in our export volume. Operating income of $3.9 million in fiscal 2014 was an $8.3 million improvement over the fiscal 2013 loss of $4.4 million. Operating margins improved to 1.3 percent in fiscal 2014 compared to negative 1.6 percent in fiscal 2013. The improvement in operating results was largely due to the impact of a better mix of higher value-added projects and improved pricing. The impact of volume growth and productivity improvements also contributed to the year-on-year increase in operating results. Architectural Services Fiscal 2015 Compared to Fiscal 2014. Net sales of $230.7 million in fiscal 2015 increased $27.3 million, or 13.4 percent over fiscal 2014. The increase was due to volume from project timing and a general increase in project activity on stronger end markets. Operating income increased $3.0 million to $7.4 million compared to $4.5 million in fiscal 2014. Operating margin was 3.2 percent in fiscal 2015 compared to 2.2 percent in fiscal 2014. The improvements in operating results for the year were a result of operating leverage on the increased volume and increasing project margins due to our focus on project selection. Fiscal 2014 Compared to Fiscal 2013. Fiscal 2014 net sales increased $16.8 million over fiscal 2013, a 9.0 percent increase. Volume growth in existing and expanded geographies was the driver of this growth. Fiscal 2014 operating income increased $5.5 million to $4.5 million compared to a loss of $1.0 million in fiscal 2013. Operating margin of 2.2 percent in fiscal 2014 was an improvement of 2.7 percentage points over fiscal 2013. The improved operating results were a result of better project margins, as we have worked through lower margin projects that were bid in the bottom of the market cycle, as well as strong execution on projects flowing through revenue. Architectural Framing Systems Fiscal 2015 Compared to Fiscal 2014. Fiscal 2015 net sales of $298.4 million increased $82.3 million, or 38.1 percent, over fiscal 2014. Organic growth, excluding our Canadian storefront and entrance business, was 23.7 percent. The organic growth in fiscal 2015 was due to double-digit volume increases at our three U.S. businesses in the segment, with the U.S. storefront and finishing businesses increasing penetration within their target sectors and geographies, the window business recovering from a prior-year gap in the schedule for complex projects, and an increase in volume due to market growth in our finishing business. Fiscal 2015 operating income of $21.8 million was an increase of $6.9 million over the $14.9 million reported in fiscal 2014, and operating margins improved to 7.3 percent in fiscal 2015 from 6.9 percent in fiscal 2014. The increase in operating results was due to the impact of income growth in the U.S. window, finishing and storefront businesses resulting from increased volume and good execution. This improvement was slightly offset by the negative effect of higher aluminum costs in the U.S. and Canadian storefront businesses, and the impact of soft Canadian markets on the Canadian storefront business in the first half of the year. Fiscal 2014 Compared to Fiscal 2013. Fiscal 2014 net sales increased $24.9 million, or 13.0 percent, over fiscal 2013.The addition of our Canadian storefront and entrance business accounted for approximately 8 percentage points of the increase for fiscal 2014. The remainder of the increase was due to improved volumes in the U.S. storefront and finishing businesses, partially offset by volume declines caused by an anticipated gap in the schedule for the window business. Fiscal 2014 operating income of $14.9 million was up slightly over the $14.6 million reported in fiscal 2013, while operating margins decreased to 6.9 percent in fiscal 2014 from 7.6 percent in fiscal 2013. The favorable impact of increased volumes in the U.S. storefront and finishing businesses was partially offset by lower sales in the window business related to the anticipated gap in the schedule for more complex projects, resulting in lower capacity utilization. Additionally, the Canadian storefront business that was acquired late in fiscal 2014 delivered an operating loss due to acquisition costs. Large-Scale Optical Technologies (LSO) Fiscal 2015 Compared to Fiscal 2014. LSO fiscal 2015 net sales of $87.7 million were up $6.6 million, or 8.1 percent, over fiscal 2014 net sales of $81.1 million. The improvement compared to fiscal 2014 was due to a positive mix of higher value-added products on relatively flat volumes. Operating income of $22.0 million was up slightly over fiscal 2014 results of $21.3 million, while operating margins dropped to 25.0 percent in fiscal 2015 compared to 26.2 percent in fiscal 2014. The impact of the strong mix of value-added products was largely offset by increased incentive compensation and investments in new product development. Fiscal 2014 Compared to Fiscal 2013. LSO revenues in fiscal 2014 increased slightly over fiscal 2013 to $81.1 million from $79.9 million. The improvement compared to fiscal 2013 was due to a positive mix of higher value-added products. Operating income of $21.3 million was relatively flat compared to fiscal 2013 levels and operating margins were consistent. The impact of the strong mix of higher value-added products was largely offset by increased promotional activities and investments for growth in new geographies and markets. Consolidated Backlog Backlog represents the dollar amount of revenues we expect to recognize in the future from firm contracts or orders received, as well as those that are in progress. Backlog is not a term defined under generally accepted accounting principles and is not a measure of contract profitability. We include a project within our backlog at the time a signed contract or a firm purchase order is received, generally as a result of a competitive bidding process. Backlog by reporting segment at February 28, 2015, November 29, 2014 and March 1, 2014 was as follows: We expect approximately $393.4 million, or 80 percent, of our February 28, 2015 backlog to be recognized in fiscal 2016, with the balance to be recognized in fiscal 2017 and beyond. We view backlog as an important statistic in evaluating the level of sales activity and short-term sales trends in our business. However, as backlog is only one indicator, and is not an effective indicator of our ultimate profitability, we do not believe that backlog should be used as the sole indicator of future earnings of the Company. Acquisitions On November 5, 2013, the Company acquired all of the shares of Alumicor Limited, a privately held business, for $52.9 million, including cash acquired of $1.6 million. Alumicor is a window, storefront, entrance and curtainwall company primarily serving the Canadian commercial construction market. The purchase price allocation was based on the fair value of assets acquired and liabilities assumed and included total assets of $61.8 million, including goodwill and intangibles of $34.9 million, and total liabilities of $10.5 million. In the second quarter of fiscal 2014, we also acquired certain assets and liabilities of a window fabrication business as part of our strategy to grow through new products and new geographies. Both of these acquisitions are reported within our Architectural Framing Systems segment. Liquidity and Capital Resources Operating activities. Cash provided by operating activities was $68.6 million in fiscal 2015, $52.9 million in fiscal 2014, and $40.5 million in fiscal 2013. Fiscal 2015 and 2014 operating cash flows were each positively impacted by the increased income reported for those fiscal years as compared to the respective prior-year periods. Non-cash working capital (current assets, excluding cash and short-term available for sale securities and short-term restricted investments, less current liabilities, excluding current portion of long-term debt) was $97.5 million at February 28, 2015. This compares to $82.0 million at March 1, 2014, and $58.8 million at March 2, 2013. The increase in fiscal 2015 was due to our investment in working capital necessary to support sales growth. The change in fiscal 2014 was a result of including partial year results of Alumicor, growth in the base business and extending our geographic footprint in certain businesses. Investing Activities. Investing activities used cash of $24.5 million in fiscal 2015, $44.0 million in fiscal 2014 and $57.1 million in fiscal 2013. The current year included capital investments of $27.2 million mainly to increase productivity, increase capacity and improve product development capabilities. Net sales of marketable securities and restricted investments generated $3.3 million of cash. In fiscal 2014, we made capital investments of $41.9 million as we made investments for productivity and product development capabilities, including a new state-of-the-art coater in our Architectural Glass segment. We reduced our restricted investments by $23.9 million, as we released $10.0 million of cash held in escrow for the recovery zone facility bonds that was used to redeem the bonds and also released $12.0 million of cash collateral to unrestricted cash related to the letter of credit supporting these bonds. We decreased our investments in marketable securities by $26.5 million in fiscal 2014 to fund the acquisition of Alumicor. During fiscal 2014, we completed two acquisitions as part of our strategy to grow through new products and new geographies. In the second quarter, we acquired certain assets and liabilities of a window fabrication business, which are included in the results of our window business within the Architectural Framing Systems segment. During the third quarter, we acquired the outstanding shares of Alumicor Limited; its results of operations are included within the Architectural Framing Systems segment. In fiscal 2013, we made capital investments of $34.7 million for growth and productivity improvements, as well as equipment to support new product introductions, and maintenance capital. The net position of our investments for fiscal 2013 resulted in $17.6 million in net purchases as a result of generating excess cash through operating activities noted above. Net purchases of $4.5 million for restricted investments during fiscal 2013 were the result of $10.0 million of industrial development bonds (reflected in financing activities) that were made available for current and future investment in our storefront and entrance business in Michigan. We expect fiscal 2016 capital expenditures to range from $45 to $50 million for investments to increase capabilities, capacity and productivity, as well as maintenance capital. We continue to review our portfolio of businesses and their assets in comparison to our internal strategic and performance objectives. As part of this review, we may acquire other businesses, pursue geographic expansion, take actions to manage capacity, and/or further invest in, fully divest and/or sell parts of our current businesses. At February 28, 2015, we had one sale and leaseback agreement for equipment that provides an option to purchase the equipment at projected future fair market value upon expiration of the lease in 2021. The lease is classified as an operating lease. We had a deferred gain of $2.8 million under the sale and leaseback transaction, which is included in the balance sheet as other current and non-current liabilities. The average annual lease payment over the life of the remaining lease is $1.0 million. Financing Activities. Total outstanding borrowings at February 28, 2015 were $20.6 million, compared to $20.7 million at March 1, 2014 and $30.8 million at March 2, 2013. During the first quarter of fiscal 2014, $10.0 million of recovery zone facility bonds that had previously been issued for future investment in the Company's Architectural Glass fabrication facility in Utah were redeemed at par. Our debt consists of $20.4 million of industrial revenue bonds and $0.2 million of other debt. The industrial revenue bonds mature in fiscal years 2021 through 2043 and the other debt matures in fiscal years 2016 through 2021. There were small amounts of current debt at February 28, 2015 and March 1, 2014. At March 2, 2013, $10.0 million of the recovery zone facility bonds were classified as current as we repaid these bonds related to our Utah facility in early fiscal 2014. Our debt-to-total-capital ratio was 5.1 percent at February 28, 2015 and 5.5 percent at March 1, 2014. During the fourth quarter of fiscal 2015, we entered into an amendment of our existing $100.0 million committed revolving credit facility. The amount of the facility was increased to $125.0 million; the expiration date was extended to December 2019; the letter of credit facility was reduced to $40.0 million from $50.0 million, the outstanding amounts of which decrease the available commitment; and the maximum debt-to-EBITDA ratio was increased to 3.00. No other provisions of the original agreement were materially amended by the amended credit agreement. No borrowings were outstanding under the facility as of February 28, 2015 or March 1, 2014. The credit facility requires that we maintain a debt-to-EBITDA ratio of not more than 3.00. This ratio is computed quarterly, with EBITDA computed on a rolling four-quarter basis. The Company’s ratio was 0.22 at February 28, 2015. The credit facility also requires the Company to maintain a minimum level of net worth, as defined in the credit facility, based on certain quarterly financial calculations. The minimum required net worth computed in accordance with the credit facility at February 28, 2015 was $318.8 million, whereas the Company’s net worth as defined in the credit facility was $382.5 million. If the Company is not in compliance with either of these covenants, the lenders may terminate the commitment and/or declare any loan then outstanding to be immediately due and payable. At February 28, 2015, the Company was in compliance with the financial covenants of the credit facility. In the second quarter of fiscal 2015, we entered into a Canadian Dollar $4.0 million revolving demand facility available to our Canadian storefront and entrance business. Borrowings under the facility are made available at the sole discretion of the lender and are payable on demand. Borrowings under the facility bear interest at rates specified in the credit agreement for the facility. We classify any outstanding balances under this demand facility as long-term debt, since outstanding amounts can be refinanced through our committed revolving credit facility. No borrowings were outstanding as of February 28, 2015. During fiscal 2004, the Board of Directors authorized a share repurchase program of 1,500,000 shares of common stock. The Board of Directors increased this authorization by 750,000 shares in January 2008 and by 1,000,000 in October 2008. We purchased 203,509 shares under the program during fiscal 2015, for a total cost of $6.9 million; there were no share repurchases during fiscal 2014. We have purchased a total of 2,482,632 shares, at a total cost of $36.5 million, since the inception of this program. We have remaining authority to repurchase 767,368 shares under this program, which has no expiration date. In addition to the shares repurchased under the repurchase plan, during fiscal 2015 and 2014 we also acquired $5.2 million and $3.6 million, respectively, of Company stock from employees in order to satisfy stock-for-stock option exercises or withholding tax obligations related to stock-based compensation, pursuant to terms of Board and shareholder-approved compensation plans. Other Financing Activities. The following summarizes our significant contractual obligations that impact our liquidity as of February 28, 2015: From time to time, we acquire the use of certain assets, such as warehouses, automobiles, forklifts, vehicles, office equipment, hardware, software and some manufacturing equipment through operating leases. Many of these operating leases have termination penalties. However, because the assets are used in the conduct of our business operations, it is unlikely that any significant portion of these operating leases would be terminated prior to the normal expiration of their lease terms. Therefore, we consider the risk related to termination penalties to be minimal. We have purchase obligations for raw material commitments and capital expenditures. As of February 28, 2015, these obligations totaled $158.9 million. We expect to make contributions of $1.0 million to our defined-benefit pension plans in fiscal 2016, which will equal or exceed our minimum funding requirements. As of February 28, 2015, we had $4.5 million and $1.8 million of unrecognized tax benefits and environmental liabilities, respectively. We expect approximately $0.7 million of the unrecognized tax benefits to lapse during the next 12 months. We are unable to reasonably estimate in which future periods the remaining unrecognized tax benefits and environmental liabilities will ultimately be settled. At February 28, 2015, we had ongoing letters of credit related to construction contracts and certain industrial revenue bonds. The Company’s $20.4 million of industrial revenue bonds are supported by $21.0 million of letters of credit that reduce availability of funds under our $125.0 million credit facility. The letters of credit by expiration period were as follows at February 28, 2015: In addition to the above standby letters of credit, which were primarily issued for our industrial revenue bonds, we are required, in the ordinary course of business, to provide surety or performance bonds that commit payments to our customers for any non-performance by us. At February 28, 2015, $76.9 million of our backlog was bonded by performance bonds with a face value of $274.0 million. Performance bonds do not have stated expiration dates, as we are released from the bonds upon completion of the contract. We have never been required to make any payments related to these performance bonds with respect to any of our current portfolio of businesses. We believe that current cash on hand and available capacity under our committed revolving credit facility, as well as the expected cash to be generated from future operating activities, will be adequate to fund our working capital requirements, planned capital expenditures and dividend payments over the next 12 months. We have total cash and short-term available-for-sale securities of $52.5 million, and $101.5 million available under our credit facility at February 28, 2015. We believe that this will provide us with the financial strength to continue our growth strategy as our end markets continue to improve. Off-balance sheet arrangements. With the exception of operating leases, we had no off-balance sheet financing arrangements at February 28, 2015 or March 1, 2014. Outlook The following statements are based on our current expectations for fiscal 2016 results. These statements are forward-looking, and actual results may differ materially. • Revenue growth of 10 to 15 percent over fiscal 2015. • We anticipate earnings per share of $2.05 to $2.20. Gross margins are anticipated to be approximately 24 percent. • Capital expenditures are projected to be approximately $45 to $50 million. Recently Issued Accounting Pronouncements See New Accounting Standards set forth in Note 1 of the Notes to Consolidated Financial Statements under Item 8 of this Form 10-K for information pertaining to recently adopted accounting standards or accounting standards to be adopted in the future, which is incorporated by reference herein. Critical Accounting Policies Management has evaluated the accounting policies and estimates used in the preparation of the accompanying financial statements and related notes, and believes those policies and estimates to be reasonable and appropriate. We believe that the most critical accounting policies and estimates applied in the presentation of our financial statements relate to accounting for future events. Future events and their effects cannot be determined with absolute certainty. Therefore, management is required to exercise judgment both in assessing the likelihood that a liability has been incurred as well as in estimating the amount of potential loss. We have identified the following accounting policies as critical to our business and in the understanding of our results of operations and financial position: Revenue recognition - Our standard product sales terms are “free on board” (FOB) shipping point or FOB destination, and revenue is recognized when title has transferred. However, our Architectural Services segment business enters into fixed-price contracts for full-service commercial building glass installation and renovation services, which are accounted for as construction-type contracts. These contracts are typically performed over a 12- to 18-month timeframe, and we record revenue for these contracts on a percentage-of-completion basis as we are able to reasonably estimate total contract revenue and total contract costs. The contracts entered into clearly specify the enforceable rights of the parties, the consideration and the terms of settlement, and both parties can be expected to satisfy all obligations under the contract. During fiscal 2015, approximately 25 percent of our consolidated sales were recorded on a percentage-of-completion basis. Under this methodology, we compare the total costs incurred to date to the total estimated costs for the contract, and record that proportion of the total contract revenue in the period. Contract costs include materials, labor and other direct costs related to contract performance. Given our ability to make reasonable estimates of our total contract revenues and total contract costs, we believe utilizing the cost-to-cost method for revenue recognition provides the greatest degree of precision in measuring progress toward completion of the installation contracts. Provisions are established for estimated losses, if any, on uncompleted contracts in the period in which such losses are determined. Amounts representing contract change orders, claims or other items are included in contract revenue only when customers have approved them. A significant number of estimates are used in these computations. Goodwill impairment - To determine if there has been any impairment in accordance with accounting standards, we evaluate the goodwill on our balance sheet annually or more frequently if impairment indicators exist through a two-step process. In step one, we value each of our reporting units and compare these values to the reporting units' net book value, including goodwill. If the fair value is less than the net book value, we perform step two, which determines the amount of goodwill to impair. Each of our seven business units represents a reporting unit under applicable accounting standards. We were not required to perform step two for fiscal 2015; the estimated fair value of each of the reporting units significantly exceeded their book value utilizing the discounted cash flow methodology at February 28, 2015. Although we consider public information for transactions made on businesses similar to ours, since there were no market comparables identified, we base our determination of fair value using a discounted cash flow methodology that involves significant judgments based upon projections of future performance. In developing our discounted cash flow analysis, assumptions about future revenues and expenses, capital expenditures and changes in working capital are based on our annual operating plan and long-term business plan for each of our reporting units. These plans take into consideration numerous factors including historical experience, anticipated future economic conditions and growth expectations for the industries and end markets in which we participate. These assumptions are determined over a five-year, long-term planning period. The five-year growth rates for revenues and operating profits vary for each reporting unit being evaluated. Revenues and operating profit beyond the five-year period are projected to grow at a nominal perpetual growth rate for all reporting units. The discount rate calculations are determined by assuming a company beta, market premium risk, size premium, the cost of debt and debt-to-capital ratio of a market participant. A significant change in the factors noted above could cause us to reduce the estimated fair value of some or all of our reporting units and recognize a corresponding impairment of our goodwill in connection with a future goodwill impairment test. There can be no assurances that these forecasts will be attained. Adverse changes in strategy, market conditions or assumed market capitalization may result in an impairment of goodwill. Reserves for disputes and claims regarding product liability and warranties - From time to time, we are subject to claims associated with our products and services, principally as a result of disputes with our customers involving the performance or aesthetics of our architectural products and services. The time period from when a claim is asserted to when it is resolved, either by dismissal, negotiation, settlement or litigation, can be several years. While we maintain product liability insurance, the insurance policies include significant self-retention of risk in the form of policy deductibles. In addition, certain claims could be determined to be uninsured. We reserve based on our estimates of known claims, as well as on anticipated claims for possible product warranty and rework costs based on historical product liability claims as a ratio of sales. Self-insurance reserves - We obtain substantial amounts of commercial insurance for potential losses for general liability, workers' compensation, automobile liability, employment practices, architect's and engineer's errors and omissions risk, product re-work and other miscellaneous coverages. However, an amount of risk is retained on a self-insured basis through a wholly-owned insurance subsidiary; as a result, a material construction project rework event could have a material adverse effect on our operating results. Reserve requirements are established based on actuarial projections of ultimate losses. Income taxes - We record a tax provision for the anticipated tax consequences of the reported results of operations. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those deferred tax assets and liabilities are expected to be realized or settled. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with management's expectations could have a material impact on the Company's financial condition and operating results. As part of our ongoing financial reporting process, a collaborative effort is undertaken involving our management with responsibility for financial reporting, product and project management, quality, legal and tax, and outside advisors such as consultants, engineers, lawyers and actuaries. The results of this effort provide management with the necessary information on which to base its judgments on these future events and develop the estimates used to prepare the financial statements. We believe that the amounts recorded in the accompanying financial statements related to these events are based on the best estimates and judgments of Apogee management. However, outcomes could differ from our estimates and could materially adversely affect our future operating results, financial position and cash flows.

<s>[INST] This discussion contains “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All forecasts and projections in this document are “forwardlooking statements,” and are based on management's current expectations or beliefs of the Company's nearterm results, based on current information available pertaining to the Company, including the risk factors noted under Item 1A in this Form 10K. From time to time, we also may provide oral and written forwardlooking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by the Company. Any or all of our forwardlooking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forwardlooking statements made by or on behalf of the Company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to, the risks and uncertainties set forth under Item 1A in this Form 10K. We wish to caution investors that other factors might in the future prove to be important in affecting the Company's results of operations. New factors emerge from time to time; it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forwardlooking statements. We undertake no obligation to update publicly or revise any forwardlooking statements, whether as a result of new information, future events or otherwise. Overview We are a leader in certain technologies that provide distinctive solutions for enclosing commercial buildings and framing art. The Company's four reportable segments are: Architectural Glass, Architectural Services, Architectural Framing Systems and LargeScale Optical (LSO). Architectural Glass segment consists of Viracon, a fabricator of coated, highperformance architectural glass for global markets. The Architectural Services segment consists of Harmon, one of the largest U.S. fullservice building glass installation and renovation companies; it designs, engineers, fabricates and installs the walls of glass, windows and other curtainwall products making up the outside skin of commercial and institutional buildings. The Architectural Framing Systems segment companies design, engineer, fabricate and finish the aluminum frames used in customized aluminum and glass window, curtainwall, storefront and entrance systems comprising the outside skin and entrances of commercial and institutional buildings. We have aggregated four operating segments into the Architectural Framing Systems reporting segment based upon their similar products, customers, distribution methods, production processes and economic characteristics: Wausau Window and Wall Systems, a manufacturer of standard and custom aluminum window systems and curtainwall for the North American commercial construction and historical renovation markets; Tubelite, a fabricator of aluminum storefront, entrance and curtainwall products for the U.S. commercial construction industry; Alumicor, a fabricator of aluminum storefront, entrance, curtainwall and window products for the Canadian commercial construction industry; and Linetec, a paint and anodize finisher of architectural aluminum and PVC shutters for U.S. markets. LSO segment consists of Tru Vue, a manufacturer of valueadded glass and acrylic for the custom picture framing and fine art markets. The following highlights the results for fiscal 2015: Consolidated revenues increased 21 percent over fiscal 2014, or 17 percent excluding the impact of Alumicor, and operating income was up 58 percent over last year. All four segments grew revenue and earnings. EPS was $1.72, including a $0.22 per share impact of a 48C tax credit. Excluding this item, adjusted EPS was $1.50, [/INST] Positive. </s>

APOGEE ENTERPRISES, INC.

2016-04-25

2016-02-27

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This discussion contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All forecasts and projections in this document are “forward-looking statements,” and are based on management's current expectations or beliefs of the Company's near-term results, based on current information available pertaining to the Company, including the risk factors noted under Item 1A in this Form 10-K. From time to time, we also may provide oral and written forward-looking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by the Company. Any or all of our forward-looking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forward-looking statements made by or on behalf of the Company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to, the risks and uncertainties set forth under Item 1A in this Form 10-K. We wish to caution investors that other factors might in the future prove to be important in affecting the Company's results of operations. New factors emerge from time to time; it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Overview We are a world leader in certain technologies involving the design and development of value-added glass solutions for enclosing commercial buildings and framing art. Our four reporting segments are: Architectural Glass, Architectural Services, Architectural Framing Systems and Large-Scale Optical Technologies (LSO). The following items highlight the results for fiscal 2016: • Consolidated net sales increased 5 percent over fiscal 2015, or 7 percent on a constant currency basis, which is a non-GAAP measure. Operating income increased 53 percent over last year. All four segments grew revenue and earnings. • Diluted EPS was $2.22, compared to $1.72 in the prior year, which included a $0.22 per share positive impact from an energy-efficient tax credit. Excluding this tax credit, fiscal 2016 diluted EPS increased 48 percent over the prior year. • Consolidated backlog was $508.0 million at February 27, 2016, up 4 percent over fiscal 2015. Results of Operations Net Sales Fiscal 2016 Compared to Fiscal 2015 Net sales in fiscal 2016 improved by 5.1 percent, or 7.0 percent on a constant currency basis, mainly due to pricing and volume growth resulting from strong commercial construction activity in the U.S, partially offset by declines in the commercial construction markets in Brazil and Canada. The Architectural Glass segment drove approximately 44 percent of the growth this year, and the Architectural Services segment drove approximately 32 percent of the growth, with nearly all of the remainder coming from the domestic Architectural Framing segment businesses. Constant currency revenue excludes the impact of fluctuations in foreign currency on our international operations. Constant currency percentages are calculated by converting prior-period local currency results using the average monthly exchange rate and comparing the adjusted amount to current period reported results. We believe constant currency information provides valuable supplemental information regarding our core operating results, consistent with how we evaluate our performance. We also refer to constant currency measures elsewhere in this report. These non-GAAP measures should be viewed in addition to, and not as an alternative to, the reported results prepared in accordance with GAAP. Fiscal 2015 Compared to Fiscal 2014 Sales increased by 21.1 percent over fiscal 2014 primarily from increased sales volume in our architectural-based segments, due to increased commercial construction activity in the U.S. and the inclusion of our Canadian storefront business acquired late in fiscal 2014. The Architectural Glass segment accounted for approximately 32 percent of the growth, and the domestic Architectural Framing Systems segment provided approximately 29 percent of the growth, with an additional 21 percent attributable to the inclusion of the Canadian storefront business. The remaining growth came from the Architectural Services segment. Currency fluctuation did not have a significant impact on our sales in fiscal 2015. Performance The relationship between various components of operations, as a percentage of net sales, is illustrated below for the past three fiscal years. Fiscal 2016 Compared to Fiscal 2015 Gross profit was 24.8 percent in fiscal 2016, an improvement of 250 basis points from fiscal 2015, primarily due to improved pricing and mix, as well as productivity and volume leverage across all architectural-based segments. Selling, general and administrative (SG&A) expense for fiscal 2016 was 14.9 percent, a decrease of 60 basis points despite an increase of $1.2 million from fiscal 2015, as a result of expense discipline relative to sales growth across our segments. The effective tax rate for fiscal 2016 was 32.9 percent, compared to 22.3 percent in fiscal 2015. After excluding the 990 basis point benefit due to an energy-efficient tax credit earned in fiscal 2015, however, the increase in our tax rate was 70 basis points over the prior year due to changes in state income tax laws combined with a higher percentage of earnings in the U.S., where the tax rate is higher than in foreign jurisdictions. Fiscal 2015 Compared to Fiscal 2014 Gross profit improved 90 basis points, due to the impact of operating leverage on increased volume and improved pricing within our Architectural Glass and Architectural Framing Systems segments. This was partially offset by manufacturing cost overruns in the Architectural Services segment, increased aluminum costs impacting the Architectural Framing Systems segment, and costs to restart the Utah facility in the Architectural Glass segment, all of which occurred in fiscal 2015. SG&A expense increased $20 million, but declined by 70 basis points from fiscal 2014. The main contributor to the increased SG&A spend in fiscal 2015 was the addition of our Canadian acquisition. In addition, we had increased incentive compensation and sales commissions on improved results and write-down of certain assets acquired in our window business in fiscal 2014. Our effective tax rate for fiscal 2015 was 22.3 percent, which includes a $6.4 million tax benefit from an energy-efficient investment credit. Excluding this credit, our effective tax rate would have been 32.2% in fiscal 2015, compared to 29.6% in fiscal 2014, due to a lesser net benefit from tax reserve adjustments in fiscal 2015. Segment Analysis Architectural Glass Fiscal 2016 Compared to Fiscal 2015. Fiscal 2016 net sales improved 9.0 percent over the prior year, or 12.2 percent on a constant currency basis, primarily due to improved pricing, mix and volume growth in the U.S. as a result of the strong U.S. construction market, partially offset by declines in volume and mix in our Brazilian operation and lower export sales. Operating margin improved 470 basis points, doubling the fiscal 2015 operating margin, with improvement driven by pricing and mix, as well as strong operational performance and volume leverage in the U.S., partially offset by the impact of ongoing challenging Brazilian economic conditions. Fiscal 2015 Compared to Fiscal 2014. Fiscal 2015 net sales improved 17.9 percent over fiscal 2014 primarily due to increased volume as a result of commercial construction market strength and some improvement in pricing. Currency fluctuation did not have a significant impact on our results in fiscal 2015. Operating margin improved 340 basis points due to operating leverage on volume growth and improved pricing. The segment also demonstrated positive manufacturing productivity that was partially offset by inefficiencies experienced as the segment expanded its workforce to meet demand and also by costs incurred to restart the Utah facility. Architectural Services Fiscal 2016 Compared to Fiscal 2015. Net sales improved 6.6 percent over the prior year, driven by volume growth due to increased commercial construction activity in the U.S. Operating margin improved 160 basis points over the prior year, as a result of continued focus on project selection, driving improved project margins, and good execution. Fiscal 2015 Compared to Fiscal 2014. Net sales improved 13.4 percent over fiscal 2014 due to volume from project timing and a general increase in project activity on stronger end markets. Operating margin improved 100 basis points as a result of operating leverage on the increased volume and increasing project margins due to our focus on project selection. Architectural Framing Systems Fiscal 2016 Compared to Fiscal 2015. Net sales improved 3.4 percent over fiscal 2015, or 6.0 percent on a constant currency basis, on volume growth from strong U.S. construction markets, and improved pricing and mix in our U.S. businesses, partially offset by volume weakness in our Canadian business. Operating margin improved 300 basis points over fiscal 2015, driven by improved pricing and mix, lower raw material costs and volume leverage in the U.S., partially offset by the volume weakness in our Canadian business. Fiscal 2015 Compared to Fiscal 2014. Fiscal 2015 net sales increased 38.1 percent over fiscal 2014. Approximately two-thirds of this growth was attributable to double-digit volume increases at our U.S. businesses, with the remainder coming from the inclusion of our Canadian storefront business acquired late in fiscal 2014. Currency fluctuation did not have a significant impact on our results in fiscal 2015. Fiscal 2015 operating margin improved 40 basis points due to volume leverage and good execution in our U.S. businesses, slightly offset by the negative effect of higher aluminum costs and the impact of soft Canadian markets on our Canadian storefront business in the first half of the year. Large-Scale Optical Technologies (LSO) Fiscal 2016 Compared to Fiscal 2015. Net sales in our LSO segment increased 1.0 percent over the prior year as a result of an improved mix of value-added products and stable demand. Operating margin improved 90 basis points over the prior year as a result of improved product mix and strong operational performance. Fiscal 2015 Compared to Fiscal 2014. Fiscal 2015 net sales were up 8.1 percent compared to fiscal 2014 due to a positive mix of higher value-added products on relatively flat volumes. Operating margin declined 120 basis points as the impact of the strong mix of value-added products was offset by increased incentive compensation and investments in new product development. Consolidated Backlog Backlog represents the dollar amount of revenues we expect to recognize in the near-term from firm contracts or orders. We use backlog as one of the metrics to evaluate near-term sales trends in our business. Backlog is not a term defined under generally accepted accounting principles and is not a measure of contract profitability. Backlog should not be used as the sole indicator of our future revenue and earnings. We include a project within our backlog at the time a signed contract or a firm purchase order is received, generally as a result of a competitive bidding process. Backlog by reporting segment was as follows: In our Architectural Glass segment, additional capacity and improved productivity have driven shorter lead times for customers, resulting in lower backlog. We have seen, and expect to continue to see, an increased portion of our revenues from shorter lead-time work that we book and ship within the same period. These book-and-ship sales are not included in our backlog within the period. We expect approximately $407 million, or 80 percent, of our February 27, 2016 backlog to be recognized in fiscal 2017, with the balance to be recognized in fiscal 2018. Liquidity and Capital Resources Operating Activities. Cash provided by operating activities was $124.0 million in fiscal 2016, an increase of $55.4 million over fiscal 2015. In all years presented, operating cash flows were positively impacted by increased income as compared to the respective prior-year period. In fiscal 2016, we also experienced improved cash from operating activities compared to fiscal 2015 as a result of continued focus on working capital management. Non-cash working capital (current assets, excluding cash and short-term securities, less current liabilities, excluding current portion of long-term debt) was $68.8 million at February 27, 2016, compared to $97.5 million at February 28, 2015, and $82.0 million at March 1, 2014. The decline in fiscal 2016 is a result of our continued efforts regarding working capital management, and timing of activity. The increase in fiscal 2015, compared to fiscal 2014, was due to our investment in working capital necessary to support sales growth. Investing Activities. Net cash used in investing activities was $77.9 million in fiscal 2016, $24.5 million in fiscal 2015 and $44.0 million in fiscal 2014. In the current year, we invested excess cash in short-term marketable securities, and made capital expenditures focused primarily on improving manufacturing productivity and on increasing capacity, including adding anodize finishing capacity within our Architectural Framing segment. In fiscal 2015, capital investments were made mainly to increase productivity and capacity and improve product capabilities. In fiscal 2014, we made capital investments for productivity and product capabilities, including a new state-of-the-art coater in our Architectural Glass segment. We reduced our restricted investments by $23.9 million and our investments in marketable securities by $26.5 million to fund acquisitions as part of our strategy to grow through new products and new geographies. To that end, we made acquisitions in fiscal 2014 of the assets of a window fabrication business and of the outstanding shares of Alumicor Limited in Canada. Both acquisitions are included within the Architectural Framing Systems segment. We estimate fiscal 2017 capital expenditures to be $50 to $60 million, which we expect will be focused on increasing product capabilities, in particular on expanding capabilities in the Architectural Glass segment to fabricate oversized glass. Capital expenditures will also be made to continue to increase manufacturing productivity and capacity. We continue to review our portfolio of businesses and their assets in comparison to our internal strategic and performance objectives. As part of this review, we may acquire other businesses, pursue geographic expansion, take actions to manage capacity and further invest in, fully divest and/or sell parts of our current businesses. Financing Activities. We paid dividends totaling $13.2 million in fiscal 2016. Additionally, we repurchased 575,000 shares under our authorized share repurchase program during fiscal 2016, for a total cost of $24.9 million and we repurchased 203,509 shares under the program during fiscal 2015, for a total cost of $6.9 million. We have repurchased a total of 3,057,632 shares, at a total cost of $61.5 million, since the inception of this program. We have remaining authority to repurchase 1,192,368 shares under this program, which has no expiration date. We maintain a $125.0 million committed revolving credit facility as described in Note 7 of the Notes to Consolidated Financial Statements. No borrowings were outstanding under this credit facility as of February 27, 2016 or February 28, 2015. At February 27, 2016, the Company was in compliance with the financial covenants of the credit facility. Our debt-to-total-capital ratio was 5.0 percent at February 27, 2016 and 5.1 percent at February 28, 2015. Other Financing Activities. The following summarizes our significant contractual obligations that impact our liquidity as of February 27, 2016: From time to time, we acquire the use of certain assets through operating leases, such as warehouses, vehicles, forklifts, office equipment, hardware, software and some manufacturing equipment. Many of these operating leases have termination penalties. However, because the assets are used in the conduct of our business operations, it is unlikely that any significant portion of these operating leases would be terminated prior to the normal expiration of their lease terms. Therefore, we consider the risk related to termination penalties to be minimal. We have purchase obligations for raw material commitments and capital expenditures. We expect to make contributions of $1.0 million to our defined-benefit pension plans in fiscal 2017, which will equal or exceed our minimum funding requirements. As of February 27, 2016, we had reserves of $4.4 million and $1.6 million for long-term unrecognized tax benefits and environmental liabilities, respectively. We expect approximately $0.9 million of the unrecognized tax benefits to lapse during the next 12 months. We are unable to reasonably estimate in which future periods the remaining unrecognized tax benefits and environmental liabilities will ultimately be settled. At February 27, 2016, we had ongoing letters of credit related to industrial revenue bonds and construction contracts that reduce availability of funds under our committed credit facility. The letters of credit by expiration period are as follows: In addition to the above standby letters of credit, we are required, in the ordinary course of business, to provide surety or performance bonds that commit payments to our customers for any non-performance by us. At February 27, 2016, $134.5 million of our backlog was bonded by performance bonds with a face value of $328.6 million. Performance bonds do not have stated expiration dates, as we are released from the bonds upon completion of the contract. We have never been required to make any payments related to these performance bonds with respect to any of our current portfolio of businesses. We had total cash and short-term marketable securities of $90.6 million, and $101.5 million available under our committed revolving credit facility at February 27, 2016. We believe that our sources of liquidity will continue to be adequate to fund our working capital requirements, planned capital expenditures and dividend payments over the next 12 months. Off-balance Sheet Arrangements. With the exception of operating leases, we had no off-balance sheet financing arrangements at February 27, 2016 or February 28, 2015. Outlook The following statements are based on our current expectations for fiscal 2017 results. These statements are forward-looking, and actual results may differ materially. • Revenue growth of approximately 10 percent over fiscal 2016. • Gross margin of at least 26 percent and operating margin of approximately 11 percent. • Earnings per share of $2.65 to $2.80. • Capital expenditures of approximately $50 to $60 million. Recently Issued Accounting Pronouncements See Note 1 of the Notes to Consolidated Financial Statements within Item 8 of this Form 10-K for information pertaining to recently issued accounting pronouncements, incorporated herein by reference. Critical Accounting Policies Our analysis of operations and financial condition is based on our consolidated financial statements prepared in accordance with U.S. GAAP. Preparation of these consolidated financial statements requires us to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the consolidated financial statements, reported amounts of revenues and expenses during the reporting period and related disclosures of contingent assets and liabilities. In developing these estimates and assumptions, a collaborative effort is undertaken involving management across the organization including finance, sales, project management, quality, legal and tax, as well as outside advisors such as consultants, engineers, lawyers and actuaries. Our estimates are evaluated on an ongoing basis and are drawn from historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results could differ under other assumptions or circumstances. The following items in our consolidated financial statements require significant estimation or judgment: Revenue recognition - We recognize revenue when title has transferred, except within our Architectural Services segment, which enters into fixed-price installation contracts. The contracts clearly specify the enforceable rights of the parties, the consideration and the terms of settlement, and both parties can be expected to satisfy all obligations under the contract. These contracts are typically performed over a 12- to 18-month timeframe, and we record revenue for these contracts on a percentage-of-completion basis as we are able to reasonably estimate total contract revenue and total contract costs. We compare the total costs incurred to date to the total estimated costs for the contract, and record that proportion of the total contract revenue in the period. Contract costs include materials, labor and other direct costs related to contract performance. We believe utilizing the cost-to-cost method for revenue recognition provides the greatest degree of accuracy in measuring revenue throughout the contract period. Provisions are established for estimated losses, if any, on uncompleted contracts in the period in which such losses are determined. Amounts representing contract change orders, claims or other items are included in contract revenue only upon customer approval. Recogizing revenue under the percentage-of-completion method of accounting requires significant estimates, including total costs and the percentage complete on the contract, as well as any potential losses or contract overruns. During fiscal 2016, approximately 25 percent of our consolidated sales were recorded on a percentage-of-completion basis. Goodwill impairment - We evaluate goodwill for impairment annually at our year-end, or more frequently if impairment indicators exist. Step one of the process compares the fair value of each of our reporting units to carrying value, including goodwill. If the fair value exceeds the carrying value, goodwill impairment is not indicated. We have seven business units that each represent a reporting unit for the goodwill impairment analysis. Based on our analysis, the estimated fair value of each reporting unit exceeded its carrying value and, therefore, goodwill impairment was not indicated. We base our determination of fair value on a discounted cash flow methodology that involves significant judgments about projections of future performance. Assumptions about future revenues and expenses, capital expenditures and changes in working capital are based on the annual operating plan and long-term business plan for each business unit. These plans take into consideration numerous factors including historical experience, anticipated future economic conditions and growth expectations for the industries and end markets in which we participate. Growth rates for revenues and operating profits vary for each reporting unit. Revenues and operating profit beyond our internal planning period are projected to grow at a perpetual growth rate of 3.0%. The discount rate assumption for each reporting unit takes into consideration our assessment of risks inherent in the future cash flows of our business and our weighted-average cost of capital. Reserves for disputes and claims regarding product liability and warranties - We are subject to claims associated with our products and services, principally as a result of disputes with our customers involving the performance or aesthetics of our architectural products and services. The time period from when a claim is asserted to when it is resolved, either by dismissal, negotiation, settlement or litigation, can be several years. While we maintain product liability insurance, the insurance policies include significant self-retention of risk in the form of policy deductibles. In addition, certain claims could be determined to be uninsured. We reserve estimated exposures on known claims, as well as on a portion of anticipated claims for product warranty and rework costs based on historical product liability claims as a ratio of sales. Self-insurance reserves - We obtain commercial insurance for potential losses for general liability, employment practices, workers' compensation, automobile liability, architect's and engineer's errors and omissions risk, product rework and other miscellaneous coverages. A substantial portion of this risk is retained on a self-insured basis through our wholly-owned insurance subsidiary. We establish a reserve for estimated ultimate losses on reported claims and those incurred but not yet reported utilizing actuarial projections. Income taxes - We record a tax provision for the anticipated tax consequences of the reported results of operations. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those deferred tax assets and liabilities are expected to be realized or settled. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws.

<s>[INST] This discussion contains “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All forecasts and projections in this document are “forwardlooking statements,” and are based on management's current expectations or beliefs of the Company's nearterm results, based on current information available pertaining to the Company, including the risk factors noted under Item 1A in this Form 10K. From time to time, we also may provide oral and written forwardlooking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by the Company. Any or all of our forwardlooking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forwardlooking statements made by or on behalf of the Company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to, the risks and uncertainties set forth under Item 1A in this Form 10K. We wish to caution investors that other factors might in the future prove to be important in affecting the Company's results of operations. New factors emerge from time to time; it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forwardlooking statements. We undertake no obligation to update publicly or revise any forwardlooking statements, whether as a result of new information, future events or otherwise. Overview We are a world leader in certain technologies involving the design and development of valueadded glass solutions for enclosing commercial buildings and framing art. Our four reporting segments are: Architectural Glass, Architectural Services, Architectural Framing Systems and LargeScale Optical Technologies (LSO). The following items highlight the results for fiscal 2016: Consolidated net sales increased 5 percent over fiscal 2015, or 7 percent on a constant currency basis, which is a nonGAAP measure. Operating income increased 53 percent over last year. All four segments grew revenue and earnings. Diluted EPS was $2.22, compared to $1.72 in the prior year, which included a $0.22 per share positive impact from an energyefficient tax credit. Excluding this tax credit, fiscal 2016 diluted EPS increased 48 percent over the prior year. Consolidated backlog was $508.0 million at February 27, 2016, up 4 percent over fiscal 2015. Results of Operations Net Sales Fiscal 2016 Compared to Fiscal 2015 Net sales in fiscal 2016 improved by 5.1 percent, or 7.0 percent on a constant currency basis, mainly due to pricing and volume growth resulting from strong commercial construction activity in the U.S, partially offset by declines in the commercial construction markets in Brazil and Canada. The Architectural Glass segment drove approximately 44 percent of the growth this year, and the Architectural Services segment drove approximately 32 percent of the growth, with nearly all of the remainder coming from the domestic Architectural Framing segment businesses. Constant currency revenue excludes the impact of fluctuations in foreign currency on our international operations. Constant currency percentages are calculated by converting priorperiod local currency results using the average monthly exchange rate and comparing the adjusted amount to current period reported results. We believe constant currency information provides valuable supplemental information regarding our core operating results, consistent with how we evaluate our performance. We also refer to constant currency measures elsewhere in this report. These nonGAAP measures should be viewed in addition to, and not as an alternative to, the reported results prepared in accordance with GAAP. Fiscal 2015 Comp [/INST] Negative. </s>

APOGEE ENTERPRISES, INC.

2017-04-28

2017-03-04

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This discussion contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All forecasts and projections in this document are “forward-looking statements,” and are based on management's current expectations or beliefs of the Company's near-term results, based on current information available pertaining to the Company, including the risk factors noted under Item 1A in this Form 10-K. From time to time, we also may provide oral and written forward-looking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by the Company. Any or all of our forward-looking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forward-looking statements made by or on behalf of the Company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to, the risks and uncertainties set forth under Item 1A in this Form 10-K. We wish to caution investors that other factors might in the future prove to be important in affecting the Company's results of operations. New factors emerge from time to time; it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Overview We are a world leader in certain technologies involving the design and development of value-added glass products and services. Our four reporting segments are: Architectural Glass, Architectural Framing Systems, Architectural Services and Large-Scale Optical Technologies (LSO). Highlights for fiscal 2017: • Consolidated net sales increased to $1.1 billion, or 14 percent over fiscal 2016. • Operating income increased to $122 million, or 25 percent over the prior year. • Diluted EPS was $2.97, compared to $2.22 in the prior year, for growth of 34 percent. • We acquired the assets of Sotawall, Inc., a Canadian privately-held designer and fabricator of high-performance, unitized curtainwall systems for commercial construction projects, for approximately $138 million on December 14, 2016. Sotawall's results since the date of acquisition have been included in the consolidated financial statements and within the Architectural Framing Systems segment. Results of Operations Net Sales Fiscal 2017 Compared to Fiscal 2016 Net sales in fiscal 2017 increased by 13.6 percent compared to fiscal 2016, due to gains in volume across all three architectural segments. Volume growth was driven by continued strength in non-residential construction end-markets and success in our strategies to expand geographically and introduce new products. The Architectural Framing Systems segment drove nearly 60 percent of our growth this year. The acquisition of Sotawall in the fourth quarter, included in this segment, contributed 13 percent of our overall growth. The Architectural Glass segment drove approximately 22 percent of our growth and the Architectural Services segment contributed nearly all of the remainder. Currency did not have a meaningful impact on our consolidated sales as compared to the prior year. Fiscal 2016 Compared to Fiscal 2015 Net sales increased by 5.1 percent, or 7.0 percent on a constant currency basis, over fiscal 2015. This was mainly due to pricing and volume growth resulting from strong commercial construction activity in the U.S, partially offset by declines in the commercial construction markets in Brazil and Canada. The Architectural Glass segment accounted for approximately 44 percent of the growth, and the Architectural Services segment drove approximately 32 percent of the growth, with nearly all of the remainder coming from the domestic Architectural Framing segment businesses. Constant currency revenue excludes the impact of fluctuations in foreign currency on our international operations. Constant currency percentages are calculated by converting prior-period local currency results using the average monthly exchange rate and comparing the adjusted amount to current period reported results. We believe constant currency information provides valuable supplemental information regarding our core operating results, consistent with how we evaluate our performance. We also refer to constant currency measures elsewhere in this report. This non-GAAP measure should be viewed in addition to, and not as an alternative to, the reported results prepared in accordance with U.S. GAAP. Performance The relationship between various components of operations, as a percentage of net sales, is provided below. Fiscal 2017 Compared to Fiscal 2016 Gross profit was 26.2 percent in fiscal 2017, an improvement of 140 basis points from fiscal 2016, driven by operating leverage on increased volume and improved productivity in our three architectural segments. Selling, general and administrative (SG&A) expense for fiscal 2017 was 15.2 percent, an increase of 30 basis points, or $23.6 million, from fiscal 2016, mainly as a result of increased incentive-related compensation and intangible asset amortization expenses. The effective tax rate for fiscal 2017 was 30.1 percent, compared to 32.9 percent in fiscal 2016. The decline of 280 basis points was a result of benefits from various tax planning strategies, including recognition of a foreign tax credit contributing 160 basis points, and increased income in foreign jurisdictions with lower tax rates. Fiscal 2016 Compared to Fiscal 2015 Gross profit improved 250 basis points from fiscal 2015 to fiscal 2016, primarily due to improved pricing and mix, as well as productivity and volume leverage across all architectural segments. SG&A expense declined by 60 basis points from 2015 to 2016, but increased $1.2 million, as a result of expense discipline relative to sales growth across our segments. Our effective tax rate for fiscal 2015 was 22.3 percent, including a $6.4 million tax benefit from an energy-efficient investment credit. Excluding this credit, our effective tax rate would have been 32.2%, compared to 32.9% in fiscal 2016. This increase of 70 basis points was due to changes in state income tax laws, combined with a higher percentage of earnings in the U.S., where the tax rate is higher than in the foreign jurisdictions in which we operate. Segment Analysis Architectural Glass Fiscal 2017 Compared to Fiscal 2016. Fiscal 2017 net sales increased $34.2 million, or 9.0 percent, over the prior year. This was primarily due to volume growth and improved pricing and mix in our U.S.-based business, as a result of our focus on growth in the mid-size building sector, as well as the effects of a positive U.S. construction market. Currency did not have a meaningful impact on segment sales as compared to the prior year. Operating margin improved 140 basis points, driven by leverage on volume growth, pricing, mix and productivity. Fiscal 2016 Compared to Fiscal 2015. Fiscal 2016 net sales improved 9.0 percent over the prior year, or 12.2 percent on a constant currency basis, primarily due to improved pricing, mix and volume growth in the U.S. as a result of the strong U.S. construction market, partially offset by declines in volume and mix in our Brazilian operation and lower export sales from the U.S. Operating margin improved 470 basis points, doubling the fiscal 2015 operating margin, with improvement driven by pricing and mix, as well as strong operational performance and volume leverage in the U.S., partially offset by the impact of ongoing challenging Brazilian economic conditions. Architectural Framing Systems Fiscal 2017 Compared to Fiscal 2016. Net sales improved 25.1 percent, or $77.4 million, over fiscal 2016 due to volume growth across our businesses. Our volume growth resulted from strong U.S. construction market conditions, increased penetration into certain geographies and new product introductions. In addition, Sotawall, acquired in the fourth quarter of fiscal 2017, contributed net sales of $17.8 million in fiscal 2017, or approximately six percentage points of growth. Currency did not have a meaningful impact on segment sales as compared to the prior year. Operating margin improved 130 basis points over fiscal 2016, driven by leverage on volume growth and productivity. Fiscal 2016 Compared to Fiscal 2015. Net sales improved 3.4 percent over fiscal 2015, or 6.0 percent on a constant currency basis, on volume growth from strong U.S. construction markets, and improved pricing and mix in our U.S. businesses, partially offset by volume weakness in our Canadian business. Operating margin improved 300 basis points over fiscal 2015, driven by improved pricing and mix, lower raw material costs and volume leverage in the U.S., partially offset by the volume weakness in our Canadian business. Architectural Services Fiscal 2017 Compared to Fiscal 2016. Net sales improved 10.2 percent, or $25.0 million, over the prior year, driven by volume growth due to year-on-year timing of project activity, as we have continued to experience strong commercial construction activity in the U.S. Operating margin improved 200 basis points over the prior year, as a result of leveraging volume growth and continued good execution on projects with better margins. Fiscal 2016 Compared to Fiscal 2015. Net sales improved 6.6 percent over the prior year, driven by volume growth due to increased commercial construction activity in the U.S. Operating margin improved 160 basis points over the prior year, as a result of continued focus on project selection, improved project margins and good execution. Large-Scale Optical Technologies (LSO) Fiscal 2017 Compared to Fiscal 2016. Net sales in our LSO segment increased 1.3 percent over the prior year. Operating margin declined 90 basis points over the prior year as a result of increased investments in new market opportunities. Fiscal 2016 Compared to Fiscal 2015. Net sales in this segment increased 1.0 percent over the prior year as a result of an improved mix of value-added products and stable demand. Operating margin improved 90 basis points over the prior year as a result of improved product mix and strong operational performance. Liquidity and Capital Resources Operating Activities. Cash provided by operating activities was $124.0 million in fiscal 2017, a decrease of $5.0 million from fiscal 2016. In all years presented, operating cash flows benefited by increased income as compared to the respective prior-year period. In addition, in fiscal 2017, cash from operations was negatively impacted by timing of working capital payments. Investing Activities. Net cash used in investing activities was $183.8 million in the current year, mainly due to the acquisition of substantially all the assets of Sotawall, Inc. for approximately $138 million. We also made capital expenditures focused primarily on increasing our product capabilities, in particular related to the oversized glass fabrication project. Additional capital investments were made to increase our manufacturing productivity across all reporting segments. In fiscal 2016 and 2015, capital investments were primarily focused on increasing manufacturing productivity and capacity. We estimate fiscal 2018 capital expenditures to be $50 to $60 million, as we continue to invest in capabilities and productivity. We continue to review our portfolio of businesses and their assets in comparison to our internal strategic and performance objectives. As part of this review, we may acquire other businesses, pursue geographic expansion, take actions to manage capacity and further invest in, fully divest and/or sell parts of our current businesses. Financing Activities. We paid dividends totaling $14.7 million in fiscal 2017. Additionally, we repurchased 250,001 shares under our authorized share repurchase program during fiscal 2017, for a total cost of $10.8 million. We repurchased 575,000 shares under the program in fiscal 2016 and 203,509 shares under the program during fiscal 2015. We have repurchased a total of 3,307,633 shares, at a total cost of $72.3 million, since the inception of this program during fiscal 2004. We have remaining authority to repurchase 942,367 shares under this program, which has no expiration date. We maintain a $175.0 million committed revolving credit facility that expires in November 2021 as further described in Note 8 of the Notes to Consolidated Financial Statements. $45.0 million was outstanding under this credit facility as of March 4, 2017, as we used this facility to partially finance the Sotawall acquisition. Nothing was outstanding under this credit facility at the end of either of the two prior years. As defined within this credit facility, we have two financial covenants which require us to stay below a maximum leverage ratio and to maintain a minimum interest expense-to-EBITDA ratio. At March 4, 2017, we were in compliance with both financial covenants. Other Financing Activities. The following summarizes our significant contractual obligations that impact our liquidity as of March 4, 2017: In addition to the committed revolving credit facility discussed above, we also have industrial revenue bond obligations of $20.4 million that mature in fiscal years 2021 through 2043. From time to time, we acquire the use of certain assets through operating leases, such as warehouses, vehicles, forklifts, office equipment, hardware, software and some manufacturing equipment. Many of these operating leases have termination penalties. However, because the assets are used in the conduct of our business operations, it is unlikely that any significant portion of these operating leases would be terminated prior to the normal expiration of their lease terms. Therefore, we consider the risk related to termination penalties to be minimal. Purchase obligations in the table above relate to raw material commitments and capital expenditures. We expect to make contributions of approximately $1.0 million to our defined-benefit pension plans in fiscal 2018, which will equal or exceed our minimum funding requirements. As of March 4, 2017, we had reserves of $4.0 million and $1.4 million for long-term unrecognized tax benefits and environmental liabilities, respectively. We expect approximately $0.4 million of the unrecognized tax benefits to lapse during the next 12 months. We are unable to reasonably estimate in which future periods the remaining unrecognized tax benefits and environmental liabilities will ultimately be settled. At March 4, 2017, we had ongoing letters of credit of $23.5 million related to industrial revenue bonds and construction contracts that expire in fiscal 2018 and that reduce availability of funds under our committed credit facility. In addition to the above standby letters of credit, we are required, in the ordinary course of business, to provide surety or performance bonds that commit payments to our customers for any non-performance by us. At March 4, 2017, $96.2 million of our backlog was bonded by performance bonds with a face value of $343.7 million. Performance bonds do not have stated expiration dates, as we are released from the bonds upon completion of the contracts. We have never been required to make any payments related to these performance bonds with respect to any of our current portfolio of businesses. We had total cash and short-term marketable securities of $20.0 million, and $106.5 million available under our committed revolving credit facility, at March 4, 2017. Due to our ability to generate strong cash from operations and borrowing capability under our committed revolving credit facility, we believe that our sources of liquidity will continue to be adequate to fund our working capital requirements, planned capital expenditures and dividend payments for at least the next 12 months. Off-balance Sheet Arrangements. With the exception of operating leases, we had no off-balance sheet financing arrangements at March 4, 2017 or February 27, 2016. Outlook The following statements are based on our current expectations for fiscal 2018 results. These statements are forward-looking, and actual results may differ materially. • Revenue growth of approximately 10 percent over fiscal 2017. • Gross margin of approximately 28 percent and operating margin of approximately 12.5 percent. • Earnings per diluted share of $3.35 to $3.55. • Capital expenditures of approximately $50 to $60 million. Recently Issued Accounting Pronouncements See Note 1 of the Notes to Consolidated Financial Statements within Item 8 of this Form 10-K for information pertaining to recently issued accounting pronouncements, incorporated herein by reference. Critical Accounting Policies Our analysis of operations and financial condition is based on our consolidated financial statements prepared in accordance with U.S. GAAP. Preparation of these consolidated financial statements requires us to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the consolidated financial statements, reported amounts of revenues and expenses during the reporting period and related disclosures of contingent assets and liabilities. In developing these estimates and assumptions, a collaborative effort is undertaken involving management across the organization including finance, sales, project management, quality, risk, legal and tax, as well as outside advisors such as consultants, engineers, lawyers and actuaries. Our estimates are evaluated on an ongoing basis and are drawn from historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results could differ under other assumptions or circumstances. The following items in our consolidated financial statements require significant estimation or judgment: Revenue recognition. We recognize revenue when title has transferred, except within our Architectural Services segment and for one business within our Architectural Framing Systems segment, which enter into fixed-price contracts for projects typically performed over a 12- to 24-month timeframe. The contracts clearly specify the enforceable rights of the parties, the consideration and the terms of settlement, and both parties can be expected to satisfy all obligations under the contract. We record revenue for these contracts on a percentage-of-completion basis as we are able to reasonably estimate total contract revenue and total contract costs. We compare the total costs incurred to date to the total estimated costs for the contract, and record that proportion of the total contract revenue in the period. Contract costs include materials, labor and other direct costs related to contract performance. We believe utilizing the cost-to-cost method for revenue recognition provides the greatest degree of accuracy in measuring revenue throughout the contract period. Provisions are established for estimated losses, if any, on uncompleted contracts in the period in which such losses are determined. Amounts representing contract change orders, claims or other items are included in contract revenue only upon customer approval. Recognizing revenue under the percentage-of-completion method of accounting requires significant estimates, including total costs and the percentage complete on the contract, as well as any potential losses or contract overruns. During fiscal 2017, approximately 26 percent of our consolidated sales were recorded on a percentage-of-completion basis. Goodwill impairment. We evaluate goodwill for impairment annually at our year-end, or more frequently if impairment indicators exist. This year we elected to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount (commonly referred to as “step 0”). If, after assessing all events and circumstances, it is determined that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then the two-step goodwill impairment assessment is unnecessary. If we proceed in the goodwill analysis, step 1 of the process compares the fair value of each of our reporting units to carrying value, including goodwill. If the fair value exceeds the carrying value, goodwill impairment is not indicated. Each of our business units represents a reporting unit for the goodwill impairment analysis. Based on our assessment process, we determined that it was not more likely than not that the fair value of any of our reporting units was less than its carrying amount. When we perform step 1 of the goodwill impairment assessment, we base our determination of fair value on a discounted cash flow methodology that involves significant judgment about projections of future performance. Assumptions about future revenues and expenses, capital expenditures and changes in working capital are based on the annual operating plan and long-term business plan for each business unit. These plans take into consideration numerous factors, including historical experience, anticipated future economic conditions and growth expectations for the industries and end markets in which we participate. Growth rates for revenues and operating profits vary for each reporting unit. The discount rate assumption for each reporting unit takes into consideration our assessment of risks inherent in the future cash flows of our business and an estimated weighted-average cost of capital. Reserves for disputes and claims regarding product liability and warranties. We are subject to claims associated with our products and services, principally as a result of disputes with our customers involving the performance or aesthetics of our architectural products and services. The time period from when a claim is asserted to when it is resolved, either by dismissal, negotiation, settlement or litigation, can be several years. While we maintain product liability insurance, the insurance policies include significant self-retention of risk in the form of policy deductibles. In addition, certain claims could be determined to be uninsured. We reserve estimated exposures on known claims, as well as on a portion of anticipated claims for product warranty and rework costs based on historical product liability claims as a ratio of sales. Factors that could have an impact on the warranty reserve in any given period include: changes in manufacturing quality, shifts in product mix and any significant changes in sales volume.

<s>[INST] This discussion contains “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All forecasts and projections in this document are “forwardlooking statements,” and are based on management's current expectations or beliefs of the Company's nearterm results, based on current information available pertaining to the Company, including the risk factors noted under Item 1A in this Form 10K. From time to time, we also may provide oral and written forwardlooking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by the Company. Any or all of our forwardlooking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forwardlooking statements made by or on behalf of the Company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to, the risks and uncertainties set forth under Item 1A in this Form 10K. We wish to caution investors that other factors might in the future prove to be important in affecting the Company's results of operations. New factors emerge from time to time; it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forwardlooking statements. We undertake no obligation to update publicly or revise any forwardlooking statements, whether as a result of new information, future events or otherwise. Overview We are a world leader in certain technologies involving the design and development of valueadded glass products and services. Our four reporting segments are: Architectural Glass, Architectural Framing Systems, Architectural Services and LargeScale Optical Technologies (LSO). Highlights for fiscal 2017: Consolidated net sales increased to $1.1 billion, or 14 percent over fiscal 2016. Operating income increased to $122 million, or 25 percent over the prior year. Diluted EPS was $2.97, compared to $2.22 in the prior year, for growth of 34 percent. We acquired the assets of Sotawall, Inc., a Canadian privatelyheld designer and fabricator of highperformance, unitized curtainwall systems for commercial construction projects, for approximately $138 million on December 14, 2016. Sotawall's results since the date of acquisition have been included in the consolidated financial statements and within the Architectural Framing Systems segment. Results of Operations Net Sales Fiscal 2017 Compared to Fiscal 2016 Net sales in fiscal 2017 increased by 13.6 percent compared to fiscal 2016, due to gains in volume across all three architectural segments. Volume growth was driven by continued strength in nonresidential construction endmarkets and success in our strategies to expand geographically and introduce new products. The Architectural Framing Systems segment drove nearly 60 percent of our growth this year. The acquisition of Sotawall in the fourth quarter, included in this segment, contributed 13 percent of our overall growth. The Architectural Glass segment drove approximately 22 percent of our growth and the Architectural Services segment contributed nearly all of the remainder. Currency did not have a meaningful impact on our consolidated sales as compared to the prior year. Fiscal 2016 Compared to Fiscal 2015 Net sales increased by 5.1 percent, or 7.0 percent on a constant currency basis, over fiscal 2015. This was mainly due to pricing and volume growth resulting from strong commercial construction activity in the U.S, partially offset by declines in the commercial construction markets in [/INST] Positive. </s>

APOGEE ENTERPRISES, INC.

2018-04-30

2018-03-03

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This discussion contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All forecasts and projections in this document are “forward-looking statements,” and are based on management's current expectations or beliefs of the Company's near-term results, based on current information available pertaining to the Company, including the risk factors noted under Item 1A in this Form 10-K. From time to time, we also may provide oral and written forward-looking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by the Company. Any or all of our forward-looking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forward-looking statements made by or on behalf of the Company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to, the risks and uncertainties set forth under Item 1A in this Form 10-K. We wish to caution investors that other factors might in the future prove to be important in affecting the Company's results of operations. New factors emerge from time to time; it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Overview We are a world leader in the design and development of value-added glass and metal products and services. Our four reporting segments are: Architectural Framing Systems, Architectural Glass, Architectural Services and Large-Scale Optical Technologies (LSO). During fiscal 2018, we advanced strategies to diversify and strengthen our revenue streams in order to improve the stability of our business throughout an economic cycle, by focusing on diversifying geographies, markets and project sizes served. We also focused on generating cash flow and expanding backlog, as we continue to execute on our strategies and grow our business in fiscal 2019 and beyond. Fiscal 2018 summary of results: • Consolidated net sales increased to $1.3 billion, or 19 percent over fiscal 2017. • Operating income was $114.3 million, a decline of 6.5 percent from $122.2 million in the prior year. • Diluted EPS was $2.76, compared to $2.97 in the prior year, a decline of 7 percent. • Adjusted operating income was $132.9 million, an increase of 6.8 percent compared to the prior year, and adjusted diluted EPS was $3.23, an increase of 6.6 percent compared to the prior year. Refer to the tables that follow for details of these adjusted amounts. • In June 2017, we acquired the assets of EFCO Corporation, a privately-held U.S. manufacturer of architectural aluminum window, curtainwall, storefront and entrance systems for commercial construction projects, for $192 million in cash. EFCO's results of operations have been included in our consolidated financial statements and within the Architectural Framing Systems segment since the date of acquisition. Adjusted operating income, adjusted operating margin and adjusted earnings per diluted share (“adjusted diluted EPS”) are supplemental non-GAAP measures provided to assess performance on a more comparable basis from period to period by excluding amounts that management does not consider part of core operating results. Management uses these non-GAAP measures to evaluate the company’s historical and prospective financial performance, measure operational profitability on a consistent basis, and provide enhanced transparency to the investment community. These non-GAAP measures should be viewed in addition to, and not as an alternative to, the reported financial results of the company prepared in accordance with GAAP. Other companies may calculate these measures differently, limiting the usefulness of the measure for comparison with other companies. Income tax impact on the adjustments is calculated based on the Company's effective tax rate for each period presented. Results of Operations Net Sales Fiscal 2018 Compared to Fiscal 2017 Net sales in fiscal 2018 increased by 19.0 percent compared to fiscal 2017 due to the acquisition of EFCO in the second quarter of 2018. This acquisition, as well as a full year of results from Sotawall (acquired in the fourth quarter of fiscal 2017) and pricing and volume gains from our existing segment businesses, resulted in overall growth in our Architectural Framing Systems segment, which was partially offset by volume declines in our Architectural Services and Architectural Glass segments. Fiscal 2017 Compared to Fiscal 2016 Net sales in fiscal 2017 increased by 13.6 percent compared to fiscal 2016, due to gains in volume across all three architectural segments, as well as the inclusion of Sotawall, acquired in the fourth quarter of fiscal 2017. Volume growth was driven by continued strength in non-residential construction end-markets and success in our strategies to expand geographically and introduce new products. The Architectural Framing Systems segment drove nearly 60 percent of our growth, with the acquisition of Sotawall in the fourth quarter contributing 13 percent of our overall growth. The Architectural Glass segment drove approximately 22 percent of our growth and the Architectural Services segment contributed nearly all of the remainder. Performance The relationship between various components of operations, as a percentage of net sales, is provided below. Fiscal 2018 Compared to Fiscal 2017 Gross profit was 25.1 percent in fiscal 2018, a decline of 110 basis points from fiscal 2017, driven by reduced operating leverage on volume within the Architectural Services and Architectural Glass segments and the inclusion of EFCO at lower margins, somewhat offset by improved productivity across all our segments. Selling, general and administrative (SG&A) expense for fiscal 2018 was 16.5 percent, an increase of 130 basis points, or $49.4 million, from fiscal 2017, mainly as a result of the inclusion of EFCO, as well as a full year of amortization expense on intangible assets acquired in the Sotawall transaction. The effective tax rate for fiscal 2018 was 27.7 percent, compared to 30.1 percent in fiscal 2017. The decline of 240 basis points was a result of benefits from the U.S. Tax Cuts and Jobs Act ("the Act"), enacted in December 2017. Fiscal 2017 Compared to Fiscal 2016 Gross profit was 26.2 percent in fiscal 2017, an improvement of 140 basis points from fiscal 2016, driven by operating leverage on increased volume and improved productivity in our three architectural segments. Selling, general and administrative expense for fiscal 2017 was 15.2 percent, an increase of 30 basis points, or $23.6 million, from fiscal 2016, mainly as a result of increased incentive-related compensation and intangible asset amortization expenses. The effective tax rate for fiscal 2017 was 30.1 percent, compared to 32.9 percent in fiscal 2016. The decline of 280 basis points was a result of benefits from various tax planning strategies, including recognition of a foreign tax credit contributing 160 basis points, and increased income in foreign jurisdictions with lower tax rates. Segment Analysis Architectural Framing Systems Fiscal 2018 Compared to Fiscal 2017. Net sales improved 75.4 percent, or $291.2 million, over fiscal 2017. EFCO, acquired in the second quarter of fiscal 2018, contributed net sales of $203.7 million in fiscal 2018, or approximately 70 percent of the total segment growth, and Sotawall contributed 19 percent of the growth in fiscal 2018. Net sales increased 8.7 percent over the prior year within our existing businesses, due to increased pricing in order to offset material inflation, volume growth due to gains in share of demand and geographic growth in North America. Operating margin declined 290 basis points over fiscal 2017, with improved margins in legacy businesses offset by the inclusion of EFCO at lower operating margins. Fiscal 2017 Compared to Fiscal 2016. Net sales improved 25.1 percent, or $77.4 million, over fiscal 2016, due to volume growth across our businesses. Our volume growth resulted from strong U.S. construction market conditions, increased penetration into certain geographies and new product introductions. In addition, Sotawall, acquired in the fourth quarter of fiscal 2017, contributed net sales of $17.8 million in fiscal 2017, or approximately six percentage points of growth. Operating margin improved 130 basis points over fiscal 2016, driven by leverage on volume growth and productivity. Architectural Glass Fiscal 2018 Compared to Fiscal 2017. Fiscal 2018 net sales decreased 6.7 percent, or $27.7 million, over the prior year. The decrease was primarily due to volume declines on larger projects in our U.S.-based business, as a result of international competition as well as lower pricing on a higher mix of less complex glass products for mid-size projects. Operating margin declined 230 basis points, driven by reduced operating leverage on lower volume, lower pricing due to project mix and restructuring-related charges associated with the closure of our Utah facility, somewhat offset by improved productivity. Fiscal 2017 Compared to Fiscal 2016. Fiscal 2017 net sales increased 9.0 percent, or $34.2 million, over the prior year. This was primarily due to volume growth and improved pricing and mix in our U.S.-based business, as a result of our focus on growth in the mid-size building sector, as well as the effects of a positive U.S. construction market. Operating margin improved 140 basis points, driven by leverage on volume growth, pricing, mix and productivity. Architectural Services Fiscal 2018 Compared to Fiscal 2017. Net sales decreased 21.1 percent, or $57.2 million, over the prior year, due to year-on-year timing of project activity. Operating margin declined 190 basis points over the prior year, as a result of lower volume leverage on fixed project management, engineering and manufacturing costs, partially offset by favorable project performance. Fiscal 2017 Compared to Fiscal 2016. Net sales improved 10.2 percent, or $25.0 million, over fiscal 2016, driven by volume growth. This growth was due to year-on-year timing of project activity, as we continued to experience strong commercial construction activity in the U.S. Operating margin improved 200 basis points over the same period, as a result of leveraging volume growth and continued good execution on projects with better margins. Large-Scale Optical Technologies (LSO) Fiscal 2018 Compared to Fiscal 2017. Net sales decreased 1.6 percent over the prior year and operating margin declined 10 basis points over the prior year, as productivity gains were offset by unfavorable pricing, mix and volume. Fiscal 2017 Compared to Fiscal 2016. Net sales increased 1.3 percent over the prior year due to volume growth. Operating margin declined 90 basis points over the prior year, as a result of increased investments in new market opportunities. Liquidity and Capital Resources Operating Activities. Cash provided by operating activities was $127.5 million in fiscal 2018, an increase of $3.5 million from fiscal 2017. In both fiscal 2018 and fiscal 2017 we maintained effective working capital management. Investing Activities. Net cash used in investing activities was $225.7 million in fiscal 2018, largely due to the acquisition of EFCO and capital expenditures focused primarily on increasing our product capabilities and manufacturing productivity. In fiscal 2017, cash of $183.8 million was used to acquire Sotawall and to make capital expenditures focused on increasing our product capabilities, in particular related to our oversized glass fabrication project, and manufacturing productivity. In fiscal 2016, capital investments were primarily focused on increasing manufacturing productivity and capacity. We estimate fiscal 2019 capital expenditures to be $60 to $65 million, as we continue to invest in productivity and capacity to capture new geographic and market segments. We continue to review our portfolio of businesses and their assets in comparison to our internal strategic and performance objectives. As part of this review, we may continue to acquire other businesses, pursue geographic expansion, take actions to manage capacity and further invest in, fully divest and/or sell parts of our current businesses. Financing Activities. We paid dividends totaling $16.4 million in fiscal 2018. Additionally, we repurchased 702,299 shares under our authorized share repurchase program during fiscal 2018, for a total cost of $33.7 million. We repurchased 250,001 shares under the program in fiscal 2017 and 575,000 shares under the program in fiscal 2016. We have repurchased a total of 4,009,932 shares, at a total cost of $106.0 million, since the 2004 inception of this program. We have remaining authority to repurchase 1,240,068 shares under this program, which has no expiration date. We maintain a $335.0 million committed revolving credit facility that expires in November 2021, as further described in Note 8 of the Notes to Consolidated Financial Statements. $195.0 million was outstanding under this credit facility as of March 3, 2018, as we used this facility to finance the EFCO acquisition. As defined within the credit facility, we have two financial covenants which require us to stay below a maximum leverage ratio and to maintain a minimum interest expense-to-EBITDA ratio. At March 3, 2018, we were in compliance with both financial covenants. Other Financing Activities. The following summarizes our significant contractual obligations that impact our liquidity as of March 3, 2018: In addition to the committed revolving credit facility discussed above, we also have industrial revenue bond obligations of $20.4 million that mature in fiscal years 2021 through 2043 and $0.5 million of other debt that matures in August 2022. We acquire the use of certain assets through operating leases, such as warehouses, vehicles, forklifts, office equipment, hardware, software and some manufacturing equipment. While many of these operating leases have termination penalties, we consider the risk related to termination penalties to be minimal. Purchase obligations in the table above relate to raw material commitments and capital expenditures. We expect to make contributions of approximately $1.0 million to our defined-benefit pension plans in fiscal 2019, which will equal or exceed our minimum funding requirements. As of March 3, 2018, we had reserves of $4.6 million and $1.3 million for long-term unrecognized tax benefits and environmental liabilities, respectively. We expect approximately $0.5 million of the unrecognized tax benefits to lapse during the next 12 months. We are unable to reasonably estimate in which future periods the remaining unrecognized tax benefits and environmental liabilities will ultimately be settled. At March 3, 2018, we had ongoing letters of credit of $23.5 million related to industrial revenue bonds and construction contracts that expire in fiscal 2019 and that reduce availability of funds under our committed credit facility. In addition to the above standby letters of credit, we are required, in the ordinary course of business, to provide surety or performance bonds that commit payments to our customers for any non-performance by us. At March 3, 2018, $238.6 million of our backlog was bonded by performance bonds with a face value of $519.3 million. Performance bonds do not have stated expiration dates, as we are released from the bonds upon completion of the contracts and any related warranty periods. We have never been required to make any payments related to these performance bonds with respect to any of our current portfolio of businesses. We had total cash and short-term marketable securities of $19.8 million, and $116.5 million available under our committed revolving credit facility, at March 3, 2018. Due to our ability to generate strong cash from operations and our borrowing capability under our committed revolving credit facility, we believe that our sources of liquidity will continue to be adequate to fund our working capital requirements, planned capital expenditures and dividend payments for at least the next 12 months. Off-balance Sheet Arrangements. With the exception of operating leases, we had no off-balance sheet arrangements at March 3, 2018 or March 4, 2017. Outlook The following statements are based on our current expectations for fiscal 2019 results. These statements are forward-looking, and actual results may differ materially. • Revenue growth of approximately 10 percent over fiscal 2018. • Operating margin of 8.8 to 9.3 percent. • Earnings per diluted share of $3.30 to $3.50. • Adjusted operating margin of 9.1 to 9.6 percent and adjusted earnings per diluted share of $3.43 to $3.63. These are non-GAAP measures that reflect the after-tax impact of amortization of short-lived acquired intangible assets from the Sotawall and EFCO acquisitions of $3.8 million ($0.13 per diluted share). • Capital expenditures of approximately $60 to $65 million. • Effective annual tax rate of approximately 24 percent. Recently Issued Accounting Pronouncements See Note 1 of the Notes to Consolidated Financial Statements within Item 8 of this Form 10-K for information pertaining to recently issued accounting pronouncements, incorporated herein by reference. Critical Accounting Policies Our analysis of operations and financial condition is based on our consolidated financial statements prepared in accordance with U.S. GAAP. Preparation of these consolidated financial statements requires us to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the consolidated financial statements, reported amounts of revenues and expenses during the reporting period and related disclosures of contingent assets and liabilities. In developing these estimates and assumptions, a collaborative effort is undertaken involving management across the organization, including finance, sales, project management, quality, risk, legal and tax, as well as outside advisors, such as consultants, engineers, lawyers and actuaries. Our estimates are evaluated on an ongoing basis and are drawn from historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results could differ under other assumptions or circumstances. We consider the following items in our consolidated financial statements to require significant estimation or judgment. Revenue recognition We recognize revenue when title has transferred, except within our Architectural Services segment and for one business within our Architectural Framing Systems segment, which enter into fixed-price contracts for projects typically performed over a 12- to 24-month timeframe. The contracts clearly specify the enforceable rights of the parties, the consideration and the terms of settlement, and both parties are expected to satisfy all obligations under the contract. We record revenue for these contracts on a percentage-of-completion basis as we are able to reasonably estimate total contract revenue and total contract costs. We compare the total costs incurred to date to the total estimated costs for the contract, and record that proportion of the total contract revenue in the period. Contract costs include materials, labor and other direct costs related to contract performance. We believe utilizing the cost-to-cost method for revenue recognition provides the greatest degree of accuracy in measuring revenue throughout the contract period. Provisions are established for estimated losses, if any, on uncompleted contracts in the period in which such losses are determined. Amounts representing contract change orders, claims or other items are included in contract revenue only upon customer approval. Recognizing revenue under the percentage-of-completion method of accounting requires significant estimates, including total costs and the percentage complete on the contract, as well as any potential losses or contract overruns. During fiscal 2018, approximately 22 percent of our consolidated sales were recorded on a percentage-of-completion basis. Goodwill and indefinite-lived intangible asset impairment Goodwill We evaluate goodwill for impairment annually at our year-end, or more frequently if events or changes in circumstances indicate that the asset might be impaired. This year we elected to bypass the qualitative assessment process and to proceed directly to comparing the fair value of each of our reporting units to carrying value, including goodwill. If the fair value exceeds the carrying value, goodwill impairment is not indicated. Each of our nine businesses (or business units) represents a reporting unit for the goodwill impairment analysis. For our goodwill impairment testing beginning in fiscal 2018, we have elected to early adopt Accounting Standards Update No. 2017-04, Simplifying the Test for Goodwill Impairment. As a result of this election, if the carrying amount of a reporting unit would be determined to be higher than its estimated fair value, an impairment loss is recognized for the excess. We base our determination of fair value on a discounted cash flow methodology that involves significant judgment and projections of future performance. Assumptions about future revenues and expenses, capital expenditures and changes in working capital are based on the annual operating plan and long-term business plan for each business unit. These plans take into consideration numerous factors, including historical experience, anticipated future economic conditions and growth expectations for the industries and end markets in which we participate. Growth rates for revenues and operating profits vary for each reporting unit. The discount rate assumption is consistent across business units and takes into consideration an estimated weighted-average cost of capital. Based on our analysis, the estimated fair value of each reporting unit exceeded its carrying value and, therefore, goodwill impairment was not indicated. However, for one of our businesses within our Architectural Framing Systems segment with goodwill of approximately $21.8 million, fair value did not exceed carrying value by a significant margin. We utilized a discount rate of 10.8 percent in determining the discounted cash flows in our fair value analysis and a perpetual growth rate of 3 percent. If our discount rate were to increase by 100 basis points, the fair value of this reporting units could fall below carrying value, which would indicate impairment of the goodwill on this business. Indefinite-lived intangible assets We hold intangible assets for certain acquired tradenames and trademarks which are determined to have indefinite useful lives. We evaluate the reasonableness of the useful life and test indefinite-lived intangible assets for impairment annually at our year-end, or more frequently if events or changes in circumstances indicate that it is more likely than not that the asset is impaired. We bypassed a qualitative assessment and performed a quantitative impairment test to compare the fair value of each indefinite-lived intangible asset with its carrying amount. If the carrying amount of an indefinite-lived intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. After an impairment loss is recognized, the adjusted carrying amount becomes the asset's new accounting basis. Fair value is measured using the relief-from-royalty method. This method assumes the trade name or mark has value to the extent that the owner is relieved of the obligation to pay royalties for the benefits received from them. This method requires us to estimate the future revenue from the related asset, the appropriate royalty rate, and the weighted average cost of capital. The assessment of fair value involves significant judgment and projections about future performance. Based on our analysis, the fair value of each indefinite-lived asset exceeded the carrying amount, and we determined indefinite-lived useful lives continue to be reasonable. However, for one of our tradenames, with a carrying value of $32.4 million, the fair value of the tradename did not exceed carrying value by a significant margin. In determining the discounted future revenue in our fair value analysis, we assumed a discount rate of 10.8 percent, a royalty rate of 1 percent, and a perpetual growth rate of 3 percent. If our discount rate were to increase by 10 basis points, the fair value of this tradename could fall below carrying value, which would indicate impairment. Reserves for disputes and claims regarding product liability and warranties We are subject to claims associated with our products and services, principally as a result of disputes with our customers involving the performance or aesthetics of our architectural products and services. The time period from when a claim is asserted to when it is resolved, either by dismissal, negotiation, settlement or litigation, can be several years. While we maintain product liability insurance, the insurance policies include significant self-retention of risk in the form of policy deductibles. In addition, certain claims could be determined to be uninsured. We reserve estimated exposures on known claims, as well as on a portion of anticipated claims for product warranty and rework costs, based on historical product liability claims, as a ratio of sales. Factors that could have an impact on the warranty reserve in any given period include: changes in manufacturing quality, shifts in product mix and any significant changes in sales volume.

<s>[INST] This discussion contains “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All forecasts and projections in this document are “forwardlooking statements,” and are based on management's current expectations or beliefs of the Company's nearterm results, based on current information available pertaining to the Company, including the risk factors noted under Item 1A in this Form 10K. From time to time, we also may provide oral and written forwardlooking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by the Company. Any or all of our forwardlooking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forwardlooking statements made by or on behalf of the Company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to, the risks and uncertainties set forth under Item 1A in this Form 10K. We wish to caution investors that other factors might in the future prove to be important in affecting the Company's results of operations. New factors emerge from time to time; it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forwardlooking statements. We undertake no obligation to update publicly or revise any forwardlooking statements, whether as a result of new information, future events or otherwise. Overview We are a world leader in the design and development of valueadded glass and metal products and services. Our four reporting segments are: Architectural Framing Systems, Architectural Glass, Architectural Services and LargeScale Optical Technologies (LSO). During fiscal 2018, we advanced strategies to diversify and strengthen our revenue streams in order to improve the stability of our business throughout an economic cycle, by focusing on diversifying geographies, markets and project sizes served. We also focused on generating cash flow and expanding backlog, as we continue to execute on our strategies and grow our business in fiscal 2019 and beyond. Fiscal 2018 summary of results: Consolidated net sales increased to $1.3 billion, or 19 percent over fiscal 2017. Operating income was $114.3 million, a decline of 6.5 percent from $122.2 million in the prior year. Diluted EPS was $2.76, compared to $2.97 in the prior year, a decline of 7 percent. Adjusted operating income was $132.9 million, an increase of 6.8 percent compared to the prior year, and adjusted diluted EPS was $3.23, an increase of 6.6 percent compared to the prior year. Refer to the tables that follow for details of these adjusted amounts. In June 2017, we acquired the assets of EFCO Corporation, a privatelyheld U.S. manufacturer of architectural aluminum window, curtainwall, storefront and entrance systems for commercial construction projects, for $192 million in cash. EFCO's results of operations have been included in our consolidated financial statements and within the Architectural Framing Systems segment since the date of acquisition. Adjusted operating income, adjusted operating margin and adjusted earnings per diluted share (“adjusted diluted EPS”) are supplemental nonGAAP measures provided to assess performance on a more comparable basis from period to period by excluding amounts that management does not consider part of core operating results. Management uses these nonGAAP measures to evaluate the company’s historical and prospective financial performance, measure operational profitability on a consistent basis, and provide enhanced transparency to the investment community [/INST] Positive. </s>

APOGEE ENTERPRISES, INC.

2019-04-26

2019-03-02

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements This discussion contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All forecasts and projections in this document are “forward-looking statements,” and are based on management's current expectations or beliefs of the Company's near-term results, based on current information available pertaining to the Company, including the risk factors noted under Item 1A in this Form 10-K. From time to time, we also may provide oral and written forward-looking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by the Company. Any or all of our forward-looking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forward-looking statements made by or on behalf of the Company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to, the risks and uncertainties set forth under Item 1A in this Form 10-K. We wish to caution investors that other factors might in the future prove to be important in affecting the Company's results of operations. New factors emerge from time to time; it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Overview We are a world leader in the design and development of value-added glass and metal products and services. Our four reporting segments are: Architectural Framing Systems, Architectural Glass, Architectural Services and Large-Scale Optical Technologies (LSO). During fiscal 2019, we continued to focus on strategies to diversify and strengthen our revenue streams in order to improve the stability of our business throughout an economic cycle. These strategies are designed to diversify geographies, markets and project sizes served. Also in fiscal 2019, we executed a balanced capital allocation approach to invest in the business for growth and margin expansion while also returning significant capital to shareholders. Positive market conditions, coupled with these strategies, are expected to support continued growth in fiscal 2020 and beyond. Fiscal 2019 summary of results: • Consolidated net sales were $1.4 billion, an increase of 6 percent over fiscal 2018. • Operating income was $67.3 million, including $40.9 million of project-related charges on certain contracts acquired with the purchase of EFCO, which was a decline of 41 percent from $114.3 million in the prior year. • Diluted EPS was $1.63, compared to $2.76 in the prior year, a decline of 41 percent. • Adjusted operating income was $116.3 million, a decrease of 13 percent compared to the prior year, and adjusted diluted EPS was $2.96, a decrease of 8% compared to the prior year. Refer to the tables that follow for details of these adjusted amounts. Adjusted operating income and adjusted earnings per diluted share (adjusted diluted EPS) are supplemental non-GAAP measures provided by the Company to assess performance on a more comparable basis from period-to-period by excluding amounts that management does not consider part of core operating results. Management uses these non-GAAP measures to evaluate the company’s historical and prospective financial performance, measure operational profitability on a consistent basis, and provide enhanced transparency to the investment community. These non-GAAP measures should be viewed in addition to, and not as an alternative to, the reported financial results of the company prepared in accordance with GAAP. Other companies may calculate these measures differently, thereby limiting the usefulness of the measures for comparison with other companies. Results of Operations Net Sales Fiscal 2019 Compared to Fiscal 2018 Net sales in fiscal 2019 increased by 5.8 percent compared to fiscal 2018, driven by strong project execution in the Architectural Services segment, as well as growth from our Architectural Framing segment, primarily due to the addition of EFCO (acquired in June 2017) for the full period, partially offset by a sales decline in the Architectural Glass segment. Fiscal 2018 Compared to Fiscal 2017 Net sales in fiscal 2018 increased by 19.0 percent compared to fiscal 2017, due to the acquisition of EFCO in the second quarter of 2018. This acquisition, as well as a full year of results from Sotawall (acquired in the fourth quarter of fiscal 2017) and pricing and volume gains from our existing segment businesses, resulted in overall growth in our Architectural Framing Systems segment, which was partially offset by volume declines in our Architectural Services and Architectural Glass segments. Performance The relationship between various components of operations, as a percentage of net sales, is provided below. Fiscal 2019 Compared to Fiscal 2018 Gross profit was 20.9 percent in fiscal 2019, a decline of 420 basis points from fiscal 2018, driven by $40.9 million of project-related charges on certain contracts acquired with the purchase of EFCO, higher operating costs in the Architectural Glass segment and negative leverage on reduced volumes and mix in the Architectural Framing segment, somewhat offset by volume leverage and good project performance in the Architectural Services segment. Selling, general and administrative (SG&A) expense for fiscal 2019 was 16.1 percent, a decrease of 40 basis points but an increase of $7.0 million from fiscal 2018. This was due to the inclusion of a full year of expense for EFCO (acquired in the second quarter of fiscal 2018), partially offset by lower amortization on acquired intangible assets. Interest and other expenses increased by 30 basis points over the prior year due to an increase in the variable interest rate on our debt and a higher average outstanding debt balance throughout fiscal 2019 compared to fiscal 2018. The effective tax rate for fiscal 2019 was 22.1 percent, compared to 27.7 percent in fiscal 2018. The decline of 560 basis points was the result of a full year of benefits from the U.S. Tax Cuts and Jobs Act (the Act), enacted in December 2017, as well as increased research and development tax credits in the current year. Fiscal 2018 Compared to Fiscal 2017 Gross profit was 25.1 percent percent in fiscal 2018, a decline of 110 basis points from fiscal 2017, driven by reduced operating leverage on volume within the Architectural Services and Architectural Glass segments and the inclusion of EFCO at lower margins, somewhat offset by improved productivity across all our segments. SG&A expense for fiscal 2018 was 16.5 percent, an increase of 130 basis points, or $49.4 million, from fiscal 2017, mainly as a result of the inclusion of EFCO, as well as a full year of amortization expense on intangible assets acquired in the Sotawall transaction. The effective tax rate for fiscal 2018 was 27.7 percent, a decline of 240 basis points compared to a rate of 30.1 percent in fiscal 2017, driven by a partial year of benefits from the Act. Segment Analysis Architectural Framing Systems Fiscal 2019 Compared to Fiscal 2018. Net sales improved 6.4 percent, or $43.6 million, over fiscal 2018, with a full year of EFCO, acquired in the second quarter of fiscal 2018, contributing approximately 60 percent of the growth. Remaining growth was driven by increased order activity in our other businesses within this segment. Operating margin declined 180 basis points over fiscal 2018, driven by the inclusion in the current year of a full year of EFCO at lower operating margins. In addition, we recorded a $3.1 million impairment charge on an indefinite-lived intangible asset at EFCO. Fiscal 2018 Compared to Fiscal 2017. Net sales improved 75.4 percent, or $291.2 million, over fiscal 2017. EFCO contributed net sales of $203.7 million in fiscal 2018, or approximately 70 percent of total segment growth, and Sotawall contributed 19 percent of the growth. Net sales increased 8.7 percent over fiscal 2017 within existing businesses, due to increased pricing in order to offset raw material cost inflation, volume growth due to gains in share of demand and geographic growth in North America. Operating margin declined 290 basis points over fiscal 2017, with improved margins in legacy businesses offset by the inclusion of EFCO at lower operating margins. Architectural Glass Fiscal 2019 Compared to Fiscal 2018. Fiscal 2019 net sales decreased 4.4 percent, or $16.9 million, over the prior year due to changes in timing of customer orders, as well as volume declines stemming from operational challenges in the second and third fiscal quarters. Operating margin declined 400 basis points, largely due to increased labor costs, lower productivity and higher cost of quality due to challenges in ramping-up production in a tight labor market to meet higher than expected order intake and customer demand. In the second half of our fiscal year, we made progress on improving productivity and controlling costs. Fiscal 2018 Compared to Fiscal 2017. Fiscal 2018 net sales decreased 6.7 percent, or $27.7 million, over fiscal 2017 primarily due to volume declines on larger projects in our U.S.-based business, as a result of international competition, as well as lower pricing on a higher mix of less complex glass products for mid-size projects. Operating margin declined 230 basis points compared to fiscal 2017, driven by reduced operating leverage on lower volume, lower pricing due to project mix and restructuring-related charges associated with the closure of our Utah facility, somewhat offset by improved productivity. Architectural Services Fiscal 2019 Compared to Fiscal 2018. Net sales increased 33.9 percent, or $72.6 million, over the prior year, due to strong project execution on maturing projects. Operating margin improved 580 basis points over the prior year, due to volume leverage and strong project performance. Fiscal 2018 Compared to Fiscal 2017. Net sales decreased 21.1 percent, or $57.2 million, over fiscal 2017, due to year-on-year timing of project activity. Operating margin declined 190 basis points over fiscal 2017, as a result of lower volume leverage on fixed project management, engineering and manufacturing costs, partially offset by favorable project performance. Large-Scale Optical Technologies (LSO) Fiscal 2019 Compared to Fiscal 2018. Net sales were consistent with the prior year and operating margin improved 110 basis points over the prior year, driven by a $1.0 million gain from an insurance recovery and good operational performance. Fiscal 2018 Compared to Fiscal 2017. Net sales decreased 1.6 percent and operating margin declined 10 basis points, compared to fiscal 2017, as productivity gains were offset by unfavorable pricing, mix and volume. Liquidity and Capital Resources Operating Activities. Cash provided by operating activities was $96.4 million in fiscal 2019, a decrease of $31.0 million from fiscal 2018, due to lower net earnings in fiscal 2019 and increased working capital needed to support the acquired project experiencing construction delays. Investing Activities. Net cash used in investing activities was $53.7 million in fiscal 2019, compared to $233.6 million in fiscal 2018, with the year-over-year decline largely due to the acquisition of EFCO in the prior year. In fiscal 2019 and 2018, we made capital expenditures focused primarily on adding product capabilities and improving manufacturing productivity. In fiscal 2019, we also benefited from the sale of an Architectural Glass manufacturing facility in Utah that was closed at the end of fiscal 2018. In fiscal 2017, we acquired Sotawall and made capital expenditures focused on increasing our product capabilities, in particular related to our oversized glass fabrication project, and manufacturing productivity. We estimate fiscal 2020 capital expenditures to be $60 to $65 million, as we continue to make investments to drive growth and productivity improvements. We continually review our portfolio of businesses and their assets and how they support our business strategy and performance objectives. As part of this review, we may continue to acquire other businesses, pursue geographic expansion, take actions to manage capacity and further invest in, fully divest and/or sell parts of our current businesses. Financing Activities. We paid dividends totaling $17.9 million in fiscal 2019. We also repurchased 1,257,983 shares under our authorized share repurchase program, at a total cost of $43.3 million. We repurchased 702,299 shares under the program in fiscal 2018 and 250,001 shares under the program in fiscal 2017. We have repurchased a total of 5,267,915 shares, at a total cost of $149.3 million, since the 2004 inception of this program. We have remaining authority to repurchase 1,982,085 shares under this program, which has no expiration date, and we will continue to evaluate making future share repurchases, depending on our cash flow and debt levels, market conditions and other potential uses of cash. We maintain a $335.0 million committed revolving credit facility that expires in November 2021, as further described in Note 8 of the Notes to Consolidated Financial Statements. $225.0 million was outstanding under this credit facility as of March 2, 2019, as we used this facility to finance the EFCO acquisition. As defined within the credit facility, we have two financial covenants which require us to stay below a maximum leverage ratio and to maintain a minimum interest expense-to-EBITDA ratio. At March 2, 2019, we were in compliance with both financial covenants. Other Financing Activities. The following summarizes our significant contractual obligations that impact our liquidity as of March 2, 2019: In addition to the committed revolving credit facility discussed above, we also have industrial revenue bond obligations of $20.4 million that mature in fiscal years 2021 through 2043 and $0.4 million of other debt that matures in August 2022. We acquire the use of certain assets through operating leases, such as warehouses, vehicles, forklifts, office equipment, hardware, software and some manufacturing equipment. While many of these operating leases have termination penalties, we consider the risk related to termination penalties to be minimal. Purchase obligations in the table above relate to raw material commitments and capital expenditures. We expect to make contributions of approximately $0.7 million to our defined-benefit pension plans in fiscal 2020, which will equal or exceed our minimum funding requirements. As of March 2, 2019, we had reserves of $4.6 million and $1.2 million for long-term unrecognized tax benefits and environmental liabilities, respectively. We expect approximately $0.5 million of the unrecognized tax benefits to lapse during the next 12 months. We are unable to reasonably estimate in which future periods the remaining unrecognized tax benefits and environmental liabilities will ultimately be settled. At March 2, 2019, we had ongoing letters of credit of $25.1 million related to industrial revenue bonds and construction contracts that expire in fiscal 2020 and that reduce availability of funds under our committed credit facility. In addition to the above standby letters of credit, we are required, in the ordinary course of business, to provide surety or performance bonds that commit payments to our customers for any non-performance. At March 2, 2019, $313.2 million of our backlog was bonded by performance bonds with a face value of $570.6 million. These bonds do not have stated expiration dates, as we are released from the bonds upon completion of the contract. We have not been required to make any payments under these bonds with respect to our existing businesses. We had total cash and short-term marketable securities of $17.1 million, and $84.9 million available under our committed revolving credit facility, at March 2, 2019. Due to our ability to generate cash from operations and our borrowing capacity under our committed revolving credit facility, we believe that our sources of liquidity will continue to be adequate to fund our working capital requirements, planned capital expenditures and dividend payments for at least the next 12 months. Off-balance Sheet Arrangements. With the exception of operating leases, we had no off-balance sheet arrangements at March 2, 2019 or March 3, 2018. Outlook The following statements are based on our current expectations for fiscal 2020 results. These statements are forward-looking, and actual results may differ materially. • Revenue growth of 1.0 to 3.0 percent over fiscal 2019. • Operating margin of 8.2 to 8.6 percent. • Earnings per diluted share of $3.00 to $3.20. • Capital expenditures of approximately $60 to $65 million. • Effective annual tax rate of approximately 24.5 percent. Recently Issued Accounting Pronouncements See Note 1 of the Notes to Consolidated Financial Statements within Item 8 of this Form 10-K for information pertaining to recently issued accounting pronouncements, incorporated herein by reference. Critical Accounting Policies Our analysis of operations and financial condition is based on our consolidated financial statements prepared in accordance with U.S. GAAP. Preparation of these consolidated financial statements requires us to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the consolidated financial statements, reported amounts of revenues and expenses during the reporting period and related disclosures of contingent assets and liabilities. In developing these estimates and assumptions, a collaborative effort is undertaken involving management across the organization, including finance, sales, project management, quality, risk, legal and tax, as well as outside advisors, such as consultants, engineers, lawyers and actuaries. Our estimates are evaluated on an ongoing basis and are drawn from historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results could differ under other assumptions or circumstances. We consider the following items in our consolidated financial statements to require significant estimation or judgment. Revenue recognition We generate revenue from the design, engineering and fabrication of architectural glass, curtainwall, window, storefront and entrance systems, and from installing those products on commercial buildings. We also manufacture value-added glass and acrylic products. Due to the diverse nature of our operations and various types of contracts with customers, we have businesses that recognize revenue over time and businesses that recognize revenue at a point in time. We believe the most significant areas of estimation and judgment relate to over-time revenue recognition on longer-term contracts. We have three businesses which operate under long-term, fixed-price contracts, representing approximately 34 percent of our total revenue in fiscal 2019. This includes one business which changed revenue recognition practices due to the adoption of the new guidance in ASC 606, moving from recognizing revenue at shipment to an over-time method of revenue recognition. The contracts for these businesses have a single, bundled performance obligation, as these businesses generally provide interrelated products and services and integrate these products and services into a combined output specified by the customer. The customer obtains control of this combined output, generally integrated window systems or installed window and curtainwall systems, over time. We measure progress on these contracts following an input method, by comparing total costs incurred to-date to the total estimated costs for the contract, and record that proportion of the total contract price as revenue in the period. Contract costs include materials, labor and other direct costs related to contract performance. We believe this method of recognizing revenue is consistent with our progress in satisfying our contract obligations. Due to the nature of the work required under these long-term contracts, the estimation of total revenue and costs incurred throughout a project is subject to many variables and requires significant judgment. It is common for these contracts to contain potential bonuses or penalties which are generally awarded or charged upon certain project milestones or cost or timing targets, and can be based on customer discretion. We estimate variable consideration at the most likely amount to which we expect to be entitled. We include estimated amounts in the transaction price to the extent that it is probable that a significant reversal of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. Our estimates of variable consideration and determination of whether to include estimated amounts in the transaction price are based largely on our assessments of anticipated performance and all information (historical, current and forecasted) that is reasonably available to us. Long-term contracts are often modified to account for changes in contract specifications and requirements of work to be performed. We consider contract modifications to exist when the modification, generally through a change order, either creates new or changes existing enforceable rights and obligations, and we evaluate these types of modifications to determine whether they may be considered distinct performance obligations. In many cases, these contract modifications are for goods or services that are not distinct from the existing contract, due to the significant integration service provided in the context of the contract. Therefore, these modifications are accounted for as part of the existing contract. The effect of a contract modification on the transaction price and our measure of progress is recognized as an adjustment to revenue, generally on a cumulative catch-up basis. Goodwill and indefinite-lived intangible asset impairment Goodwill We evaluate goodwill for impairment annually at our year-end, or more frequently if events or changes in circumstances indicate that the asset might be impaired. This year we elected to bypass the qualitative assessment process and to proceed directly to comparing the fair value of each of our reporting units to carrying value, including goodwill. If the fair value exceeds the carrying value, goodwill impairment is not indicated. Each of our nine businesses (or business units) represents a reporting unit for the goodwill impairment analysis. For our goodwill impairment testing beginning in fiscal 2018, we elected to early adopt Accounting Standards Update No. 2017-04, Simplifying the Test for Goodwill Impairment. As a result of this election, if the carrying amount of a reporting unit would be determined to be higher than its estimated fair value, an impairment loss is recognized for the excess. We base our determination of fair value on a discounted cash flow methodology that involves significant judgment and projections of future performance. Assumptions about future revenues and expenses, capital expenditures and changes in working capital are based on the annual operating plan and long-term business plan for each business unit. These plans take into consideration numerous factors, including historical experience, anticipated future economic conditions and growth expectations for the industries and end markets in which we participate. Growth rates for revenues and operating profits vary for each reporting unit. The discount rate assumption is consistent across business units and takes into consideration an estimated weighted-average cost of capital. Based on our analysis, the estimated fair value of each reporting unit exceeded its carrying value and, therefore, goodwill impairment was not indicated. However, for two of our businesses within the Architectural Framing Systems segment with goodwill of approximately $111.5 million, fair value did not exceed carrying value by a significant margin. We utilized a discount rate of 10.9 percent in determining the discounted cash flows in our fair value analysis and a perpetual growth rate of 3.0 percent. If our discount rate were to increase by 120 basis points, the fair value of these reporting units could fall below carrying value, which would indicate impairment of the goodwill. Indefinite-lived intangible assets We hold intangible assets for certain acquired tradenames and trademarks which are determined to have indefinite useful lives. We evaluate the reasonableness of the useful life and test indefinite-lived intangible assets for impairment annually at our year-end, or more frequently if events or changes in circumstances indicate that it is more likely than not that the asset is impaired. We bypassed a qualitative assessment and performed a quantitative impairment test to compare the fair value of each indefinite-lived intangible asset with its carrying amount. If the carrying amount of an indefinite-lived intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. After an impairment loss is recognized, the adjusted carrying amount becomes the asset's new accounting basis. Fair value is measured using the relief-from-royalty method. This method assumes the trade name or mark has value to the extent that the owner is relieved of the obligation to pay royalties for the benefits received from them. This method requires us to estimate the future revenue from the related asset, the appropriate royalty rate, and the weighted average cost of capital. The assessment of fair value involves significant judgment and projections about future performance. In determining the discounted future revenue in our fair value analysis, we assumed a discount rate of 10.9 percent, a royalty rate of 1.0 percent, and a perpetual growth rate of 3.0 percent. Based on our analysis, the fair value of one of our tradenames, with a carrying value of $32.4 million, was below its estimated fair value by $3.1 million and therefore we recorded this amount as an impairment charge in fiscal 2019. We continue to conclude that the useful life of our indefinite-lived intangible assets is appropriate. Reserves for disputes and claims regarding product liability, warranties and other project-related contingencies We are subject to claims associated with our products and services, principally as a result of disputes with our customers involving the performance or aesthetics of our products, some of which may be covered under our warranty policies. We also are subject to project management and installation-related contingencies as a result of our fixed-price material supply and installation service contracts, primarily in our Architectural Services segment and certain of our Architectural Framing Systems businesses, including those taken on with our acquisition of EFCO. The time period from when a claim is asserted to when it is resolved, either by dismissal, negotiation, settlement or litigation, can be several years. While we maintain various types of product liability insurance, the insurance policies include significant self-retention of risk in the form of policy deductibles. In addition, certain claims could be determined to be uninsured. We also actively manage the risk of these exposures through contract negotiations and proactive project management. We reserve estimated exposures on known claims, as well as on a portion of anticipated claims for product warranty and rework costs, based on historical product liability claims, as a ratio of sales. We also reserve for estimated exposures on other claims as they are known and reasonably estimable.

<s>[INST] This discussion contains “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements reflect our current views with respect to future events and financial performance. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “forecast,” “project,” “should” and similar expressions are intended to identify “forwardlooking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All forecasts and projections in this document are “forwardlooking statements,” and are based on management's current expectations or beliefs of the Company's nearterm results, based on current information available pertaining to the Company, including the risk factors noted under Item 1A in this Form 10K. From time to time, we also may provide oral and written forwardlooking statements in other materials we release to the public, such as press releases, presentations to securities analysts or investors, or other communications by the Company. Any or all of our forwardlooking statements in this report and in any public statements we make could be materially different from actual results. Accordingly, we wish to caution investors that any forwardlooking statements made by or on behalf of the Company are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other risk factors include, but are not limited to, the risks and uncertainties set forth under Item 1A in this Form 10K. We wish to caution investors that other factors might in the future prove to be important in affecting the Company's results of operations. New factors emerge from time to time; it is not possible for management to predict all such factors, nor can it assess the impact of each such factor on the business or the extent to which any factor, or a combination of factors, may cause actual results to differ materially from those contained in any forwardlooking statements. We undertake no obligation to update publicly or revise any forwardlooking statements, whether as a result of new information, future events or otherwise. Overview We are a world leader in the design and development of valueadded glass and metal products and services. Our four reporting segments are: Architectural Framing Systems, Architectural Glass, Architectural Services and LargeScale Optical Technologies (LSO). During fiscal 2019, we continued to focus on strategies to diversify and strengthen our revenue streams in order to improve the stability of our business throughout an economic cycle. These strategies are designed to diversify geographies, markets and project sizes served. Also in fiscal 2019, we executed a balanced capital allocation approach to invest in the business for growth and margin expansion while also returning significant capital to shareholders. Positive market conditions, coupled with these strategies, are expected to support continued growth in fiscal 2020 and beyond. Fiscal 2019 summary of results: Consolidated net sales were $1.4 billion, an increase of 6 percent over fiscal 2018. Operating income was $67.3 million, including $40.9 million of projectrelated charges on certain contracts acquired with the purchase of EFCO, which was a decline of 41 percent from $114.3 million in the prior year. Diluted EPS was $1.63, compared to $2.76 in the prior year, a decline of 41 percent. Adjusted operating income was $116.3 million, a decrease of 13 percent compared to the prior year, and adjusted diluted EPS was $2.96, a decrease of 8% compared to the prior year. Refer to the tables that follow for details of these adjusted amounts. Adjusted operating income and adjusted earnings per diluted share (adjusted diluted EPS) are supplemental nonGAAP measures provided by the Company to assess performance on a more comparable basis from periodtoperiod by excluding amounts that management does not consider part of core operating results. Management uses these nonGAAP measures to evaluate the company’s historical and prospective financial performance, measure operational profitability on a consistent basis, and provide enhanced transparency to the investment community. These nonGAAP measures should be viewed in addition to, and not as an alternative to, the reported financial results of the company prepared in accordance with GAAP. Other companies may calculate these measures differently [/INST] Positive. </s>

PACCAR INC

2015-02-26

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. OVERVIEW: PACCAR is a global technology company whose Truck segment includes the design and manufacture of high-quality, light-, medium- and heavy-duty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business is the manufacturing and marketing of industrial winches. Consolidated net sales and revenues of $18.99 billion in 2014 were the highest in the Company’s history. The increase of 11% from $17.12 billion in 2013 was mainly due to record truck and aftermarket parts sales and higher financial services revenues. Truck unit sales increased in 2014 to 142,900 units from 137,100 units in 2013, reflecting higher industry retail sales in the U.S. and Canada, partially offset by a lower over 16-tonne market in Europe. Record freight volumes and improving fleet utilization are contributing to excellent parts and service business. In 2014, PACCAR earned net income for the 76th consecutive year. Net income in 2014 of $1.36 billion was the second highest in the Company’s history, increasing from $1.17 billion in 2013, primarily due to record Truck and Parts segment sales, improved Truck segment operating margin and record Financial Services segment pre-tax income. Earnings per diluted share of $3.82 was the second best in the Company’s history. DAF introduced a new range of Euro 6 CF and XF four-axle trucks and tractors for heavy-duty applications. These new vehicles expand DAF’s product range in the construction, container and refuse markets and complement DAF’s award-winning Euro 6 on-highway trucks. In addition, DAF introduced the new DAF Euro 6 CF Silent distribution truck for deliveries in urban areas with noise restrictions, and the new DAF Euro 6 CF and XF Low Deck tractors which maximize trailer volume within European height and length regulations. These new vehicles expand DAF’s product range in distribution and over-the-road applications and expand DAF’s Euro 6 range of trucks. Kenworth and Peterbilt launched their new medium-duty cab-over-engine distribution trucks with extensive exterior and interior enhancements. In addition, new vocational Kenworth T880 and Peterbilt Model 567 trucks were introduced, which expanded PACCAR’s offerings in the construction, utility and refuse markets. In 2014, the Company’s research and development expenses were $215.6 million compared to $251.4 million in 2013. PACCAR Parts opened a new distribution center in Montreal, Canada and now has 17 parts distribution centers supporting over 2,000 DAF, Kenworth and Peterbilt dealer locations. PACCAR began construction of a new 160,000 square-foot distribution center in Renton, Washington. The new facility will increase the distribution capacity for the Company’s dealers and customers in the northwestern U.S. and western Canada. The PACCAR Financial Services (PFS) group of companies has operations covering four continents and 22 countries. The global breadth of PFS and its rigorous credit application process support a portfolio of loans and leases with total assets of $11.92 billion that earned a record pre-tax profit of $370.4 million. PFS issued $1.58 billion in medium-term notes during the year to support portfolio growth. Truck and Parts Outlook Truck industry retail sales in the U.S. and Canada in 2015 are expected to be 250,000-280,000 units compared to 249,400 units in 2014 driven by expansion of truck industry fleet capacity and economic growth. In Europe, the 2015 truck industry registrations for over 16-tonne vehicles are expected to be 200,000-240,000 units, compared to the 226,900 truck registrations in 2014. Heavy-duty truck industry sales for South America were 129,000 units in 2014, and heavy-duty truck industry sales are estimated to be in a range of 110,000 to 130,000 units in 2015. The production of DAF trucks in Brasil and the continued growth of the DAF Brasil dealer network will further enhance PACCAR’s vehicle sales in South America. In 2015, PACCAR Parts sales are expected to grow 5-8% in North America, reflecting steady economic growth and high fleet utilization. PACCAR Parts deliveries are expected to increase in Europe, reflecting slightly improving freight markets and PACCAR Parts’ innovative customer service programs. Sales in Europe may be affected by recent declines in the values of the euro relative to the U.S. dollar. Capital investments in 2015 are expected to be $300 to $350 million, focused on enhanced powertrain development and increased operating efficiency for our factories and distribution centers. Research and development (R&D) in 2015 is expected to be $220 to $260 million, focused on new products and services. Financial Services Outlook Based on the truck market outlook, average earning assets in 2015 are expected to be slightly higher than current levels. Current levels of freight tonnage, freight rates and fleet utilization are contributing to customers’ profitability and cash flow. If current freight transportation conditions decline due to weaker economic conditions, then past due accounts, truck repossessions and credit losses would likely increase from the current low levels. See the Forward-Looking Statements section of Management’s Discussion and Analysis for factors that may affect these outlooks. RESULTS OF OPERATIONS: The following provides an analysis of the results of operations for the Company’s three reportable segments - Truck, Parts and Financial Services. Where possible, the Company has quantified the impact of factors identified in the following discussion and analysis. In cases where it is not possible to quantify the impact of factors, the Company lists them in estimated order of importance. Factors for which the Company is unable to specifically quantify the impact include market demand, fuel prices, freight tonnage and economic conditions affecting the Company’s results of operations. 2014 Compared to 2013: Truck The Company’s Truck segment accounted for 77% and 76% of total revenues for 2014 and 2013, respectively. In 2014, industry retail sales in the heavy-duty market in the U.S. and Canada increased to 249,400 units from 212,200 units in 2013. The Company’s heavy-duty truck retail market share was 27.9% compared to 28.0% in 2013. The medium-duty market was 73,300 units in 2014 compared to 65,900 units in 2013. The Company’s medium-duty market share was a record 16.7% in 2014 compared to 15.7% in 2013. The over 16-tonne truck market in Western and Central Europe in 2014 was 226,900 units, a 6% decrease from 240,800 units in 2013. The largest decreases were in the U.K. and France, partially offset by increases in Germany and Spain. The Company’s market share was 13.8% in 2014, a decrease from 16.2% in 2013. The decrease in market share was primarily due to the lower DAF registrations in the U.K. and the Netherlands which were impacted by the Euro 5/Euro 6 transition rules. The 6 to 16-tonne market in 2014 was 46,900 units compared to 57,200 units in 2013. The Company’s market share was 8.8% in 2014, a decrease from 11.8% in 2013. The decline in market share is a result of reduced registrations in the U.K. which were also affected by the Euro 5/Euro 6 transition rules. The major factors for the changes in net sales and revenues, cost of sales and revenues and gross margin between 2014 and 2013 for the Truck segment are as follows: The Company’s worldwide parts net sales and revenues increased due to higher aftermarket demand in all markets. The increase in Parts segment income before taxes and pre-tax return on revenues was primarily due to higher sales and gross margins. The major factors for the changes in net sales and revenues, cost of sales and revenues and gross margin between 2014 and 2013 for the Parts segment are as follows: • Higher market demand in all markets resulted in increased aftermarket parts sales volume of $187.8 million and related cost of sales by $120.0 million. • Average aftermarket parts sales prices increased sales by $82.5 million reflecting improved price realization in all markets. • Average aftermarket parts direct costs increased $57.8 million due to higher material costs in all markets. • Warehouse and other indirect costs increased $8.0 million primarily due to additional costs to support higher sales volume. • Parts gross margins in 2014 of 25.9% increased from 25.3% in 2013 due to higher price realization and other factors noted above. Parts SG&A expense for 2014 increased to $207.5 million from $204.1 million in 2013. The increase was primarily due to higher salaries and related expenses. As a percentage of sales, Parts SG&A decreased to 6.7% in 2014 from 7.2% in 2013, reflecting higher sales volume. Financial Services The Company’s Financial Services segment accounted for 6.3% and 6.9% of total revenues for 2014 and 2013, respectively. In 2014, new loan and lease volume of $4.46 billion increased 3% compared to $4.32 billion in 2013. PFS’s finance market share on new PACCAR truck sales was 27.7% in 2014 compared to 29.2% in 2013 due to increased competition. PFS revenue of $1.20 billion in 2014 was comparable to $1.17 billion in 2013. PFS income before income taxes increased to a record $370.4 million compared to $340.2 million in 2013, primarily due to higher finance and lease margins related to increased average earning asset balances. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin for the year ended December 31, 2014 are outlined below: The major factors for the changes in operating lease, rental and other revenues, depreciation and other expense and related lease margin for the year ended December 31, 2014 are outlined below: • A lower volume of used truck sales decreased operating lease, rental and other revenues by $20.5 million and decreased depreciation and other expense by $20.7 million. • Average operating lease assets increased $222.3 million in 2014, which increased revenues by $39.7 million and related depreciation and other expense by $30.6 million. • Revenue per asset increased $10.5 million due to higher rental rates, partially offset by lower fee income. Cost per asset increased $15.7 million due to higher depreciation and maintenance expenses. The following table summarizes the provision for losses on receivables and net charge-offs: The provision for losses on receivables was $15.4 million in 2014, an increase of $2.5 million compared to 2013, mainly due to a higher portfolio balance in the U.S., higher past dues resulting from a weaker mining industry in Australia, partially offset by improved portfolio performance across other markets. The Company modifies loans and finance leases as a normal part of its Financial Services operations. The Company may modify loans and finance leases for commercial reasons or for credit reasons. Modifications for commercial reasons are changes to contract terms for customers that are not considered to be in financial difficulty. Insignificant delays are modifications extending terms up to three months for customers experiencing some short-term financial stress, but not considered to be in financial difficulty. Modifications for credit reasons are changes to contract terms for customers considered to be in financial difficulty. The Company’s modifications typically result in granting more time to pay the contractual amounts owed and charging a fee and interest for the term of the modification. When considering whether to modify customer accounts for credit reasons, the Company evaluates the creditworthiness of the customers and modifies those accounts that the Company considers likely to perform under the modified terms. When the Company modifies loans and finance leases for credit reasons and grants a concession, the modifications are classified as troubled debt restructurings (TDR). * Recorded investment immediately after modification as a percentage of ending retail portfolio. In 2014, total modification activity decreased compared to 2013 primarily due to lower modifications for commercial reasons and insignificant delays, partially offset by an increase in TDR modifications. The decrease in commercial modifications primarily reflects lower levels of additional equipment financed and end-of-contract modifications. The decline in modifications for insignificant delays reflects 2013 extensions granted to two customers in Australia primarily due to business disruptions arising from flooding. TDR modifications increased primarily due to a contract modification for a large customer in the U.S. The following table summarizes the Company’s 30+ days past due accounts: Accounts 30+ days past due were .5% at December 31, 2014 and 2013. The higher past dues in Europe, Mexico and Australia were offset by lower past dues in the U.S. and Canada. The Company continues to focus on maintaining low past due balances. When the Company modifies a 30+ days past due account, the customer is then generally considered current under the revised contractual terms. The Company modified $4.0 million of accounts worldwide during the fourth quarter of 2014 and $4.9 million during the fourth quarter of 2013 that were 30+ days past due and became current at the time of modification. Had these accounts not been modified and continued to not make payments, the pro forma percentage of retail loan and lease accounts 30+ days past due would have been as follows: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2014 and 2013. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2014 and 2013. The Company’s 2014 and 2013 pre-tax return on average earning assets for Financial Services was 3.3% and 3.2%, respectively. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment, including a portion of corporate expense. Other sales represent approximately 1% of consolidated net sales and revenues for 2014 and 2013. Other SG&A was $59.5 million in 2014 and $47.1 million in 2013. The increase in SG&A was primarily due to higher salaries and related expenses of $11.4 million. Other income (loss) before tax was a loss of $31.9 million in 2014 compared to a loss of $26.5 million in 2013. The higher loss in 2014 was primarily due to higher salaries and related expenses and lower income before tax from the winch business. Investment income was $22.3 million in 2014 compared to $28.6 million in 2013. The lower investment income in 2014 primarily reflects lower yields on investments due to lower market interest rates, partially offset by higher average investment balances. The 2014 effective income tax rate of 32.7% increased from 30.9% in 2013. The increase in the effective tax rate was primarily due to a higher proportion of income generated in higher taxed jurisdictions. The higher income before income taxes and pre-tax return on revenues for domestic operations were primarily due to higher revenues from trucks and parts operations and higher truck margins. The lower income before income taxes and pre-tax return on revenues for foreign operations were primarily due to lower revenues and truck margins in all foreign markets, except Canada. 2013 Compared to 2012: Truck The Company’s Truck segment accounted for 76% and 77% of total revenues for 2013 and 2012, respectively. The Company’s worldwide truck net sales and revenues decreased due to lower market demand in the U.S. and Canada ($329.7 million), South America ($342.3 million) and Australia ($94.8 million), partially offset by higher market demand in Europe ($627.3 million). Truck segment income before income taxes and pre-tax return on revenues reflects improved price realization, primarily in Europe, and lower R&D and SG&A expenses, partially offset by lower truck unit deliveries. The Company’s new truck deliveries are summarized below: In 2013, industry retail sales in the heavy-duty market in the U.S. and Canada decreased to 212,200 units compared to 224,900 units in 2012. The Company’s heavy-duty truck retail market share was 28.0% compared to 28.9% in 2012. The medium-duty market was 65,900 units in 2013 compared to 64,600 units in 2012. The Company’s medium-duty market share was 15.7% in 2013 compared to 15.4% in 2012. The over 16-tonne truck market in Western and Central Europe in 2013 was 240,800 units, an 8% increase from 222,000 units in 2012 reflecting a pre-buy of Euro 5 trucks by some customers ahead of Euro 6 emissions regulations effective in 2014. The Company’s market share was a record 16.2% in 2013, an increase from 16.0% in 2012. The 6 to 16-tonne market in 2013 was 57,200 units compared to 55,500 units in 2012. The Company’s market share was a record 11.8% in 2013, an increase from 11.4% in 2012. Sales in Mexico, South America, Australia and other markets decreased in 2013 primarily due to fewer new truck deliveries in Colombia. The major factors for the changes in net sales and revenues, cost of sales and revenues and gross margin between 2013 and 2012 for the Truck segment are as follows: • Truck delivery volume reflects lower truck deliveries in all markets except Europe. Higher deliveries in Europe reflect purchases of Euro 5 vehicles ahead of the Euro 6 emission requirement in 2014. • Average truck sales prices increased sales by $57.6 million, reflecting increased price realization from higher market demand in Europe. • Factory overhead and other indirect costs increased $20.6 million, primarily due to higher depreciation expense. • Operating lease revenues and cost of sales increased due to a higher volume of operating leases in Europe. • Truck gross margins in 2013 of 10.1% decreased slightly from 10.2% in 2012 primarily from lower truck volume as noted above. Truck SG&A was $214.1 million in 2013 compared to $231.0 million in 2012. The lower spending in 2013 was primarily due to lower sales and marketing expense of $5.9 million and ongoing cost controls. As a percentage of sales, SG&A decreased to 1.6% in 2013 compared to 1.8% in 2012. Parts The Company’s Parts segment accounted for 16% of total revenues for both 2013 and 2012. The Company’s worldwide parts net sales and revenues increased due to higher aftermarket demand worldwide. The increase in Parts segment income before taxes and pre-tax return on revenues was primarily due to higher sales, gross margins and cost controls. The major factors for the changes in net sales and revenues, cost of sales and revenues and gross margin between 2013 and 2012 for the Parts segment are as follows: • Higher market demand in all markets resulted in increased aftermarket parts sales volume of $103.6 million and related cost of sales by $67.4 million. • Average aftermarket parts sales prices increased sales by $38.3 million reflecting improved price realization. • Average aftermarket parts direct costs increased $29.6 million due to higher material costs. • Warehouse and other indirect costs increased $6.5 million primarily due to higher costs from warehouse capacity expansion to support sales volume. • Parts gross margins in 2013 of 25.3% increased slightly from 25.2% in 2012 due to the factors noted above. Parts SG&A decreased slightly to $204.1 million in 2013 from $206.0 million in 2012 due to lower sales and marketing expenses. As a percentage of sales, Parts SG&A decreased to 7.2% in 2013 from 7.7% in 2012, due to cost controls and higher sales volume. Financial Services The Company’s Financial Services segment accounted for 6.9% and 6.4% of total revenues for 2013 and 2012, respectively. In 2013, new loan and lease volume decreased 7% to $4.32 billion from $4.62 billion in 2012. The lower volume in 2013 primarily reflects lower market shares. PFS’s finance market share on new PACCAR truck sales was 29.2% in 2013 compared to 30.6% in the prior year primarily due to lower market share in the U.S. and Canada and Europe. The increase in PFS revenue to $1.17 billion in 2013 from $1.10 billion in 2012 primarily resulted from higher average earning asset balances, partially offset by lower yields. PFS income before income taxes increased to a record $340.2 million compared to $307.8 million in 2012 primarily due to higher finance and lease margins and a lower provision for losses on receivables. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin for the year ended December 31, 2013 are outlined below: • Average finance receivables increased $590.5 million (net of foreign exchange effects) in 2013 from retail portfolio new business volume exceeding collections, partially offset by a decrease in dealer wholesale financing, primarily in the U.S. and Canada. • Average debt balances increased $671.5 million in 2013 and included increased medium-term note funding. The higher average debt balances reflect funding for a higher average earning asset portfolio, including loans, finance leases and equipment on operating leases. • Lower market rates resulted in lower portfolio yields (5.6% in 2013 and 5.8% in 2012) and lower borrowing rates (2.0% in 2013 and 2.2% in 2012). The following table summarizes operating lease, rental and other revenues and depreciation and other expense: The major factors for the changes in operating lease, rental and other revenues, depreciation and other expense and related lease margin for the year ended December 31, 2013 are outlined below: • Used truck sales and other revenues decreased operating lease, rental and other revenues by $10.1 million and decreased depreciation and other expense by $12.2 million, reflecting a lower number of used truck units sold. • Average operating lease assets increased $282.9 million in 2013, which increased revenues by $55.3 million and related depreciation and other expense by $43.6 million, as a result of a higher demand for leased vehicles. • Revenue and cost per asset increased $17.5 million and $16.0 million, respectively, reflecting the higher demand for leased vehicles and the related costs for higher fleet utilization. The following table summarizes the provision for losses on receivables and net charge-offs: The provision for losses on receivables was $12.9 million in 2013, a decrease of $7.1 million compared to 2012, due to lower provisions in all markets reflecting improved portfolio performance. The Company modifies loans and finance leases as a normal part of its Financial Services operations. The Company may modify loans and finance leases for commercial reasons or for credit reasons. Modifications for commercial reasons are changes to contract terms for customers that are not considered to be in financial difficulty. Insignificant delays are modifications extending terms up to three months for customers experiencing some short-term financial stress, but not considered to be in financial difficulty. Modifications for credit reasons are changes to contract terms for customers considered to be in financial difficulty. The Company’s modifications typically result in granting more time to pay the contractual amounts owed and charging a fee and interest for the term of the modification. When considering whether to modify customer accounts for credit reasons, the Company evaluates the creditworthiness of the customer and modifies those accounts that the Company considers likely to perform under the modified terms. When the Company modifies loans and finance leases for credit reasons and grants a concession, the modifications are classified as troubled debt restructurings (TDR). The post-modification balances of accounts modified during the years ended December 31, 2013 and 2012 are summarized below: * Recorded investment immediately after modification as a percentage of ending retail portfolio. In 2013, total modification activity increased slightly compared to 2012 due to higher modifications for commercial reasons and insignificant delays, partially offset by lower credit modifications. The increase in commercial modifications primarily reflects higher levels of additional equipment financed and end-of-contract modifications. The higher modifications for insignificant delays were mainly due to granting two customers in Australia extensions due to business disruptions arising from flooding and granting one large fleet customer in the U.S. a one-month extension. The following table summarizes the Company’s 30+ days past due accounts: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2013 and 2012. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2013 and 2012. The Company’s 2013 and 2012 pre-tax return on average earning assets for Financial Services was 3.2%. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment, including a portion of corporate expense. Other sales represent approximately 1.0% of consolidated net sales and revenues for 2013 and 2012. Other SG&A was $47.1 million in 2013 and $39.4 million in 2012 as higher salaries and related expenses of $6.2 million and charitable contributions of $3.0 million were partially offset by lower professional fees of $1.6 million. Other income (loss) before tax was a loss of $26.5 million in 2013 compared to a loss of $7.0 million in 2012. The higher loss in 2013 was primarily due to lower income before tax from the winch business. Investment income was $28.6 million in 2013 compared to $33.1 million in 2012. The lower investment income in 2013 primarily reflects lower yields on investments from lower market interest rates. The 2013 effective income tax rate of 30.9% decreased from 31.8% in 2012. The decrease in the effective tax rate was primarily due to a higher proportion of income generated in lower taxed jurisdictions. The Company’s total cash and marketable debt securities at December 31, 2014 was comparable to December 31, 2013. The change in cash and cash equivalents is summarized below: 2014 Compared to 2013: Operating activities: Cash provided by operations decreased $252.1 million to $2.12 billion in 2014 compared to $2.38 billion in 2013. Lower operating cash flow reflects a higher increase in Financial Services segment wholesale receivables of $150.3 million and a higher increase in net purchases of inventories of $149.9 million. In addition, lower cash inflows resulted from a reduction in liabilities for residual value guarantees (RVG) and deferred revenues of $138.7 million, primarily due to a lower volume of new RVG contracts compared to 2013, and $54.9 million in higher pension contributions. These outflows were partially offset by $187.5 million of higher net income and $74.5 million of higher depreciation on property, plant and equipment. Investing activities: Cash used in investing activities of $1.53 billion in 2014 decreased $619.1 million from the $2.15 billion used in 2013, primarily due to lower net new loan and lease originations of $257.0 million, lower payments for property, plant and equipment of $212.4 million and lower cash used in the acquisitions of equipment for operating leases of $123.1 million. Financing activities: Cash used in financing activities was $520.5 million for 2014 compared to cash provided by financing activities of $273.8 million in 2013. The Company paid $623.8 million of dividends in 2014 compared to $283.1 million paid in 2013, an increase of $340.7 million. The higher dividends in 2014 reflect a special dividend declared in 2013 and paid in early 2014. In 2013, there was no special dividend payment, as the 2012 special dividend was declared and paid in 2012. The Company also repurchased .7 million shares of common stock for $42.7 million in 2014. In 2014, the Company issued $1.65 billion in long-term debt and $349.1 million of commercial paper and short-term bank loans to repay long-term debt of $1.88 billion. In 2013, the Company issued $2.13 billion in medium-term debt to repay medium-term debt of $568.9 million and reduce its outstanding commercial paper and bank loans by $1.04 billion. This resulted in cash provided by borrowing activities of $116.9 million, $409.0 million lower than cash provided by borrowing activities of $525.9 million in 2013. 2013 Compared to 2012: Operating activities: Cash provided by operations increased $856.7 million to $2.38 billion in 2013 primarily due to an improvement in working capital and $164.6 million in lower pension contributions. Higher operating cash flow reflects a $544.4 million higher inflow for purchases of goods and services in accounts payable and accrued expenses in excess of payments, $87.9 million in higher depreciation of equipment on operating leases and $59.7 million of higher net income. In addition, there was a $21.9 million lower increase in inventories. These cash inflows were partially offset by a $190.2 million increase in sales of goods and services in accounts receivable exceeding cash receipts. Investing activities: Cash used in investing activities of $2.15 billion in 2013 decreased $437.0 million from the $2.59 billion used in 2012. Net new loan and lease originations in the Financial Services segment in 2013 were $307.6 million lower, reflecting a lower growth in the portfolio. In addition, net purchases of marketable securities were $179.4 million lower in 2013. Financing activities: Cash provided by financing activities increased to $273.8 million from $209.5 million in 2012. The Company paid $283.1 million of dividends in 2013, a decrease of $526.4 million, compared to the $809.5 million paid in 2012. The higher dividends paid in 2012 reflect a special dividend declared in 2011 and paid in early 2012, and a special dividend declared and paid at the end of 2012. The special dividend declared in 2013 is payable in 2014. In addition, there were no purchases of treasury stock in 2013, compared to $162.1 million purchased in 2012. In 2013, the Company issued $2.13 billion of medium-term debt, $67.0 million less than 2012. The proceeds were used to repay medium-term debt of $568.9 million and to reduce outstanding balances on commercial paper and bank loans by $1.04 billion, resulting in cash provided by borrowing activities of $525.9 million, $641.3 million lower than the cash provided by borrowing activities of $1.17 billion in 2012. Credit Lines and Other: The Company has line of credit arrangements of $3.50 billion, of which $3.37 billion were unused at December 31, 2014. Included in these arrangements are $3.0 billion of syndicated bank facilities, of which $1.0 billion matures in June 2015, $1.0 billion matures in June 2018 and $1.0 billion matures in June 2019. The Company intends to replace these credit facilities as they expire with facilities of similar amounts and duration. These credit facilities are maintained primarily to provide backup liquidity for commercial paper borrowings and maturing medium-term notes. There were no borrowings under the syndicated bank facilities for the year ended December 31, 2014. In December 2011, PACCAR Inc filed a shelf registration under the Securities Act of 1933; the registration expired in the fourth quarter of 2014. Upon maturity in February 2014, $500.0 million of medium-term notes, of which $150.0 million was manufacturing debt, were repaid in full. In December 2011, PACCAR’s Board of Directors approved the repurchase of $300.0 million of the Company’s common stock, and as of December 31, 2014, $234.7 million of shares have been repurchased pursuant to the authorization. At December 31, 2014 and December 31, 2013, the Company had cash and cash equivalents and marketable debt securities of $1.60 billion and $1.75 billion, respectively, which are considered indefinitely reinvested in foreign subsidiaries. The Company periodically repatriates foreign earnings that are not indefinitely reinvested. Dividends paid by foreign subsidiaries to the U.S. parent were $.24 billion, $.19 billion and $.23 billion in 2014, 2013 and 2012, respectively. The Company believes that its U.S. cash and cash equivalents and marketable debt securities, future operating cash flow and access to the capital markets, along with periodic repatriation of foreign earnings, will be sufficient to meet U.S. liquidity requirements. Truck, Parts and Other The Company provides funding for working capital, capital expenditures, R&D, dividends, stock repurchases and other business initiatives and commitments primarily from cash provided by operations. Management expects this method of funding to continue in the future. Investments for property, plant and equipment in 2014 totaled $220.8 million compared to $406.5 million in 2013 as the Company invested in new products and expanded its aftermarket distribution centers and enhanced its production facilities. Investments in 2014 were lower than 2013, as 2013 included higher spending for new product development and construction of the Eindhoven parts distribution center in Europe and the DAF Brasil factory. Over the past decade, the Company’s combined investments in worldwide capital projects and R&D totaled $5.83 billion, which have significantly increased operating capacity and efficiency of its facilities and the competitive advantage of the Company’s premium products. In 2015, capital investments are expected to be $300 to $350 million and are targeted for enhanced powertrain development and increased operating efficiency of the Company’s factories and parts distribution centers. Spending on R&D in 2015 is expected to be $220 to $260 million, as PACCAR will continue to focus on new products and increased manufacturing capacity. The Company conducts business in Spain, Italy, Portugal, Ireland, Greece, Russia, Ukraine and certain other countries which have been experiencing significant financial stress, fiscal or political strain and are subject to potential default. The Company routinely monitors its financial exposure to global financial conditions, its global counterparties and its operating environments. As of December 31, 2014, the Company had finance and trade receivables in these countries of approximately 1% of consolidated total assets. As of December 31, 2014, the Company did not have any marketable debt security investments in corporate or sovereign government securities in these countries. In addition, the Company had no derivative counterparty credit exposures in these countries as of December 31, 2014. Financial Services The Company funds its financial services activities primarily from collections on existing finance receivables and borrowings in the capital markets. The primary sources of borrowings in the capital markets are commercial paper and medium-term notes issued in the public markets and, to a lesser extent, bank loans. An additional source of funds is loans from other PACCAR companies. The Company issues commercial paper for a portion of its funding in its Financial Services segment. Some of this commercial paper is converted to fixed interest rate debt through the use of interest rate swaps, which are used to manage interest rate risk. In the event of a future significant disruption in the financial markets, the Company may not be able to issue replacement commercial paper. As a result, the Company is exposed to liquidity risk from the shorter maturity of short-term borrowings paid to lenders compared to the longer timing of receivable collections from customers. The Company believes its cash balances and investments, collections on existing finance receivables, syndicated bank lines and current investment-grade credit ratings of A+/A1 will continue to provide it with sufficient resources and access to capital markets at competitive interest rates and therefore contribute to the Company maintaining its liquidity and financial stability. A decrease in these credit ratings could negatively impact the Company’s ability to access capital markets at competitive interest rates and the Company’s ability to maintain liquidity and financial stability. In November 2012, the Company’s U.S. finance subsidiary, PACCAR Financial Corp. (PFC), filed a shelf registration under the Securities Act of 1933. The total amount of medium-term notes outstanding for PFC as of December 31, 2014 was $4.15 billion. The registration expires in November 2015 and does not limit the principal amount of debt securities that may be issued during that period. As of December 31, 2014, the Company’s European finance subsidiary, PACCAR Financial Europe, had €366.9 million available for issuance under a €1.50 billion medium-term note program registered with the London Stock Exchange. The program was renewed in the second quarter of 2014 and is renewable annually through the filing of a new prospectus. In April 2011, PACCAR Financial Mexico registered a 10.00 billion peso medium-term note and commercial paper program with the Comision Nacional Bancaria y de Valores. The registration expires in 2016 and limits the amount of commercial paper (up to one year) to 5.00 billion pesos. At December 31, 2014, 8.00 billion pesos remained available for issuance. PACCAR believes its Financial Services companies will be able to continue funding receivables, servicing debt and paying dividends through internally generated funds, access to public and private debt markets and lines of credit. Commitments The following summarizes the Company’s contractual cash commitments at December 31, 2014: * Borrowings include commercial paper and other short-term debt. ** Includes interest on fixed and floating-rate term debt. Interest on floating-rate debt is based on the applicable market rates at December 31, 2014. Total cash commitments for borrowings and interest on term debt are $8.36 billion and were related to the Financial Services segment. As described in Note I of the consolidated financial statements, borrowings consist primarily of term notes and commercial paper issued by the Financial Services segment. The Company expects to fund its maturing Financial Services debt obligations principally from funds provided by collections from customers on loans and lease contracts, as well as from the proceeds of commercial paper and medium-term note borrowings. Purchase obligations are the Company’s contractual commitments to acquire future production inventory and capital equipment. Other obligations include deferred cash compensation. The Company’s other commitments include the following at December 31, 2014: Loan and lease commitments are for funding new retail loan and lease contracts. Residual value guarantees represent the Company’s commitment to acquire trucks at a guaranteed value if the customer decides to return the truck at a specified date in the future. IMPACT OF ENVIRONMENTAL MATTERS: The Company, its competitors and industry in general are subject to various domestic and foreign requirements relating to the environment. The Company believes its policies, practices and procedures are designed to prevent unreasonable risk of environmental damage and that its handling, use and disposal of hazardous or toxic substances have been in accordance with environmental laws and regulations enacted at the time such use and disposal occurred. The Company is involved in various stages of investigations and cleanup actions in different countries related to environmental matters. In certain of these matters, the Company has been designated as a “potentially responsible party” by domestic and foreign environmental agencies. The Company has provided an accrual for the estimated costs to investigate and complete cleanup actions where it is probable that the Company will incur such costs in the future. Expenditures related to environmental activities in the years ended December 31, 2014, 2013 and 2012 were $1.2 million, $2.3 million and $1.7 million, respectively. Management expects that these matters will not have a significant effect on the Company’s consolidated cash flow, liquidity or financial condition. CRITICAL ACCOUNTING POLICIES: The Company’s significant accounting policies are disclosed in Note A of the consolidated financial statements. In the preparation of the Company’s financial statements, in accordance with U.S. generally accepted accounting principles, management uses estimates and makes judgments and assumptions that affect asset and liability values and the amounts reported as income and expense during the periods presented. The following are accounting policies which, in the opinion of management, are particularly sensitive and which, if actual results are different from estimates used by management, may have a material impact on the financial statements. Operating Leases Trucks sold pursuant to agreements accounted for as operating leases are disclosed in Note E of the consolidated financial statements. In determining its estimate of the residual value of such vehicles, the Company considers the length of the lease term, the truck model, the expected usage of the truck and anticipated market demand. Operating lease terms generally range from three to five years. The resulting residual values on operating leases generally range between 30% and 50% of original equipment cost. If the sales price of the trucks at the end of the term of the agreement differs from the Company’s estimated residual value, a gain or loss will result. Future market conditions, changes in government regulations and other factors outside the Company’s control could impact the ultimate sales price of trucks returned under these contracts. Residual values are reviewed regularly and adjusted if market conditions warrant. A decrease in the estimated equipment residual values would increase annual depreciation expense over the remaining lease term. During 2014, 2013 and 2012, market values on equipment returning upon operating lease maturity were generally higher than the residual values on the equipment, resulting in a decrease in depreciation expense of $10.6 million, $4.4 million and $5.0 million, respectively. At December 31, 2014, the aggregate residual value of equipment on operating leases in the Financial Services segment and residual value guarantee on trucks accounted for as operating leases in the Truck segment was $1.91 billion. A 10% decrease in used truck values worldwide, expected to persist over the remaining maturities of the Company’s operating leases, would reduce residual value estimates and result in the Company recording an average of approximately $47.8 million of additional depreciation per year. Allowance for Credit Losses The allowance for credit losses related to the Company’s loans and finance leases is disclosed in Note D of the consolidated financial statements. The Company has developed a systematic methodology for determining the allowance for credit losses for its two portfolio segments, retail and wholesale. The retail segment consists of retail loans and direct and sales-type finance leases, net of unearned interest. The wholesale segment consists of truck inventory financing loans to dealers that are collateralized by trucks and other collateral. The wholesale segment generally has less risk than the retail segment. Wholesale receivables generally are shorter in duration than retail receivables, and the Company requires monthly reporting of the wholesale dealer’s financial condition, conducts periodic audits of the trucks being financed and in many cases, obtains personal guarantees or other security such as dealership assets. In determining the allowance for credit losses, retail loans and finance leases are evaluated together since they relate to a similar customer base, their contractual terms require regular payment of principal and interest, generally over 36 to 60 months, and they are secured by the same type of collateral. The allowance for credit losses consists of both specific and general reserves. The Company individually evaluates certain finance receivables for impairment. Finance receivables that are evaluated individually for impairment consist of all wholesale accounts and certain large retail accounts with past due balances or otherwise determined to be at a higher risk of loss. A finance receivable is impaired if it is considered probable the Company will be unable to collect all contractual interest and principal payments as scheduled. In addition, all retail loans and leases which have been classified as TDRs and all customer accounts over 90 days past due are considered impaired. Generally, impaired accounts are on non-accrual status. Impaired accounts classified as TDRs which have been performing for 90 consecutive days are placed on accrual status if it is deemed probable that the Company will collect all principal and interest payments. Impaired receivables are generally considered collateral dependent. Large balance retail and all wholesale impaired receivables are individually evaluated to determine the appropriate reserve for losses. The determination of reserves for large balance impaired receivables considers the fair value of the associated collateral. When the underlying collateral fair value exceeds the Company’s recorded investment, no reserve is recorded. Small balance impaired receivables with similar risk characteristics are evaluated as a separate pool to determine the appropriate reserve for losses using the historical loss information discussed below. For finance receivables that are not individually impaired, the Company collectively evaluates and determines the general allowance for credit losses for both retail and wholesale receivables based on historical loss information, using past due account data and current market conditions. Information used includes assumptions regarding the likelihood of collecting current and past due accounts, repossession rates, the recovery rate on the underlying collateral based on used truck values and other pledged collateral or recourse. The Company has developed a range of loss estimates for each of its country portfolios based on historical experience, taking into account loss frequency and severity in both strong and weak truck market conditions. A projection is made of the range of estimated credit losses inherent in the portfolio from which an amount is determined as probable based on current market conditions and other factors impacting the creditworthiness of the Company’s borrowers and their ability to repay. After determining the appropriate level of the allowance for credit losses, a provision for losses on finance receivables is charged to income as necessary to reflect management’s estimate of incurred credit losses, net of recoveries, inherent in the portfolio. The adequacy of the allowance is evaluated quarterly based on the most recent past due account information and current market conditions. As accounts become past due, the likelihood that they will not be fully collected increases. The Company’s experience indicates the probability of not fully collecting past due accounts ranges between 20% and 80%. Over the past three years, the Company’s year-end 30+ days past due accounts have ranged between .5% and .6% of loan and lease receivables. Historically, a 100 basis point increase in the 30+ days past due percentage has resulted in an increase in credit losses of 5 to 30 basis points of receivables. Past dues were .5% at December 31, 2014. If past dues were 100 basis points higher or 1.5% as of December 31, 2014, the Company’s estimate of credit losses would likely have increased by a range of $5 to $25 million depending on the extent of the past dues, the estimated value of the collateral as compared to amounts owed and general economic factors. Product Warranty Product warranty is disclosed in Note H of the consolidated financial statements. The expenses related to product warranty are estimated and recorded at the time products are sold based on historical and current data and reasonable expectations for the future regarding the frequency and cost of warranty claims, net of recoveries. Management takes actions to minimize warranty costs through quality-improvement programs; however, actual claim costs incurred could materially differ from the estimated amounts and require adjustments to the reserve. Historically those adjustments have not been material. Over the past three years, warranty expense as a percentage of Truck, Parts and Other net sales and revenues has ranged between 1.2% and 1.6%. If the 2014 warranty expense had been .2% higher as a percentage of net sales and revenues in 2014, warranty expense would have increased by approximately $36 million. Pension Benefits Employee benefits are disclosed in Note L of the consolidated financial statements. The Company’s accounting for employee pension benefit costs and obligations is based on management assumptions about the future used by actuaries to estimate net costs and liabilities. These assumptions include discount rates, long-term rates of return on plan assets, inflation rates, retirement rates, mortality rates and other factors. Management bases these assumptions on historical results, the current environment and reasonable estimates of future events. The discount rate for pension benefits is based on market interest rates of high-quality corporate bonds with a maturity profile that matches the timing of the projected benefit payments of the plans. Changes in the discount rate affect the valuation of the plan benefits obligation and funded status of the plans. The long-term rate of return on plan assets is based on projected returns for each asset class and relative weighting of those asset classes in the plans. Because differences between actual results and the assumptions for returns on plan assets, retirement rates and mortality rates are accumulated and amortized into expense over future periods, management does not believe these differences or a typical percentage change in these assumptions worldwide would have a material effect on its financial results in the next year. The most significant assumption which could negatively affect pension expense is a decrease in the discount rate. If the discount rate was to decrease .5%, 2014 net pension expense would increase to $76.2 million from $53.1 million and the projected benefit obligation would increase $219.6 million to $2.6 billion from $2.4 billion. Income Taxes Income taxes are disclosed in Note M of the consolidated financial statements. The Company calculates income tax expense on pre-tax income based on current tax law. Deferred tax assets and liabilities are recorded for future tax consequences on temporary differences between recorded amounts in the financial statements and their respective tax basis. The determination of income tax expense requires management estimates and involves judgment regarding indefinitely reinvested foreign earnings, jurisdictional mix of earnings and future outcomes regarding tax law issues included in tax returns. The Company updates its assumptions on all of these factors each quarter as well as new information on tax laws and differences between estimated taxes and actual returns when filed. If the Company’s assessment of these matters changes, the effect is accounted for in earnings in the period the change is made. FORWARD-LOOKING STATEMENTS: This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements relating to future results of operations or financial position and any other statement that does not relate to any historical or current fact. Such statements are based on currently available operating, financial and other information and are subject to risks and uncertainties that may affect actual results. Risks and uncertainties include, but are not limited to: a significant decline in industry sales; competitive pressures; reduced market share; reduced availability of or higher prices for fuel; increased safety, emissions, or other regulations resulting in higher costs and/or sales restrictions; currency or commodity price fluctuations; lower used truck prices; insufficient or under-utilization of manufacturing capacity; supplier interruptions; insufficient liquidity in the capital markets; fluctuations in interest rates; changes in the levels of the Financial Services segment new business volume due to unit fluctuations in new PACCAR truck sales or reduced market shares; changes affecting the profitability of truck owners and operators; price changes impacting truck sales prices and residual values; insufficient supplier capacity or access to raw materials; labor disruptions; shortages of commercial truck drivers; increased warranty costs or litigation; or legislative and governmental regulations. A more detailed description of these and other risks is included under the heading Part 1, Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.

<s>[INST] PACCAR is a global technology company whose Truck segment includes the design and manufacture of highquality, light, medium and heavyduty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business is the manufacturing and marketing of industrial winches. Consolidated net sales and revenues of $18.99 billion in 2014 were the highest in the Company’s history. The increase of 11% from $17.12 billion in 2013 was mainly due to record truck and aftermarket parts sales and higher financial services revenues. Truck unit sales increased in 2014 to 142,900 units from 137,100 units in 2013, reflecting higher industry retail sales in the U.S. and Canada, partially offset by a lower over 16tonne market in Europe. Record freight volumes and improving fleet utilization are contributing to excellent parts and service business. In 2014, PACCAR earned net income for the 76th consecutive year. Net income in 2014 of $1.36 billion was the second highest in the Company’s history, increasing from $1.17 billion in 2013, primarily due to record Truck and Parts segment sales, improved Truck segment operating margin and record Financial Services segment pretax income. Earnings per diluted share of $3.82 was the second best in the Company’s history. DAF introduced a new range of Euro 6 CF and XF fouraxle trucks and tractors for heavyduty applications. These new vehicles expand DAF’s product range in the construction, container and refuse markets and complement DAF’s awardwinning Euro 6 onhighway trucks. In addition, DAF introduced the new DAF Euro 6 CF Silent distribution truck for deliveries in urban areas with noise restrictions, and the new DAF Euro 6 CF and XF Low Deck tractors which maximize trailer volume within European height and length regulations. These new vehicles expand DAF’s product range in distribution and overtheroad applications and expand DAF’s Euro 6 range of trucks. Kenworth and Peterbilt launched their new mediumduty caboverengine distribution trucks with extensive exterior and interior enhancements. In addition, new vocational Kenworth T880 and Peterbilt Model 567 trucks were introduced, which expanded PACCAR’s offerings in the construction, utility and refuse markets. In 2014, the Company’s research and development expenses were $215.6 million compared to $251.4 million in 2013. PACCAR Parts opened a new distribution center in Montreal, Canada and now has 17 parts distribution centers supporting over 2,000 DAF, Kenworth and Peterbilt dealer locations. PACCAR began construction of a new 160,000 squarefoot distribution center in Renton, Washington. The new facility will increase the distribution capacity for the Company’s dealers and customers in the northwestern U.S. and western Canada. The PACCAR Financial Services (PFS) group of companies has operations covering four continents and 22 countries. The global breadth of PFS and its rigorous credit application process support a portfolio of loans and leases with total assets of $11.92 billion that earned a record pretax profit of $370.4 million. PFS issued $1.58 billion in mediumterm notes during the year to support portfolio growth. Truck and Parts Outlook Truck industry retail sales in the U.S. and Canada in 2015 are expected to be 250,000280,000 units compared to 249,400 units in 2014 driven by expansion of truck industry fleet capacity and economic growth. In Europe, the 201 [/INST] Negative. </s>

PACCAR INC

2016-02-16

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. OVERVIEW: PACCAR is a global technology company whose Truck segment includes the design and manufacture of high-quality, light-, medium- and heavy-duty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. Consolidated net sales and revenues of $19.12 billion in 2015 were the highest in the Company’s history. The increase from $18.99 billion in 2014 was primarily due to stronger industry truck sales in the U.S. and Europe, partially offset by the effects of translating weaker foreign currencies, primarily the euro, to the U.S. dollar. In 2015, PACCAR earned net income for the 77th consecutive year. Net income in 2015 of $1.60 billion was the highest in the Company’s history, increasing from $1.36 billion in 2014. The results reflect increased truck sales in the U.S. and Europe and strong aftermarket parts and financial services results. The U.S. truck market benefited from record freight demand and expansion of industry fleet capacity. Earnings per diluted share were $4.51 compared to $3.82 in 2014. The Company is expanding its range of PACCAR engines in North America with the introduction of the PACCAR MX-11 engine, with an output of up to 430 HP and 1,550 lb.-ft. of torque. The PACCAR MX-11 is scheduled to be available in Kenworth and Peterbilt trucks in early 2016. The PACCAR MX-11 engine is designed to deliver excellent performance and fuel economy, industry-leading durability and reliability, and a quiet operating environment for the driver. Kenworth and Peterbilt launched new vehicle technologies that provide customers real-time diagnostic information to enhance their vehicle operating performance. Kenworth TruckTech+ and Peterbilt SmartLinq diagnostic systems are in production on new Class 8 trucks equipped with the PACCAR MX-13 engine. In addition, Predictive Cruise Control is in production for Kenworth T680 and T660 trucks and Peterbilt Model 579 and Model 567 trucks, specified with the PACCAR MX-13 engine. The new driver assist systems integrate cruise control with global positioning system data to anticipate road contours, enabling the PACCAR MX-13 engine to achieve outstanding fuel economy. Kenworth and Peterbilt have developed additional technologies to enhance customers’ driver performance and profitability. Driver Performance Assistant and Driver Shift Aid are standard equipment on Kenworth T680 and T660 trucks and Peterbilt Model 579 and Model 567 trucks, specified with the PACCAR MX-13 engine. Driver Performance Assistant provides drivers with real-time coaching on driving behavior and a scoring system to optimize driver performance and fuel economy. Driver Shift Aid provides drivers in vehicles with manual transmissions a visual cue to shift at the optimal RPM and engine torque to maximize fuel economy. DAF introduced the new LF 2016 Edition which features enhancements to the PACCAR PX-5 4.5 liter engine, resulting in up to 5% better fuel efficiency. In addition, a new DAF aerodynamic package results in 4% better fuel efficiency, while advanced technologies such as Lane Departure Warning System, Advanced Emergency Braking System, Forward Collision Warning and Adaptive Cruise Control enhance comfort and safety. PACCAR Parts added 18 dealer-owned TRP stores in 2015, building on the success of PACCAR Parts’ TRP brand of aftermarket parts for all makes of medium- and heavy-duty trucks, trailers and buses. TRP stores are strategically located to bring TRP products and technical expertise close to the customer. PACCAR’s new 160,000 square-foot distribution center in Renton, Washington is under construction and is expected to open in the second quarter of 2016. The PACCAR Financial Services (PFS) group of companies has operations covering four continents and 22 countries. The global breadth of PFS and its rigorous credit application process support a portfolio of loans and leases with total assets of $12.25 billion that earned pre-tax profit of $362.6 million. PFS issued $1.92 billion in medium-term notes during the year to support portfolio growth. In 2015, the Company’s capital investments were $308.4 million compared to $223.1 million in 2014, and research and development (R&D) expenses were $239.8 million in 2015 compared to $215.6 million in 2014. Truck Outlook Truck industry retail sales in the U.S. and Canada in 2016 are expected to be 230,000 to 260,000 units compared to 278,400 in 2015. In Europe, the 2016 truck industry registrations for over 16-tonne vehicles are projected to increase to a range of 260,000 to 290,000 units, compared to the 269,100 truck registrations in 2015. In South America, heavy-duty truck industry sales were 74,000 units in 2015, and the 2016 heavy-duty truck industry sales are estimated to be in a range of 70,000 to 80,000 units. Parts Outlook In 2016, PACCAR Parts sales in North America are expected to increase 3-5%, reflecting steady economic growth and high fleet utilization. In 2016, Europe aftermarket sales are expected to increase 3-5%, reflecting good freight markets and PACCAR Parts’ innovative customer service programs. The U.S. dollar value of sales in Europe may continue to be affected by recent declines in the value of the euro relative to the U.S. dollar. Financial Services Outlook Based on the truck market outlook, average earning assets in 2016 are expected to be comparable to the record levels achieved in 2015. Current strong levels of freight tonnage, freight rates and fleet utilization are contributing to customers’ profitability and cash flow. If current freight transportation conditions decline due to weaker economic conditions, then past due accounts, truck repossessions and credit losses would likely increase from the current low levels and new business volumes would likely decline. Capital Spending and R&D Outlook Capital investments in 2016 are expected to be $325 to $375 million, and R&D is expected to be $240 to $270 million focused on enhanced aftermarket support, manufacturing facilities and new product development. See the Forward-Looking Statements section of Management’s Discussion and Analysis for factors that may affect these outlooks. RESULTS OF OPERATIONS: The following provides an analysis of the results of operations for the Company’s three reportable segments - Truck, Parts and Financial Services. Where possible, the Company has quantified the impact of factors identified in the following discussion and analysis. In cases where it is not possible to quantify the impact of factors, the Company lists them in estimated order of importance. Factors for which the Company is unable to specifically quantify the impact include market demand, fuel prices, freight tonnage and economic conditions affecting the Company’s results of operations. 2015 Compared to 2014: Truck The Company’s Truck segment accounted for 77% of total revenues for both 2015 and 2014. The Company’s worldwide truck net sales and revenues increased to $14.78 billion from $14.59 billion in 2014, primarily due to higher truck deliveries in the U.S and Europe. The effects of translating weaker foreign currencies to the U.S. dollar, primarily the euro, reduced 2015 worldwide truck net sales and revenues by $940.0 million. Truck segment income before income taxes and pre-tax return on revenues reflect higher truck unit deliveries and improved gross margins in the U.S. and Europe. The effects on income before income taxes of translating weaker foreign currencies to the U.S. dollar, primarily the euro, were largely offset by lower costs of North American MX engine components imported from Europe. The Company’s new truck deliveries are summarized below: Truck selling, general and administrative expenses (SG&A) for 2015 decreased to $192.6 million from $198.2 million in 2014. The decrease was primarily due to currency translation effect ($21.8 million), mostly related to a decline in the value of the euro relative to the U.S. dollar, partially offset by higher promotion and marketing costs ($11.6 million) and higher salaries and related expenses ($7.6 million). As a percentage of sales, SG&A decreased to 1.3% in 2015 compared to 1.4% in 2014, reflecting higher sales volume. Parts The Company’s Parts segment accounted for 16% of total revenues for both 2015 and 2014. • Higher market demand, primarily in the U.S. and Canada and Europe, resulted in increased aftermarket parts sales volume of $123.5 million and related cost of sales of $69.1 million. • Average aftermarket parts sales prices increased sales by $52.4 million reflecting improved price realization in the U.S. and Canada ($31.1 million) and Europe ($21.3 million). • Average aftermarket parts direct costs increased $2.9 million due to higher material costs. • Warehouse and other indirect costs increased $7.3 million, primarily due to additional costs to support higher sales volume. • The currency translation effect on sales and cost of sales reflects a decline in the value of foreign currencies relative to the U.S. dollar, primarily the euro. • Parts gross margins in 2015 of 27.0% increased from 25.9% in 2014 due to the factors noted above. Parts SG&A expense for 2015 decreased to $194.7 million from $207.5 million in 2014. The decrease was primarily due to the effects of currency translation ($21.7 million), mostly related to a decline in the value of the euro relative to the U.S. dollar, partially offset by higher salaries and related expenses ($10.3 million). As a percentage of sales, Parts SG&A decreased to 6.4% in 2015 from 6.7% in 2014. Financial Services The Company’s Financial Services segment accounted for 6% of total revenues for both 2015 and 2014. New loan and lease volume was $4.44 billion in 2015 compared to $4.46 billion in 2014. PFS finance market share on new PACCAR truck sales was 25.9% in 2015 compared to 27.7% in 2014 due to increased competition. PFS revenue decreased to $1.17 billion in 2015 from $1.20 billion in 2014. The decrease was primarily due to the effects of translating weaker foreign currencies to the U.S. dollar and lower yields, partially offset by revenues on higher average earning asset balances. The effects of currency translation lowered PFS revenues by $79.3 million for 2015. PFS income before income taxes decreased to $362.6 million from $370.4 million in 2014, primarily due to the effects of translating weaker foreign currencies into the U.S. dollar and lower yields, partially offset by higher average earning asset balances and lower borrowing rates. The effects of currency translation lowered PFS income before income taxes by $21.9 million for 2015. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin between 2015 and 2014 are outlined below: The major factors for the changes in operating lease, rental and other revenues, depreciation and other expenses and lease margin between 2015 and 2014 are outlined below: • A higher volume of used truck sales increased operating lease, rental and other revenues by $9.5 million and increased depreciation and other expenses by $11.9 million. • Results on returned lease assets increased depreciation and other expenses by $7.7 million, primarily due to lower gains on sales of returned lease units. • Average operating lease assets increased $188.2 million in 2015 (excluding foreign exchange effects), which increased revenues by $17.3 million and related depreciation and other expenses by $13.6 million. • Revenue per asset increased $8.1 million primarily due to higher fee income and higher rental rates, partially offset by lower fuel revenue. Cost per asset increased $4.6 million, primarily due to higher depreciation expense, partially offset by lower fuel expense. • The currency translation effects reflect a decline in the value of foreign currencies relative to the U.S. dollar, primarily the euro. The following table summarizes the provision for losses on receivables and net charge-offs: The provision for losses on receivables was $12.4 million in 2015, a decrease of $3.0 million compared to 2014, mainly due to improved portfolio performance in Europe and the effects of translating weaker foreign currencies to the U.S. dollar, partially offset by higher portfolio balances in Europe and the U.S. and Canada. The Company modifies loans and finance leases as a normal part of its Financial Services operations. The Company may modify loans and finance leases for commercial reasons or for credit reasons. Modifications for commercial reasons are changes to contract terms for customers that are not considered to be in financial difficulty. Insignificant delays are modifications extending terms up to three months for customers experiencing some short-term financial stress, but not considered to be in financial difficulty. Modifications for credit reasons are changes to contract terms for customers considered to be in financial difficulty. The Company’s modifications typically result in granting more time to pay the contractual amounts owed and charging a fee and interest for the term of the modification. When considering whether to modify customer accounts for credit reasons, the Company evaluates the creditworthiness of the customers and modifies those accounts that the Company considers likely to perform under the modified terms. When the Company modifies loans and finance leases for credit reasons and grants a concession, the modifications are classified as troubled debt restructurings (TDR). The post-modification balance of accounts modified during the years ended December 31, 2015 and 2014 are summarized below: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2015 and 2014. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2015 and 2014. The Company’s 2015 and 2014 pre-tax return on average earning assets for Financial Services was 3.2% and 3.3%, respectively. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment, including a portion of corporate expense. Other sales represents less than 1% of consolidated net sales and revenues for 2015 and 2014. Other SG&A was $58.7 million in 2015 and $59.5 million in 2014. The decrease in SG&A was primarily due to lower salaries and related expenses. Other income (loss) before tax was a loss of $43.2 million in 2015 compared to a loss of $31.9 million in 2014. The higher loss in 2015 was primarily due to lower income before tax from the winch business which has been affected by lower oilfield related business. Investment income was $21.8 million in 2015 compared to $22.3 million in 2014. The lower investment income in 2015 was primarily due to the effects of translating weaker foreign currencies to the U.S. dollar, partially offset by higher realized gains and average portfolio balances. Income Taxes The 2015 effective income tax rate of 31.4% decreased from 32.7% in 2014. The decrease in the effective tax rate was primarily due to an increase in research tax credits in 2015. The Company’s worldwide truck net sales and revenues increased to $14.59 billion from $13.0 billion in 2013, primarily due to higher truck deliveries in the U.S. and Canada, higher price realization in Europe related to higher content Euro 6 emission vehicles, partially offset by lower truck deliveries in Europe and Mexico. Truck segment income before income taxes and pre-tax return on revenues reflect higher truck unit deliveries and improved price realization in the U.S. and Canada and lower R&D spending, partially offset by lower deliveries in Europe and Mexico. The Company’s new truck deliveries are summarized below: • Truck delivery volume reflects higher truck deliveries in the U.S. and Canada which resulted in higher sales ($1,798.6 million) and cost of sales ($1,511.5 million), partially offset by lower truck deliveries in Europe and Mexico which resulted in lower sales ($564.3 million) and costs of sales ($457.8 million). • Average truck sales prices increased sales by $477.4 million, primarily due to higher content Euro 6 emission vehicles in Europe ($274.9 million), improved price realization in the U.S. and Canada ($146.6 million) and in Mexico ($31.9 million). • Average cost per truck increased cost of sales by $408.6 million, primarily due to higher content Euro 6 emission vehicles in Europe ($352.6 million). • Factory overhead and other indirect costs increased $63.6 million, primarily due to higher salaries and related costs ($59.5 million) to support higher sales volume, higher depreciation expense ($13.0 million), partially offset by lower Euro 6 project expenses ($17.4 million). • Operating lease revenues and cost of sales decreased due to lower average asset balances as lease maturities exceeded new lease volume. • Truck gross margins in 2014 of 10.2% increased from 10.1% in 2013 due to factors noted above. Truck SG&A expenses for 2014 decreased to $198.2 million from $214.1 million in 2013. The decrease was primarily due to lower promotion and marketing costs. As a percentage of sales, SG&A decreased to 1.4% in 2014 compared to 1.6% in 2013, reflecting higher sales volume and ongoing cost controls. Parts The Company’s Parts segment accounted for 16% of total revenues for both 2014 and 2013. • Higher market demand in all markets resulted in increased aftermarket parts sales volume of $187.8 million and related cost of sales by $120.0 million. • Average aftermarket parts sales prices increased sales by $82.5 million reflecting improved price realization in all markets. • Average aftermarket parts direct costs increased $57.8 million due to higher material costs in all markets. • Warehouse and other indirect costs increased $8.0 million primarily due to additional costs to support higher sales volume. • Parts gross margins in 2014 of 25.9% increased from 25.3% in 2013 due to the factors noted above. Parts SG&A expense for 2014 increased to $207.5 million from $204.1 million in 2013. The increase was primarily due to higher salaries and related expenses. As a percentage of sales, Parts SG&A decreased to 6.7% in 2014 from 7.2% in 2013, reflecting higher sales volume. Financial Services The Company’s Financial Services segment accounted for 6% and 7% of total revenues for 2014 and 2013, respectively. In 2014, new loan and lease volume of $4.46 billion increased 3% compared to $4.32 billion in 2013. PFS finance market share on new PACCAR truck sales was 27.7% in 2014 compared to 29.2% in 2013 due to increased competition. PFS revenue of $1.20 billion in 2014 was comparable to $1.17 billion in 2013. PFS income before income taxes increased to a record $370.4 million compared to $340.2 million in 2013, primarily due to higher finance and lease margins related to increased average earning asset balances. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin between 2014 and 2013 are outlined below: • A lower volume of used truck sales decreased operating lease, rental and other revenues by $20.5 million and decreased depreciation and other expenses by $20.7 million. • Average operating lease assets increased $222.3 million in 2014, which increased revenues by $39.7 million and related depreciation and other expenses by $30.6 million. • Revenue per asset increased $10.5 million due to higher rental rates, partially offset by lower fee income. Cost per asset increased $15.7 million due to higher depreciation and maintenance expenses. The following table summarizes the provision for losses on receivables and net charge-offs: * Recorded investment immediately after modification as a percentage of the year-end retail portfolio balance. In 2014, total modification activity decreased compared to 2013 primarily due to lower modifications for commercial reasons and insignificant delays, partially offset by an increase in TDR modifications. The decrease in commercial modifications primarily reflects lower levels of additional equipment financed and end-of-contract modifications. The decline in modifications for insignificant delays reflects 2013 extensions granted to two customers in Australia primarily due to business disruptions arising from flooding. TDR modifications increased primarily due to a contract modification for a large customer in the U.S. The following table summarizes the Company’s 30+ days past due accounts: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2014 and 2013. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2014 and 2013. The Company’s 2014 and 2013 pre-tax return on average earning assets for Financial Services was 3.3% and 3.2%, respectively. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment, including a portion of corporate expense. Other sales represent approximately 1% of consolidated net sales and revenues for 2014 and 2013. Other SG&A was $59.5 million in 2014 and $47.1 million in 2013. The increase in SG&A was primarily due to higher salaries and related expenses of $11.4 million. Other income (loss) before tax was a loss of $31.9 million in 2014 compared to a loss of $26.5 million in 2013. The higher loss in 2014 was primarily due to higher salaries and related expenses and lower income before tax from the winch business. Investment income was $22.3 million in 2014 compared to $28.6 million in 2013. The lower investment income in 2014 primarily reflects lower yields on investments due to lower market interest rates, partially offset by higher average investment balances. Income Taxes The 2014 effective income tax rate of 32.7% increased from 30.9% in 2013. The increase in the effective tax rate was primarily due to a higher proportion of income generated in higher taxed jurisdictions. 2015 Compared to 2014: Operating activities: Cash provided by operations increased $432.4 million to $2.56 billion in 2015 compared to $2.12 billion in 2014. Higher operating cash flow reflects $245.2 million of higher net income and $253.8 million from inventory as there was $64.3 million in net inventory reductions in 2015 vs. $189.5 million in net inventory purchases in 2014. In addition, higher cash inflows reflects $176.6 million from accounts receivables as collections exceeded sales in 2015 ($105.3 million) compared to sales exceeding collections in 2014 ($71.3 million). A lower increase in Financial Services sales-type finance leases and dealer direct loans on new trucks also contributed $126.5 million. These cash inflows were partially offset by cash outflows of $414.9 million from accounts payable and accrued expenses, where payments from goods and services exceeded purchases in 2015 ($162.6 million) compared to purchases exceeding payments in 2014 ($252.3 million). Investing activities: Cash used in investing activities of $1.97 billion in 2015 increased $443.0 million from the $1.53 billion used in 2014, primarily due to higher cash used in the acquisitions of equipment for operating leases of $199.4 million, $169.7 million higher net purchases of marketable securities and $116.0 million in higher net originations of retail loans and direct financing leases in 2015. These outflows were partially offset by higher proceeds from asset disposals of $53.3 million. Financing activities: Cash used in financing activities was $196.5 million in 2015 compared to $520.5 million in 2014. The Company paid $680.5 million of dividends in 2015 compared to $623.8 million paid in 2014, an increase of $56.7 million. In addition, the Company repurchased 3.8 million shares of common stock for $201.6 million in 2015 compared to .7 million shares for $42.7 million in 2014. In 2015, the Company issued $1.99 billion of term debt and $250.7 million of commercial paper and short-term bank loans and repaid maturing term debt of $1.58 billion. In 2014, the Company issued $1.65 billion of term debt and $349.1 million of commercial paper and short-term bank loans and repaid maturing term debt of $1.88 billion. This resulted in cash provided by borrowing activities of $663.8 million in 2015, $546.9 million higher than cash provided by borrowing activities of $116.9 million in 2014. 2014 Compared to 2013: Operating activities: Cash provided by operations decreased $252.1 million to $2.12 billion in 2014 compared to $2.38 billion in 2013. Lower operating cash flow reflects a higher increase in Financial Services segment wholesale receivables of $150.3 million and a higher increase in net purchases of inventories of $149.9 million. In addition, lower cash inflows resulted from a reduction in liabilities for residual value guarantees (RVG) and deferred revenues of $138.7 million, primarily due to a lower volume of new RVG contracts compared to 2013, and $54.9 million in higher pension contributions. These outflows were partially offset by $187.5 million of higher net income and $74.5 million of higher depreciation on property, plant and equipment. Investing activities: Cash used in investing activities of $1.53 billion in 2014 decreased $619.1 million from the $2.15 billion used in 2013, primarily due to lower net new loan and lease originations of $257.0 million, lower payments for property, plant and equipment of $212.4 million and lower cash used in the acquisitions of equipment for operating leases of $123.1 million. Financing activities: Cash used in financing activities was $520.5 million for 2014 compared to cash provided by financing activities of $273.8 million in 2013. The Company paid $623.8 million of dividends in 2014 compared to $283.1 million paid in 2013, an increase of $340.7 million. The higher dividends in 2014 reflect a special dividend declared in 2013 and paid in early 2014. In 2013, there was no special dividend payment, as the 2012 special dividend was declared and paid in 2012. The Company also repurchased .7 million shares of common stock for $42.7 million in 2014. In 2014, the Company issued $1.65 billion in term debt and $349.1 million of commercial paper and short-term bank loans and repaid term debt of $1.88 billion. In 2013, the Company issued $2.13 billion in term debt and repaid term debt of $568.9 million and reduced its outstanding commercial paper and bank loans by $1.04 billion. This resulted in cash provided by borrowing activities of $116.9 million, $409.0 million lower than cash provided by borrowing activities of $525.9 million in 2013. Credit Lines and Other: The Company has line of credit arrangements of $3.43 billion, of which $3.26 billion were unused at December 31, 2015. Included in these arrangements are $3.0 billion of syndicated bank facilities, of which $1.0 billion expires in June 2016, $1.0 billion expires in June 2019 and $1.0 billion expires in June 2020. The Company intends to replace these credit facilities on or before expiration with facilities of similar amounts and duration. These credit facilities are maintained primarily to provide backup liquidity for commercial paper borrowings and maturing medium-term notes. There were no borrowings under the syndicated bank facilities for the year ended December 31, 2015. On September 21, 2015, the Company completed the repurchase of $300.0 million of the Company’s common stock under authorizations approved in December 2011. On September 23, 2015, PACCAR’s Board of Directors approved the repurchase of an additional $300.0 million of the Company’s common stock, and as of December 31, 2015, $136.3 million of shares have been repurchased pursuant to the 2015 authorization. At December 31, 2015 and December 31, 2014, the Company had cash and cash equivalents and marketable debt securities of $1.82 billion and $1.60 billion, respectively, which are considered indefinitely reinvested in foreign subsidiaries. The Company periodically repatriates foreign earnings that are not indefinitely reinvested. Dividends paid by foreign subsidiaries to the U.S. parent were $.24 billion, $.24 billion and $.19 billion in 2015, 2014 and 2013, respectively. The Company believes that its U.S. cash and cash equivalents and marketable debt securities, future operating cash flow and access to the capital markets, along with periodic repatriation of foreign earnings, will be sufficient to meet U.S. liquidity requirements. Truck, Parts and Other The Company provides funding for working capital, capital expenditures, R&D, dividends, stock repurchases and other business initiatives and commitments primarily from cash provided by operations. Management expects this method of funding to continue in the future. Investments for property, plant and equipment in 2015 increased to $306.5 million from $220.8 million in 2014, primarily due to higher investments by DAF in Europe and the construction of a new parts distribution center in Renton, Washington. Over the past decade, the Company’s combined investments in worldwide capital projects and R&D totaled $5.92 billion, which have significantly increased the operating capacity and efficiency of its facilities and the competitive advantage of the Company’s premium products. In 2016, capital investments are expected to be $325 to $375 million, and R&D is expected to be $240 to $270 million focused on enhanced aftermarket support, manufacturing facilities and new product development. The Company conducts business in Spain, Italy, Portugal, Ireland, Greece, Russia, Ukraine and certain other countries which have been experiencing significant financial stress, fiscal or political strain and the corresponding potential default. The Company routinely monitors its financial exposure to global financial conditions, global counterparties and operating environments. As of December 31, 2015, the Company had finance and trade receivables in these countries of approximately 1% of consolidated total assets. In addition, the Company’s exposures in these countries were insignificant for both derivative counterparty credit and marketable debt security investments in corporate or sovereign government securities as of December 31, 2015. Financial Services The Company funds its financial services activities primarily from collections on existing finance receivables and borrowings in the capital markets. The primary sources of borrowings in the capital markets are commercial paper and medium-term notes issued in the public markets and, to a lesser extent, bank loans. An additional source of funds is loans from other PACCAR companies. The Company issues commercial paper for a portion of its funding in its Financial Services segment. Some of this commercial paper is converted to fixed interest rate debt through the use of interest-rate swaps, which are used to manage interest-rate risk. In November 2015, the Company’s U.S. finance subsidiary, PACCAR Financial Corp. (PFC), filed a shelf registration under the Securities Act of 1933. The total amount of medium-term notes outstanding for PFC as of December 31, 2015 was $4.40 billion. The registration expires in November 2018 and does not limit the principal amount of debt securities that may be issued during that period. As of December 31, 2015, the Company’s European finance subsidiary, PACCAR Financial Europe, had €269.0 million available for issuance under a €1.50 billion medium-term note program listed on the Professional Securities Market of the London Stock Exchange. This program replaced an expiring program in the second quarter of 2015 and is renewable annually through the filing of new listing particulars. In April 2011, PACCAR Financial Mexico (PFM) registered a 10.00 billion peso medium-term note and commercial paper program with the Comision Nacional Bancaria y de Valores. The registration expires in April 2016 and limits the amount of commercial paper (up to one year) to 5.00 billion pesos. At December 31, 2015, 8.04 billion pesos remained available for issuance. PFM intends to file a new program in April 2016. In the event of a future significant disruption in the financial markets, the Company may not be able to issue replacement commercial paper. As a result, the Company is exposed to liquidity risk from the shorter maturity of short-term borrowings paid to lenders compared to the longer timing of receivable collections from customers. The Company believes its cash balances and investments, collections on existing finance receivables, syndicated bank lines and current investment-grade credit ratings of A+/A1 will continue to provide it with sufficient resources and access to capital markets at competitive interest rates and therefore contribute to the Company maintaining its liquidity and financial stability. A decrease in these credit ratings could negatively impact the Company’s ability to access capital markets at competitive interest rates and the Company’s ability to maintain liquidity and financial stability. PACCAR believes its Financial Services companies will be able to continue funding receivables, servicing debt and paying dividends through internally generated funds, access to public and private debt markets and lines of credit. Commitments The following summarizes the Company’s contractual cash commitments at December 31, 2015: Loan and lease commitments are for funding new retail loan and lease contracts. Residual value guarantees represent the Company’s commitment to acquire trucks at a guaranteed value if the customer decides to return the truck at a specified date in the future. IMPACT OF ENVIRONMENTAL MATTERS: The Company, its competitors and industry in general are subject to various domestic and foreign requirements relating to the environment. The Company believes its policies, practices and procedures are designed to prevent unreasonable risk of environmental damage and that its handling, use and disposal of hazardous or toxic substances have been in accordance with environmental laws and regulations in effect at the time such use and disposal occurred. The Company is involved in various stages of investigations and cleanup actions in different countries related to environmental matters. In certain of these matters, the Company has been designated as a “potentially responsible party” by domestic and foreign environmental agencies. The Company has accrued the estimated costs to investigate and complete cleanup actions where it is probable that the Company will incur such costs in the future. Expenditures related to environmental activities in the years ended December 31, 2015, 2014 and 2013 were $2.0 million, $1.2 million and $2.3 million, respectively. Management expects that these matters will not have a significant effect on the Company’s consolidated cash flow, liquidity or financial condition. CRITICAL ACCOUNTING POLICIES: The Company’s significant accounting policies are disclosed in Note A of the consolidated financial statements. In the preparation of the Company’s financial statements, in accordance with U.S. generally accepted accounting principles, management uses estimates and makes judgments and assumptions that affect asset and liability values and the amounts reported as income and expense during the periods presented. The following are accounting policies which, in the opinion of management, are particularly sensitive and which, if actual results are different from estimates used by management, may have a material impact on the financial statements. Operating Leases Trucks sold pursuant to agreements accounted for as operating leases are disclosed in Note E of the consolidated financial statements. In determining its estimate of the residual value of such vehicles, the Company considers the length of the lease term, the truck model, the expected usage of the truck and anticipated market demand. Operating lease terms generally range from three to five years. The resulting residual values on operating leases generally range between 30% and 50% of original equipment cost. If the sales price of the trucks at the end of the term of the agreement differs from the Company’s estimated residual value, a gain or loss will result. Future market conditions, changes in government regulations and other factors outside the Company’s control could impact the ultimate sales price of trucks returned under these contracts. Residual values are reviewed regularly and adjusted if market conditions warrant. A decrease in the estimated equipment residual values would increase annual depreciation expense over the remaining lease term. During 2015, 2014 and 2013, market values on equipment returning upon operating lease maturity were generally higher than the residual values on the equipment, resulting in a decrease in depreciation expense of $5.8 million, $10.6 million and $4.4 million, respectively. At December 31, 2015, the aggregate residual value of equipment on operating leases in the Financial Services segment and residual value guarantee on trucks accounted for as operating leases in the Truck segment was $2.10 billion. A 10% decrease in used truck values worldwide, expected to persist over the remaining maturities of the Company’s operating leases, would reduce residual value estimates and result in the Company recording an average of approximately $52.6 million of additional depreciation per year. Allowance for Credit Losses The allowance for credit losses related to the Company’s loans and finance leases is disclosed in Note D of the consolidated financial statements. The Company has developed a systematic methodology for determining the allowance for credit losses for its two portfolio segments, retail and wholesale. The retail segment consists of retail loans and direct and sales-type finance leases, net of unearned interest. The wholesale segment consists of truck inventory financing loans to dealers that are collateralized by trucks and other collateral. The wholesale segment generally has less risk than the retail segment. Wholesale receivables generally are shorter in duration than retail receivables, and the Company requires periodic reporting of the wholesale dealer’s financial condition, conducts periodic audits of the trucks being financed and in many cases, obtains guarantees or other security such as dealership assets. In determining the allowance for credit losses, retail loans and finance leases are evaluated together since they relate to a similar customer base, their contractual terms require regular payment of principal and interest, generally over 36 to 60 months, and they are secured by the same type of collateral. The allowance for credit losses consists of both specific and general reserves. The Company individually evaluates certain finance receivables for impairment. Finance receivables that are evaluated individually for impairment consist of all wholesale accounts and certain large retail accounts with past due balances or otherwise determined to be at a higher risk of loss. A finance receivable is impaired if it is considered probable the Company will be unable to collect all contractual interest and principal payments as scheduled. In addition, all retail loans and leases which have been classified as TDRs and all customer accounts over 90 days past due are considered impaired. Generally, impaired accounts are on non-accrual status. Impaired accounts classified as TDRs which have been performing for 90 consecutive days are placed on accrual status if it is deemed probable that the Company will collect all principal and interest payments. Impaired receivables are generally considered collateral dependent. Large balance retail and all wholesale impaired receivables are individually evaluated to determine the appropriate reserve for losses. The determination of reserves for large balance impaired receivables considers the fair value of the associated collateral. When the underlying collateral fair value exceeds the Company’s recorded investment, no reserve is recorded. Small balance impaired receivables with similar risk characteristics are evaluated as a separate pool to determine the appropriate reserve for losses using the historical loss information discussed below. The Company evaluates finance receivables that are not individually impaired on a collective basis and determines the general allowance for credit losses for both retail and wholesale receivables based on historical loss information, using past due account data and current market conditions. Information used includes assumptions regarding the likelihood of collecting current and past due accounts, repossession rates, the recovery rate on the underlying collateral based on used truck values and other pledged collateral or recourse. The Company has developed a range of loss estimates for each of its country portfolios based on historical experience, taking into account loss frequency and severity in both strong and weak truck market conditions. A projection is made of the range of estimated credit losses inherent in the portfolio from which an amount is determined as probable based on current market conditions and other factors impacting the creditworthiness of the Company’s borrowers and their ability to repay. After determining the appropriate level of the allowance for credit losses, a provision for losses on finance receivables is charged to income as necessary to reflect management’s estimate of incurred credit losses, net of recoveries, inherent in the portfolio. The adequacy of the allowance is evaluated quarterly based on the most recent past due account information and current market conditions. As accounts become past due, the likelihood that they will not be fully collected increases. The Company’s experience indicates the probability of not fully collecting past due accounts ranges between 20% and 70%. Over the past three years, the Company’s year-end 30+ days past due accounts were .5% of loan and lease receivables. Historically, a 100 basis point increase in the 30+ days past due percentage has resulted in an increase in credit losses of 5 to 30 basis points of receivables. At December 31, 2015, 30+ days past dues were .5%. If past dues were 100 basis points higher or 1.5% as of December 31, 2015, the Company’s estimate of credit losses would likely have increased by a range of $5 to $25 million depending on the extent of the past dues, the estimated value of the collateral as compared to amounts owed and general economic factors. Product Warranty Product warranty is disclosed in Note H of the consolidated financial statements. The expenses related to product warranty are estimated and recorded at the time products are sold based on historical and current data and reasonable expectations for the future regarding the frequency and cost of warranty claims, net of recoveries. Management takes actions to minimize warranty costs through quality-improvement programs; however, actual claim costs incurred could materially differ from the estimated amounts and require adjustments to the reserve. Historically those adjustments have not been material. Over the past three years, warranty expense as a percentage of Truck, Parts and Other net sales and revenues has ranged between 1.4% and 1.8%. If the 2015 warranty expense had been .2% higher as a percentage of net sales and revenues in 2015, warranty expense would have increased by approximately $36 million. Pension Benefits Employee benefits are disclosed in Note L of the consolidated financial statements. The Company’s accounting for employee pension benefit costs and obligations is based on management assumptions about the future used by actuaries to estimate net costs and liabilities. These assumptions include discount rates, long-term rates of return on plan assets, inflation rates, retirement rates, mortality rates and other factors. Management bases these assumptions on historical results, the current environment and reasonable estimates of future events. The discount rate for pension benefits is based on market interest rates of high-quality corporate bonds with a maturity profile that matches the timing of the projected benefit payments of the plans. Changes in the discount rate affect the valuation of the plan benefits obligation and funded status of the plans. The long-term rate of return on plan assets is based on projected returns for each asset class and relative weighting of those asset classes in the plans. Because differences between actual results and the assumptions for returns on plan assets, retirement rates and mortality rates are accumulated and amortized into expense over future periods, management does not believe these differences or a typical percentage change in these assumptions worldwide would have a material effect on its financial results in the next year. The most significant assumption which could negatively affect pension expense is a decrease in the discount rate. If the discount rate were to decrease .5%, 2015 net pension expense would increase to $107.6 million from $85.0 million and the projected benefit obligation would increase $207.2 million to $2.5 billion from $2.3 billion. Income Taxes Income taxes are disclosed in Note M of the consolidated financial statements. The Company calculates income tax expense on pre-tax income based on current tax law. Deferred tax assets and liabilities are recorded for future tax consequences on temporary differences between recorded amounts in the financial statements and their respective tax basis. The determination of income tax expense requires management estimates and involves judgment regarding indefinitely reinvested foreign earnings, jurisdictional mix of earnings and future outcomes regarding tax law issues included in tax returns. The Company updates its assumptions on all of these factors each quarter as well as new information on tax laws and differences between estimated taxes and actual returns when filed. If the Company’s assessment of these matters changes, the effect is accounted for in earnings in the period the change is made. FORWARD-LOOKING STATEMENTS: This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements relating to future results of operations or financial position and any other statement that does not relate to any historical or current fact. Such statements are based on currently available operating, financial and other information and are subject to risks and uncertainties that may affect actual results. Risks and uncertainties include, but are not limited to: a significant decline in industry sales; competitive pressures; reduced market share; reduced availability of or higher prices for fuel; increased safety, emissions, or other regulations resulting in higher costs and/or sales restrictions; currency or commodity price fluctuations; lower used truck prices; insufficient or under-utilization of manufacturing capacity; supplier interruptions; insufficient liquidity in the capital markets; fluctuations in interest rates; changes in the levels of the Financial Services segment new business volume due to unit fluctuations in new PACCAR truck sales or reduced market shares; changes affecting the profitability of truck owners and operators; price changes impacting truck sales prices and residual values; insufficient supplier capacity or access to raw materials; labor disruptions; shortages of commercial truck drivers; increased warranty costs or litigation; or legislative and governmental regulations. A more detailed description of these and other risks is included under the heading Part 1, Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015.

<s>[INST] PACCAR is a global technology company whose Truck segment includes the design and manufacture of highquality, light, medium and heavyduty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. Consolidated net sales and revenues of $19.12 billion in 2015 were the highest in the Company’s history. The increase from $18.99 billion in 2014 was primarily due to stronger industry truck sales in the U.S. and Europe, partially offset by the effects of translating weaker foreign currencies, primarily the euro, to the U.S. dollar. In 2015, PACCAR earned net income for the 77th consecutive year. Net income in 2015 of $1.60 billion was the highest in the Company’s history, increasing from $1.36 billion in 2014. The results reflect increased truck sales in the U.S. and Europe and strong aftermarket parts and financial services results. The U.S. truck market benefited from record freight demand and expansion of industry fleet capacity. Earnings per diluted share were $4.51 compared to $3.82 in 2014. The Company is expanding its range of PACCAR engines in North America with the introduction of the PACCAR MX11 engine, with an output of up to 430 HP and 1,550 lb.ft. of torque. The PACCAR MX11 is scheduled to be available in Kenworth and Peterbilt trucks in early 2016. The PACCAR MX11 engine is designed to deliver excellent performance and fuel economy, industryleading durability and reliability, and a quiet operating environment for the driver. Kenworth and Peterbilt launched new vehicle technologies that provide customers realtime diagnostic information to enhance their vehicle operating performance. Kenworth TruckTech+ and Peterbilt SmartLinq diagnostic systems are in production on new Class 8 trucks equipped with the PACCAR MX13 engine. In addition, Predictive Cruise Control is in production for Kenworth T680 and T660 trucks and Peterbilt Model 579 and Model 567 trucks, specified with the PACCAR MX13 engine. The new driver assist systems integrate cruise control with global positioning system data to anticipate road contours, enabling the PACCAR MX13 engine to achieve outstanding fuel economy. Kenworth and Peterbilt have developed additional technologies to enhance customers’ driver performance and profitability. Driver Performance Assistant and Driver Shift Aid are standard equipment on Kenworth T680 and T660 trucks and Peterbilt Model 579 and Model 567 trucks, specified with the PACCAR MX13 engine. Driver Performance Assistant provides drivers with realtime coaching on driving behavior and a scoring system to optimize driver performance and fuel economy. Driver Shift Aid provides drivers in vehicles with manual transmissions a visual cue to shift at the optimal RPM and engine torque to maximize fuel economy. DAF introduced the new LF 2016 Edition which features enhancements to the PACCAR PX5 4.5 liter engine, resulting in up to 5% better fuel efficiency. In addition, a new DAF aerodynamic package results in 4% better fuel efficiency, while advanced technologies such as Lane Departure Warning System, Advanced Emergency Braking System, Forward Collision Warning and Adaptive Cruise Control enhance comfort and safety. PACCAR Parts added 18 dealerowned TRP stores in 2015, building on the success of PACCAR Parts’ TRP brand of aftermarket parts for all makes of medium and heavyduty trucks, trailers and buses. TRP stores are strategically located to bring TRP products [/INST] Positive. </s>

PACCAR INC

2017-02-21

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. OVERVIEW: PACCAR is a global technology company whose Truck segment includes the design and manufacture of high-quality light-, medium- and heavy-duty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. 2016 Financial Highlights • Worldwide net sales and revenues were $17.03 billion in 2016 compared to $19.12 billion in 2015. • Truck sales were $12.77 billion in 2016 compared to $14.78 billion in 2015, reflecting lower industry truck sales in the U.S. and Canada, partially offset by higher truck sales in Europe. • Parts sales were $3.01 billion in 2016 compared to $3.06 billion in 2015, reflecting lower demand in North America and the effect of translating weaker foreign currencies into the U.S. dollar. • Financial Services revenues were $1.19 billion in 2016 compared to $1.17 billion in 2015, primarily due to higher average earning assets, partially offset by currency translation effects. • In 2016, PACCAR earned net income for the 78th consecutive year. Net income was $521.7 million ($1.48 per diluted share) in 2016. On July 19, 2016, the European Commission (EC) concluded its investigation of all major European truck manufacturers and reached a settlement with DAF. Excluding the $833.0 million non-recurring, non-tax-deductible EC charge recorded in the first half of 2016, the Company earned adjusted net income (non-GAAP) of $1.35 billion ($3.85 per diluted share) in 2016 compared to net income of $1.60 billion ($4.51 per diluted share) in 2015. The operating results reflect lower truck and parts sales in the U.S., partially offset by increased truck sales in Europe. See Reconciliation of GAAP to Non-GAAP Financial Measures on page 33. • Capital investments were $402.7 million in 2016 compared to $308.4 million in 2015, reflecting additional investments for the construction of a new DAF cab paint facility in Europe, the Peterbilt plant expansion in Denton, Texas and a new parts distribution center (PDC) in Renton, Washington. • After-tax return on beginning equity (ROE) was 7.5%. Excluding the EC charge, adjusted ROE (non-GAAP) was 19.5%. See Reconciliation of GAAP to Non-GAAP Financial Measures on page 33. • Research and development (R&D) expenses were $247.2 million in 2016 compared to $239.8 million in 2015. In April 2016, the Company opened its new 160,000 square-foot PDC in Renton, Washington. The new PDC provides enhanced aftermarket support for dealers and customers in the Pacific Northwest and Western Canada. In addition, the Company will begin construction of a new 160,000 square-foot distribution center in Toronto, Canada in 2017. The Company launched its DAF Connect telematics system in Europe, which provides customers with fleet management data to enhance vehicle and driver performance. Customers can access information through a secure online service, enabling them to optimize vehicle utilization and uptime, reduce operational expenses and enhance logistical efficiency. Peterbilt constructed a 102,000 square-foot expansion to its truck manufacturing facility in Denton, Texas. The expansion is Peterbilt’s largest facility investment since the construction of the Denton plant in 1980 and will enhance manufacturing efficiency and provide additional production capacity. The Company launched a new proprietary tandem axle in North America that reduces vehicle weight by up to 150 pounds and improves fuel economy. The axle became available to customers in January 2017. In addition, the Company is enhancing its range of MX engines for 2017. The updated PACCAR engines will deliver increased power and fuel efficiency and reduce operating costs for customers. PACCAR Australia launched the Kenworth T610 truck in the fourth quarter of 2016. The Kenworth T610 represents the largest production investment in PACCAR Australia’s 45-year history. The T610 was designed specifically for Australia’s demanding road transport market and delivers industry-leading durability, reliability and fuel efficiency. The new 2.1 meter-wide cab features more driver space, enhanced visibility and excellent ergonomics. DAF is constructing a new $110 million environmentally friendly, robotic cab paint facility at its factory in Westerlo, Belgium, which will increase capacity and efficiency, and minimize emissions and energy consumption. The facility is expected to open in mid-2017. This strategic investment will support DAF’s market share growth and reflects DAF’s leadership in producing high quality vehicles. PACCAR Financial Services (PFS) has operations covering four continents and 23 countries. PFS, with its global breadth and its rigorous credit application process, supports a portfolio of loans and leases with total assets of $12.19 billion that earned pre-tax profit of $306.5 million. PFS issued $1.94 billion in medium term notes during 2016 to support portfolio growth and repay maturing debt. Truck Outlook Truck industry retail sales in the U.S. and Canada in 2017 are expected to be 190,000 to 220,000 units compared to 215,700 in 2016. In Europe, the 2017 truck industry registrations for over 16-tonne vehicles are expected to be 260,000 to 290,000 units compared to 302,500 in 2016. In South America, heavy-duty truck industry sales were 59,000 units in 2016 and in 2017 are estimated to be in a range of 60,000 to 70,000 units. Parts Outlook In 2017, PACCAR Parts sales in North America are expected to grow 2-4% compared to 2016 sales. In 2017, Europe aftermarket sales are expected to increase 1-3%. Financial Services Outlook Based on the truck market outlook, average earning assets in 2017 are expected to be comparable to 2016. Current good levels of freight tonnage, freight rates and fleet utilization are contributing to customers’ profitability and cash flow. If current freight transportation conditions decline due to weaker economic conditions, then past due accounts, truck repossessions and credit losses would likely increase from the current low levels and new business volume would likely decline. Capital Spending and R&D Outlook Capital investments in 2017 are expected to be $375 to $425 million, and R&D is expected to be $250 to $280 million. The Company is investing for future growth in PACCAR’s integrated powertrain, advanced driver assistance and truck connectivity technologies, and additional capacity and operating efficiency of the Company’s manufacturing and parts distribution facilities. DAF’s new $110 million cab paint facility is on schedule to open in mid-2017. See the Forward-Looking Statements section of Management’s Discussion and Analysis for factors that may affect these outlooks. RESULTS OF OPERATIONS: * In 2016, Other includes the EC charge of $833.0. ** See Reconciliation of GAAP to Non-GAAP Financial Measures for 2016 on page 33. The following provides an analysis of the results of operations for the Company’s three reportable segments - Truck, Parts and Financial Services. Where possible, the Company has quantified the impact of factors identified in the following discussion and analysis. In cases where it is not possible to quantify the impact of factors, the Company lists them in estimated order of importance. Factors for which the Company is unable to specifically quantify the impact include market demand, fuel prices, freight tonnage and economic conditions affecting the Company’s results of operations. 2016 Compared to 2015: Truck The Company’s Truck segment accounted for 75% of revenue in 2016 compared to 77% in 2015. The Company’s new truck deliveries are summarized below: In 2016, industry retail sales in the heavy-duty market in the U.S. and Canada decreased to 215,700 units from 278,400 units in 2015. The Company’s heavy-duty truck retail market share increased to 28.5% in 2016 from 27.4% in 2015. The medium-duty market was 85,200 units in 2016 compared to 80,200 units in 2015. The Company’s medium-duty market share was 16.2% in 2016 compared to 17.0% in 2015. The over 16-tonne truck market in Europe in 2016 increased to 302,500 units from 269,100 units in 2015, and DAF’s market share increased to 15.5% in 2016 from 14.6% in 2015. The 6 to 16-tonne market in 2016 increased to 52,900 units from 49,000 units in 2015. DAF market share in the 6 to 16-tonne market in 2016 increased to 10.1% from 9.0% in 2015. The Company’s worldwide truck net sales and revenues are summarized below: Truck selling, general and administrative expenses (SG&A) for 2016 increased to $202.5 million from $192.6 million in 2015. The increase was primarily due to higher salaries and related expenses. As a percentage of sales, Truck SG&A increased to 1.6% in 2016 compared to 1.3% in 2015, reflecting the lower sales volume. Parts The Company’s Parts segment accounted for 18% of revenues in 2016 compared to 16% in 2015. • Aftermarket parts sales volume decreased by $43.0 million and related cost of sales decreased by $28.9 million, primarily due to lower market demand in North America. • Average aftermarket parts sales prices increased sales by $22.5 million reflecting higher price realization in Europe. • Average aftermarket parts direct costs decreased $4.1 million due to lower material costs. • Warehouse and other indirect costs increased $8.5 million primarily due to start-up costs and higher depreciation expense for the new parts distribution center in Renton, Washington, and higher maintenance expense. • The currency translation effect on sales and cost of sales reflects a decline in the value of foreign currencies relative to the U.S. dollar, primarily the British pound. • Parts gross margins decreased to 26.9% in 2016 from 27.0% in 2015 due to the factors noted above. Parts SG&A expense for 2016 was $191.7 million compared to $194.7 million in 2015. As a percentage of sales, Parts SG&A was 6.4% in 2016 and 2015, reflecting lower sales offset by ongoing cost control. Financial Services The Company’s Financial Services segment accounted for 7% of revenues in 2016 compared to 6% in 2015. New loan and lease volume was $4.22 billion in 2016 compared to $4.44 billion in 2015, primarily due to lower truck deliveries in the U.S. and Canada. PFS finance market share on new PACCAR truck sales was 26.7% in 2016 compared to 25.9% in 2015. PFS revenue increased to $1.19 billion in 2016 from $1.17 billion in 2015. The increase was primarily due to higher average earning asset balances, partially offset by the effects of translating weaker foreign currencies to the U.S. dollar. The effects of currency translation lowered PFS revenues by $27.1 million for 2016. PFS income before income taxes decreased to $306.5 million in 2016 from $362.6 million in 2015, primarily due to lower results on returned lease assets, higher borrowing rates, the effects of translating weaker foreign currencies to the U.S. dollar and a higher provision for losses on receivables, partially offset by higher average earning asset balances. The effects of currency translation lowered PFS income before income taxes by $9.7 million for 2016. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin between 2016 and 2015 are outlined below: • A higher volume of used truck sales increased operating lease, rental and other revenues by $3.2 million. Depreciation and other expenses increased by $5.2 million due to higher volume and impairments of used trucks reflecting lower used truck prices. • Results on returned lease assets increased depreciation and other expenses by $19.2 million, primarily due to gains on sales of returned lease units in 2015 versus losses in 2016. • Average operating lease assets increased $178.3 million in 2016 (excluding foreign exchange effects), which increased revenues by $29.2 million and related depreciation and other expenses by $24.0 million. • Revenue per asset increased $11.8 million, primarily due to higher rental rates in Europe, partially offset by lower rental utilization and fuel surcharge revenue. Cost per asset increased $12.5 million, primarily due to higher depreciation expense in Europe. • The currency translation effects reflect a decline in the value of foreign currencies relative to the U.S. dollar, primarily the Mexican peso and British pound. The following table summarizes the provision for losses on receivables and net charge-offs: * Recorded investment immediately after modification as a percentage of the year-end retail portfolio balance. In 2016, total modification activity increased compared to 2015, primarily reflecting higher volume of refinancings for commercial reasons, including a contract modification for one large customer in the U.S. The increase in modifications for insignificant delay reflects more fleet customers requesting payment relief for up to three months. Credit - no concession modifications increased primarily due to extensions granted to one customer in Australia. The following table summarizes the Company’s 30+ days past due accounts: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2016 and 2015. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2016 and 2015. The Company’s 2016 and 2015 annualized pre-tax return on average earning assets for Financial Services was 2.6% and 3.2%, respectively. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment, including the EC charge and a portion of corporate expense. Other sales represent less than 1% of consolidated net sales and revenues for 2016 and 2015. Other SG&A was $46.6 million in 2016 and $58.7 million in 2015. The decrease in SG&A was primarily due to lower salaries and related expenses and lower professional fees. Other income (loss) before tax was a loss of $873.3 million in 2016 compared to a loss of $43.2 million in 2015. The higher loss in 2016 was primarily due to the EC charge and lower pre-tax results from the winch business, which has been affected by lower oilfield related sales, partially offset by lower SG&A expense. Investment income increased to $27.6 million in 2016 from $21.8 million in 2015, primarily due to higher yields on investments due to higher market interest rates and higher realized gains. Income Taxes In 2016, the effective tax rate increased to 53.8% from 31.4% in 2015, and substantially all of the difference in tax rates was due to the non-deductible expense of $833.0 million for the EC charge in 2016. Based on existing tax laws, with the exception of 2016, the Company believes that its historical effective tax rates will be indicative of the Company’s future tax rates. The Company’s worldwide truck net sales and revenues increased to $14.78 billion from $14.59 billion in 2014, primarily due to higher truck deliveries in the U.S. and Europe. The effects of translating weaker foreign currencies to the U.S. dollar, primarily the euro, reduced 2015 worldwide truck net sales and revenues by $940.0 million. Truck SG&A for 2015 decreased to $192.6 million from $198.2 million in 2014. The decrease was primarily due to currency translation effect ($21.8 million), mostly related to a decline in the value of the euro relative to the U.S. dollar, partially offset by higher promotion and marketing costs ($11.6 million) and higher salaries and related expenses ($7.6 million). As a percentage of sales, SG&A decreased to 1.3% in 2015 compared to 1.4% in 2014, reflecting higher sales volume. Parts The Company’s Parts segment accounted for 16% of total revenues for both 2015 and 2014. • Higher market demand, primarily in the U.S. and Canada and Europe, resulted in increased aftermarket parts sales volume of $123.5 million and related cost of sales of $69.1 million. • Average aftermarket parts sales prices increased sales by $52.4 million reflecting improved price realization in the U.S. and Canada ($31.1 million) and Europe ($21.3 million). • Average aftermarket parts direct costs increased $2.9 million due to higher material costs. • Warehouse and other indirect costs increased $7.3 million, primarily due to additional costs to support higher sales volume. • The currency translation effect on sales and cost of sales reflects a decline in the value of foreign currencies relative to the U.S. dollar, primarily the euro. • Parts gross margins in 2015 of 27.0% increased from 25.9% in 2014 due to the factors noted above. Parts SG&A expense for 2015 decreased to $194.7 million from $207.5 million in 2014. The decrease was primarily due to the effects of currency translation ($21.7 million), mostly related to a decline in the value of the euro relative to the U.S. dollar, partially offset by higher salaries and related expenses ($10.3 million). As a percentage of sales, Parts SG&A decreased to 6.4% in 2015 from 6.7% in 2014. Financial Services The Company’s Financial Services segment accounted for 6% of total revenues for both 2015 and 2014. New loan and lease volume was $4.44 billion in 2015 compared to $4.46 billion in 2014. PFS finance market share on new PACCAR truck sales was 25.9% in 2015 compared to 27.7% in 2014 due to increased competition. PFS revenue decreased to $1.17 billion in 2015 from $1.20 billion in 2014. The decrease was primarily due to the effects of translating weaker foreign currencies to the U.S. dollar and lower yields, partially offset by revenues on higher average earning asset balances. The effects of currency translation lowered PFS revenues by $79.3 million for 2015. PFS income before income taxes decreased to $362.6 million from $370.4 million in 2014, primarily due to the effects of translating weaker foreign currencies into the U.S. dollar and lower yields, partially offset by higher average earning asset balances and lower borrowing rates. The effects of currency translation lowered PFS income before income taxes by $21.9 million for 2015. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin between 2015 and 2014 are outlined below: • A higher volume of used truck sales increased operating lease, rental and other revenues by $9.5 million and increased depreciation and other expenses by $11.9 million. • Results on returned lease assets increased depreciation and other expenses by $7.7 million, primarily due to lower gains on sales of returned lease units. • Average operating lease assets increased $188.2 million in 2015 (excluding foreign exchange effects), which increased revenues by $17.3 million and related depreciation and other expenses by $13.6 million. • Revenue per asset increased $8.1 million primarily due to higher fee income and higher rental rates, partially offset by lower fuel revenue. Cost per asset increased $4.6 million, primarily due to higher depreciation expense, partially offset by lower fuel expense. • The currency translation effects reflect a decline in the value of foreign currencies relative to the U.S. dollar, primarily the euro. The following table summarizes the provision for losses on receivables and net charge-offs: * Recorded investment immediately after modification as a percentage of the year-end retail portfolio balance. In 2015, total modification activity increased compared to 2014, primarily due to higher modifications for credit - TDRs, partially offset by the effects of translating weaker foreign currencies to the U.S. dollar and lower commercial modifications. TDR modifications increased primarily due to contract modifications in Mexico. The decrease in commercial modifications reflects lower volumes of refinancing. The following table summarizes the Company’s 30+ days past due accounts: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2015 and 2014. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2015 and 2014. The Company’s 2015 and 2014 pre-tax return on average earning assets for Financial Services was 3.2% and 3.3%, respectively. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment, including a portion of corporate expense. Other sales represents less than 1% of consolidated net sales and revenues for 2015 and 2014. Other SG&A was $58.7 million in 2015 and $59.5 million in 2014. The decrease in SG&A was primarily due to lower salaries and related expenses. Other income (loss) before tax was a loss of $43.2 million in 2015 compared to a loss of $31.9 million in 2014. The higher loss in 2015 was primarily due to lower income before tax from the winch business which has been affected by lower oilfield related business. Investment income was $21.8 million in 2015 compared to $22.3 million in 2014. The lower investment income in 2015 was primarily due to the effects of translating weaker foreign currencies to the U.S. dollar, partially offset by higher realized gains and average portfolio balances. Income Taxes The 2015 effective income tax rate of 31.4% decreased from 32.7% in 2014. The decrease in the effective tax rate was primarily due to an increase in research tax credits in 2015. 2016 Compared to 2015: Operating activities: Cash provided by operations decreased by $255.2 million to $2.30 billion in 2016. Lower operating cash flows reflect lower net income of $521.7 million in 2016, which includes payment of the $833.0 million EC charge, and higher pension contributions of $122.8 million. This was partially offset by $675.0 million from Financial Services segment wholesale receivables, whereby cash receipts exceeded originations in 2016 ($401.6 million) compared to originations exceeding cash receipts in 2015 ($273.4 million). In addition, there was a lower cash outflow for payment of income taxes of $281.4 million. Investing activities: Cash used in investing activities decreased by $410.6 million to $1.56 billion in 2016 from $1.97 billion in 2015. Lower net cash used in investing activities reflects $567.2 million from marketable debt securities as there was $272.9 million in net proceeds from sales of marketable debt securities in 2016 versus $294.3 million in net purchases of marketable debt securities in 2015 and higher net originations of retail loans and direct financing leases of $100.7 million. This was partially offset by higher cash used in the acquisitions of equipment for operating leases of $151.2 million and higher payments for property, plant and equipment of $88.5 million. Financing activities: Cash used in financing activities was $823.5 million in 2016 compared to cash used in financing activities of $196.5 million in 2015. The Company paid $829.3 million in dividends in 2016 compared to $680.5 million in 2015; the increase of $148.8 million was primarily due to an increase for the 2015 special dividend paid in January 2016. In 2016, the Company issued $1.99 billion of term debt, repaid term debt of $1.63 billion and reduced its outstanding commercial paper and short-term bank loans by $322.8 million. In 2015, the Company issued $1.99 billion of term debt, increased its outstanding commercial paper and short-term bank loans by $250.7 million and repaid term debt of $1.58 billion. This resulted in cash provided by borrowing activities of $46.9 million in 2016, $616.9 million lower than the cash provided by borrowing activities of $663.8 million in 2015. The Company repurchased 1.4 million shares of common stock for $70.5 million in 2016 compared to 3.8 million shares for $201.6 million in 2015, a decline of $131.1 million. 2015 Compared to 2014: Operating activities: Cash provided by operations increased $432.4 million to $2.56 billion in 2015 compared to $2.12 billion in 2014. Higher operating cash flow reflects $245.2 million of higher net income and $253.8 million from inventory as there was $64.3 million in net inventory reductions in 2015 vs. $189.5 million in net inventory purchases in 2014. In addition, higher cash inflows reflects $176.6 million from accounts receivables as collections exceeded sales in 2015 ($105.3 million) compared to sales exceeding collections in 2014 ($71.3 million). A lower increase in Financial Services sales-type finance leases and dealer direct loans on new trucks also contributed $126.5 million. These cash inflows were partially offset by cash outflows of $414.9 million from accounts payable and accrued expenses, where payments from goods and services exceeded purchases in 2015 ($162.6 million) compared to purchases exceeding payments in 2014 ($252.3 million). Investing activities: Cash used in investing activities of $1.97 billion in 2015 increased $443.0 million from the $1.53 billion used in 2014, primarily due to higher cash used in the acquisitions of equipment for operating leases of $199.4 million, $169.7 million higher net purchases of marketable securities and $116.0 million in higher net originations of retail loans and direct financing leases in 2015. These outflows were partially offset by higher proceeds from asset disposals of $53.3 million. Financing activities: Cash used in financing activities was $196.5 million in 2015 compared to $520.5 million in 2014. The Company paid $680.5 million of dividends in 2015 compared to $623.8 million paid in 2014, an increase of $56.7 million. In addition, the Company repurchased 3.8 million shares of common stock for $201.6 million in 2015 compared to .7 million shares for $42.7 million in 2014. In 2015, the Company issued $1.99 billion of term debt and $250.7 million of commercial paper and short-term bank loans and repaid maturing term debt of $1.58 billion. In 2014, the Company issued $1.65 billion of term debt and $349.1 million of commercial paper and short-term bank loans and repaid maturing term debt of $1.88 billion. This resulted in cash provided by borrowing activities of $663.8 million in 2015, $546.9 million higher than cash provided by borrowing activities of $116.9 million in 2014. Credit Lines and Other: The Company has line of credit arrangements of $3.43 billion, of which $3.22 billion were unused at December 31, 2016. Included in these arrangements are $3.0 billion of syndicated bank facilities, of which $1.0 billion expires in June 2017, $1.0 billion expires in June 2020 and $1.0 billion expires in June 2021. The Company intends to replace these credit facilities on or before expiration with facilities of similar amounts and duration. These credit facilities are maintained primarily to provide backup liquidity for commercial paper borrowings and maturing medium-term notes. There were no borrowings under the syndicated bank facilities for the year ended December 31, 2016. On September 23, 2015, PACCAR’s Board of Directors approved the repurchase of up to $300.0 million of the Company’s common stock, and as of December 31, 2016, $206.7 million of shares have been repurchased pursuant to the 2015 authorization. At December 31, 2016 and December 31, 2015, the Company had cash and cash equivalents and marketable debt securities of $1.33 billion and $1.82 billion, respectively, which are considered indefinitely reinvested in foreign subsidiaries. The Company periodically repatriates foreign earnings that are not indefinitely reinvested. Dividends paid by foreign subsidiaries to the U.S. parent were $.33 billion, $.24 billion and $.24 billion in 2016, 2015 and 2014, respectively. The Company believes that its U.S. cash and cash equivalents and marketable debt securities, future operating cash flow and access to the capital markets, along with periodic repatriation of foreign earnings, will be sufficient to meet U.S. liquidity requirements. Truck, Parts and Other The Company provides funding for working capital, capital expenditures, R&D, dividends, stock repurchases and other business initiatives and commitments primarily from cash provided by operations. Management expects this method of funding to continue in the future. On July 19, 2016, the EC concluded its investigation of all major European truck manufacturers and reached a settlement with DAF under which the EC imposed a fine on DAF of €752.7 million ($833.0 million) for infringement of European Union competition rules. The fine is not tax deductible. In August 2016, DAF paid the fine. Investments for property, plant and equipment in 2016 increased to $394.6 million from $306.5 million in 2015, reflecting additional investments for the construction of a new DAF cab paint facility in Europe, the Peterbilt plant expansion in Denton, Texas and a new PDC in Renton, Washington. Over the past decade, the Company’s combined investments in worldwide capital projects and R&D totaled $6.09 billion, and have significantly increased the operating capacity and efficiency of its facilities and enhanced the quality and operating efficiency of the Company’s premium products. In 2017, capital investments are expected to be $375 to $425 million, and R&D is expected to be $250 to $280 million. The Company is investing for future growth in PACCAR’s new truck models integrated powertrain, advanced driver assistance and truck connectivity technologies, and additional capacity and operating efficiency of the Company’s manufacturing and parts distribution facilities. The Company conducts business in certain countries which have been experiencing or may experience significant financial stress, fiscal or political strain and are subject to the corresponding potential for default. The Company routinely monitors its financial exposure to global financial conditions, global counterparties and operating environments. As of December 31, 2016, the Company’s exposures in such countries were insignificant. Financial Services The Company funds its financial services activities primarily from collections on existing finance receivables and borrowings in the capital markets. The primary sources of borrowings in the capital markets are commercial paper and medium-term notes issued in the public markets and, to a lesser extent, bank loans. An additional source of funds is loans from other PACCAR companies. The Company issues commercial paper for a portion of its funding in its Financial Services segment. Some of this commercial paper is converted to fixed interest rate debt through the use of interest-rate swaps, which are used to manage interest-rate risk. In November 2015, the Company’s U.S. finance subsidiary, PACCAR Financial Corp. (PFC), filed a shelf registration under the Securities Act of 1933. The total amount of medium-term notes outstanding for PFC as of December 31, 2016 was $4.75 billion. The registration expires in November 2018 and does not limit the principal amount of debt securities that may be issued during that period. As of December 31, 2016, the Company’s European finance subsidiary, PACCAR Financial Europe, had €1,313.4 million available for issuance under a €2.50 billion medium-term note program listed on the Professional Securities Market of the London Stock Exchange. This program replaced an expiring program in the second quarter of 2016 and is renewable annually through the filing of new listing particulars. In April 2016, PACCAR Financial Mexico registered a 10.00 billion peso medium-term note and commercial paper program with the Comision Nacional Bancaria y de Valores. The registration expires in April 2021 and limits the amount of commercial paper (up to one year) to 5.00 billion pesos. At December 31, 2016, 8.88 billion pesos were available for issuance. In the event of a future significant disruption in the financial markets, the Company may not be able to issue replacement commercial paper. As a result, the Company is exposed to liquidity risk from the shorter maturity of short-term borrowings paid to lenders compared to the longer timing of receivable collections from customers. The Company believes its cash balances and investments, collections on existing finance receivables, syndicated bank lines and current investment-grade credit ratings of A+/A1 will continue to provide it with sufficient resources and access to capital markets at competitive interest rates and therefore contribute to the Company maintaining its liquidity and financial stability. A decrease in these credit ratings could negatively impact the Company’s ability to access capital markets at competitive interest rates and the Company’s ability to maintain liquidity and financial stability. PACCAR believes its Financial Services companies will be able to continue funding receivables, servicing debt and paying dividends through internally generated funds, access to public and private debt markets and lines of credit. Commitments The following summarizes the Company’s contractual cash commitments at December 31, 2016: Loan and lease commitments are for funding new retail loan and lease contracts. Residual value guarantees represent the Company’s commitment to acquire trucks at a guaranteed value if the customer decides to return the truck at a specified date in the future. RECONCILIATION OF GAAP TO NON-GAAP FINANCIAL MEASURES: This Form 10-K includes “adjusted net income (non-GAAP)” and “adjusted net income per diluted share (non-GAAP)”, which are financial measures that are not in accordance with U.S. generally accepted accounting principles (“GAAP”), since they exclude the non-recurring EC charge in 2016. These measures differ from the most directly comparable measures calculated in accordance with GAAP and may not be comparable to similarly titled non-GAAP financial measures used by other companies. In addition, the Form 10-K includes the financial ratios noted below calculated based on non-GAAP measures. Management utilizes these non-GAAP measures to evaluate the Company’s performance and believes these measures allow investors and management to evaluate operating trends by excluding a significant non-recurring charge that is not representative of underlying operating trends. Reconciliations from the most directly comparable GAAP measures to adjusted non-GAAP measures are as follows: * Calculated using adjusted net income. IMPACT OF ENVIRONMENTAL MATTERS: The Company, its competitors and industry in general are subject to various domestic and foreign requirements relating to the environment. The Company believes its policies, practices and procedures are designed to prevent unreasonable risk of environmental damage and that its handling, use and disposal of hazardous or toxic substances have been in accordance with environmental laws and regulations in effect at the time such use and disposal occurred. The Company is involved in various stages of investigations and cleanup actions in different countries related to environmental matters. In certain of these matters, the Company has been designated as a “potentially responsible party” by domestic and foreign environmental agencies. The Company has accrued the estimated costs to investigate and complete cleanup actions where it is probable that the Company will incur such costs in the future. Expenditures related to environmental activities in the years ended December 31, 2016, 2015 and 2014 were $2.2 million, $2.0 million and $1.2 million, respectively. Management expects that these matters will not have a significant effect on the Company’s consolidated cash flow, liquidity or financial condition. CRITICAL ACCOUNTING POLICIES: The Company’s significant accounting policies are disclosed in Note A of the consolidated financial statements. In the preparation of the Company’s financial statements, in accordance with U.S. generally accepted accounting principles, management uses estimates and makes judgments and assumptions that affect asset and liability values and the amounts reported as income and expense during the periods presented. The following are accounting policies which, in the opinion of management, are particularly sensitive and which, if actual results are different from estimates used by management, may have a material impact on the financial statements. Operating Leases Trucks sold pursuant to agreements accounted for as operating leases are disclosed in Note E of the consolidated financial statements. In determining its estimate of the residual value of such vehicles, the Company considers the length of the lease term, the truck model, the expected usage of the truck and anticipated market demand. Operating lease terms generally range from three to five years. The resulting residual values on operating leases generally range between 30% and 60% of original equipment cost. If the sales price of the trucks at the end of the term of the agreement differs from the Company’s estimated residual value, a gain or loss will result. Future market conditions, changes in government regulations and other factors outside the Company’s control could impact the ultimate sales price of trucks returned under these contracts. Residual values are reviewed regularly and adjusted if market conditions warrant. A decrease in the estimated equipment residual values would increase annual depreciation expense over the remaining lease term. During 2016, market values on equipment returning upon operating lease maturity decreased, resulting in an increase in depreciation expense of $9.6 million. During 2015 and 2014, market values on equipment returning upon operating lease maturity were generally higher than the residual values on the equipment, resulting in a reduction in depreciation expense of $5.8 million and $10.6 million, respectively. At December 31, 2016, the aggregate residual value of equipment on operating leases in the Financial Services segment and residual value guarantee on trucks accounted for as operating leases in the Truck segment was $2.31 billion. A 10% decrease in used truck values worldwide, if expected to persist over the remaining maturities of the Company’s operating leases, would reduce residual value estimates and result in the Company recording an average of approximately $57.7 million of additional depreciation per year. Allowance for Credit Losses The allowance for credit losses related to the Company’s loans and finance leases is disclosed in Note D of the consolidated financial statements. The Company has developed a systematic methodology for determining the allowance for credit losses for its two portfolio segments, retail and wholesale. The retail segment consists of retail loans and direct and sales-type finance leases, net of unearned interest. The wholesale segment consists of truck inventory financing loans to dealers that are collateralized by trucks and other collateral. The wholesale segment generally has less risk than the retail segment. Wholesale receivables generally are shorter in duration than retail receivables, and the Company requires periodic reporting of the wholesale dealer’s financial condition, conducts periodic audits of the trucks being financed and in many cases, obtains guarantees or other security such as dealership assets. In determining the allowance for credit losses, retail loans and finance leases are evaluated together since they relate to a similar customer base, their contractual terms require regular payment of principal and interest, generally over 36 to 60 months, and they are secured by the same type of collateral. The allowance for credit losses consists of both specific and general reserves. The Company individually evaluates certain finance receivables for impairment. Finance receivables that are evaluated individually for impairment consist of all wholesale accounts and certain large retail accounts with past due balances or otherwise determined to be at a higher risk of loss. A finance receivable is impaired if it is considered probable the Company will be unable to collect all contractual interest and principal payments as scheduled. In addition, all retail loans and leases which have been classified as TDRs and all customer accounts over 90 days past due are considered impaired. Generally, impaired accounts are on non-accrual status. Impaired accounts classified as TDRs which have been performing for 90 consecutive days are placed on accrual status if it is deemed probable that the Company will collect all principal and interest payments. Impaired receivables are generally considered collateral dependent. Large balance retail and all wholesale impaired receivables are individually evaluated to determine the appropriate reserve for losses. The determination of reserves for large balance impaired receivables considers the fair value of the associated collateral. When the underlying collateral fair value exceeds the Company’s recorded investment, no reserve is recorded. Small balance impaired receivables with similar risk characteristics are evaluated as a separate pool to determine the appropriate reserve for losses using the historical loss information discussed below. The Company evaluates finance receivables that are not individually impaired on a collective basis and determines the general allowance for credit losses for both retail and wholesale receivables based on historical loss information, using past due account data and current market conditions. Information used includes assumptions regarding the likelihood of collecting current and past due accounts, repossession rates, the recovery rate on the underlying collateral based on used truck values and other pledged collateral or recourse. The Company has developed a range of loss estimates for each of its country portfolios based on historical experience, taking into account loss frequency and severity in both strong and weak truck market conditions. A projection is made of the range of estimated credit losses inherent in the portfolio from which an amount is determined as probable based on current market conditions and other factors impacting the creditworthiness of the Company’s borrowers and their ability to repay. After determining the appropriate level of the allowance for credit losses, a provision for losses on finance receivables is charged to income as necessary to reflect management’s estimate of incurred credit losses, net of recoveries, inherent in the portfolio. The adequacy of the allowance is evaluated quarterly based on the most recent past due account information and current market conditions. As accounts become past due, the likelihood that they will not be fully collected increases. The Company’s experience indicates the probability of not fully collecting past due accounts ranges between 20% and 70%. Over the past three years, the Company’s year-end 30+ days past due accounts were .5% of loan and lease receivables. Historically, a 100 basis point increase in the 30+ days past due percentage has resulted in an increase in credit losses of 5 to 30 basis points of receivables. At December 31, 2016, 30+ days past dues were .5%. If past dues were 100 basis points higher or 1.5% as of December 31, 2016, the Company’s estimate of credit losses would likely have increased by a range of $5 to $20 million depending on the extent of the past dues, the estimated value of the collateral as compared to amounts owed and general economic factors. Product Warranty Product warranty is disclosed in Note H of the consolidated financial statements. The expenses related to product warranty are estimated and recorded at the time products are sold based on historical and current data and reasonable expectations for the future regarding the frequency and cost of warranty claims, net of recoveries. Management takes actions to minimize warranty costs through quality-improvement programs; however, actual claim costs incurred could materially differ from the estimated amounts and require adjustments to the reserve. Historically those adjustments have not been material. Over the past three years, warranty expense as a percentage of Truck, Parts and Other net sales and revenues has ranged between 1.3% and 1.8%. If the 2016 warranty expense had been .2% higher as a percentage of net sales and revenues in 2016, warranty expense would have increased by approximately $32 million. Pension Benefits Employee benefits are disclosed in Note L of the consolidated financial statements. The Company’s accounting for employee pension benefit costs and obligations is based on management assumptions about the future used by actuaries to estimate net costs and liabilities. These assumptions include discount rates, long-term rates of return on plan assets, inflation rates, retirement rates, mortality rates and other factors. Management bases these assumptions on historical results, the current environment and reasonable estimates of future events. The discount rate for pension benefits is based on market interest rates of high quality corporate bonds with a maturity profile that matches the timing of the projected benefit payments of the plans. Changes in the discount rate affect the valuation of the plan benefits obligation and funded status of the plans. The long-term rate of return on plan assets is based on projected returns for each asset class and relative weighting of those asset classes in the plans. Because differences between actual results and the assumptions for returns on plan assets, retirement rates and mortality rates are accumulated and amortized into expense over future periods, management does not believe these differences or a typical percentage change in these assumptions worldwide would have a material effect on its financial results in the next year. The most significant assumption which could negatively affect pension expense is a decrease in the discount rate. If the discount rate were to decrease .5%, 2016 net pension expense would increase to $92.9 million from $70.1 million and the projected benefit obligation would increase $208.0 million to $2.7 billion from $2.5 billion. Effective January 2017, the Company will change the method used to estimate service cost and interest cost components of pension expense from a single weighted-average method, which is a single discount rate determined at the pension plans’ measurement date, to an individual spot rate approach, which applies specific spot rates along the yield curve to the relevant projected cash flows. This approach is a more precise measurement of net periodic benefit costs and does not impact the benefit obligation. The Company considers this a change in estimate inseparable from a change in accounting principle, which will be accounted for prospectively. This change is expected to lower pension expense by approximately $15.0 million in 2017. Income Taxes Income taxes are disclosed in Note M of the consolidated financial statements. The Company calculates income tax expense on pre-tax income based on current tax law. Deferred tax assets and liabilities are recorded for future tax consequences on temporary differences between recorded amounts in the financial statements and their respective tax basis. The determination of income tax expense requires management estimates and involves judgment regarding indefinitely reinvested foreign earnings, jurisdictional mix of earnings and future outcomes regarding tax law issues included in tax returns. The Company updates its assumptions on all of these factors each quarter as well as new information on tax laws and differences between estimated taxes and actual returns when filed. If the Company’s assessment of these matters changes, the effect is accounted for in earnings in the period the change is made. FORWARD-LOOKING STATEMENTS: This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements relating to future results of operations or financial position and any other statement that does not relate to any historical or current fact. Such statements are based on currently available operating, financial and other information and are subject to risks and uncertainties that may affect actual results. Risks and uncertainties include, but are not limited to: a significant decline in industry sales; competitive pressures; reduced market share; reduced availability of or higher prices for fuel; increased safety, emissions, or other regulations resulting in higher costs and/or sales restrictions; currency or commodity price fluctuations; lower used truck prices; insufficient or under-utilization of manufacturing capacity; supplier interruptions; insufficient liquidity in the capital markets; fluctuations in interest rates; changes in the levels of the Financial Services segment new business volume due to unit fluctuations in new PACCAR truck sales or reduced market shares; changes affecting the profitability of truck owners and operators; price changes impacting truck sales prices and residual values; insufficient supplier capacity or access to raw materials; labor disruptions; shortages of commercial truck drivers; increased warranty costs or litigation; or legislative and governmental regulations. A more detailed description of these and other risks is included under the heading Part 1, Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016.

<s>[INST] PACCAR is a global technology company whose Truck segment includes the design and manufacture of highquality light, medium and heavyduty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. 2016 Financial Highlights Worldwide net sales and revenues were $17.03 billion in 2016 compared to $19.12 billion in 2015. Truck sales were $12.77 billion in 2016 compared to $14.78 billion in 2015, reflecting lower industry truck sales in the U.S. and Canada, partially offset by higher truck sales in Europe. Parts sales were $3.01 billion in 2016 compared to $3.06 billion in 2015, reflecting lower demand in North America and the effect of translating weaker foreign currencies into the U.S. dollar. Financial Services revenues were $1.19 billion in 2016 compared to $1.17 billion in 2015, primarily due to higher average earning assets, partially offset by currency translation effects. In 2016, PACCAR earned net income for the 78th consecutive year. Net income was $521.7 million ($1.48 per diluted share) in 2016. On July 19, 2016, the European Commission (EC) concluded its investigation of all major European truck manufacturers and reached a settlement with DAF. Excluding the $833.0 million nonrecurring, nontaxdeductible EC charge recorded in the first half of 2016, the Company earned adjusted net income (nonGAAP) of $1.35 billion ($3.85 per diluted share) in 2016 compared to net income of $1.60 billion ($4.51 per diluted share) in 2015. The operating results reflect lower truck and parts sales in the U.S., partially offset by increased truck sales in Europe. See Reconciliation of GAAP to NonGAAP Financial Measures on page 33. Capital investments were $402.7 million in 2016 compared to $308.4 million in 2015, reflecting additional investments for the construction of a new DAF cab paint facility in Europe, the Peterbilt plant expansion in Denton, Texas and a new parts distribution center (PDC) in Renton, Washington. Aftertax return on beginning equity (ROE) was 7.5%. Excluding the EC charge, adjusted ROE (nonGAAP) was 19.5%. See Reconciliation of GAAP to NonGAAP Financial Measures on page 33. Research and development (R&D) expenses were $247.2 million in 2016 compared to $239.8 million in 2015. In April 2016, the Company opened its new 160,000 squarefoot PDC in Renton, Washington. The new PDC provides enhanced aftermarket support for dealers and customers in the Pacific Northwest and Western Canada. In addition, the Company will begin construction of a new 160,000 squarefoot distribution center in Toronto, Canada in 2017. The Company launched its DAF Connect telematics system in Europe, which provides customers with fleet management data to enhance vehicle and driver performance. Customers can access information through a secure online service, enabling them to optimize vehicle utilization and uptime, reduce operational expenses and enhance logistical efficiency. Peterbilt constructed a 102,000 squarefoot expansion to its truck manufacturing facility in Denton, Texas. The expansion is Peterbilt’s largest facility investment since the construction of the Denton plant [/INST] Negative. </s>

PACCAR INC

2018-02-21

2017-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. OVERVIEW: PACCAR is a global technology company whose Truck segment includes the design and manufacture of high-quality light-, medium- and heavy-duty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. 2017 Financial Highlights • Worldwide net sales and revenues were a record $19.46 billion in 2017 compared to $17.03 billion in 2016. • Truck sales were $14.77 billion in 2017 compared to $12.77 billion in 2016, reflecting higher truck deliveries in the U.S. and Canada, Europe and Australia. • Parts sales were a record $3.33 billion in 2017 compared to $3.01 billion in 2016 reflecting higher demand in all markets. • Financial Services revenues were $1.27 billion in 2017 compared to $1.19 billion in 2016. The increase was primarily revenues from higher average operating lease assets. • In 2017, PACCAR earned net income for the 79th consecutive year. Net income of $1.68 billion ($4.75 per diluted share) includes a one-time net tax benefit of $173.4 million from the Tax Cuts and Jobs Act (“the Tax Act”). Excluding this one-time net benefit, the Company earned adjusted net income (non-GAAP) of $1.50 billion ($4.26 per diluted share) in 2017. The operating results in 2017 reflect higher truck deliveries and record worldwide Parts segment sales and profit, partially offset by lower Financial Services segment results. Net income in 2016 was $521.7 million ($1.48 per diluted share). Excluding the $833.0 million non-recurring EC charge, the Company earned adjusted net income (non-GAAP) of $1.35 billion ($3.85 per diluted share) in 2016. See Reconciliation of GAAP to Non-GAAP Financial Measures on page 33. • Capital investments were $433.1 million in 2017 compared to $402.7 million in 2016, reflecting additional investments in the Company’s manufacturing facilities, new product development and enhanced aftermarket support. • After-tax return on beginning equity (ROE) was 24.7% in 2017, which includes the one-time net tax benefit of $173.4 million from the Tax Act. Excluding the one-time net benefit, adjusted ROE (non-GAAP) was 22.2% in 2017. This compares to an ROE of 7.5% in 2016. Excluding the EC charge, adjusted ROE (non-GAAP) was 19.5% in 2016. See Reconciliation of GAAP to Non-GAAP Financial Measures on page 33. • Research and development (R&D) expenses were $264.7 million in 2017 compared to $247.2 million in 2016. The Company opened the PACCAR Innovation Center in Sunnyvale, California in the third quarter of 2017. The advanced technology research and development center coordinates next-generation product development and identifies emerging technologies to enhance future vehicle performance. Technology areas of focus include advanced driver assistance systems, artificial intelligence, vehicle connectivity and powertrain electrification. In the third quarter of 2017, the Company launched a new proprietary 12-speed automated transmission in North America, the lightest transmission for Class 8 on-highway vehicles. The PACCAR automated transmission is designed to complement the superior performance of PACCAR MX engines and PACCAR axles. The transmission reduces vehicle weight by up to 105 pounds, enhances low-speed maneuverability through excellent gear ratio coverage, and contributes to increased customer uptime with its industry-leading 750,000 mile oil change interval. The Company is constructing a new 160,000 square-foot Parts distribution center in Toronto, Canada. The $35 million facility is expected to open in mid-2018. PACCAR Parts opened new distribution centers in Brisbane, Australia and Panama City, Panama during the fourth quarter of 2017. The Company’s Dynacraft division is constructing a new 130,000 square-foot manufacturing facility in McKinney, Texas to manufacture components and subassemblies such as battery cables, door assemblies and air conditioning assemblies for Kenworth and Peterbilt trucks. The facility will support Peterbilt’s operations in Denton, Texas and manufacture PACCAR’s new 20,000-pound front axle for Peterbilt and Kenworth Class 8 trucks. The Company’s Kenworth division will collaborate with the PACCAR Technical Center and the Company’s DAF division to launch its U.S. Department of Energy (DOE) SuperTruck II program. The five-year project will utilize the Kenworth T680 with a 76-inch sleeper and the fuel-efficient PACCAR MX-13 engine with the goal to double Class 8 vehicle freight efficiency and achieve greenhouse gas emissions requirements effective in 2021, 2024 and 2027. Beginning in the first quarter of 2018, the Company’s DAF division will participate in a two-year truck platooning trial organized by the United Kingdom Department for Transport. The trial is organized to demonstrate that wirelessly-linked truck combinations, or platoons, can deliver improved efficiency to the transportation industry by lowering fuel consumption, reducing CO2 emissions, improving traffic flow and contributing to increased road safety. Truck Outlook Truck industry retail sales in the U.S. and Canada in 2018 are expected to be 235,000 to 265,000 units compared to 218,400 in 2017. In Europe, the 2018 truck industry registrations for over 16-tonne vehicles are expected to be 290,000 to 320,000 units compared to 306,100 in 2017. In South America, heavy-duty truck industry sales were 68,700 units in 2017 and in 2018 are estimated to be in a range of 65,000 to 75,000 units. Parts Outlook In 2018, PACCAR Parts sales are expected to grow 5-8% compared to 2017 sales. Financial Services Outlook Based on the truck market outlook, average earning assets in 2018 are expected to increase 2-4% compared to 2017. Current good levels of freight tonnage, freight rates and fleet utilization are contributing to customers’ profitability and cash flow. If current freight transportation conditions decline due to weaker economic conditions, then past due accounts, truck repossessions and credit losses would likely increase from the current low levels and new business volume would likely decline. Capital Spending and R&D Outlook Capital investments in 2018 are expected to be $425 to $475 million, and R&D is expected to be $280 to $310 million. The Company is investing in new truck models, integrated powertrain, enhanced aerodynamic truck designs, advanced driver assistance and truck connectivity technologies, and expanded manufacturing and parts distribution facilities. See the Forward-Looking Statements section of Management’s Discussion and Analysis for factors that may affect these outlooks. RESULTS OF OPERATIONS: * In 2016, Other includes the EC charge of $833.0 million. ** In 2017, Income Taxes include a one-time benefit of $173.4 million from the Tax Act. *** See Reconciliation of GAAP to non-GAAP Financial Measures on page 33. The following provides an analysis of the results of operations for the Company’s three reportable segments - Truck, Parts and Financial Services. Where possible, the Company has quantified the impact of factors identified in the following discussion and analysis. In cases where it is not possible to quantify the impact of factors, the Company lists them in estimated order of importance. Factors for which the Company is unable to specifically quantify the impact include market demand, fuel prices, freight tonnage and economic conditions affecting the Company’s results of operations. 2017 Compared to 2016: Truck The Company’s Truck segment accounted for 76% of revenue in 2017 compared to 75% in 2016. The Company’s new truck deliveries are summarized below: In 2017, industry retail sales in the heavy-duty market in the U.S. and Canada increased to 218,400 units from 215,700 units in 2016. The Company’s heavy-duty truck retail market share increased to 30.7% in 2017 from 28.5% in 2016. The medium-duty market was 81,300 units in 2017 compared to 85,600 units in 2016. The Company’s medium-duty market share was 17.1% in 2017 compared to 16.2% in 2016. The over 16-tonne truck market in Europe in 2017 increased to 306,100 units from 302,500 units in 2016, and DAF’s market share decreased to 15.3% in 2017 from 15.5% in 2016. The 6 to 16-tonne market in 2017 decreased to 52,600 units from 52,900 units in 2016. DAF market share in the 6 to 16-tonne market in 2017 increased to 10.5% from 10.1% in 2016. The Company’s worldwide truck net sales and revenues are summarized below: The Company’s worldwide truck net sales and revenues increased to $14.77 billion in 2017 from $12.77 billion in 2016, primarily reflecting higher truck deliveries in the U.S. and Canada, Europe and Australia. Truck segment income before income taxes in 2017 reflects higher truck deliveries, while pre-tax return on revenues were unchanged at the higher volumes due to a lower gross margin percentage. The major factors for the changes in net sales and revenues, cost of sales and revenues and gross margin between 2017 and 2016 for the Truck segment are as follows: • Truck delivery volume, which resulted in higher sales and cost of sales, primarily reflects higher truck deliveries in the U.S. and Canada ($1,309.0 million sales and $1,104.3 million cost of sales) and Europe ($370.4 million sales and $312.2 million cost of sales). • Average truck sales prices increased sales by $121.6 million, primarily due to higher price realization in Europe ($66.7 million) and the U.S. and Canada ($66.2 million), partially offset by lower price realization in Mexico ($12.5 million). • Average cost per truck increased cost of sales by $100.5 million, reflecting higher material costs. • Factory overhead and other indirect costs increased $81.6 million, primarily due to higher salaries and related expenses ($38.9 million), higher maintenance costs ($27.8 million) as well as higher depreciation expense ($12.7 million). • Operating lease revenues decreased by $28.1 million and cost of sales decreased by $25.2 million, reflecting higher revenues deferred and lower revenues recognized. • The currency translation effect on sales primarily reflects an increase in the value of the euro relative to the U.S. dollar, partially offset by a weaker British pound. The currency effect on cost of sales primarily reflects the stronger euro relative to the U.S. dollar. • Truck gross margins decreased to 11.5% in 2017 from 11.8% in 2016 primarily due to the factors noted above. Truck selling, general and administrative expenses (SG&A) for 2017 increased to $206.5 million from $202.5 million in 2016. The increase was primarily due to higher professional fees and salaries and related expenses, partially offset by lower sales and marketing expenses. As a percentage of sales, Truck SG&A decreased to 1.4% in 2017 from 1.6% in 2016 due to higher net sales. Parts The Company’s Parts segment accounted for 17% of revenues in 2017 compared to 18% in 2016. The Company’s worldwide parts net sales and revenues increased to a record $3.33 billion in 2017 from $3.01 billion in 2016, due to higher aftermarket demand and successful marketing programs in all markets. The increase in Parts segment income before income taxes and pre-tax return on revenues in 2017 was primarily due to higher sales volume. The major factors for the changes in net sales, cost of sales and gross margin between 2017 and 2016 for the Parts segment are as follows: • Aftermarket parts sales volume increased by $270.0 million and related cost of sales increased by $183.6 million due to higher demand in all markets. • Average aftermarket parts sales prices increased sales by $45.9 million, reflecting higher price realization in the U.S. and Canada and Europe. • Average aftermarket parts direct costs increased $37.5 million due to higher material costs. • Warehouse and other indirect costs increased $17.1 million, primarily due to higher salaries and related expenses to support the higher sales volume. • The currency translation effect on sales primarily reflects an increase in the value of the euro relative to the U.S. dollar, partially offset by a weaker British pound. The currency effect on cost of sales primarily reflects the stronger euro relative to the U.S. dollar. • Parts gross margins in 2017 decreased to 26.5% from 26.9% in 2016 due to the factors noted above. Parts SG&A expense for 2017 was $195.0 million compared to $191.7 million in 2016 primarily due to higher salaries and related expenses. As a percentage of sales, Parts SG&A was 5.9% in 2017, down from 6.4% in 2016, due to higher net sales. Financial Services The Company’s Financial Services segment accounted for 7% of revenues in 2017 and 2016. New loan and lease volume was $4.33 billion in 2017 compared to $4.22 billion in 2016, primarily due to higher truck deliveries in 2017. PFS finance market share on new PACCAR truck sales was 24.9% in 2017 compared to 26.7% in 2016. PFS revenues increased to $1.27 billion in 2017 from $1.19 billion in 2016. The increase was primarily due to higher average operating lease earning assets, and higher used truck sales, partially offset by unfavorable effects of currency translation, which decreased PFS revenues by $.6 million in 2017. PFS income before income taxes decreased to $264.0 million in 2017 from $306.5 million in 2016, primarily due to lower results on returned lease assets, higher borrowing rates, a higher provision for losses on receivables, and the effects of translating weaker foreign currencies to the U.S. dollar, partially offset by higher average earning asset balances. The currency exchange impact decreased PFS income before income taxes by $1.2 million in 2017. Included in Financial Services “Other Assets” on the Company’s Consolidated Balance Sheets are used trucks held for sale, net of impairments, of $221.7 million at December 31, 2017 and $267.2 million at December 31, 2016. These trucks are primarily units returned from matured operating leases in the ordinary course of business, and also includes trucks acquired from repossessions or through acquisitions of used trucks in trades related to new truck sales. The Company recognized losses on used trucks, excluding repossessions, of $45.1 million in 2017 compared to $16.4 million in 2016, including losses on multiple unit transactions of $29.2 million in 2017 compared to $6.8 million in 2016. Used truck losses related to repossessions, which are recognized as credit losses, were $5.1 million and $3.4 million in 2017 and 2016, respectively. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin between 2017 and 2016 are outlined below: • Average finance receivables increased $89.1 million (excluding foreign exchange effects) in 2017 as a result of retail portfolio new business volume exceeding collections. • Average debt balances increased $130.6 million (excluding foreign exchange effects) in 2017. The higher average debt balances reflect funding for a higher average earning assets portfolio, which includes loans, finance leases, wholesale and equipment on operating lease. • Higher portfolio yields (4.81% in 2017 compared to 4.77% in 2016) increased interest and fees by $5.3 million. The higher portfolio yields reflect higher lending volumes in North America which have higher market rates than Europe. • Higher borrowing rates (1.7% in 2017 compared to 1.5% in 2016) were primarily due to higher debt market rates in North America, partially offset by lower debt market rates in Europe. • The currency translation effects reflect a decline in the value of foreign currencies relative to the U.S. dollar, primarily the Mexican peso and the British pound, partially offset by a strengthening euro. The following table summarizes operating lease, rental and other revenues and depreciation and other expenses: The major factors for the changes in operating lease, rental and other revenues, depreciation and other expenses and lease margin between 2017 and 2016 are outlined below: • A higher volume of used truck sales increased operating lease, rental and other revenues by $9.7 million and increased depreciation and other expenses by $8.5 million. • Results on returned lease assets increased depreciation and other expenses by $31.0 million, primarily due to higher losses on sales of returned lease units. • Average operating lease assets increased $223.8 million (excluding foreign exchange effects), which increased revenues by $56.5 million and related depreciation and other expenses by $47.9 million. • Revenue per asset increased $5.5 million primarily due to higher rental income. Cost per asset increased $5.1 million due to higher depreciation expense, partially offset by lower vehicle operating expenses. • The currency translation effects reflect an increase in the value of foreign currencies, relative to the U.S. dollar, primarily the euro, partially offset by a weakening of the British pound. The following table summarizes the provision for losses on receivables and net charge-offs: The provision for losses on receivables was $22.3 million in 2017, an increase of $3.9 million compared to 2016, reflecting higher portfolio balances in Mexico, Australia and other and Europe. The Company modifies loans and finance leases as a normal part of its Financial Services operations. The Company may modify loans and finance leases for commercial reasons or for credit reasons. Modifications for commercial reasons are changes to contract terms for customers that are not considered to be in financial difficulty. Insignificant delays are modifications extending terms up to three months for customers experiencing some short-term financial stress, but not considered to be in financial difficulty. Modifications for credit reasons are changes to contract terms for customers considered to be in financial difficulty. The Company’s modifications typically result in granting more time to pay the contractual amounts owed and charging a fee and interest for the term of the modification. When considering whether to modify customer accounts for credit reasons, the Company evaluates the creditworthiness of the customers and modifies those accounts that the Company considers likely to perform under the modified terms. When the Company modifies loans and finance leases for credit reasons and grants a concession, the modifications are classified as troubled debt restructurings (TDR). The post-modification balance of accounts modified during the years ended December 31, 2017 and 2016 are summarized below: * Recorded investment immediately after modification as a percentage of the year-end retail portfolio balance. In 2017, total modification activity decreased compared to 2016, reflecting lower volumes of refinancing for commercial reasons, primarily in the U.S. The decrease in modifications for insignificant delay reflects fewer fleet customers requesting payment relief for up to three months. Credit - TDR modifications decreased to $20.5 million in 2017 from $31.6 million in 2016 mainly due to the contract modifications for two fleet customers in 2016. The following table summarizes the Company’s 30+ days past due accounts: Accounts 30+ days past due were .5% at December 31, 2017 and December 31, 2016, reflecting lower past dues in Europe as well as Mexico, Australia and other, offset by an increase in the U.S. and Canada. The Company continues to focus on maintaining low past due balances. When the Company modifies a 30+ days past due account, the customer is then generally considered current under the revised contractual terms. The Company modified $.6 million and $2.6 million of accounts worldwide during the fourth quarter of 2017 and the fourth quarter of 2016, respectively, which were 30+ days past due and became current at the time of modification. Had these accounts not been modified and continued to not make payments, the pro forma percentage of retail loan and lease accounts 30+ days past due would have been as follows: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2017 and 2016. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2017 and 2016. The Company’s 2017 and 2016 annualized pre-tax return on average earning assets for Financial Services was 2.2% and 2.6%, respectively. The decrease was due primarily to higher losses on used trucks in 2017. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment, including the EC charge and a portion of corporate expense. Other sales represent less than 1% of consolidated net sales and revenues for 2017 and 2016. Other SG&A was $48.1 million in 2017 and $46.6 million in 2016. The increase in other SG&A was primarily due to higher labor related costs. Other income (loss) before tax was a loss of $37.1 million in 2017 compared to a loss of $873.3 million in 2016, which included the impact of the $833.0 million EC charge. Investment income increased to $35.3 million in 2017 from $27.6 million in 2016, primarily due to higher average U.S. portfolio balances and higher yields on U.S. investments due to higher market interest rates. Income Taxes In 2017, the effective tax rate was 22.9% compared to 53.8% in 2016. The lower rate is due to the 2017 one-time impact from the change in U.S. tax law as explained below, and the unfavorable 2016 impact of the one-time non-deductible expense of $833.0 million for the EC charge. On December 22, 2017, the U.S. enacted new federal income tax legislation, the Tax Cuts and Jobs Act (“the Tax Act”). The Tax Act lowered the U.S. statutory income tax rate from 35% to 21%, imposed a one-time transition tax on the Company’s foreign earnings, which previously, had been deferred from U.S. income tax and created a modified territorial system. As a result, the Company recorded a provisional amount of $304.0 million of deferred tax benefits, due to the re-measurement of net deferred tax liabilities at the new lower statutory tax rate. In addition, the Company recorded a provisional amount of $130.6 million of tax expense on the Company’s foreign earnings, which previously had been deferred from U.S. income tax. These provisional amounts may change in 2018, as new information becomes available, as the Tax Act continues to be interpreted and as new technical guidance is issued. Based on the Company’s current operations, the Company does not expect its future foreign earnings will be subject to significant U.S. federal income tax as a result of the new modified territorial system. The Company’s effective tax rate for 2018 is estimated at 23% to 25%, reflecting the reduced federal tax rate of 21% and other provisions of the Act. In 2017, the improvement in domestic income before taxes was due to higher truck deliveries and improved aftermarket demand. Foreign income (loss) before taxes improved due to stronger truck and aftermarket demand as well as the 2016 impact of the $833.0 million EC charge. 2016 Compared to 2015: Truck The Company’s Truck segment accounted for 75% of revenue in 2016 compared to 77% in 2015. The Company’s new truck deliveries are summarized below: In 2016, industry retail sales in the heavy-duty market in the U.S. and Canada decreased to 215,700 units from 278,400 units in 2015. The Company’s heavy-duty truck retail market share increased to 28.5% in 2016 from 27.4% in 2015. The medium-duty market was 85,600 units in 2016 compared to 80,200 units in 2015. The Company’s medium-duty market share was 16.2% in 2016 compared to 17.0% in 2015. The over 16-tonne truck market in Europe in 2016 increased to 302,500 units from 269,100 units in 2015, and DAF’s market share increased to 15.5% in 2016 from 14.6% in 2015. The 6 to 16-tonne market in 2016 increased to 52,900 units from 49,000 units in 2015. DAF market share in the 6 to 16-tonne market in 2016 increased to 10.1% from 9.0% in 2015. The Company’s worldwide truck net sales and revenues are summarized below: The Company’s worldwide truck net sales and revenues decreased to $12.77 billion in 2016 from $14.78 billion in 2015, primarily due to lower truck deliveries in the U.S. and Canada, partially offset by higher truck deliveries in Europe. Truck segment income before income taxes and pre-tax return on revenues decreased in 2016, reflecting the lower truck unit deliveries and lower margins. The major factors for the changes in net sales and revenues, cost of sales and revenues and gross margin between 2016 and 2015 for the Truck segment are as follows: • Truck delivery volume reflects lower truck deliveries in the U.S. and Canada, which resulted in lower sales ($2,276.0 million) and cost of sales ($1,954.1 million), partially offset by higher truck deliveries in Europe which resulted in higher sales ($413.3 million) and cost of sales ($320.5 million). • Average truck sales prices decreased sales by $147.8 million, primarily due to lower price realization in the U.S. and Canada ($108.9 million) and Europe ($26.3 million). • Average cost per truck decreased cost of sales by $110.5 million, primarily due to lower material costs. • Factory overhead and other indirect costs decreased $35.6 million, primarily due to lower salaries and related expense ($24.7 million) and lower maintenance costs ($18.3 million), partially offset by higher depreciation expense ($8.3 million). • Operating lease revenues increased by $88.7 million and cost of sales increased by $87.4 million due to higher average asset balances. • The currency translation effect on sales and cost of sales reflects a decline in the value of foreign currencies relative to the U.S. dollar, primarily the British pound and the Canadian dollar. • Truck gross margins decreased to 11.8% in 2016 from 12.2% in 2015 due to the factors noted above. Truck selling, general and administrative expenses (SG&A) for 2016 increased to $202.5 million from $192.6 million in 2015. The increase was primarily due to higher salaries and related expenses. As a percentage of sales, Truck SG&A increased to 1.6% in 2016 compared to 1.3% in 2015, reflecting the lower sales volume. Parts The Company’s Parts segment accounted for 18% of revenues in 2016 compared to 16% in 2015. The Company’s worldwide parts net sales and revenues decreased to $3.01 billion in 2016 from $3.06 billion in 2015, primarily due to lower aftermarket demand in North America and the effect of translating weaker foreign currencies into the U.S. dollar. The decrease in Parts segment income before income taxes and pre-tax return on revenues in 2016 was primarily due to lower sales volume and margins in North America and the effect of translating weaker foreign currencies into the U.S. dollar. The major factors for the changes in net sales, cost of sales and gross margin between 2016 and 2015 for the Parts segment are as follows: • Aftermarket parts sales volume decreased by $43.0 million and related cost of sales decreased by $28.9 million, primarily due to lower market demand in North America. • Average aftermarket parts sales prices increased sales by $22.5 million reflecting higher price realization in Europe. • Average aftermarket parts direct costs decreased $4.1 million due to lower material costs. • Warehouse and other indirect costs increased $8.5 million primarily due to start-up costs and higher depreciation expense for the new parts distribution center in Renton, Washington, and higher maintenance expense. • The currency translation effect on sales and cost of sales reflects a decline in the value of foreign currencies relative to the U.S. dollar, primarily the British pound. • Parts gross margins decreased to 26.9% in 2016 from 27.0% in 2015 due to the factors noted above. Parts SG&A expense for 2016 was $191.7 million compared to $194.7 million in 2015. As a percentage of sales, Parts SG&A was 6.4% in 2016 and 2015, reflecting lower sales offset by ongoing cost control. Financial Services The Company’s Financial Services segment accounted for 7% of revenues in 2016 compared to 6% in 2015. New loan and lease volume was $4.22 billion in 2016 compared to $4.44 billion in 2015, primarily due to lower truck deliveries in the U.S. and Canada. PFS finance market share on new PACCAR truck sales was 26.7% in 2016 compared to 25.9% in 2015. PFS revenues increased to $1.19 billion in 2016 from $1.17 billion in 2015. The increase was primarily due to higher average earning asset balances, partially offset by the effects of translating weaker foreign currencies to the U.S. dollar. The effects of currency translation lowered PFS revenues by $27.1 million for 2016. PFS income before income taxes decreased to $306.5 million in 2016 from $362.6 million in 2015, primarily due to lower results on returned lease assets, higher borrowing rates, the effects of translating weaker foreign currencies to the U.S. dollar and a higher provision for losses on receivables, partially offset by higher average earning asset balances. The effects of currency translation lowered PFS income before income taxes by $9.7 million for 2016. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin between 2016 and 2015 are outlined below: • Average finance receivables decreased $43.9 million (excluding foreign exchange effects) in 2016 as a result of lower dealer wholesale financing, partially offset by loans and finance leases and retail portfolio volume exceeding collections. • Average debt balances decreased $9.0 million (excluding foreign exchange effects) in 2016. The lower average debt balances reflect lower funding requirements as the higher average earning asset portfolio (which includes loans, finance leases, wholesale and equipment on operating lease) was funded with retained equity. • Lower portfolio yields (4.91% in 2016 compared to 4.92% in 2015) decreased interest and fees by $1.0 million. The lower portfolio yields reflect higher lending volumes in Europe at lower relative market rates. • Higher borrowing rates (1.5% in 2016 compared to 1.4% in 2015) were primarily due to higher debt market rates in North America, partially offset by lower debt market rates in Europe. • The currency translation effects reflect a decline in the value of foreign currencies relative to the U.S. dollar. The following table summarizes operating lease, rental and other revenues and depreciation and other expenses: The major factors for the changes in operating lease, rental and other revenues, depreciation and other expenses and lease margin between 2016 and 2015 are outlined below: • A higher volume of used truck sales increased operating lease, rental and other revenues by $3.2 million. Depreciation and other expenses increased by $5.2 million due to higher volume and impairments of used trucks reflecting lower used truck prices. • Results on returned lease assets increased depreciation and other expenses by $19.2 million, primarily due to gains on sales of returned lease units in 2015 versus losses in 2016. • Average operating lease assets increased $178.3 million in 2016 (excluding foreign exchange effects), which increased revenues by $29.2 million and related depreciation and other expenses by $24.0 million. • Revenue per asset increased $11.8 million, primarily due to higher rental rates in Europe, partially offset by lower rental utilization and fuel surcharge revenue. Cost per asset increased $12.5 million, primarily due to higher depreciation expense in Europe. • The currency translation effects reflect a decline in the value of foreign currencies relative to the U.S. dollar, primarily the Mexican peso and British pound. The following table summarizes the provision for losses on receivables and net charge-offs: The provision for losses on receivables was $18.4 million in 2016, an increase of $6.0 million compared to 2015, reflecting higher losses in the oil and gas sector in the U.S. and Canada, partially offset by improved portfolio performance in Europe. The Company modifies loans and finance leases as a normal part of its Financial Services operations. The Company may modify loans and finance leases for commercial reasons or for credit reasons. Modifications for commercial reasons are changes to contract terms for customers that are not considered to be in financial difficulty. Insignificant delays are modifications extending terms up to three months for customers experiencing some short-term financial stress, but not considered to be in financial difficulty. Modifications for credit reasons are changes to contract terms for customers considered to be in financial difficulty. The Company’s modifications typically result in granting more time to pay the contractual amounts owed and charging a fee and interest for the term of the modification. When considering whether to modify customer accounts for credit reasons, the Company evaluates the creditworthiness of the customers and modifies those accounts that the Company considers likely to perform under the modified terms. When the Company modifies loans and finance leases for credit reasons and grants a concession, the modifications are classified as troubled debt restructurings (TDR). The post-modification balance of accounts modified during the years ended December 31, 2016 and 2015 are summarized below: * Recorded investment immediately after modification as a percentage of the year-end retail portfolio balance. In 2016, total modification activity increased compared to 2015, primarily reflecting higher volume of refinancings for commercial reasons, including a contract modification for one large customer in the U.S. The increase in modifications for insignificant delay reflects more fleet customers requesting payment relief for up to three months. Credit - no concession modifications increased primarily due to extensions granted to one customer in Australia. The following table summarizes the Company’s 30+ days past due accounts: Accounts 30+ days past due were .5% at December 31, 2016 and 2015, reflecting lower past dues in Europe offset by higher past dues in Mexico. The Company continues to focus on maintaining low past due balances. When the Company modifies a 30+ days past due account, the customer is then generally considered current under the revised contractual terms. The Company modified $2.6 million of accounts worldwide during the fourth quarter of 2016 and the fourth quarter of 2015 which were 30+ days past due and became current at the time of modification. Had these accounts not been modified and continued to not make payments, the pro forma percentage of retail loan and lease accounts 30+ days past due would have been as follows: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2016 and 2015. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2016 and 2015. The Company’s 2016 and 2015 annualized pre-tax return on average earning assets for Financial Services was 2.6% and 3.2%, respectively. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment, including the EC charge and a portion of corporate expense. Other sales represent less than 1% of consolidated net sales and revenues for 2016 and 2015. Other SG&A was $46.6 million in 2016 and $58.7 million in 2015. The decrease in SG&A was primarily due to lower salaries and related expenses and lower professional fees. Other income (loss) before tax was a loss of $873.3 million in 2016 compared to a loss of $43.2 million in 2015. The higher loss in 2016 was primarily due to the EC charge and lower pre-tax results from the winch business, which has been affected by lower oilfield related sales, partially offset by lower SG&A expense. Investment income increased to $27.6 million in 2016 from $21.8 million in 2015, primarily due to higher yields on investments due to higher market interest rates and higher realized gains. Income Taxes In 2016, the effective tax rate increased to 53.8% from 31.4% in 2015, and substantially all of the difference in tax rates was due to the non-deductible expense of $833.0 million for the EC charge in 2016. In 2016, the decline in income before income taxes and return on revenues for domestic operations was primarily due to lower revenues from truck operations. In 2016, the EC charge of $833.0 million resulted in a loss before income taxes and a negative return on revenues for foreign operations. Excluding the EC charge, foreign operations income before income taxes and return on revenues increased primarily due to higher revenues from European truck operations as a result of improved truck volumes and margins in Europe. LIQUIDITY AND CAPITAL RESOURCES: The Company’s total cash and marketable debt securities at December 31, 2017 increased $675.2 million from the balances at December 31, 2016, mainly due to an increase in cash and cash equivalents. The change in cash and cash equivalents is summarized below: 2017 Compared to 2016: Operating activities: Cash provided by operations increased by $415.0 million to $2.72 billion in 2017. Higher operating cash flows reflect higher net income of $1.68 billion in 2017, compared to net income of $521.7 million in 2016, which includes payment of the $833.0 million EC charge. In addition, there were higher cash inflows of $342.2 million from accounts payable and accrued expenses as purchases of goods and services exceeded payments. The higher cash inflows were offset by wholesale receivables on new trucks of $673.6 million as originations exceeded cash receipts in 2017 ($272.0 million) compared to cash receipts exceeding originations in 2016 ($401.6 million). Additionally, there was a higher cash usage of $214.0 million from inventory due to $149.9 million in net inventory purchases in 2017 versus $64.1 million in net inventory reductions in 2016. Finally, there was a higher cash outflow for payment of income taxes of $160.0 million. Investing activities: Cash used in investing activities increased by $400.3 million to $1.96 billion in 2017 from $1.56 billion in 2016. Higher net cash used in investing activities reflects $463.7 million in marketable debt securities as there was $190.8 million in net purchases of marketable debt securities in 2017 compared to $272.9 million in net proceeds from sales of marketable debt securities in 2016. In addition, there were higher net originations of retail loans and direct financing leases of $87.0 million in 2017 compared to 2016. The outflows were partially offset by lower cash used in the acquisitions of equipment for operating leases of $166.5 million. Financing activities: Cash used in financing activities was $393.8 million in 2017 compared to cash used in financing activities of $823.5 million in 2016. The Company paid $558.3 million in dividends in 2017 compared to $829.3 million in 2016; the decrease of $271.0 million was primarily due to a lower special dividend paid in January 2017 than the special dividend paid in January 2016. In 2016, the Company repurchased 1.4 million shares of common stock for $70.5 million, while there were no stock repurchases in 2017. In 2017, the Company issued $1.67 billion of term debt, increased its outstanding commercial paper and short-term bank loans by $352.1 million and repaid term debt of $1.90 billion. In 2016, the Company issued $1.99 billion of term debt, repaid term debt of $1.63 billion and reduced its outstanding commercial paper and short-term bank loans by $322.8 million. This resulted in cash provided by borrowing activities of $125.2 million in 2017, $78.3 million higher than the cash provided by borrowing activities of $46.9 million in 2016. 2016 Compared to 2015: Operating activities: Cash provided by operations decreased by $255.2 million to $2.30 billion in 2016. Lower operating cash flows reflect lower net income of $521.7 million in 2016, which includes payment of the $833.0 million EC charge, and higher pension contributions of $122.8 million. This was partially offset by $675.0 million from Financial Services segment wholesale receivables, whereby cash receipts exceeded originations in 2016 ($401.6 million) compared to originations exceeding cash receipts in 2015 ($273.4 million). In addition, there was a lower cash outflow for payment of income taxes of $281.4 million. Investing activities: Cash used in investing activities decreased by $410.6 million to $1.56 billion in 2016 from $1.97 billion in 2015. Lower net cash used in investing activities reflects $567.2 million from marketable debt securities as there was $272.9 million in net proceeds from sales of marketable debt securities in 2016 versus $294.3 million in net purchases of marketable debt securities in 2015 and higher net originations of retail loans and direct financing leases of $100.7 million. This was partially offset by higher cash used in the acquisitions of equipment for operating leases of $151.2 million and higher payments for property, plant and equipment of $88.5 million. Financing activities: Cash used in financing activities was $823.5 million in 2016 compared to cash used in financing activities of $196.5 million in 2015. The Company paid $829.3 million in dividends in 2016 compared to $680.5 million in 2015; the increase of $148.8 million was primarily due to an increase for the 2015 special dividend paid in January 2016. In 2016, the Company issued $1.99 billion of term debt, repaid term debt of $1.63 billion and reduced its outstanding commercial paper and short-term bank loans by $322.8 million. In 2015, the Company issued $1.99 billion of term debt, increased its outstanding commercial paper and short-term bank loans by $250.7 million and repaid term debt of $1.58 billion. This resulted in cash provided by borrowing activities of $46.9 million in 2016, $616.9 million lower than the cash provided by borrowing activities of $663.8 million in 2015. The Company repurchased 1.4 million shares of common stock for $70.5 million in 2016 compared to 3.8 million shares for $201.6 million in 2015, a decline of $131.1 million. Credit Lines and Other: The Company has line of credit arrangements of $3.52 billion, of which $3.31 billion were unused at December 31, 2017. Included in these arrangements are $3.0 billion of syndicated bank facilities, of which $1.0 billion expires in June 2018, $1.0 billion expires in June 2021 and $1.0 billion expires in June 2022. The Company intends to replace these credit facilities on or before expiration with facilities of similar amounts and duration. These credit facilities are maintained primarily to provide backup liquidity for commercial paper borrowings and maturing medium-term notes. There were no borrowings under the syndicated bank facilities for the year ended December 31, 2017. On September 23, 2015, PACCAR’s Board of Directors approved the repurchase of up to $300.0 million of the Company’s common stock, and as of December 31, 2017, $206.7 million of shares have been repurchased pursuant to the 2015 authorization. At December 31, 2017 and December 31, 2016, the Company had cash and cash equivalents and marketable debt securities of $1.84 billion and $1.33 billion, respectively, which are reinvested in foreign subsidiaries. The Company periodically repatriates foreign earnings. Dividends paid by foreign subsidiaries to the U.S. parent were nil, $.33 billion and $.24 billion in 2017, 2016 and 2015, respectively. The Company believes that its U.S. cash and cash equivalents and marketable debt securities, future operating cash flow and access to the capital markets, along with periodic repatriation of foreign earnings, will be sufficient to meet U.S. liquidity requirements. Truck, Parts and Other The Company provides funding for working capital, capital expenditures, R&D, dividends, stock repurchases and other business initiatives and commitments primarily from cash provided by operations. Management expects this method of funding to continue in the future. Investments for property, plant and equipment in 2017 increased to $425.7 million from $394.6 million in 2016, reflecting additional investments in the Company’s manufacturing facilities, new product development and enhanced aftermarket support. Over the past decade, the Company’s combined investments in worldwide capital projects and R&D totaled $6.11 billion, and have significantly increased the operating capacity and efficiency of its facilities and enhanced the quality and operating efficiency of the Company’s premium products. Capital investments in 2018 are expected to be $425 to $475 million, and R&D is expected to be $280 to $310 million. The Company is investing in PACCAR’s new truck models, integrated powertrains, enhanced aerodynamic truck designs, advanced driver assistance and truck connectivity technologies, and expanded manufacturing and parts distribution facilities. The Company conducts business in certain countries which have been experiencing or may experience significant financial stress, fiscal or political strain and are subject to the corresponding potential for default. The Company routinely monitors its financial exposure to global financial conditions, global counterparties and operating environments. As of December 31, 2017, the Company’s exposures in such countries were insignificant. Financial Services The Company funds its financial services activities primarily from collections on existing finance receivables and borrowings in the capital markets. The primary sources of borrowings in the capital markets are commercial paper and medium-term notes issued in the public markets and, to a lesser extent, bank loans. An additional source of funds is loans from other PACCAR companies. The Company issues commercial paper for a portion of its funding in its Financial Services segment. Some of this commercial paper is converted to fixed interest rate debt through the use of interest-rate swaps, which are used to manage interest-rate risk. In November 2015, the Company’s U.S. finance subsidiary, PACCAR Financial Corp. (PFC), filed a shelf registration under the Securities Act of 1933. The total amount of medium-term notes outstanding for PFC as of December 31, 2017 was $4.45 billion. The registration expires in November 2018 and does not limit the principal amount of debt securities that may be issued during that period. PFC intends to renew the registration in 2018. As of December 31, 2017, the Company’s European finance subsidiary, PACCAR Financial Europe, had €1.34 billion available for issuance under a €2.50 billion medium-term note program listed on the Professional Securities Market of the London Stock Exchange. This program replaced an expiring program in the second quarter of 2017 and is renewable annually through the filing of new listing particulars. In April 2016, PACCAR Financial Mexico registered a 10.00 billion peso medium-term note and commercial paper program with the Comision Nacional Bancaria y de Valores. The registration expires in April 2021 and limits the amount of commercial paper (up to one year) to 5.00 billion pesos. At December 31, 2017, 6.25 billion pesos were available for issuance. In the event of a future significant disruption in the financial markets, the Company may not be able to issue replacement commercial paper. As a result, the Company is exposed to liquidity risk from the shorter maturity of short-term borrowings paid to lenders compared to the longer timing of receivable collections from customers. The Company believes its cash balances and investments, collections on existing finance receivables, syndicated bank lines and current investment-grade credit ratings of A+/A1 will continue to provide it with sufficient resources and access to capital markets at competitive interest rates and therefore contribute to the Company maintaining its liquidity and financial stability. A decrease in these credit ratings could negatively impact the Company’s ability to access capital markets at competitive interest rates and the Company’s ability to maintain liquidity and financial stability. PACCAR believes its Financial Services companies will be able to continue funding receivables, servicing debt and paying dividends through internally generated funds, access to public and private debt markets and lines of credit. Commitments The following summarizes the Company’s contractual cash commitments at December 31, 2017: * Commercial paper included in borrowings is at par value. ** Interest on floating-rate debt is based on the applicable market rates at December 31, 2017. Total cash commitments for borrowings and interest on term debt are $9.13 billion and were related to the Financial Services segment. As described in Note I of the consolidated financial statements, borrowings consist primarily of term notes and commercial paper issued by the Financial Services segment. The Company expects to fund its maturing Financial Services debt obligations principally from funds provided by collections from customers on loans and lease contracts, as well as from the proceeds of commercial paper and medium-term note borrowings. Purchase obligations are the Company’s contractual commitments to acquire future production inventory and capital equipment. Other obligations include deferred cash compensation. The Company’s other commitments include the following at December 31, 2017: Loan and lease commitments are for funding new retail loan and lease contracts. Residual value guarantees represent the Company’s commitment to acquire trucks at a guaranteed value if the customer decides to return the truck at a specified date in the future. RECONCILIATION OF GAAP TO NON-GAAP FINANCIAL MEASURES: This Form 10-K includes “adjusted net income (non-GAAP)” and “adjusted net income per diluted share (non-GAAP)”, which are financial measures that are not in accordance with U.S. generally accepted accounting principles (“GAAP”), since they exclude the one-time tax benefit from the Tax Cuts and Jobs Act (“the Tax Act”) in 2017 and the non-recurring European Commission charge in 2016. These measures differ from the most directly comparable measures calculated in accordance with GAAP and may not be comparable to similarly titled non-GAAP financial measures used by other companies. In addition, the Form 10-K includes the financial ratios noted below calculated based on non-GAAP measures. Management utilizes these non-GAAP measures to evaluate the Company’s performance and believes these measures allow investors and management to evaluate operating trends by excluding significant non-recurring items that are not representative of underlying operating trends. Reconciliations from the most directly comparable GAAP measures of: adjusted net income (non-GAAP) and adjusted net income per diluted share (non-GAAP) are as follows: * Calculated using adjusted net income. IMPACT OF ENVIRONMENTAL MATTERS: The Company, its competitors and industry in general are subject to various domestic and foreign requirements relating to the environment. The Company believes its policies, practices and procedures are designed to prevent unreasonable risk of environmental damage and that its handling, use and disposal of hazardous or toxic substances have been in accordance with environmental laws and regulations in effect at the time such use and disposal occurred. The Company is involved in various stages of investigations and cleanup actions in different countries related to environmental matters. In certain of these matters, the Company has been designated as a “potentially responsible party” by domestic and foreign environmental agencies. The Company has accrued the estimated costs to investigate and complete cleanup actions where it is probable that the Company will incur such costs in the future. Expenditures related to environmental activities in the years ended December 31, 2017, 2016 and 2015 were $1.9 million, $2.2 million and $2.0 million, respectively. Management expects that these matters will not have a significant effect on the Company's consolidated cash flow, liquidity or financial condition. CRITICAL ACCOUNTING POLICIES: The Company’s significant accounting policies are disclosed in Note A of the consolidated financial statements. In the preparation of the Company’s financial statements, in accordance with U.S. generally accepted accounting principles, management uses estimates and makes judgments and assumptions that affect asset and liability values and the amounts reported as income and expense during the periods presented. The following are accounting policies which, in the opinion of management, are particularly sensitive and which, if actual results are different from estimates used by management, may have a material impact on the financial statements. Operating Leases Trucks sold pursuant to agreements accounted for as operating leases are disclosed in Note E of the consolidated financial statements. In determining its estimate of the residual value of such vehicles, the Company considers the length of the lease term, the truck model, the expected usage of the truck and anticipated market demand. Operating lease terms generally range from three to five years. The resulting residual values on operating leases generally range between 30% and 60% of original equipment cost. If the sales price of the trucks at the end of the term of the agreement differs from the Company’s estimated residual value, a gain or loss will result. Future market conditions, changes in government regulations and other factors outside the Company’s control could impact the ultimate sales price of trucks returned under these contracts. Residual values are reviewed regularly and adjusted if market conditions warrant. A decrease in the estimated equipment residual values would increase annual depreciation expense over the remaining lease term. During 2017, market values on equipment returning upon operating lease maturity decreased, resulting in an increase in depreciation expense of $41.2 million. During 2016, market values on equipment returning upon operating lease maturity decreased, resulting in an increase in depreciation expense of $9.6 million. During 2015, market values on equipment returning upon operating lease maturity were generally higher than the residual values on the equipment, resulting in a reduction in depreciation expense of $5.8 million. At December 31, 2017, the aggregate residual value of equipment on operating leases in the Financial Services segment and residual value guarantee on trucks accounted for as operating leases in the Truck segment was $2.73 billion. A 10% decrease in used truck values worldwide, if expected to persist over the remaining maturities of the Company’s operating leases, would reduce residual value estimates and result in the Company recording an average of approximately $78.1 million of additional depreciation per year. Allowance for Credit Losses The allowance for credit losses related to the Company’s loans and finance leases is disclosed in Note D of the consolidated financial statements. The Company has developed a systematic methodology for determining the allowance for credit losses for its two portfolio segments, retail and wholesale. The retail segment consists of retail loans and direct and sales-type finance leases, net of unearned interest. The wholesale segment consists of truck inventory financing loans to dealers that are collateralized by trucks and other collateral. The wholesale segment generally has less risk than the retail segment. Wholesale receivables generally are shorter in duration than retail receivables, and the Company requires periodic reporting of the wholesale dealer’s financial condition, conducts periodic audits of the trucks being financed and in many cases, obtains guarantees or other security such as dealership assets. In determining the allowance for credit losses, retail loans and finance leases are evaluated together since they relate to a similar customer base, their contractual terms require regular payment of principal and interest, generally over three to five years, and they are secured by the same type of collateral. The allowance for credit losses consists of both specific and general reserves. The Company individually evaluates certain finance receivables for impairment. Finance receivables that are evaluated individually for impairment consist of all wholesale accounts and certain large retail accounts with past due balances or otherwise determined to be at a higher risk of loss. A finance receivable is impaired if it is considered probable the Company will be unable to collect all contractual interest and principal payments as scheduled. In addition, all retail loans and leases which have been classified as TDRs and all customer accounts over 90 days past due are considered impaired. Generally, impaired accounts are on non-accrual status. Impaired accounts classified as TDRs which have been performing for 90 consecutive days are placed on accrual status if it is deemed probable that the Company will collect all principal and interest payments. Impaired receivables are generally considered collateral dependent. Large balance retail and all wholesale impaired receivables are individually evaluated to determine the appropriate reserve for losses. The determination of reserves for large balance impaired receivables considers the fair value of the associated collateral. When the underlying collateral fair value exceeds the Company’s recorded investment, no reserve is recorded. Small balance impaired receivables with similar risk characteristics are evaluated as a separate pool to determine the appropriate reserve for losses using the historical loss information discussed below. The Company evaluates finance receivables that are not individually impaired on a collective basis and determines the general allowance for credit losses for both retail and wholesale receivables based on historical loss information, using past due account data and current market conditions. Information used includes assumptions regarding the likelihood of collecting current and past due accounts, repossession rates, the recovery rate on the underlying collateral based on used truck values and other pledged collateral or recourse. The Company has developed a range of loss estimates for each of its country portfolios based on historical experience, taking into account loss frequency and severity in both strong and weak truck market conditions. A projection is made of the range of estimated credit losses inherent in the portfolio from which an amount is determined as probable based on current market conditions and other factors impacting the creditworthiness of the Company’s borrowers and their ability to repay. After determining the appropriate level of the allowance for credit losses, a provision for losses on finance receivables is charged to income as necessary to reflect management’s estimate of incurred credit losses, net of recoveries, inherent in the portfolio. The adequacy of the allowance is evaluated quarterly based on the most recent past due account information and current market conditions. As accounts become past due, the likelihood that they will not be fully collected increases. The Company’s experience indicates the probability of not fully collecting past due accounts ranges between 30% and 80%. Over the past three years, the Company’s year-end 30+ days past due accounts were 0.5% of loan and lease receivables. Historically, a 100 basis point increase in the 30+ days past due percentage has resulted in an increase in credit losses of 8 to 38 basis points of receivables. At December 31, 2017, 30+ days past dues were 0.5%. If past dues were 100 basis points higher or 1.5% as of December 31, 2017, the Company’s estimate of credit losses would likely have increased by a range of $6 to $30 million depending on the extent of the past dues, the estimated value of the collateral as compared to amounts owed and general economic factors. Product Warranty Product warranty is disclosed in Note H of the consolidated financial statements. The expenses related to product warranty are estimated and recorded at the time products are sold based on historical and current data and reasonable expectations for the future regarding the frequency and cost of warranty claims, net of recoveries. Management takes actions to minimize warranty costs through quality-improvement programs; however, actual claim costs incurred could materially differ from the estimated amounts and require adjustments to the reserve. Historically those adjustments have not been material. Over the past three years, warranty expense as a percentage of Truck, Parts and Other net sales and revenues has ranged between 1.3% and 1.4%. If the 2017 warranty expense had been .2% higher as a percentage of net sales and revenues in 2017, warranty expense would have increased by approximately $36 million. Income Taxes Income taxes are disclosed in Note M of the consolidated financial statements. The Company calculates income tax expense on pre-tax income based on current tax law. Deferred tax assets and liabilities are recorded for future tax consequences on temporary differences between recorded amounts in the financial statements and their respective tax basis. The determination of income tax expense requires management estimates and judgement regarding the future outcomes of tax law issues included in tax returns and jurisdictional mix of earnings. The Company updates its assumptions on all of these factors each quarter as well as new information on tax laws and differences between estimated taxes and actual returns when filed. If the Company’s assessment of these matters changes, the effect is accounted for in earnings in the period the change is made. FORWARD-LOOKING STATEMENTS: This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements relating to future results of operations or financial position and any other statement that does not relate to any historical or current fact. Such statements are based on currently available operating, financial and other information and are subject to risks and uncertainties that may affect actual results. Risks and uncertainties include, but are not limited to: a significant decline in industry sales; competitive pressures; reduced market share; reduced availability of or higher prices for fuel; increased safety, emissions, or other regulations resulting in higher costs and/or sales restrictions; currency or commodity price fluctuations; lower used truck prices; insufficient or under-utilization of manufacturing capacity; supplier interruptions; insufficient liquidity in the capital markets; fluctuations in interest rates; changes in the levels of the Financial Services segment new business volume due to unit fluctuations in new PACCAR truck sales or reduced market shares; changes affecting the profitability of truck owners and operators; price changes impacting truck sales prices and residual values; insufficient supplier capacity or access to raw materials; labor disruptions; shortages of commercial truck drivers; increased warranty costs; litigation, including EC-related claims; or legislative and governmental regulations. A more detailed description of these and other risks is included under the heading Part 1, Item 1A, “Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

<s>[INST] OVERVIEW: PACCAR is a global technology company whose Truck segment includes the design and manufacture of highquality light, medium and heavyduty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. 2017 Financial Highlights Worldwide net sales and revenues were a record $19.46 billion in 2017 compared to $17.03 billion in 2016. Truck sales were $14.77 billion in 2017 compared to $12.77 billion in 2016, reflecting higher truck deliveries in the U.S. and Canada, Europe and Australia. Parts sales were a record $3.33 billion in 2017 compared to $3.01 billion in 2016 reflecting higher demand in all markets. Financial Services revenues were $1.27 billion in 2017 compared to $1.19 billion in 2016. The increase was primarily revenues from higher average operating lease assets. In 2017, PACCAR earned net income for the 79th consecutive year. Net income of $1.68 billion ($4.75 per diluted share) includes a onetime net tax benefit of $173.4 million from the Tax Cuts and Jobs Act (“the Tax Act”). Excluding this onetime net benefit, the Company earned adjusted net income (nonGAAP) of $1.50 billion ($4.26 per diluted share) in 2017. The operating results in 2017 reflect higher truck deliveries and record worldwide Parts segment sales and profit, partially offset by lower Financial Services segment results. Net income in 2016 was $521.7 million ($1.48 per diluted share). Excluding the $833.0 million nonrecurring EC charge, the Company earned adjusted net income (nonGAAP) of $1.35 billion ($3.85 per diluted share) in 2016. See Reconciliation of GAAP to NonGAAP Financial Measures on page 33. Capital investments were $433.1 million in 2017 compared to $402.7 million in 2016, reflecting additional investments in the Company’s manufacturing facilities, new product development and enhanced aftermarket support. Aftertax return on beginning equity (ROE) was 24.7% in 2017, which includes the onetime net tax benefit of $173.4 million from the Tax Act. Excluding the onetime net benefit, adjusted ROE (nonGAAP) was 22.2% in 2017. This compares to an ROE of 7.5% in 2016. Excluding the EC charge, adjusted ROE (nonGAAP) was 19.5% in 2016. See Reconciliation of GAAP to NonGAAP Financial Measures on page 33. Research and development (R&D) expenses were $264.7 million in 2017 compared to $247.2 million in 2016. The Company opened the PACCAR Innovation Center in Sunnyvale, California in the third quarter of 2017. The advanced technology research and development center coordinates nextgeneration product development and identifies emerging technologies to enhance future vehicle performance. Technology areas of focus include advanced driver assistance systems, artificial intelligence, vehicle connectivity and powertrain electrification. In the third quarter of 2017, the Company launched a new proprietary 12speed automated transmission in North America, the lightest transmission for Class 8 onhighway vehicles. The PACCAR automated transmission is designed to complement the superior performance of [/INST] Positive. </s>

PACCAR INC

2019-02-21

2018-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. OVERVIEW: PACCAR is a global technology company whose Truck segment includes the design and manufacture of high-quality light-, medium- and heavy-duty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. 2018 Financial Highlights • Worldwide net sales and revenues were a record $23.50 billion in 2018 compared to $19.46 billion in 2017 due to record revenues in the Truck, Parts and Financial Services segments. • Truck sales were $18.19 billion in 2018 compared to $14.77 billion in 2017 primarily due to higher truck deliveries in all of the Company’s primary markets. • Parts sales were a record $3.84 billion in 2018 compared to $3.33 billion in 2017 reflecting higher demand in all markets. • Financial Services revenues were $1.36 billion in 2018 compared to $1.27 billion in 2017. The increase was primarily due to higher average earning asset balances and higher interest rates. • In 2018, PACCAR earned net income for the 80th consecutive year. Net income was a record $2.20 billion ($6.24 per diluted share) compared to $1.68 billion ($4.75 per diluted share) in 2017, which included a one-time net tax benefit of $173.4 million from the Tax Cuts and Jobs Act (“the Tax Act”). Excluding this one-time net tax benefit, the Company earned adjusted net income (non-GAAP) of $1.50 billion ($4.26 per diluted share) in 2017. See Reconciliation of GAAP to Non-GAAP Financial Measures on pages 33-34. • Capital investments were $437.1 million in 2018 compared to $433.1 million in 2017, reflecting additional investments in the Company’s manufacturing facilities, new product development and enhanced aftermarket support. • After-tax return on beginning equity (ROE) was 27.3% in 2018 compared to 24.7% in 2017. Excluding the one-time net tax benefit, adjusted ROE (non-GAAP) was 22.2% in 2017. See Reconciliation of GAAP to Non-GAAP Financial Measures on pages 33-34. • Research and development (R&D) expenses were $306.1 million in 2018 compared to $264.7 million in 2017. Peterbilt launched its new Model 579 UltraLoft in the first quarter of 2018, which offers customers a high-roof, integrated cab and sleeper that enhances driver comfort and operational efficiency. The UltraLoft dimensions represent an 18% increase in interior space giving drivers best-in-class living quarters. The Model 579 UltraLoft is an excellent tractor for long-haul routes, team driving and driver training. Kenworth introduced the W990 in the third quarter of 2018. This new conventional truck is designed to maximize performance in many customer applications including over-the-road and vocational. The Kenworth model W990 features the PACCAR MX-13 engine rated up to 510-hp and 1,850 lb-ft of torque, the 12-speed PACCAR automated transmission, PACCAR tandem rear axles, and the Kenworth TruckTech+ connected truck system. DAF highlighted its leadership in fuel efficiency and advanced powertrain technology by displaying a full range of innovative vehicles at the IAA truck show in Hannover, Germany. DAF showcased its CF Electric and LF Electric heavy- and medium-duty urban distribution vehicles. DAF also presented its CF Hybrid vehicle with the PACCAR MX-11 engine that delivers zero emissions in urban areas. PACCAR Parts continues to add global parts distribution capacity to deliver industry-leading availability and to support the growth of PACCAR MX engine parts sales and the global fleet service program. A new 160,000 square-foot distribution center in Toronto, Ontario, Canada opened in October 2018. PACCAR has been honored as a global leader in environmental practices by environmental reporting firm CDP, earning recognition on the 2018 CDP Climate Change A List. Every year, over 6,000 companies disclose data about their environmental impacts, risks and opportunities to CDP for independent assessment. Reporting companies receive scores of A to D- rating their effectiveness in tackling climate change and other environmental issues. PACCAR earned a CDP score of “A”, which places PACCAR in the top 2% of reporting companies. In January 2019, PACCAR displayed innovative electric and hydrogen fuel cell trucks at the CES 2019 show in Las Vegas, Nevada. CES is one of the world’s largest showcases for technological innovation. PACCAR exhibited three zero emission vehicles: a battery-electric Peterbilt Model 579EV; a battery-electric Peterbilt Model 220EV; and a hydrogen fuel cell electric Kenworth T680 developed in collaboration with Toyota. These trucks are designed for a range of customer applications, including over-the-road transportation, port operations and urban distribution. PACCAR was the only commercial vehicle manufacturer displaying trucks at CES. Truck Outlook Truck industry retail sales in the U.S. and Canada in 2019 are expected to increase to 285,000 to 315,000 units compared to 284,800 in 2018. In Europe, the 2019 truck industry registrations for over 16-tonne vehicles are expected to be 290,000 to 320,000 units compared to 318,800 in 2018. In South America, heavy-duty truck industry sales in 2019 are estimated to increase to 100,000 to 110,000 units compared to 88,500 units in 2018. Parts Outlook In 2019, PACCAR Parts sales are expected to grow 5-8% compared to 2018 sales. Financial Services Outlook Based on the truck market outlook, average earning assets in 2019 are expected to increase 3-5% compared to 2018. Current high levels of freight tonnage, freight rates and fleet utilization are contributing to customers’ profitability and cash flow. If current freight transportation conditions decline due to weaker economic conditions, then past due accounts, truck repossessions and credit losses would likely increase from the current low levels and new business volume would likely decline. Capital Spending and R&D Outlook Capital investments in 2019 are expected to be $525 to $575 million, and R&D is expected to be $320 to $350 million. The Company is investing for long-term growth in new truck models, integrated powertrains including zero emission electrification and hydrogen fuel cell technologies, enhanced aerodynamic truck designs, advanced driver assistance systems and truck connectivity, and expanded manufacturing and parts distribution facilities. See the Forward-Looking Statements section of Management’s Discussion and Analysis for factors that may affect these outlooks. RESULTS OF OPERATIONS: The Company’s results of operations for the years ended December 31, 2018, 2017 and 2016 are presented below. The balances for 2017 and 2016 have been restated to reflect the adoption of ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. Refer to Note A in the Notes to Consolidated Financial Statements for additional details. * In 2016, Other includes the EC charge of $833.0 million. See Note L in the Notes to Consolidated Financial Statements. ** In 2017, Income taxes include a one-time benefit of $173.4 million from the Tax Act. *** See Reconciliation of GAAP to non-GAAP Financial Measures on pages 33-34. The following provides an analysis of the results of operations for the Company’s three reportable segments - Truck, Parts and Financial Services. Where possible, the Company has quantified the impact of factors identified in the following discussion and analysis. In cases where it is not possible to quantify the impact of factors, the Company lists them in estimated order of importance. Factors for which the Company is unable to specifically quantify the impact include market demand, fuel prices, freight tonnage and economic conditions affecting the Company’s results of operations. 2018 Compared to 2017: Truck The Company’s Truck segment accounted for 77% of revenues in 2018 compared to 76% in 2017. The Company’s new truck deliveries are summarized below: In 2018, industry retail sales in the heavy-duty market in the U.S. and Canada increased to 284,800 units from 218,400 units in 2017. The Company’s heavy-duty truck retail market share was 29.4% in 2018 compared to 30.7% in 2017. The medium-duty market was 98,000 units in 2018 compared to 81,900 units in 2017. The Company’s medium-duty market share was 17.7% in 2018 compared to 17.1% in 2017. The over 16-tonne truck market in Europe in 2018 increased to 318,800 units from 306,100 units in 2017, and DAF’s market share was 16.6% in 2018 compared to 15.3% in 2017. The 6 to 16-tonne market in 2018 decreased to 51,900 units from 52,600 units in 2017. DAF’s market share in the 6 to 16-tonne market in 2018 was 9.0% compared to 10.5% in 2017. The Company’s worldwide truck net sales and revenues are summarized below: The Company’s worldwide truck net sales and revenues increased to $18.19 billion in 2018 from $14.77 billion in 2017, primarily reflecting higher truck deliveries in all of the Company’s primary markets. Truck segment income before income taxes and pre-tax return on revenues increased in 2018, reflecting the higher truck unit deliveries and higher gross margins. The major factors for the changes in net sales and revenues, cost of sales and revenues and gross margin between 2018 and 2017 for the Truck segment are as follows: • Truck sales volume primarily reflects higher truck deliveries in the U.S. and Canada ($2,305.0 million sales and $1,890.7 million cost of sales) and Europe ($394.5 million sales and $333.0 million cost of sales). • Average truck sales prices increased sales by $377.0 million, primarily due to higher price realization in North America and Europe. • Average cost per truck increased cost of sales by $303.0 million, primarily reflecting higher material costs. • Factory overhead and other indirect costs increased $109.7 million, primarily due to higher salaries and related expenses ($57.9 million) and higher supplies and maintenance costs ($47.5 million) to support increased truck production. • Extended warranties, operating leases and other decreased revenues by $72.9 million and cost of sales by $76.5 million, primarily due to lower revenues and costs from operating leases. The decrease was partially offset by higher revenues and costs from service contracts. • The currency translation effect on sales and cost of sales primarily reflects an increase in the value of the euro relative to the U.S. dollar. • Truck gross margins increased to 11.8% in 2018 from 11.3% in 2017, primarily due to the factors noted above. Truck selling, general and administrative expenses (SG&A) for 2018 increased to $248.3 million from $216.0 million in 2017. The increase was primarily due to higher professional fees ($20.1 million) and higher salaries and related expenses ($10.6 million). As a percentage of sales, Truck SG&A decreased to 1.4% in 2018 from 1.5% in 2017 due to higher net sales. Parts The Company’s Parts segment accounted for 16% of revenues in 2018 compared to 17% in 2017. The Company’s worldwide parts net sales and revenues increased to a record $3.84 billion in 2018 from $3.33 billion in 2017, due to higher aftermarket demand and successful marketing programs in all markets. The increase in Parts segment income before income taxes and pre-tax return on revenues in 2018 was primarily due to higher sales volume. The major factors for the changes in net sales, cost of sales and gross margin between 2018 and 2017 for the Parts segment are as follows: • Aftermarket parts sales volume increased by $369.8 million and related cost of sales increased by $224.7 million due to higher demand in all markets. • Average aftermarket parts sales prices increased sales by $107.5 million, primarily due to higher price realization in the U.S. and Canada and Europe. • Average aftermarket parts direct costs increased $83.2 million due to higher material costs. • Warehouse and other indirect costs increased $18.4 million, primarily due to higher salaries and related expenses and higher maintenance costs. • The currency translation effect on sales and cost of sales primarily reflects an increase in the value of the euro relative to the U.S. dollar. • Parts gross margins in 2018 increased to 27.2% from 26.5% in 2017 due to the factors noted above. Parts SG&A expense for 2018 was $206.2 million compared to $197.6 million in 2017 primarily due to higher salaries and related expenses and the effects of currency translation, partially offset by lower sales and marketing costs. As a percentage of sales, Parts SG&A was 5.4% in 2018, down from 5.9% in 2017, due to higher net sales. Financial Services The Company’s Financial Services segment accounted for 6% of revenues in 2018 compared to 7% in 2017. New loan and lease volume was a record $5.23 billion in 2018 compared to $4.33 billion in 2017, primarily due to higher truck deliveries in 2018. PFS finance market share of new PACCAR truck sales was 23.9% in 2018 compared to 24.9% in 2017. PFS revenues increased to $1.36 billion in 2018 from $1.27 billion in 2017. The increase was primarily due to revenue on higher average earning assets and higher portfolio yields reflecting higher market interest rates in North America. The effects of currency translation increased PFS revenues by $10.9 million in 2018. PFS income before income taxes increased to $305.9 million in 2018 from $261.7 million in 2017, primarily due to higher average earning asset balances and higher results on returned lease assets. Included in Financial Services “Other Assets” on the Company’s Consolidated Balance Sheets are used trucks held for sale, net of impairments, of $226.4 million at December 31, 2018 and $221.7 million at December 31, 2017. These trucks are primarily units returned from matured operating leases in the ordinary course of business, and also include trucks acquired from repossessions or through acquisitions of used trucks in trades related to new truck sales. The Company recognized losses on used trucks, excluding repossessions, of $35.4 million in 2018 compared to $45.1 million in 2017, including losses on multiple unit transactions of $20.2 million in 2018 compared to $29.2 million in 2017. Used truck losses related to repossessions, which are recognized as credit losses, were $.9 million and $5.1 million in 2018 and 2017, respectively. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin between 2018 and 2017 are outlined below: • Average finance receivables increased $845.3 million (excluding foreign exchange effects) in 2018 as a result of retail portfolio new business volume exceeding collections and higher dealer wholesale balances. • Average debt balances increased $666.7 million (excluding foreign exchange effects) in 2018. The higher average debt balances reflect funding for a higher average earning assets portfolio, which includes loans, finance leases, wholesale and equipment on operating lease. • Higher portfolio yields (5.0% in 2018 compared to 4.8% in 2017) increased interest and fees by $21.0 million. The higher portfolio yields were primarily due to higher market rates in North America. • Higher borrowing rates (2.0% in 2018 compared to 1.7% in 2017) were primarily due to higher debt market rates in North America. The following table summarizes operating lease, rental and other revenues and depreciation and other expenses: The major factors for the changes in operating lease, rental and other revenues, depreciation and other expenses and lease margin between 2018 and 2017 are outlined below: • A lower sales volume of used trucks received on trade decreased operating lease, rental and other revenues by $20.5 million and decreased depreciation and other expenses by $21.9 million. • Results on returned lease assets decreased depreciation and other expenses by $11.5 million, primarily due to lower losses on sales of returned lease units. • Average operating lease assets increased $49.4 million (excluding foreign exchange effects), which increased revenues by $15.7 million and related depreciation and other expenses by $12.6 million. • Revenue per asset increased $16.0 million primarily due to higher rental utilization. Cost per asset increased $12.0 million due to higher depreciation expense and vehicle operating expenses. • The currency translation effects reflect an increase in the value of foreign currencies relative to the U.S. dollar, primarily the euro, partially offset by the Mexican peso. The following table summarizes the provision for losses on receivables and net charge-offs: The provision for losses on receivables was $16.5 million in 2018 compared to $22.3 million in 2017, reflecting continued good portfolio performance. The lower provision for losses on receivables in Europe primarily reflects higher recoveries on charged-off accounts. The Company modifies loans and finance leases as a normal part of its Financial Services operations. The Company may modify loans and finance leases for commercial reasons or for credit reasons. Modifications for commercial reasons are changes to contract terms for customers that are not considered to be in financial difficulty. Insignificant delays are modifications extending terms up to three months for customers experiencing some short-term financial stress, but not considered to be in financial difficulty. Modifications for credit reasons are changes to contract terms for customers considered to be in financial difficulty. The Company’s modifications typically result in granting more time to pay the contractual amounts owed and charging a fee and interest for the term of the modification. When considering whether to modify customer accounts for credit reasons, the Company evaluates the creditworthiness of the customers and modifies those accounts that the Company considers likely to perform under the modified terms. When the Company modifies a loan or finance lease for credit reasons and grants a concession, the modification is classified as a troubled debt restructuring (TDR). The post-modification balance of accounts modified during the years ended December 31, 2018 and 2017 are summarized below: * Recorded investment immediately after modification as a percentage of the year-end retail portfolio balance. In 2018, total modification activity decreased compared to 2017, reflecting lower modifications for insignificant delays, credit - no concession and credit - TDRs, partially offset by higher commercial modifications. The increase in modifications for commercial reasons primarily reflects higher volumes of refinancing. The decrease in modifications for insignificant delay reflects fewer fleet customers requesting payment relief for up to three months. The decrease in modifications for credit - no concession is primarily due to lower volumes of refinancing for customers in financial difficulty. Credit - TDR modifications decreased to $13.1 million in 2018 from $20.5 million in 2017 mainly due to the contract modifications for two fleet customers in 2017. The following table summarizes the Company’s 30+ days past due accounts: Accounts 30+ days past due were .4% at December 31, 2018 and .5% at December 31, 2017. Lower past dues in the U.S. and Canada were partially offset by higher past dues in Europe and Mexico. The Company continues to focus on maintaining low past due balances. When the Company modifies a 30+ days past due account, the customer is then generally considered current under the revised contractual terms. The Company modified $7.2 million and $.6 million of accounts worldwide during the fourth quarter of 2018 and the fourth quarter of 2017, respectively, which were 30+ days past due and became current at the time of modification. Had these accounts not been modified and continued to not make payments, the pro forma percentage of retail loan and lease accounts 30+ days past due would have been as follows: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2018 and 2017. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2018 and 2017. The Company’s 2018 and 2017 annualized pre-tax return on average assets for Financial Services was 2.2% and 2.1%, respectively. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment. Other also includes non-service cost components of pension (income) expense and a portion of corporate expense. Other sales represent less than 1% of consolidated net sales and revenues for 2018 and 2017. Other SG&A was $70.4 million in 2018 and $50.4 million in 2017. The increase in Other SG&A was primarily due to higher compensation costs. Other income before tax decreased to $2.7 million in 2018 from $12.5 million in 2017 primarily due to higher salaries and related expenses, partially offset by improved results in the winch business. Investment income increased to $60.9 million in 2018 from $35.3 million in 2017, primarily due to higher average portfolio balances and higher yields on U.S. investments due to higher market interest rates. Income Taxes In 2018, the effective tax rate was 21.9% compared to 22.9% in 2017, reflecting the reduced federal tax rate of 21% enacted on December 22, 2017. The Company’s effective tax rate for 2018 was impacted by a one-time reduction in tax liability related to extended warranty contracts and higher realized R&D tax credits. In 2018, the improvement in domestic and foreign income before taxes was primarily due to higher revenues and margins from truck and parts operations. Domestic and foreign pre-tax return on revenues increased primarily due to the improved truck and parts results. 2017 Compared to 2016: Truck The Company’s Truck segment accounted for 76% of revenues in 2017 compared to 75% in 2016. The Company’s new truck deliveries are summarized below: In 2017, industry retail sales in the heavy-duty market in the U.S. and Canada increased to 218,400 units from 215,700 units in 2016. The Company’s heavy-duty truck retail market share increased to 30.7% in 2017 from 28.5% in 2016. The medium-duty market was 81,900 units in 2017 compared to 85,500 units in 2016. The Company’s medium-duty market share was 17.1% in 2017 compared to 16.2% in 2016. The over 16-tonne truck market in Europe in 2017 increased to 306,100 units from 302,500 units in 2016, and DAF’s market share decreased to 15.3% in 2017 from 15.5% in 2016. The 6 to 16-tonne market in 2017 decreased to 52,600 units from 52,900 units in 2016. DAF market share in the 6 to 16-tonne market in 2017 increased to 10.5% from 10.1% in 2016. The Company’s worldwide truck net sales and revenues are summarized below: The Company’s worldwide truck net sales and revenues increased to $14.77 billion in 2017 from $12.77 billion in 2016, primarily reflecting higher truck deliveries in the U.S. and Canada, Europe and Australia. Truck segment income before income taxes in 2017 reflects higher truck deliveries, while pre-tax return on revenues decreased at the higher volumes due to a lower gross margin percentage. The major factors for the changes in net sales and revenues, cost of sales and revenues and gross margin between 2017 and 2016 for the Truck segment are as follows: • Truck delivery volume, which resulted in higher sales and cost of sales, primarily reflects higher truck deliveries in the U.S. and Canada ($1,309.0 million sales and $1,104.3 million cost of sales) and Europe ($370.4 million sales and $312.2 million cost of sales). • Average truck sales prices increased sales by $121.6 million, primarily due to higher price realization in Europe ($66.7 million) and the U.S. and Canada ($66.2 million), partially offset by lower price realization in Mexico ($12.5 million). • Average cost per truck increased cost of sales by $102.7 million, reflecting higher material costs. • Factory overhead and other indirect costs increased $97.8 million, primarily due to higher salaries and related expenses ($55.1 million), higher maintenance costs ($27.8 million) as well as higher depreciation expense ($12.7 million). • Operating lease revenues decreased by $28.1 million and cost of sales decreased by $25.2 million, reflecting higher revenues deferred and lower revenues recognized. • The currency translation effect on sales primarily reflects an increase in the value of the euro relative to the U.S. dollar, partially offset by a weaker British pound. The currency effect on cost of sales primarily reflects the stronger euro relative to the U.S. dollar. • Truck gross margins decreased to 11.3% in 2017 from 11.7% in 2016 primarily due to the factors noted above. Truck selling, general and administrative expenses (SG&A) for 2017 increased to $216.0 million from $205.7 million in 2016. The increase was primarily due to higher professional fees and salaries and related expenses, partially offset by lower sales and marketing expenses. As a percentage of sales, Truck SG&A decreased to 1.5% in 2017 from 1.6% in 2016 due to higher net sales. Parts The Company’s Parts segment accounted for 17% of revenues in 2017 compared to 18% in 2016. The Company’s worldwide parts net sales and revenues increased to a record $3.33 billion in 2017 from $3.01 billion in 2016, due to higher aftermarket demand and successful marketing programs in all markets. The increase in Parts segment income before income taxes and pre-tax return on revenues in 2017 was primarily due to higher sales volume. The major factors for the changes in net sales, cost of sales and gross margin between 2017 and 2016 for the Parts segment are as follows: • Aftermarket parts sales volume increased by $270.0 million and related cost of sales increased by $183.6 million due to higher demand in all markets. • Average aftermarket parts sales prices increased sales by $45.9 million, reflecting higher price realization in the U.S. and Canada and Europe. • Average aftermarket parts direct costs increased $37.5 million due to higher material costs. • Warehouse and other indirect costs increased $18.0 million, primarily due to higher salaries and related expenses to support the higher sales volume. • The currency translation effect on sales primarily reflects an increase in the value of the euro relative to the U.S. dollar, partially offset by a weaker British pound. The currency effect on cost of sales primarily reflects the stronger euro relative to the U.S. dollar. • Parts gross margins in 2017 decreased to 26.5% from 26.9% in 2016 due to the factors noted above. Parts SG&A expense for 2017 was $197.6 million compared to $192.7 million in 2016 primarily due to higher salaries and related expenses. As a percentage of sales, Parts SG&A was 5.9% in 2017, down from 6.4% in 2016, due to higher net sales. Financial Services The Company’s Financial Services segment accounted for 7% of revenues in 2017 and 2016. New loan and lease volume was $4.33 billion in 2017 compared to $4.22 billion in 2016, primarily due to higher truck deliveries in 2017. PFS finance market share on new PACCAR truck sales was 24.9% in 2017 compared to 26.7% in 2016. PFS revenues increased to $1.27 billion in 2017 from $1.19 billion in 2016. The increase was primarily due to higher average operating lease earning assets, and higher used truck sales, partially offset by unfavorable effects of currency translation, which decreased PFS revenues by $.6 million in 2017. PFS income before income taxes decreased to $261.7 million in 2017 from $305.7 million in 2016, primarily due to lower results on returned lease assets, higher borrowing rates, a higher provision for losses on receivables, and the effects of translating weaker foreign currencies to the U.S. dollar, partially offset by higher average earning asset balances. The currency exchange impact decreased PFS income before income taxes by $1.2 million in 2017. Included in Financial Services “Other Assets” on the Company’s Consolidated Balance Sheets are used trucks held for sale, net of impairments, of $221.7 million at December 31, 2017 and $267.2 million at December 31, 2016. These trucks are primarily units returned from matured operating leases in the ordinary course of business, and also includes trucks acquired from repossessions or through acquisitions of used trucks in trades related to new truck sales. The Company recognized losses on used trucks, excluding repossessions, of $45.1 million in 2017 compared to $16.4 million in 2016, including losses on multiple unit transactions of $29.2 million in 2017 compared to $6.8 million in 2016. Used truck losses related to repossessions, which are recognized as credit losses, were $5.1 million and $3.4 million in 2017 and 2016, respectively. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin between 2017 and 2016 are outlined below: • Average finance receivables increased $89.1 million (excluding foreign exchange effects) in 2017 as a result of retail portfolio new business volume exceeding collections. • Average debt balances increased $130.6 million (excluding foreign exchange effects) in 2017. The higher average debt balances reflect funding for a higher average earning assets portfolio, which includes loans, finance leases, wholesale and equipment on operating lease. • Higher portfolio yields (4.81% in 2017 compared to 4.77% in 2016) increased interest and fees by $5.3 million. The higher portfolio yields reflect higher lending volumes in North America which have higher market rates than Europe. • Higher borrowing rates (1.7% in 2017 compared to 1.5% in 2016) were primarily due to higher debt market rates in North America, partially offset by lower debt market rates in Europe. • The currency translation effects reflect a decline in the value of foreign currencies relative to the U.S. dollar, primarily the Mexican peso and the British pound, partially offset by a strengthening euro. The following table summarizes operating lease, rental and other revenues and depreciation and other expenses: The major factors for the changes in operating lease, rental and other revenues, depreciation and other expenses and lease margin between 2017 and 2016 are outlined below: • A higher volume of used truck sales increased operating lease, rental and other revenues by $9.7 million and increased depreciation and other expenses by $8.5 million. • Results on returned lease assets increased depreciation and other expenses by $31.0 million, primarily due to higher losses on sales of returned lease units. • Average operating lease assets increased $223.8 million (excluding foreign exchange effects), which increased revenues by $56.5 million and related depreciation and other expenses by $47.9 million. • Revenue per asset increased $5.5 million primarily due to higher rental income. Cost per asset increased $5.1 million due to higher depreciation expense, partially offset by lower vehicle operating expenses. • The currency translation effects reflect an increase in the value of foreign currencies relative to the U.S. dollar, primarily the euro, partially offset by a weakening of the British pound. The following table summarizes the provision for losses on receivables and net charge-offs: The provision for losses on receivables was $22.3 million in 2017, an increase of $3.9 million compared to 2016, reflecting higher portfolio balances in Mexico, Australia and other and Europe. The Company modifies loans and finance leases as a normal part of its Financial Services operations. The Company may modify loans and finance leases for commercial reasons or for credit reasons. Modifications for commercial reasons are changes to contract terms for customers that are not considered to be in financial difficulty. Insignificant delays are modifications extending terms up to three months for customers experiencing some short-term financial stress, but not considered to be in financial difficulty. Modifications for credit reasons are changes to contract terms for customers considered to be in financial difficulty. The Company’s modifications typically result in granting more time to pay the contractual amounts owed and charging a fee and interest for the term of the modification. When considering whether to modify customer accounts for credit reasons, the Company evaluates the creditworthiness of the customers and modifies those accounts that the Company considers likely to perform under the modified terms. When the Company modifies a loan or finance lease for credit reasons and grants a concession, the modification is classified as a troubled debt restructuring (TDR). The post-modification balance of accounts modified during the years ended December 31, 2017 and 2016 are summarized below: * Recorded investment immediately after modification as a percentage of the year-end retail portfolio balance. In 2017, total modification activity decreased compared to 2016, reflecting lower volumes of refinancing for commercial reasons, primarily in the U.S. The decrease in modifications for insignificant delay reflects fewer fleet customers requesting payment relief for up to three months. Credit - TDR modifications decreased to $20.5 million in 2017 from $31.6 million in 2016 mainly due to the contract modifications for two fleet customers in 2016. The following table summarizes the Company’s 30+ days past due accounts: Accounts 30+ days past due were .5% at December 31, 2017 and December 31, 2016, reflecting lower past dues in Europe as well as Mexico, Australia and other, offset by an increase in the U.S. and Canada. The Company continues to focus on maintaining low past due balances. When the Company modifies a 30+ days past due account, the customer is then generally considered current under the revised contractual terms. The Company modified $.6 million and $2.6 million of accounts worldwide during the fourth quarter of 2017 and the fourth quarter of 2016, respectively, which were 30+ days past due and became current at the time of modification. Had these accounts not been modified and continued to not make payments, the pro forma percentage of retail loan and lease accounts 30+ days past due would have been as follows: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2017 and 2016. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2017 and 2016. The Company’s 2017 and 2016 annualized pre-tax return on average assets for Financial Services was 2.1% and 2.5%, respectively. The decrease was due primarily to higher losses on used trucks in 2017. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment. Other also includes the EC charge, non-service cost components of pension (income) expense and a portion of corporate expense. Other sales represent less than 1% of consolidated net sales and revenues for 2017 and 2016. Other SG&A was $50.4 million in 2017 and $44.2 million in 2016. The increase in Other SG&A was primarily due to higher labor related costs. Other income (loss) before tax was an income of $12.5 million in 2017 compared to a loss of $852.4 million in 2016, which included the impact of the $833.0 million EC charge. Investment income increased to $35.3 million in 2017 from $27.6 million in 2016, primarily due to higher average U.S. portfolio balances and higher yields on U.S. investments due to higher market interest rates. Income Taxes In 2017, the effective tax rate was 22.9% compared to 53.8% in 2016. The lower rate is due to the 2017 one-time impact from the change in U.S. tax law as explained below and the unfavorable 2016 impact of the one-time non-deductible expense of $833.0 million for the EC charge. On December 22, 2017, the U.S. enacted new federal income tax legislation, the Tax Cuts and Jobs Act (“the Tax Act”). The Tax Act lowered the U.S. statutory income tax rate from 35% to 21%, imposed a one-time transition tax on the Company’s foreign earnings, which previously had been deferred from U.S. income tax and created a modified territorial system. As a result, the Company recorded a provisional amount of $304.0 million of deferred tax benefits, due to the re-measurement of net deferred tax liabilities at the new lower statutory tax rate. In addition, the Company recorded a provisional amount of $130.6 million of tax expense on the Company’s foreign earnings, which previously had been deferred from U.S. income tax. In 2017, the improvement in domestic income before taxes was due to higher truck deliveries and improved aftermarket demand. Foreign income (loss) before taxes improved due to stronger truck and aftermarket demand as well as the 2016 impact of the $833.0 million EC charge. LIQUIDITY AND CAPITAL RESOURCES: The Company’s total cash and marketable debt securities at December 31, 2018 increased $724.5 million from the balances at December 31, 2017, mainly due to an increase in cash and cash equivalents. The change in cash and cash equivalents is summarized below: 2018 Compared to 2017: Operating activities: Cash provided by operations increased by $276.5 million to $2.99 billion in 2018 from $2.72 billion in 2017. Higher operating cash flows reflect higher net income of $2.20 billion in 2018 compared to $1.68 billion in 2017, which includes a net deferred tax benefit of $173.9 million primarily due to the 2017 Tax Act. Additionally, there were higher cash inflows of $195.3 million from accounts payable and accrued expenses as purchases of goods and services exceeded payments. The higher cash inflows were offset by a higher increase in Financial Services segment wholesale receivables of $240.3 million and a higher increase in net purchases of inventory of $182.8 million. In addition, the higher cash inflows were offset by an increase of $98.9 million in sales-type finance leases and dealer direct loans, whereby originations exceeded cash receipts in 2018 ($27.0 million) compared to cash receipts exceeding origination in 2017 ($71.9 million). The higher cash inflows were also offset by a net change in derivatives of $82.5 million which was mainly related to the settlement of matured interest rate contracts. Investing activities: Cash used in investing activities decreased by $33.9 million to $1.93 billion in 2018 from $1.96 billion in 2017. Lower net cash used in investing activities reflects a $506.4 million increase from marketable debt securities, as there were $315.6 million in net proceeds from sales of marketable debt securities in 2018 compared to $190.8 million in net purchases of marketable debt securities in 2017. In addition, there were higher proceeds from asset disposals of $183.0 million. The inflows were partially offset by higher net originations from retail loans and direct financing leases of $541.8 million, higher cash used in the acquisition of equipment on operating leases of $71.5 million, and higher payments for property, plant and equipment of $34.2 million. Financing activities: Cash provided by financing activities was $71.1 million in 2018 compared to cash used in financing activities of $393.8 million in 2017. In 2018, the Company issued $2.34 billion of term debt, repaid term debt of $1.76 billion and increased its outstanding commercial paper and short-term bank loans by $625.9 million. In 2017, the Company issued $1.67 billion of term debt, repaid term debt of $1.90 billion and increased its outstanding commercial paper and short-term bank loans by $352.1 million. This resulted in cash provided by borrowing activities of $1.21 billion in 2018, $1.09 billion higher than the cash provided by borrowing activities of $125.2 million in 2017. The company paid $804.3 million in dividends in 2018 compared to $558.3 million in 2017; the increase of $246.0 million was primarily due to a special dividend paid in January 2018 that was higher than the special dividend paid in January 2017. In 2018, the Company also repurchased 5.8 million shares of common stock for $354.4 million. There were no stock repurchases in 2017. 2017 Compared to 2016: Operating activities: Cash provided by operations increased by $415.0 million to $2.72 billion in 2017. Higher operating cash flows reflect higher net income of $1.68 billion in 2017, compared to net income of $521.7 million in 2016, which includes payment of the $833.0 million EC charge. In addition, there were higher cash inflows of $342.2 million from accounts payable and accrued expenses as purchases of goods and services exceeded payments. The higher cash inflows were offset by wholesale receivables on new trucks of $673.6 million as originations exceeded cash receipts in 2017 ($272.0 million) compared to cash receipts exceeding originations in 2016 ($401.6 million). Additionally, there was a higher cash usage of $214.0 million from inventory due to $149.9 million in net inventory purchases in 2017 versus $64.1 million in net inventory reductions in 2016. Finally, there was a higher cash outflow for payment of income taxes of $160.0 million. Investing activities: Cash used in investing activities increased by $400.3 million to $1.96 billion in 2017 from $1.56 billion in 2016. Higher net cash used in investing activities reflects $463.7 million in marketable debt securities as there was $190.8 million in net purchases of marketable debt securities in 2017 compared to $272.9 million in net proceeds from sales of marketable debt securities in 2016. In addition, there were higher net originations of retail loans and direct financing leases of $87.0 million in 2017 compared to 2016. The outflows were partially offset by lower cash used in the acquisitions of equipment for operating leases of $166.5 million. Financing activities: Cash used in financing activities was $393.8 million in 2017 compared to cash used in financing activities of $823.5 million in 2016. The Company paid $558.3 million in dividends in 2017 compared to $829.3 million in 2016; the decrease of $271.0 million was primarily due to a lower special dividend paid in January 2017 than the special dividend paid in January 2016. In 2016, the Company repurchased 1.4 million shares of common stock for $70.5 million, while there were no stock repurchases in 2017. In 2017, the Company issued $1.67 billion of term debt, increased its outstanding commercial paper and short-term bank loans by $352.1 million and repaid term debt of $1.90 billion. In 2016, the Company issued $1.99 billion of term debt, repaid term debt of $1.63 billion and reduced its outstanding commercial paper and short-term bank loans by $322.8 million. This resulted in cash provided by borrowing activities of $125.2 million in 2017, $78.3 million higher than the cash provided by borrowing activities of $46.9 million in 2016. Credit Lines and Other: The Company has line of credit arrangements of $3.50 billion, of which $3.27 billion were unused at December 31, 2018. Included in these arrangements are $3.00 billion of syndicated bank facilities, of which $1.00 billion expires in June 2019, $1.00 billion expires in June 2022 and $1.00 billion expires in June 2023. The Company intends to replace these credit facilities on or before expiration with facilities of similar amounts and duration. These credit facilities are maintained primarily to provide backup liquidity for commercial paper borrowings and maturing medium-term notes. There were no borrowings under the syndicated bank facilities for the year ended December 31, 2018. As of June 30, 2018, the Company completed the repurchase of $300.0 million of the Company’s common stock under the authorization approved in September 2015. On July 9, 2018, PACCAR’s Board of Directors approved another plan to repurchase up to $300.0 million of the Company’s outstanding common stock. As of December 31, 2018, $260.1 million of shares have been repurchased under this plan. On December 4, 2018, the Company’s Board of Directors approved a plan to repurchase an additional $500.0 million of PACCAR’s outstanding common stock upon completion of the prior plan. Truck, Parts and Other The Company provides funding for working capital, capital expenditures, R&D, dividends, stock repurchases and other business initiatives and commitments primarily from cash provided by operations. Management expects this method of funding to continue in the future. Over the past decade, the Company’s combined investments in worldwide capital projects and R&D totaled $6.04 billion, and have significantly increased the operating capacity and efficiency of its facilities and enhanced the quality and operating efficiency of the Company’s premium products. Capital investments in 2019 are expected to be $525 to $575 million, and R&D is expected to be $320 to $350 million. The Company is investing for long-term growth in new truck models, integrated powertrains including zero emission electrification and hydrogen fuel cell technologies, enhanced aerodynamic truck designs, advanced driver assistance systems and truck connectivity, and expanded manufacturing and parts distribution facilities. The Company conducts business in certain countries which have been experiencing or may experience significant financial stress, fiscal or political strain and are subject to the corresponding potential for default. The Company routinely monitors its financial exposure to global financial conditions, global counterparties and operating environments. As of December 31, 2018, the Company’s exposures in such countries were insignificant. Financial Services The Company funds its financial services activities primarily from collections on existing finance receivables and borrowings in the capital markets. The primary sources of borrowings in the capital markets are commercial paper and medium-term notes issued in the public markets and, to a lesser extent, bank loans. An additional source of funds is loans from other PACCAR companies. The Company issues commercial paper for a portion of its funding in its Financial Services segment. Some of this commercial paper is converted to fixed interest rate debt through the use of interest-rate swaps, which are used to manage interest-rate risk. In November 2018, the Company’s U.S. finance subsidiary, PACCAR Financial Corp. (PFC), filed a shelf registration under the Securities Act of 1933. The total amount of medium-term notes outstanding for PFC as of December 31, 2018 was $4.90 billion. The registration expires in November 2021 and does not limit the principal amount of debt securities that may be issued during that period. As of December 31, 2018, the Company’s European finance subsidiary, PACCAR Financial Europe, had €1.35 billion available for issuance under a €2.50 billion medium-term note program listed on the Professional Securities Market of the London Stock Exchange. This program replaced an expiring program in the second quarter of 2018 and is renewable annually through the filing of new listing particulars. In April 2016, PACCAR Financial Mexico registered a 10.00 billion peso medium-term note and commercial paper program with the Comision Nacional Bancaria y de Valores. The registration expires in April 2021 and limits the amount of commercial paper (up to one year) to 5.00 billion pesos. At December 31, 2018, 7.75 billion pesos were available for issuance. In August 2018, the Company’s Australian subsidiary, PACCAR Financial Pty. Ltd. (PFPL), registered a medium-term note program. The program does not limit the principal amount of debt securities that may be issued under the program. The total amount of medium-term notes outstanding for PFPL as of December 31, 2018 was 150.0 million Australian dollars. In the event of a future significant disruption in the financial markets, the Company may not be able to issue replacement commercial paper. As a result, the Company is exposed to liquidity risk from the shorter maturity of short-term borrowings paid to lenders compared to the longer timing of receivable collections from customers. The Company believes its cash balances and investments, collections on existing finance receivables, syndicated bank lines and current investment-grade credit ratings of A+/A1 will continue to provide it with sufficient resources and access to capital markets at competitive interest rates and therefore contribute to the Company maintaining its liquidity and financial stability. A decrease in these credit ratings could negatively impact the Company’s ability to access capital markets at competitive interest rates and the Company’s ability to maintain liquidity and financial stability. PACCAR believes its Financial Services companies will be able to continue funding receivables, servicing debt and paying dividends through internally generated funds, access to public and private debt markets and lines of credit. Commitments The following summarizes the Company’s contractual cash commitments at December 31, 2018: * Commercial paper included in borrowings is at par value. ** Interest on floating-rate debt is based on the applicable market rates at December 31, 2018. Total cash commitments for borrowings and interest on term debt are $10.29 billion and were related to the Financial Services segment. As described in Note J of the consolidated financial statements, borrowings consist primarily of term notes and commercial paper issued by the Financial Services segment. The Company expects to fund its maturing Financial Services debt obligations principally from funds provided by collections from customers on loans and lease contracts, as well as from the proceeds of commercial paper and medium-term note borrowings. Purchase obligations are the Company’s contractual commitments to acquire future production inventory and capital equipment. Other obligations include deferred cash compensation. The Company’s other commitments include the following at December 31, 2018: Loan and lease commitments are for funding new retail loan and lease contracts. Residual value guarantees represent the Company’s commitment to acquire trucks at a guaranteed value if the customer decides to return the truck at a specified date in the future. RECONCILIATION OF GAAP TO NON-GAAP FINANCIAL MEASURES: This Form 10-K includes “adjusted net income (non-GAAP)” and “adjusted net income per diluted share (non-GAAP)”, which are financial measures that are not in accordance with U.S. generally accepted accounting principles (“GAAP”), since they exclude the one-time tax benefit from the Tax Cuts and Jobs Act (“the Tax Act”) in 2017 and the non-recurring European Commission charge in 2016. These measures differ from the most directly comparable measures calculated in accordance with GAAP and may not be comparable to similarly titled non-GAAP financial measures used by other companies. In addition, the Form 10-K includes the financial ratios noted below calculated based on non-GAAP measures. Management utilizes these non-GAAP measures to evaluate the Company’s performance and believes these measures allow investors and management to evaluate operating trends by excluding significant non-recurring items that are not representative of underlying operating trends. Reconciliations from the most directly comparable GAAP measures of adjusted net income (non-GAAP) and adjusted net income per diluted share (non-GAAP) are as follows: * Calculated using adjusted net income. IMPACT OF ENVIRONMENTAL MATTERS: The Company, its competitors and industry in general are subject to various domestic and foreign requirements relating to the environment. The Company believes its policies, practices and procedures are designed to prevent unreasonable risk of environmental damage and that its handling, use and disposal of hazardous or toxic substances have been in accordance with environmental laws and regulations in effect at the time such use and disposal occurred. The Company is involved in various stages of investigations and cleanup actions in different countries related to environmental matters. In certain of these matters, the Company has been designated as a “potentially responsible party” by domestic and foreign environmental agencies. The Company has accrued the estimated costs to investigate and complete cleanup actions where it is probable that the Company will incur such costs in the future. Expenditures related to environmental activities in the years ended December 31, 2018, 2017 and 2016 were $1.2 million, $1.9 million and $2.2 million, respectively. While the timing and amount of the ultimate costs associated with future environmental cleanup cannot be determined, management expects that these matters will not have a significant effect on the Company's consolidated cash flow, liquidity or financial condition. CRITICAL ACCOUNTING POLICIES: The Company’s significant accounting policies are disclosed in Note A of the consolidated financial statements. In the preparation of the Company’s financial statements, in accordance with U.S. generally accepted accounting principles, management uses estimates and makes judgments and assumptions that affect asset and liability values and the amounts reported as income and expense during the periods presented. The following are accounting policies which, in the opinion of management, are particularly sensitive and which, if actual results are different from estimates used by management, may have a material impact on the financial statements. Operating Leases Trucks sold pursuant to agreements accounted for as operating leases are disclosed in Note F of the consolidated financial statements. In determining its estimate of the residual value of such vehicles, the Company considers the length of the lease term, the truck model, the expected usage of the truck and anticipated market demand. Operating lease terms generally range from three to five years. The resulting residual values on operating leases generally range between 30% and 70% of original equipment cost. If the sales price of the trucks at the end of the term of the agreement differs from the Company’s estimated residual value, a gain or loss will result. Future market conditions, changes in government regulations and other factors outside the Company’s control could impact the ultimate sales price of trucks returned under these contracts. Residual values are reviewed regularly and adjusted if market conditions warrant. A decrease in the estimated equipment residual values would increase annual depreciation expense over the remaining lease term. During 2018, 2017 and 2016, market values on equipment returning upon operating lease maturity were generally lower than the residual values on the equipment, resulting in an increase in depreciation expense of $31.0 million, $45.5 million and $9.6 million, respectively. At December 31, 2018, the aggregate residual value of equipment on operating leases in the Financial Services segment and residual value guarantee on trucks accounted for as operating leases in the Truck segment was $2.41 billion. A 10% decrease in used truck values worldwide, if expected to persist over the remaining maturities of the Company’s operating leases, would reduce residual value estimates and result in the Company recording an average of approximately $69 million of additional depreciation per year. Allowance for Credit Losses The allowance for credit losses related to the Company’s loans and finance leases is disclosed in Note E of the consolidated financial statements. The Company has developed a systematic methodology for determining the allowance for credit losses for its two portfolio segments, retail and wholesale. The retail segment consists of retail loans and direct and sales-type finance leases, net of unearned interest. The wholesale segment consists of truck inventory financing loans to dealers that are collateralized by trucks and other collateral. The wholesale segment generally has less risk than the retail segment. Wholesale receivables generally are shorter in duration than retail receivables, and the Company requires periodic reporting of the wholesale dealer’s financial condition, conducts periodic audits of the trucks being financed and in many cases, obtains guarantees or other security such as dealership assets. In determining the allowance for credit losses, retail loans and finance leases are evaluated together since they relate to a similar customer base, their contractual terms require regular payment of principal and interest, generally over three to five years, and they are secured by the same type of collateral. The allowance for credit losses consists of both specific and general reserves. The Company individually evaluates certain finance receivables for impairment. Finance receivables that are evaluated individually for impairment consist of all wholesale accounts and certain large retail accounts with past due balances or otherwise determined to be at a higher risk of loss. A finance receivable is impaired if it is considered probable the Company will be unable to collect all contractual interest and principal payments as scheduled. In addition, all retail loans and leases which have been classified as TDRs and all customer accounts over 90 days past due are considered impaired. Generally, impaired accounts are on non-accrual status. Impaired accounts classified as TDRs which have been performing for 90 consecutive days are placed on accrual status if it is deemed probable that the Company will collect all principal and interest payments. Impaired receivables are generally considered collateral dependent. Large balance retail and all wholesale impaired receivables are individually evaluated to determine the appropriate reserve for losses. The determination of reserves for large balance impaired receivables considers the fair value of the associated collateral. When the underlying collateral fair value exceeds the Company’s recorded investment, no reserve is recorded. Small balance impaired receivables with similar risk characteristics are evaluated as a separate pool to determine the appropriate reserve for losses using the historical loss information discussed below. The Company evaluates finance receivables that are not individually impaired on a collective basis and determines the general allowance for credit losses for both retail and wholesale receivables based on historical loss information, using past due account data and current market conditions. Information used includes assumptions regarding the likelihood of collecting current and past due accounts, repossession rates, the recovery rate on the underlying collateral based on used truck values and other pledged collateral or recourse. The Company has developed a range of loss estimates for each of its country portfolios based on historical experience, taking into account loss frequency and severity in both strong and weak truck market conditions. A projection is made of the range of estimated credit losses inherent in the portfolio from which an amount is determined as probable based on current market conditions and other factors impacting the creditworthiness of the Company’s borrowers and their ability to repay. After determining the appropriate level of the allowance for credit losses, a provision for losses on finance receivables is charged to income as necessary to reflect management’s estimate of incurred credit losses, net of recoveries, inherent in the portfolio. The adequacy of the allowance is evaluated quarterly based on the most recent past due account information and current market conditions. As accounts become past due, the likelihood that they will not be fully collected increases. The Company’s experience indicates the probability of not fully collecting past due accounts ranges between 30% and 70%. Over the past three years, the Company’s year-end 30+ days past due accounts have ranged between .4% and .5% of loan and lease receivables. Historically, a 100 basis point increase in the 30+ days past due percentage has resulted in an increase in credit losses of 3 to 39 basis points of receivables. At December 31, 2018, 30+ days past dues were .4%. If past dues were 100 basis points higher or 1.4% as of December 31, 2018, the Company’s estimate of credit losses would likely have increased by a range of $2 to $33 million depending on the extent of the past dues, the estimated value of the collateral as compared to amounts owed and general economic factors. Product Warranty Product warranty is disclosed in Note I of the consolidated financial statements. The expenses related to product warranty are estimated and recorded at the time products are sold based on historical and current data and reasonable expectations for the future regarding the frequency and cost of warranty claims, net of recoveries. Management takes actions to minimize warranty costs through quality-improvement programs; however, actual claim costs incurred could materially differ from the estimated amounts and require adjustments to the reserve. Historically those adjustments have not been material. Over the past three years, warranty expense as a percentage of Truck, Parts and Other net sales and revenues has ranged between 1.3% and 1.6%. If the 2018 warranty expense had been .2% higher as a percentage of net sales and revenues in 2018, warranty expense would have increased by approximately $44.3 million. FORWARD-LOOKING STATEMENTS: This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements relating to future results of operations or financial position and any other statement that does not relate to any historical or current fact. Such statements are based on currently available operating, financial and other information and are subject to risks and uncertainties that may affect actual results. Risks and uncertainties include, but are not limited to: a significant decline in industry sales; competitive pressures; reduced market share; reduced availability of or higher prices for fuel; increased safety, emissions, or other regulations resulting in higher costs and/or sales restrictions; currency or commodity price fluctuations; lower used truck prices; insufficient or under-utilization of manufacturing capacity; supplier interruptions; insufficient liquidity in the capital markets; fluctuations in interest rates; changes in the levels of the Financial Services segment new business volume due to unit fluctuations in new PACCAR truck sales or reduced market shares; changes affecting the profitability of truck owners and operators; price changes impacting truck sales prices and residual values; insufficient supplier capacity or access to raw materials; labor disruptions; shortages of commercial truck drivers; increased warranty costs; litigation, including EC settlement-related claims; or legislative and governmental regulations. A more detailed description of these and other risks is included under the heading Part 1, Item 1A, “Risk Factors” and Item 3, “Legal Proceedings” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.

<s>[INST] OVERVIEW: PACCAR is a global technology company whose Truck segment includes the design and manufacture of highquality light, medium and heavyduty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. 2018 Financial Highlights Worldwide net sales and revenues were a record $23.50 billion in 2018 compared to $19.46 billion in 2017 due to record revenues in the Truck, Parts and Financial Services segments. Truck sales were $18.19 billion in 2018 compared to $14.77 billion in 2017 primarily due to higher truck deliveries in all of the Company’s primary markets. Parts sales were a record $3.84 billion in 2018 compared to $3.33 billion in 2017 reflecting higher demand in all markets. Financial Services revenues were $1.36 billion in 2018 compared to $1.27 billion in 2017. The increase was primarily due to higher average earning asset balances and higher interest rates. In 2018, PACCAR earned net income for the 80th consecutive year. Net income was a record $2.20 billion ($6.24 per diluted share) compared to $1.68 billion ($4.75 per diluted share) in 2017, which included a onetime net tax benefit of $173.4 million from the Tax Cuts and Jobs Act (“the Tax Act”). Excluding this onetime net tax benefit, the Company earned adjusted net income (nonGAAP) of $1.50 billion ($4.26 per diluted share) in 2017. See Reconciliation of GAAP to NonGAAP Financial Measures on pages 3334. Capital investments were $437.1 million in 2018 compared to $433.1 million in 2017, reflecting additional investments in the Company’s manufacturing facilities, new product development and enhanced aftermarket support. Aftertax return on beginning equity (ROE) was 27.3% in 2018 compared to 24.7% in 2017. Excluding the onetime net tax benefit, adjusted ROE (nonGAAP) was 22.2% in 2017. See Reconciliation of GAAP to NonGAAP Financial Measures on pages 3334. Research and development (R&D) expenses were $306.1 million in 2018 compared to $264.7 million in 2017. Peterbilt launched its new Model 579 UltraLoft in the first quarter of 2018, which offers customers a highroof, integrated cab and sleeper that enhances driver comfort and operational efficiency. The UltraLoft dimensions represent an 18% increase in interior space giving drivers bestinclass living quarters. The Model 579 UltraLoft is an excellent tractor for longhaul routes, team driving and driver training. Kenworth introduced the W990 in the third quarter of 2018. This new conventional truck is designed to maximize performance in many customer applications including overtheroad and vocational. The Kenworth model W990 features the PACCAR MX13 engine rated up to 510hp and 1,850 lbft of torque, the 12speed PACCAR automated transmission, PACCAR tandem rear axles, and the Kenworth TruckTech+ connected truck system. DAF highlighted its leadership in fuel efficiency and advanced powertrain technology by displaying a full range of innovative vehicles at the IAA truck show in Hannover [/INST] Positive. </s>

PACCAR INC

2020-02-19

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. OVERVIEW: PACCAR is a global technology company whose Truck segment includes the design and manufacture of high-quality light-, medium- and heavy-duty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. 2019 Financial Highlights • Worldwide net sales and revenues were a record $25.60 billion in 2019 compared to $23.50 billion in 2018 due to record revenues in the Truck, Parts and Financial Services segments. • Truck sales were $19.99 billion in 2019 compared to $18.19 billion in 2018 primarily due to higher truck deliveries in the U.S. and Canada and Latin America. • Parts sales were $4.02 billion in 2019 compared to $3.84 billion in 2018 primarily due to higher demand in the U.S. and Canada. • Financial Services revenues were $1.48 billion in 2019 compared to $1.36 billion in 2018. The increase was primarily due to higher average earning asset balances and higher yields in North America. • In 2019, PACCAR earned net income for the 81st consecutive year. Net income was $2.39 billion ($6.87 per diluted share) in 2019 compared to $2.20 billion ($6.24 per diluted share) in 2018 primarily reflecting higher Truck and Parts revenues and operating results. • Capital investments were $743.9 million in 2019 compared to $437.1 million in 2018 reflecting continued investments in the Company’s manufacturing facilities, new product development and enhanced aftermarket support. • After-tax return on beginning equity (ROE) was 27.8% in 2019 compared to 27.3% in 2018. • Research and development (R&D) expenses were $326.6 million in 2019 compared to $306.1 million in 2018. PACCAR opened Global Embedded Software centers in Kirkland, Washington and Eindhoven, the Netherlands, which will accelerate embedded software development and connected vehicle solutions to benefit customers’ operating efficiency. In January 2020, PACCAR exhibited three vehicles with autonomous and alternative powertrain technologies at the CES 2020 show in Las Vegas, Nevada: a level 4 autonomous Kenworth T680; a battery-electric Peterbilt Model 520EV; and a battery-electric Kenworth K270E. These trucks are designed for a range of customer applications, including over-the-road transportation, refuse collection and urban distribution. Peterbilt, Kenworth and DAF are field-testing battery-electric, hydrogen fuel cell and hybrid powertrain trucks with customers in North America and Europe. These customer field tests are providing excellent feedback on future truck technologies, which will support PACCAR’s environmental and engineering leadership with the development of innovative alternative powertrain technologies. PACCAR continues to add global distribution capacity to deliver industry-leading aftermarket parts availability to customers. PACCAR will open a new 250,000 square-foot parts distribution center in Las Vegas, Nevada and a new 160,000 square-foot parts distribution center in Ponta Grossa, Brasil in 2020 to enhance parts availability for customers. PACCAR has been honored for the second consecutive year as a global leader in environmental practices by environmental reporting firm CDP, earning recognition on the 2019 CDP Climate Change A List. Over 8,000 companies disclosed data about their environmental impacts, risks and opportunities to CDP for independent assessment. PACCAR is one of only 35 companies in the U.S. earning a CDP score of “A” and is placed in the top 2% of reporting companies worldwide. The PACCAR Financial Services (PFS) group of companies has operations covering four continents and 25 countries. The global breadth of PFS and its rigorous credit application process support a portfolio of loans and leases with record total assets of $16.07 billion. PFS issued $2.49 billion in medium-term notes during 2019 to support portfolio growth and repay maturing debt. Truck Outlook Heavy-duty truck industry retail sales in the U.S. and Canada in 2020 are expected to decrease to 230,000 to 260,000 units compared to 308,800 in 2019. In Europe, the 2020 truck industry registrations for over 16-tonne vehicles are expected to be 260,000 to 290,000 units compared to 320,200 in 2019. In South America, heavy-duty truck industry sales in 2020 are estimated to be 100,000 to 110,000 units compared to 105,000 units in 2019. Parts Outlook In 2020, PACCAR Parts sales are expected to grow 4-6% compared to 2019. Financial Services Outlook Based on the truck market outlook, average earning assets in 2020 are expected to remain similar to 2019 levels. Current strong levels of freight tonnage are contributing to customers’ profitability and cash flow. If current freight transportation conditions decline due to weaker economic conditions, then past due accounts, truck repossessions and credit losses would likely increase from the current low levels and new business volume would likely decline. Capital Spending and R&D Outlook Capital investments in 2020 are expected to be $625 to $675 million, and R&D is expected to be $310 to $340 million. The Company is investing for long-term growth in aerodynamic truck models, integrated powertrains including diesel, electric, hybrid and hydrogen fuel cell technologies, advanced driver assistance systems, digital services and next-generation manufacturing and distribution capabilities. See the Forward-Looking Statements section of Management’s Discussion and Analysis for factors that may affect these outlooks. RESULTS OF OPERATIONS: The Company’s results of operations for the years ended December 31, 2019 and 2018 are presented below. For information on the year ended December 31, 2017, refer to Part II, Item 7 in the 2018 Annual Report on Form 10-K. The following provides an analysis of the results of operations for the Company’s three reportable segments - Truck, Parts and Financial Services. Where possible, the Company has quantified the impact of factors identified in the following discussion and analysis. In cases where it is not possible to quantify the impact of factors, the Company lists them in estimated order of importance. Factors for which the Company is unable to specifically quantify the impact include market demand, fuel prices, freight tonnage and economic conditions affecting the Company’s results of operations. 2019 Compared to 2018: Truck The Company’s Truck segment accounted for 78% of revenues in 2019 compared to 77% in 2018. The Company’s new truck deliveries are summarized below: In 2019, industry retail sales in the heavy-duty market in the U.S. and Canada increased to 308,800 units from 284,800 units in 2018. The Company’s heavy-duty truck retail market share was 30.0% in 2019 compared to 29.4% in 2018. The medium-duty market was 108,100 units in 2019 compared to 98,100 units in 2018. The Company’s medium-duty market share was 16.9% in 2019 compared to 17.7% in 2018. The over 16-tonne truck market in Europe in 2019 increased to 320,200 units from 318,800 units in 2018, and DAF’s market share was 16.2% in 2019 compared to 16.6% in 2018. The 6 to 16-tonne market in 2019 increased to 53,600 units from 51,900 units in 2018. DAF’s market share in the 6 to 16-tonne market in 2019 was 9.7% compared to 9.0% in 2018. The Company’s worldwide truck net sales and revenues are summarized below: The Company’s worldwide truck net sales and revenues increased to $19.99 billion in 2019 from $18.19 billion in 2018, primarily due to higher truck deliveries in the U.S. and Canada and Latin America, partially offset by unfavorable currency translation effects. Truck segment income before income taxes and pre-tax return on revenues increased in 2019, reflecting higher truck unit deliveries and higher gross margins. The major factors for the Truck segment changes in net sales and revenues, cost of sales and revenues and gross margin between 2019 and 2018 are as follows: • Truck sales volume primarily reflects higher truck deliveries in the U.S. and Canada ($1,414.4 million sales and $1,180.0 million cost of sales). In Europe, the impact of lower truck unit deliveries was more than offset by a decrease in units accounted for as operating leases, resulting in higher sales ($236.8 million) and cost of sales ($217.9 million). • Average truck sales prices increased sales by $489.8 million, primarily due to higher price realization in North America. • Average cost per truck increased cost of sales by $297.8 million, primarily reflecting higher material and labor costs. • Factory overhead and other indirect costs increased $65.2 million, primarily due to higher salaries and related expenses and higher supplies and maintenance costs to support increased truck production. • Extended warranties, operating leases and other revenues increased by $71.9 million primarily due to a higher volume of repair and maintenance (R&M) and extended warranty contracts, as well as higher revenues from operating leases. Cost of sales and revenues increased by $101.9 million primarily due to higher impairments and losses on used trucks and higher costs of extended warranty and R&M contracts. • The currency translation effect on sales and cost of sales reflects a decline in the value of foreign currencies relative to the U.S. dollar, primarily the euro. • Truck gross margins increased to 12.1% in 2019 from 11.8% in 2018, primarily due to the factors noted above. Truck selling, general and administrative expenses (SG&A) for 2019 increased to $269.7 million from $248.3 million in 2018. The increase was primarily due to higher professional fees ($24.4 million) and higher salaries and related expenses ($6.8 million), partially offset by favorable currency translation effects ($9.7 million). As a percentage of sales, Truck SG&A decreased to 1.3% in 2019 from 1.4% in 2018 due to higher net sales. Parts The Company’s Parts segment accounted for 16% of revenues in 2019 and 2018. The Company’s worldwide parts net sales and revenues increased to a record $4.02 billion in 2019 from $3.84 billion in 2018, due to higher aftermarket demand in U.S. and Canada. The increase in Parts segment income before income taxes and pre-tax return on revenues in 2019 was primarily due to higher sales volume and higher price realization, partially offset by unfavorable currency translation. The major factors for the Parts segment changes in net sales and revenues, cost of sales and revenues and gross margin between 2019 and 2018 are as follows: • Aftermarket parts sales volume increased by $75.4 million and related cost of sales increased by $51.1 million due to higher demand in all markets. • Average aftermarket parts sales prices increased sales by $173.9 million primarily due to higher price realization in the U.S. and Canada. • Average aftermarket parts direct costs increased $85.5 million due to higher material costs. • Warehouse and other indirect costs increased $17.6 million, primarily due to higher salaries and related expenses and higher depreciation expense. • The currency translation effect on sales and cost of sales primarily reflects a decline in the value of foreign currencies relative to the U.S. dollar, primarily the euro. • Parts gross margins in 2019 increased to 27.8% from 27.2% in 2018 due to the factors noted above. Parts SG&A expense for 2019 was $207.8 million compared to $206.2 million in 2018 primarily due to higher salaries and related expenses, partially offset by lower sales and marketing costs and favorable currency translation effects. As a percentage of sales, Parts SG&A decreased to 5.2% in 2019 from 5.4% in 2018, primarily due to higher net sales. Financial Services The Company’s Financial Services segment accounted for 6% of revenues in 2019 and 2018. New loan and lease volume was a record $5.63 billion in 2019 compared to $5.23 billion in 2018, primarily reflecting higher truck deliveries in the U.S. and Canada. PFS finance market share of new PACCAR truck sales was 24.5% in 2019 compared to 23.9% in 2018. PFS revenues increased to $1.48 billion in 2019 from $1.36 billion in 2018. The increase was primarily due to revenue on higher average earning assets and higher portfolio yields reflecting higher market interest rates in North America, and higher used truck sales volume in Europe, partially offset by the effects of translating weaker foreign currencies to the U.S. dollar. The effects of currency translation decreased PFS revenues by $26.7 million in 2019, primarily due to changes in the euro. PFS income before income taxes decreased to $298.9 million in 2019 from $305.9 million in 2018, primarily due to lower results on returned lease assets and higher SG&A expenses as $12.0 million of certain initial direct costs were immediately expensed in 2019 with the adoption of the new lease standard, partially offset by higher average earning assets balances. Currency exchange effects decreased PFS income before taxes by $3.2 million in 2019. Included in Financial Services “Other Assets” on the Company’s Consolidated Balance Sheets are used trucks held for sale, net of impairments, of $391.4 million at December 31, 2019 and $226.4 million at December 31, 2018. These trucks are primarily units returned from matured operating leases in the ordinary course of business, and also include trucks acquired from repossessions, through acquisitions of used trucks in trades related to new truck sales and trucks returned from residual value guarantees (RVGs). The Company recognized losses on used trucks, excluding repossessions, of $57.5 million in 2019 compared to $35.4 million in 2018, including losses on multiple unit transactions of $19.1 million in 2019 compared to $20.2 million in 2018. Used truck losses related to repossessions, which are recognized as credit losses, were not significant for 2019 or 2018. The major factors for the changes in interest and fees, interest and other borrowing expenses and finance margin between 2019 and 2018 are outlined below: • Average finance receivables increased $1,452.5 million (excluding foreign exchange effects) in 2019 as a result of retail portfolio new business volume exceeding collections and higher dealer wholesale balances. • Average debt balances increased $1,456.1 million (excluding foreign exchange effects) in 2019. The higher average debt balances reflect funding for a higher average earning assets portfolio, which includes loans, finance leases, wholesale receivables and equipment on operating lease. • Higher portfolio yields (5.2% in 2019 compared to 5.0% in 2018) increased interest and fees by $16.6 million. The higher portfolio yields were primarily due to higher market rates in North America. • Higher borrowing rates (2.2% in 2019 compared to 2.0% in 2018) were primarily due to higher debt market rates in North America. • The currency translation effects reflect a decrease in the value of foreign currencies relative to the U.S. dollar, primarily the euro, the Australian and Canadian dollars and the British pound. The following table summarizes operating lease, rental and other revenues and depreciation and other expenses: The major factors for the changes in operating lease, rental and other revenues, depreciation and other expenses and lease margin between 2019 and 2018 are outlined below: • A higher sales volume of used trucks received on trade increased operating lease, rental and other revenues by $32.3 million and increased depreciation and other expenses by $31.1 million. • Results on returned lease assets increased depreciation and other expenses by $28.9 million primarily due to higher losses on sales of returned lease units in Europe. • Average operating lease assets increased $173.2 million (excluding foreign exchange effects), which increased revenues by $34.7 million and related depreciation and other expenses by $30.0 million. • Revenue per asset decreased $11.2 million primarily due to lower rental income and lower fleet utilization. Cost per asset decreased $.9 million due to lower depreciation expense and lower vehicle related expenses, partially offset by higher operating lease impairments in Europe. • The currency translation effects reflect a decrease in the value of foreign currencies relative to the U.S. dollar, primarily the euro. Financial Services SG&A expense increased to $137.0 million in 2019 from $119.8 million in 2018. The increase was due to higher salaries and related expenses to support portfolio growth and the adoption of the new lease accounting standard under which $12.0 million of certain initial direct costs were immediately expensed. In prior years, these costs were capitalized and amortized to expense over the lease term. As a percentage of revenues, Financial Services SG&A increased to 9.3% in 2019 from 8.8% in 2018. The following table summarizes the provision for losses on receivables and net charge-offs: The provision for losses on receivables was $15.4 million in 2019 compared to $16.5 million in 2018, reflecting continued good portfolio performance. The decrease in provision for losses was primarily driven by higher recoveries on charged-off accounts in Europe. The Company modifies loans and finance leases as a normal part of its Financial Services operations. The Company may modify loans and finance leases for commercial reasons or for credit reasons. Modifications for commercial reasons are changes to contract terms for customers that are not considered to be in financial difficulty. Insignificant delays are modifications extending terms up to three months for customers experiencing some short-term financial stress, but not considered to be in financial difficulty. Modifications for credit reasons are changes to contract terms for customers considered to be in financial difficulty. The Company’s modifications typically result in granting more time to pay the contractual amounts owed and charging a fee and interest for the term of the modification. When considering whether to modify customer accounts for credit reasons, the Company evaluates the creditworthiness of the customers and modifies those accounts that the Company considers likely to perform under the modified terms. When the Company modifies a loan or finance lease for credit reasons and grants a concession, the modification is classified as a troubled debt restructuring (TDR). The post-modification balance of accounts modified during the years ended December 31, 2019 and 2018 are summarized below: * Recorded investment immediately after modification as a percentage of the year-end retail portfolio balance. In 2019, total modification activity increased compared to 2018 due to higher modifications for commercial reasons and insignificant delay, partially offset by lower modifications for credit - no concession and credit - TDR. The increase in modifications for commercial reasons primarily reflects higher volumes of refinancing. The increase in modifications for insignificant delay reflects more fleet customers requesting payment relief for up to three months. The decrease in modifications for credit - no concession is primarily due to lower volumes of refinancing in Europe for customers in financial difficulty. Credit - TDR modifications decreased to $2.5 million in 2019 from $13.1 million in 2018 as there were no large fleet modifications in 2019 compared to modifications for two fleet customers in 2018. The following table summarizes the Company’s 30+ days past due accounts: Accounts 30+ days past due increased slightly to .7% at December 31, 2019 from .4% at December 31, 2018, and remain at low levels. The Company continues to focus on maintaining low past due balances. When the Company modifies a 30+ days past due account, the customer is then generally considered current under the revised contractual terms. The Company modified $1.7 million and $7.2 million of accounts worldwide during the fourth quarter of 2019 and the fourth quarter of 2018, respectively, which were 30+ days past due and became current at the time of modification. Had these accounts not been modified and continued to not make payments, the pro forma percentage of retail loan and lease accounts 30+ days past due would have been as follows: Modifications of accounts in prior quarters that were more than 30 days past due at the time of modification are included in past dues if they were not performing under the modified terms at December 31, 2019 and 2018. The effect on the allowance for credit losses from such modifications was not significant at December 31, 2019 and 2018. The Company’s 2019 and 2018 annualized pre-tax return on average assets for Financial Services was 2.0% and 2.2%, respectively. Other Other includes the winch business as well as sales, income and expenses not attributable to a reportable segment. Other also includes non-service cost components of pension expense and a portion of corporate expense. Other sales represent less than 1% of consolidated net sales and revenues for 2019 and 2018. Other SG&A increased to $84.0 million in 2019 from $70.4 million in 2018 primarily due to higher compensation costs. Other (loss) income before tax was $(17.7) million in 2019 compared to $2.7 million in 2018. The loss in 2019 compared to income in 2018 was primarily due to higher compensation costs, lower results from the winch business and higher expected costs to resolve certain environmental matters. Investment income increased to $82.3 million in 2019 from $60.9 million in 2018, primarily due to higher average portfolio balances and higher yields on U.S. investments due to higher market interest rates. Income Taxes In 2019, the effective tax rate was 23.0% compared to 21.9% in 2018. The Company’s effective tax rate for 2018 benefitted from a one-time reduction in tax liability related to extended warranty contracts. In 2019, domestic income before income taxes and pre-tax return on revenues improved primarily due to higher revenues from truck operations. The decrease in foreign income before income taxes and pre-tax return on revenues was primarily due to lower truck and finance results in Europe and lower truck volumes in Australia. LIQUIDITY AND CAPITAL RESOURCES: The Company’s total cash and marketable debt securities at December 31, 2019 increased $880.9 million from the balances at December 31, 2018, primarily due to an increase in cash and cash equivalents. The change in cash and cash equivalents is summarized below: Operating activities: Cash provided by operations decreased by $132.0 million to $2.86 billion in 2019 from $2.99 billion in 2018. The decrease in operating cash flows reflects lower cash inflows of $556.5 million from accounts payable and accrued expenses, as payments for goods and services exceeded purchases by $27.6 million in 2019 compared to purchases of goods and services exceeding payments by $528.9 million in 2018. Additionally, lower operating cash flows reflect a reduction in liabilities for RVGs and deferred revenues of $454.7 million, primarily due to a lower volume of new RVG contracts accounted for as operating leases in 2019 compared to 2018. The lower cash inflows were partially offset by higher cash inflow of $357.3 million from inventories as there were $24.6 million in net inventory reductions in 2019 versus $332.7 million in net purchases in 2018. There was a $226.8 million increase from accounts receivable as sales of goods and services exceeding cash receipts were lower in 2019 compared to 2018. In addition, there was a higher net income of $192.8 million and an increase of $140.3 million from income taxes, primarily due to lower tax payments in 2019 compared to 2018. Investing activities: Cash used in investing activities increased by $276.7 million to $2.21 billion in 2019 from $1.93 billion in 2018. Higher net cash used in investing activities reflects $450.7 million for marketable debt securities as there were $135.1 million in net purchases of marketable debt securities in 2019 compared to $315.6 million in net proceeds from sales of marketable debt securities in 2018. Payments for property, plant and equipment increased by $116.4 million. This was partially offset by lower net originations from retail loans and finance leases of $251.9 million and fewer acquisitions of equipment on operating leases of $97.9 million. Financing activities: Cash provided by financing activities was $83.4 million in 2019, $12.3 million higher than the $71.1 million provided in 2018. In 2019, the Company issued $2.50 billion of term debt, repaid term debt of $1.79 billion and increased its outstanding commercial paper and short-term bank loans by $557.1 million. In 2018, the Company issued $2.34 billion of term debt, repaid term debt of $1.76 billion and increased its outstanding commercial paper and short-term bank loans by $625.9 million. This resulted in cash provided by borrowing activities of $1.27 billion in 2019, $60.9 million higher than the cash provided by borrowing activities of $1.21 billion in 2018. The Company paid $1.14 billion in dividends in 2019, $334.3 million higher than the $804.3 million paid in 2018 due primarily to a higher extra dividend paid in January 2019. In addition, the Company repurchased 1.7 million shares of common stock for $110.2 million in 2019 compared to the purchase of 5.8 million shares for $354.4 million in 2018. Credit Lines and Other: The Company has line of credit arrangements of $3.58 billion, of which $3.27 billion were unused at December 31, 2019. Included in these arrangements are $3.00 billion of committed bank facilities, of which $1.00 billion expires in June 2020, $1.00 billion expires in June 2023 and $1.00 billion expires in June 2024. The Company intends to extend or replace these credit facilities on or before expiration to maintain facilities of similar amounts and duration. These credit facilities are maintained primarily to provide backup liquidity for commercial paper borrowings and maturing medium-term notes. There were no borrowings under the committed bank facilities for the year ended December 31, 2019. On July 9, 2018, PACCAR’s Board of Directors approved the repurchase of up to $300.0 million of the Company’s outstanding common stock, and on December 4, 2018, approved a plan to repurchase an additional $500.0 million of common stock upon completion of the prior plan. During the second quarter of 2019, the Company completed the repurchase of $300.0 million of the Company’s common stock under the authorization approved on July 9, 2018. As of December 31, 2019, the Company has repurchased $69.5 million of shares under the December 4, 2018 authorization. Truck, Parts and Other The Company provides funding for working capital, capital expenditures, R&D, dividends, stock repurchases and other business initiatives and commitments primarily from cash provided by operations. Management expects this method of funding to continue in the future. Over the past decade, the Company’s combined investments in worldwide capital projects and R&D totaled $6.77 billion, and have significantly increased the operating capacity and efficiency of its facilities and enhanced the quality and operating efficiency of the Company’s premium products. Capital investments in 2020 are expected to be $625 to $675 million, and R&D is expected to be $310 to $340 million. The Company is investing for long-term growth in aerodynamic truck models, integrated powertrains including diesel, electric, hybrid and hydrogen fuel cell technologies, advanced driver assistance systems, digital services and next-generation manufacturing and distribution capabilities. The Company conducts business in certain countries which have been experiencing or may experience significant financial stress, fiscal or political strain and are subject to the corresponding potential for default. The Company routinely monitors its financial exposure to global financial conditions, global counterparties and operating environments. As of December 31, 2019, the Company’s exposures in such countries were insignificant. Financial Services The Company funds its financial services activities primarily from collections on existing finance receivables and borrowings in the capital markets. The primary sources of borrowings in the capital markets are commercial paper and medium-term notes issued in the public markets and, to a lesser extent, bank loans. An additional source of funds is loans from other PACCAR companies. In November 2018, the Company’s U.S. finance subsidiary, PACCAR Financial Corp. (PFC), filed a shelf registration under the Securities Act of 1933. The total amount of medium-term notes outstanding for PFC as of December 31, 2019 was $5.55 billion. In February 2020, PFC issued $300.0 million of medium-term notes under this registration. The registration expires in November 2021 and does not limit the principal amount of debt securities that may be issued during that period. As of December 31, 2019, the Company’s European finance subsidiary, PACCAR Financial Europe, had €1.35 billion available for issuance under a €2.50 billion medium-term note program listed on the Professional Securities Market of the London Stock Exchange. This program replaced an expiring program in the second quarter of 2019 and is renewable annually through the filing of a new listing. In April 2016, PACCAR Financial Mexico registered a 10.00 billion peso medium-term note and commercial paper program with the Comision Nacional Bancaria y de Valores. The registration expires in April 2021 and limits the amount of commercial paper (up to one year) to 5.00 billion pesos. At December 31, 2019, 6.80 billion pesos were available for issuance. In August 2018, the Company’s Australian subsidiary, PACCAR Financial Pty. Ltd. (PFPL), registered a medium-term note program. The program does not limit the principal amount of debt securities that may be issued under the program. The total amount of medium-term notes outstanding for PFPL as of December 31, 2019 was 300.0 million Australian dollars. The Company believes its cash balances and investments, collections on existing finance receivables, committed bank facilities, and current investment-grade credit ratings of A+/A1 will continue to provide it with sufficient resources and access to capital markets at competitive interest rates and therefore contribute to the Company maintaining its liquidity and financial stability. In the event of a decrease in the Company’s credit ratings or a disruption in the financial markets, the Company may not be able to refinance its maturing debt in the financial markets. In such circumstances, the Company would be exposed to liquidity risk to the degree that the timing of debt maturities differs from the timing of receivable collections from customers. The Company believes its various sources of liquidity, including committed bank facilities, would continue to provide it with sufficient funding resources to service its maturing debt obligations. Commitments The following summarizes the Company’s contractual cash commitments at December 31, 2019: * Commercial paper included in borrowings is at par value. ** Interest on floating-rate debt is based on the applicable market rates at December 31, 2019. Total cash commitments for borrowings and interest on term debt were $11.57 billion and were related to the Financial Services segment. As described in Note J of the consolidated financial statements, borrowings consist primarily of term notes and commercial paper issued by the Financial Services segment. The Company expects to fund its maturing Financial Services debt obligations principally from funds provided by collections from customers on loans and lease contracts, as well as from the proceeds of commercial paper and medium-term note borrowings. Purchase obligations are the Company’s contractual commitments to acquire future production inventory and capital equipment. Other obligations primarily include commitments to purchase energy. The Company’s other commitments include the following at December 31, 2019: Loan and lease commitments are for funding new retail loan and lease contracts. Residual value guarantees represent the Company’s commitment to acquire trucks at a guaranteed value if the customer decides to return the truck at a specified date in the future. IMPACT OF ENVIRONMENTAL MATTERS: The Company, its competitors and industry in general are subject to various domestic and foreign requirements relating to the environment. The Company believes its policies, practices and procedures are designed to prevent unreasonable risk of environmental damage and that its handling, use and disposal of hazardous or toxic substances have been in accordance with environmental laws and regulations in effect at the time such use and disposal occurred. The Company is involved in various stages of investigations and cleanup actions in different countries related to environmental matters. In certain of these matters, the Company has been designated as a “potentially responsible party” by domestic and foreign environmental agencies. The Company has accrued the estimated costs to investigate and complete cleanup actions where it is probable that the Company will incur such costs in the future. Expenditures related to environmental activities in the years ended December 31, 2019 and 2018 were $1.3 million and $1.2 million, respectively. While the timing and amount of the ultimate costs associated with future environmental cleanup cannot be determined, management expects that these matters will not have a significant effect on the Company's consolidated cash flow, liquidity or financial condition. CRITICAL ACCOUNTING POLICIES: The Company’s significant accounting policies are disclosed in Note A of the consolidated financial statements. In the preparation of the Company’s financial statements, in accordance with U.S. generally accepted accounting principles, management uses estimates and makes judgments and assumptions that affect asset and liability values and the amounts reported as income and expense during the periods presented. The following are accounting policies which, in the opinion of management, are particularly sensitive and which, if actual results are different from estimates used by management, may have a material impact on the financial statements. Operating Leases Trucks sold pursuant to agreements accounted for as operating leases are disclosed in Note F of the consolidated financial statements. In determining its estimate of the residual value of such vehicles, the Company considers the length of the lease term, the truck model, the expected usage of the truck and anticipated market demand. Operating lease terms generally range from three to five years. The resulting residual values on operating leases generally range between 30% and 70% of the original equipment cost. If the sales price of a truck at the end of the term of the agreement differs from the Company’s estimated residual value, a gain or loss will result. Future market conditions, changes in government regulations and other factors outside the Company’s control could impact the ultimate sales price of trucks returned under these contracts. Residual values are reviewed regularly and adjusted if market conditions warrant. A decrease in the estimated equipment residual values would increase annual depreciation expense over the remaining lease term. During 2019 and 2018, market values on equipment returning upon operating lease maturity were generally lower than the residual values on the equipment, resulting in an increase in depreciation expense of $109.0 million and $45.7 million, respectively. At December 31, 2019, the aggregate residual value of equipment on operating leases in the Financial Services segment and residual value guarantee on trucks accounted for as operating leases in the Truck segment was $2.36 billion. A 10% decrease in used truck values worldwide, if expected to persist over the remaining maturities of the Company’s operating leases, would reduce residual value estimates and result in the Company recording an average of approximately $67 million of additional depreciation per year. Allowance for Credit Losses The allowance for credit losses related to the Company’s loans and finance leases is disclosed in Note E of the consolidated financial statements. The Company has developed a systematic methodology for determining the allowance for credit losses for its two portfolio segments, retail and wholesale. The retail segment consists of retail loans and finance leases, net of unearned interest. The wholesale segment consists of truck inventory financing loans to dealers that are collateralized by trucks and other collateral. The wholesale segment generally has less risk than the retail segment. Wholesale receivables generally are shorter in duration than retail receivables, and the Company requires periodic reporting of the wholesale dealer’s financial condition, conducts periodic audits of the trucks being financed and in many cases obtains guarantees or other security such as dealership assets. In determining the allowance for credit losses, retail loans and finance leases are evaluated together since they relate to a similar customer base, their contractual terms require regular payment of principal and interest, generally over three to five years, and they are secured by the same type of collateral. The allowance for credit losses consists of both specific and general reserves. The Company individually evaluates certain finance receivables for impairment. Finance receivables that are evaluated individually for impairment consist of all wholesale accounts and certain large retail accounts with past due balances or otherwise determined to be at a higher risk of loss. A finance receivable is impaired if it is considered probable the Company will be unable to collect all contractual interest and principal payments as scheduled. In addition, all retail loans and leases which have been classified as TDRs and all customer accounts over 90 days past due are considered impaired. Generally, impaired accounts are on non-accrual status. Impaired accounts classified as TDRs which have been performing for 90 consecutive days are placed on accrual status if it is deemed probable that the Company will collect all principal and interest payments. Impaired receivables are generally considered collateral dependent. Large balance retail and all wholesale impaired receivables are individually evaluated to determine the appropriate reserve for losses. The determination of reserves for large balance impaired receivables considers the fair value of the associated collateral. When the underlying collateral fair value exceeds the Company’s recorded investment, no reserve is recorded. Small balance impaired receivables with similar risk characteristics are evaluated as a separate pool to determine the appropriate reserve for losses using the historical loss information discussed below. The Company evaluates finance receivables that are not individually impaired on a collective basis and determines the general allowance for credit losses for both retail and wholesale receivables based on historical loss information, using past due account data and current market conditions. Information used includes assumptions regarding the likelihood of collecting current and past due accounts, repossession rates, the recovery rate on the underlying collateral based on used truck values and other pledged collateral or recourse. The Company has developed a range of loss estimates for each of its country portfolios based on historical experience, taking into account loss frequency and severity in both strong and weak truck market conditions. A projection is made of the range of estimated credit losses inherent in the portfolio from which an amount is determined as probable based on current market conditions and other factors impacting the creditworthiness of the Company’s borrowers and their ability to repay. After determining the appropriate level of the allowance for credit losses, a provision for losses on finance receivables is charged to income as necessary to reflect management’s estimate of incurred credit losses, net of recoveries, inherent in the portfolio. The adequacy of the allowance is evaluated quarterly based on the most recent past due account information and current market conditions. As accounts become past due, the likelihood that they will not be fully collected increases. The Company’s experience indicates the probability of not fully collecting past due accounts ranges between 30% and 70%. Over the past three years, the Company’s year-end 30+ days past due accounts have ranged between .4% and .7% of loan and lease receivables. Historically, a 100 basis point increase in the 30+ days past due percentage has resulted in an increase in credit losses of 2 to 35 basis points of receivables. At December 31, 2019, 30+ days past dues were .7%. If past dues were 100 basis points higher or 1.7% as of December 31, 2019, the Company’s estimate of credit losses would likely have increased by a range of $2 to $32 million depending on the extent of the past dues, the estimated value of the collateral as compared to amounts owed and general economic factors. Product Warranty Product warranty is disclosed in Note I of the consolidated financial statements. The expenses related to product warranty are estimated and recorded at the time products are sold based on historical and current data and reasonable expectations for the future regarding the frequency and cost of warranty claims, net of recoveries. Management takes actions to minimize warranty costs through quality-improvement programs; however, actual claim costs incurred could materially differ from the estimated amounts and require adjustments to the reserve. Historically those adjustments have not been material. Over the past two years, warranty expense as a percentage of Truck, Parts and Other net sales and revenues has ranged between 1.6% and 1.7%. If the 2019 warranty expense had been .2% higher as a percentage of net sales and revenues in 2019, warranty expense would have increased by approximately $48 million. FORWARD-LOOKING STATEMENTS: This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include statements relating to future results of operations or financial position and any other statement that does not relate to any historical or current fact. Such statements are based on currently available operating, financial and other information and are subject to risks and uncertainties that may affect actual results. Risks and uncertainties include, but are not limited to: a significant decline in industry sales; competitive pressures; reduced market share; reduced availability of or higher prices for fuel; increased safety, emissions, or other regulations or tariffs resulting in higher costs and/or sales restrictions; currency or commodity price fluctuations; lower used truck prices; insufficient or under-utilization of manufacturing capacity; supplier interruptions; insufficient liquidity in the capital markets; fluctuations in interest rates; changes in the levels of the Financial Services segment new business volume due to unit fluctuations in new PACCAR truck sales or reduced market shares; changes affecting the profitability of truck owners and operators; price changes impacting truck sales prices and residual values; insufficient supplier capacity or access to raw materials; labor disruptions; shortages of commercial truck drivers; increased warranty costs; litigation, including EC settlement-related claims; or legislative and governmental regulations. A more detailed description of these and other risks is included under the heading Part 1, Item 1A, “Risk Factors” and Item 3, “Legal Proceedings” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.

<s>[INST] OVERVIEW: PACCAR is a global technology company whose Truck segment includes the design and manufacture of highquality light, medium and heavyduty commercial trucks. In North America, trucks are sold under the Kenworth and Peterbilt nameplates, in Europe, under the DAF nameplate and in Australia and South America, under the Kenworth and DAF nameplates. The Parts segment includes the distribution of aftermarket parts for trucks and related commercial vehicles. The Company’s Financial Services segment derives its earnings primarily from financing or leasing PACCAR products in North America, Europe and Australia. The Company’s Other business includes the manufacturing and marketing of industrial winches. 2019 Financial Highlights Worldwide net sales and revenues were a record $25.60 billion in 2019 compared to $23.50 billion in 2018 due to record revenues in the Truck, Parts and Financial Services segments. Truck sales were $19.99 billion in 2019 compared to $18.19 billion in 2018 primarily due to higher truck deliveries in the U.S. and Canada and Latin America. Parts sales were $4.02 billion in 2019 compared to $3.84 billion in 2018 primarily due to higher demand in the U.S. and Canada. Financial Services revenues were $1.48 billion in 2019 compared to $1.36 billion in 2018. The increase was primarily due to higher average earning asset balances and higher yields in North America. In 2019, PACCAR earned net income for the 81st consecutive year. Net income was $2.39 billion ($6.87 per diluted share) in 2019 compared to $2.20 billion ($6.24 per diluted share) in 2018 primarily reflecting higher Truck and Parts revenues and operating results. Capital investments were $743.9 million in 2019 compared to $437.1 million in 2018 reflecting continued investments in the Company’s manufacturing facilities, new product development and enhanced aftermarket support. Aftertax return on beginning equity (ROE) was 27.8% in 2019 compared to 27.3% in 2018. Research and development (R&D) expenses were $326.6 million in 2019 compared to $306.1 million in 2018. PACCAR opened Global Embedded Software centers in Kirkland, Washington and Eindhoven, the Netherlands, which will accelerate embedded software development and connected vehicle solutions to benefit customers’ operating efficiency. In January 2020, PACCAR exhibited three vehicles with autonomous and alternative powertrain technologies at the CES 2020 show in Las Vegas, Nevada: a level 4 autonomous Kenworth T680; a batteryelectric Peterbilt Model 520EV; and a batteryelectric Kenworth K270E. These trucks are designed for a range of customer applications, including overtheroad transportation, refuse collection and urban distribution. Peterbilt, Kenworth and DAF are fieldtesting batteryelectric, hydrogen fuel cell and hybrid powertrain trucks with customers in North America and Europe. These customer field tests are providing excellent feedback on future truck technologies, which will support PACCAR’s environmental and engineering leadership with the development of innovative alternative powertrain technologies. PACCAR continues to add global distribution capacity to deliver industryleading aftermarket parts availability to customers. PACCAR will open a new 250,000 squarefoot parts distribution center in Las Vegas, Nevada and a new 160,000 squarefoot parts distribution center in Ponta Grossa, Brasil in 2020 to enhance parts availability for customers. PACCAR has been honored for the second consecutive year as a global leader in environmental practices by environmental reporting firm CDP, earning recognition on the 2019 CDP Climate Change A List. Over 8,000 companies disclosed data about their environmental impacts, risks and opportunities to CD [/INST] Positive. </s>

ALLERGAN INC

2015-02-19

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This financial review presents our operating results for each of the three years in the period ended December 31, 2014, and our financial condition at December 31, 2014. Except for the historical information contained herein, the following discussion contains forward-looking statements which are subject to known and unknown risks, uncertainties and other factors that may cause our actual results to differ materially from those expressed or implied by such forward-looking statements. We discuss such risks, uncertainties and other factors throughout this report and specifically under Item 1A of Part I of this report, “Risk Factors.” In addition, the following review should be read in connection with the information presented in our consolidated financial statements and the related notes to our consolidated financial statements. Critical Accounting Policies, Estimates and Assumptions The preparation and presentation of financial statements in conformity with accounting principles generally accepted in the United States, or GAAP, requires us to establish policies and to make estimates and assumptions that affect the amounts reported in our consolidated financial statements. In our judgment, the accounting policies, estimates and assumptions described below have the greatest potential impact on our consolidated financial statements. Accounting assumptions and estimates are inherently uncertain and actual results may differ materially from our estimates. Revenue Recognition We recognize revenue from product sales when goods are shipped and title and risk of loss transfer to our customers. A substantial portion of our revenue is generated by the sale of specialty pharmaceutical products (primarily eye care pharmaceuticals and skin care and other products) to wholesalers within the United States, and we have a policy to attempt to maintain average U.S. wholesaler inventory levels at an amount less than eight weeks of our net sales. A portion of our revenue is generated from consigned inventory of breast implants maintained at physician, hospital and clinic locations. These customers are contractually obligated to maintain a specific level of inventory and to notify us upon the use of consigned inventory. Revenue for consigned inventory is recognized at the time we are notified by the customer that the product has been used. Notification is usually through the replenishing of the inventory, and we periodically review consignment inventories to confirm the accuracy of customer reporting. We generally offer cash discounts to customers for the early payment of receivables. Those discounts are recorded as a reduction of revenue and accounts receivable in the same period that the related sale is recorded. The amounts reserved for cash discounts were $7.5 million and $6.3 million at December 31, 2014 and 2013, respectively. Provisions for cash discounts deducted from consolidated sales in 2014, 2013 and 2012 were $87.2 million, $76.9 million and $69.2 million, respectively. We permit returns of product from most product lines by any class of customer if such product is returned in a timely manner, in good condition and from normal distribution channels. Return policies in certain international markets and for certain medical device products, primarily breast implants, provide for more stringent guidelines in accordance with the terms of contractual agreements with customers. Our estimates for sales returns are based upon the historical patterns of product returns matched against sales, and management’s evaluation of specific factors that may increase the risk of product returns. The amount of allowances for sales returns recognized in our consolidated balance sheets at December 31, 2014 and 2013 were $83.4 million and $84.4 million, respectively, and are recorded in “Other accrued expenses” and “Trade receivables, net” in our consolidated balance sheets. See Note 5, “Composition of Certain Financial Statement Captions” in the notes to our consolidated financial statements listed under Item 15 of Part IV of this report, “Exhibits and Financial Statement Schedules.” Provisions for sales returns deducted from consolidated sales were $447.5 million, $465.0 million and $408.3 million in 2014, 2013 and 2012, respectively. The decrease in the provisions for sales returns in 2014 compared to 2013 is primarily due to a decrease in estimated product sales return rates for our breast aesthetics products, partially offset by increased overall product sales volume. The increase in the provisions for sales returns in 2013 compared to 2012 is primarily due to increased overall product sales volume and an increase in estimated product sales return rates for our breast aesthetics products, partially offset by a decrease in estimated product sales return rates for our skin care and other products. Actual historical allowances for cash discounts and product returns have been consistent with the amounts reserved or accrued. We participate in various U.S. federal and state government rebate programs, the largest of which are Medicaid, Medicare and the U.S. Department of Veterans Affairs. We also have contracts with various managed care and group purchasing organizations that provide for sales rebates and other contractual discounts. In the United States, we also incur chargebacks, which are reimbursements to wholesalers for honoring contracted prices to third parties. Outside of the United States, we incur sales allowances based on contractual provisions and legislative mandates. We also offer rebate and other incentive programs directly to our customers for our aesthetic products and certain therapeutic products, including Botox® for both therapeutic and cosmetic uses, the Juvéderm® franchise, Latisse®, Natrelle®, Acuvail®, Aczone® and Restasis®, and for certain other skin care products. Sales rebates and incentive accruals reduce revenue in the same period that the related sale is recorded and are included in “Other accrued expenses” in our consolidated balance sheets. The amounts accrued for sales rebates and other incentive programs were $372.1 million and $279.3 million at December 31, 2014 and 2013, respectively. Provisions for sales rebates and other incentive programs deducted from consolidated sales were $1,471.1 million, $1,151.2 million and $933.4 in 2014, 2013 and 2012, respectively. The $319.9 million increase in the provisions for sales rebates and other incentive programs in 2014 is due to a $121.6 million increase in provisions for rebates associated with U.S. federal and state government programs, a $37.0 million increase in managed health care rebates and other contractual discounts, an $84.6 million increase in chargebacks, primarily due to increases in the list prices of certain eye care pharmaceuticals products that are subject to fixed contractual prices with government agencies, a $21.9 million increase in sales allowances outside of the United States and a $54.8 million increase in provisions for consumer coupons and other customer incentives. The $217.8 million increase in the provisions for sales rebates and other incentive programs in 2013 is due to a $97.6 million increase in provisions for rebates associated with U.S. federal and state government programs, an $18.9 million increase in managed health care rebates and other contractual discounts, a $27.0 million increase in chargebacks, a $24.2 million increase in sales allowances outside of the United States and a $50.1 million increase in provisions for consumer coupons and other customer incentives. The increase in the provisions for sales rebates and other incentive programs in 2014 compared to 2013 and the increase in the provisions for sales rebates and other incentive programs in 2013 compared to 2012 are primarily due to increased eye care pharmaceutical sales in the United States and a shift in U.S. patient populations to government reimbursed programs, which typically have higher rebate percentages than other managed care programs. Rebates related to the Medicare Part D coverage gap in the United States increased in 2014 compared to 2013, primarily due to higher estimated utilization rates. Rebates related to the Medicare Part D coverage gap in the United States increased in 2013 compared to 2012, which we believe was primarily due to an increase in patients covered under employer group waiver plans. In addition, an increase in our published list prices in the United States for pharmaceutical products, which occurred for several of our products in each of 2014 and 2013, generally results in higher provisions for sales rebates and other incentive programs deducted from consolidated sales. Our procedures for estimating amounts accrued for sales rebates and other incentive programs at the end of any period are based on available quantitative data and are supplemented by management’s judgment with respect to many factors, including but not limited to, current market dynamics, changes in contract terms, changes in sales trends, an evaluation of current laws and regulations and product pricing. Quantitatively, we use historical sales, product utilization and rebate data and apply forecasting techniques in order to estimate our liability amounts. Qualitatively, management’s judgment is applied to these items to modify, if appropriate, the estimated liability amounts. There are inherent risks in this process. For example, customers may not achieve assumed utilization levels; customers may misreport their utilization to us; actual utilization and reimbursement rates under government rebate programs may differ from those estimated; and actual movements of the U.S. Consumer Price Index for All Urban Consumers, or CPI-U, which affect our rebate programs with U.S. federal and state government agencies, may differ from those estimated. On a quarterly basis, adjustments to our estimated liabilities for sales rebates and other incentive programs related to sales made in prior periods have not been material and have generally been less than 0.5% of consolidated product net sales. An adjustment to our estimated liabilities of 0.5% of consolidated product net sales on a quarterly basis would result in an increase or decrease to net sales and earnings before income taxes of approximately $9.0 million to $10.0 million. The sensitivity of our estimates can vary by program and type of customer. Additionally, there is a significant time lag between the date we determine the estimated liability and when we actually pay the liability. Due to this time lag, we record adjustments to our estimated liabilities over several periods, which can result in a net increase to earnings or a net decrease to earnings in those periods. Material differences may result in the amount of revenue we recognize from product sales if the actual amount of rebates and incentives differ materially from the amounts estimated by management. We recognize license fees, royalties and reimbursement income for services provided as other revenues based on the facts and circumstances of each contractual agreement. In general, we recognize income upon the signing of a contractual agreement that grants rights to products or technology to a third party if we have no further obligation to provide products or services to the third party after entering into the contract. We recognize contingent consideration earned from the achievement of a substantive milestone in its entirety in the period in which the milestone is achieved. We defer income under contractual agreements when we have further obligations that indicate that a separate earnings process has not been completed. Contingent Consideration Contingent consideration liabilities represent future amounts we may be required to pay in conjunction with various business combinations. The ultimate amount of future payments is based on specified future criteria, such as sales performance and the achievement of certain future development, regulatory and sales milestones and other contractual performance conditions. We estimate the fair value of the contingent consideration liabilities related to sales performance using the income approach, which involves forecasting estimated future net cash flows and discounting the net cash flows to their present value using a risk-adjusted rate of return. We estimate the fair value of the contingent consideration liabilities related to the achievement of future development and regulatory milestones by assigning an achievement probability to each potential milestone and discounting the associated cash payment to its present value using a risk-adjusted rate of return. We estimate the fair value of the contingent consideration liabilities associated with sales milestones by employing Monte Carlo simulations to estimate the volatility and systematic relative risk of revenues subject to sales milestone payments and discounting the associated cash payment amounts to their present values using a credit-risk-adjusted interest rate. The fair value of other contractual performance conditions is measured by assigning an achievement probability to each payment and discounting the payment to its present value using our estimated cost of borrowing. We evaluate our estimates of the fair value of contingent consideration liabilities on a periodic basis. Any changes in the fair value of contingent consideration liabilities are recorded through earnings as “Selling, general and administrative” in the accompanying consolidated statements of earnings. The total estimated fair value of contingent consideration liabilities was $365.9 million and $225.2 million at December 31, 2014 and 2013, respectively, and was included in “Other accrued expenses” and “Other liabilities” in our consolidated balance sheets. Pensions We sponsor various pension plans in the United States and abroad in accordance with local laws and regulations. Our U.S. pension plans account for a large majority of our aggregate pension plans' net periodic benefit costs and projected benefit obligations. In connection with these plans, we use certain actuarial assumptions to determine the plans' net periodic benefit costs and projected benefit obligations, the most significant of which are the expected long-term rate of return on assets and the discount rate. In October 2014, we announced that we had amended our U.S. qualified and unqualified defined benefit pension plans to close the plans to any future participant service credits (plan freeze) effective December 31, 2014. In December 2014, we announced that we had amended our Ireland and U.K. pension plans to close the plans to any future participant service credits effective December 31, 2014 and February 28, 2015, respectively. In conjunction with the plan freezes, we added one additional year of service credit to the calculation of benefits for all active members of the U.S., Ireland and U.K pension plans as of December 31, 2014. The effect of the plan amendments, the additional year of service credit and the related impact from severance actions associated with our 2014 restructuring plans resulted in a net decrease of $112.4 million in net accrued benefit costs on the balance sheet at December 31, 2014, a pre-tax settlement charge of $0.9 million and certain plan settlement payments of $2.2 million. Additionally, in 2014 we initiated and completed a program to offer voluntary lump-sum pension payouts to terminated vested participants of our U.S. qualified defined benefit pension plan. The program provided participants with a one-time choice of electing to receive a lump-sum settlement of their remaining pension benefit. As part of this voluntary lump-sum program, we paid approximately $63.6 million from our pension assets with a corresponding reduction in pension obligations and recognized an associated $13.0 million settlement charge. Our assumption for the weighted average expected long-term rate of return on assets in our U.S. funded pension plan for determining the net periodic benefit cost is 6.25% for 2014 and 2013 and 6.75% for 2012, respectively. Our assumptions for the weighted average expected long-term rate of return on assets in our non-U.S. funded pension plans are 4.56%, 4.36% and 4.80% for 2014, 2013 and 2012, respectively. For our U.S. funded pension plan, we determine, based upon recommendations from our pension plan's investment advisors, the expected rate of return using a building block approach that considers diversification and rebalancing for a long-term portfolio of invested assets. Our investment advisors study historical market returns and preserve long-term historical relationships between equities and fixed income in a manner consistent with the widely-accepted capital market principle that assets with higher volatility generate a greater return over the long run. They also evaluate market factors such as inflation and interest rates before long-term capital market assumptions are determined. For our non-U.S. funded pension plans, the expected rate of return was determined based on asset distribution and assumed long-term rates of return on fixed income instruments and equities. Market conditions and other factors can vary over time and could significantly affect our estimates of the weighted average expected long-term rate of return on plan assets. The expected rate of return is applied to the market-related value of plan assets. As a sensitivity measure, the effect of a 0.25% decline in our rate of return on assets assumptions for our U.S. and non-U.S. funded pension plans would increase our expected 2015 pre-tax pension benefit cost by approximately $2.4 million. The weighted average discount rates used to calculate our U.S. and non-U.S. pension benefit obligations at December 31, 2014 were 4.21% and 2.64%, respectively, and at December 31, 2013 were 5.05% and 4.19%, respectively. The weighted average discount rates used to calculate our U.S. and non-U.S. net periodic benefit costs for 2014 were 5.05% and 4.19%, respectively, for 2013, 4.23% and 4.55%, respectively, and for 2012, 4.63% and 5.14%, respectively. We determine the discount rate based upon a hypothetical portfolio of high quality fixed income investments with maturities that mirror the pension benefit obligations at the plans' measurement date. Market conditions and other factors can vary over time and could significantly affect our estimates for the discount rates used to calculate our pension benefit obligations and net periodic benefit costs for future years. As a sensitivity measure, the effect of a 0.25% decline in the discount rate assumption for our U.S. and non-U.S. pension plans would increase our expected 2015 pre-tax pension benefit costs by approximately $1.0 million and increase our pension plans' projected benefit obligations at December 31, 2014 by approximately $66.5 million. Share-Based Compensation We recognize compensation expense for all share-based awards made to employees and directors. The fair value of share-based awards is estimated at the grant date. The fair value of stock option awards that vest based on a service condition is estimated using the Black-Scholes option-pricing model. The fair value of share-based awards that contain a market condition is generally estimated using a Monte Carlo simulation model, and the fair value of modifications to share-based awards is generally estimated using a lattice model. The determination of fair value using the Black-Scholes, Monte Carlo simulation and lattice models is affected by our stock price as well as assumptions regarding a number of complex and subjective variables, including expected stock price volatility, risk-free interest rate, expected dividends and projected employee stock option exercise behaviors. We currently estimate stock price volatility based upon an equal weighting of the historical average over the expected life of the award and the average implied volatility of at-the-money options traded in the open market. We estimate employee stock option exercise behavior based on actual historical exercise activity and assumptions regarding future exercise activity of unexercised, outstanding options. Compensation expense for share-based awards based solely on a service condition is recognized only for those awards that are ultimately expected to vest, and we have applied an estimated forfeiture rate to unvested awards for the purpose of calculating compensation cost. These estimates will be revised in future periods if actual forfeitures differ from the estimates. Changes in forfeiture estimates impact compensation cost in the period in which the change in estimate occurs. Compensation expense for share-based awards based on a service condition is recognized over the requisite service period using the straight-line single option method. Compensation expense for share-based awards that contain a market condition is recognized over the requisite service period and is not subject to forfeiture unless the requisite service is not rendered prior to satisfaction of the market condition. Product Liability Self-Insurance We are largely self-insured for future product liability losses related to all of our products. We have historically been and continue to be self-insured for any product liability losses related to our breast implant products. Future product liability losses are, by their nature, uncertain and are based upon complex judgments and probabilities. The factors to consider in developing product liability reserves include the merits and jurisdiction of each claim, the nature and the number of other similar current and past claims, the nature of the product use and the likelihood of settlement. In addition, we accrue for certain potential product liability losses estimated to be incurred, but not reported, to the extent they can be reasonably estimated. We estimate these accruals for potential losses based primarily on historical claims experience and data regarding product usage. The total value of self-insured product liability claims settled in 2014, 2013 and 2012, respectively, and the value of known and reasonably estimable incurred but unreported self-insured product liability claims pending as of December 31, 2014 are not expected to have a material effect on our results of operations or liquidity. Income Taxes The provision for income taxes is determined using an estimated annual effective tax rate, which is generally less than the U.S. federal statutory rate, primarily because of lower tax rates in certain non-U.S. jurisdictions, research and development, or R&D, tax credits available in the United States, California and other foreign jurisdictions and deductions available in the United States for domestic production activities. Our effective tax rate may be subject to fluctuations during the year as new information is obtained, which may affect the assumptions used to estimate the annual effective tax rate, including factors such as the mix of pre-tax earnings in the various tax jurisdictions in which we operate, valuation allowances against deferred tax assets, the recognition or derecognition of tax benefits related to uncertain tax positions, expected utilization of R&D tax credits and changes in or the interpretation of tax laws in jurisdictions where we conduct business. The Tax Increase Prevention Act of 2014 was enacted on December 19, 2014 and retroactively reinstated the U.S. R&D tax credit to January 1, 2014. In the fourth quarter of 2014, the Company recognized the full year benefit of $19.8 million for the U.S. R&D tax credit for fiscal year 2014. We recognize deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities along with net operating loss and tax credit carryovers. We record a valuation allowance against our deferred tax assets to reduce the net carrying value to an amount that we believe is more likely than not to be realized. When we establish or reduce the valuation allowance against our deferred tax assets, our provision for income taxes will increase or decrease, respectively, in the period such determination is made. Valuation allowances against deferred tax assets were $39.1 million and $48.9 million at December 31, 2014 and 2013, respectively. Changes in the valuation allowances are generally recognized in the provision for income taxes as a component of the estimated annual effective tax rate. We have not provided for withholding and U.S. taxes for the unremitted earnings of certain non-U.S. subsidiaries because we have currently reinvested these earnings indefinitely in these foreign operations. At December 31, 2014, we had approximately $4,485.3 million in unremitted earnings outside the United States for which withholding and U.S. taxes were not provided. Income tax expense would be incurred if these earnings were remitted to the United States. It is not practicable to estimate the amount of the deferred tax liability on such unremitted earnings. Upon remittance, certain foreign countries impose withholding taxes that are then available, subject to certain limitations, for use as credits against our U.S. tax liability, if any. We annually update our estimate of unremitted earnings outside the United States after the completion of each fiscal year. Acquisitions The accounting for acquisitions requires extensive use of estimates and judgments to measure the fair value of the identifiable tangible and intangible assets acquired, including in-process research and development, and liabilities assumed. Additionally, we must determine whether an acquired entity is considered to be a business or a set of net assets, because the excess of the purchase price over the fair value of net assets acquired can only be recognized as goodwill in a business combination. On August 13, 2014, we acquired LiRIS Biomedical, Inc., or LiRIS, for $67.5 million in cash and estimated contingent consideration of $170.5 million as of the acquisition date. On March 1, 2013, we acquired MAP Pharmaceuticals, Inc., or MAP, for an aggregate purchase price of approximately $871.7 million, net of cash acquired. On April 12, 2013, we acquired Exemplar Pharma, LLC, or Exemplar, for an aggregate purchase price of approximately $16.1 million, net of cash acquired. We accounted for these acquisitions as business combinations. In March 2014, we completed the acquisition of certain assets related to technology under development for use as a dermal filler from Aline Aesthetics, LLC and Tautona Group, L.P. for an upfront payment of $10.0 million and potential future payments for certain milestone events. We accounted for this acquisition as a purchase of net assets. The tangible and intangible assets acquired and liabilities assumed in connection with these acquisitions were recognized based on their estimated fair values at the acquisition dates. The determination of estimated fair values requires significant estimates and assumptions including, but not limited to, determining the timing and estimated costs to complete the in-process projects, projecting regulatory approvals, estimating future cash flows and developing appropriate discount rates. We believe the estimated fair values assigned to the assets acquired and liabilities assumed are based on reasonable assumptions. Impairment Evaluations for Goodwill and Intangible Assets We evaluate goodwill for impairment on an annual basis, or more frequently if we believe indicators of impairment exist. We have identified two reporting units, specialty pharmaceuticals and medical devices, and perform our annual evaluation as of October 1 each year. For our specialty pharmaceuticals reporting unit, we performed a qualitative assessment to determine whether it is more likely than not that its fair value is less than its carrying amount. For our medical devices reporting unit, we evaluated goodwill for impairment by comparing its carrying value to its estimated fair value. We primarily use the income approach and the market approach that include the discounted cash flow method, the guideline company method, as well as other generally accepted valuation methodologies to determine the fair value. Upon completion of the October 2014 annual impairment assessment, we determined that no impairment was indicated. As of December 31, 2014, we are not aware of any significant indicators of impairment that exist for our goodwill that would require additional analysis. We also review intangible assets for impairment when events or changes in circumstances indicate that the carrying value of our intangible assets may not be recoverable. An impairment in the carrying value of an intangible asset is recognized whenever anticipated future undiscounted cash flows from an intangible asset are estimated to be less than its carrying value. As of December 31, 2014, we believe that the carrying values of our amortizable intangible assets are recoverable and the fair value exceeds the carrying value of our indefinite-lived in-process research and development intangible assets. In the fourth quarter of 2013, we recorded a pre-tax charge of $11.4 million related to the impairment of an intangible asset for distribution rights acquired in connection with our 2011 acquisition of Precision Light, Inc. as a result of our decision to discontinue the sale of products related to those distribution rights. In the fourth quarter of 2012, we recorded a pre-tax charge of $17.0 million related to the partial impairment of an indefinite-lived in-process research and development asset acquired in connection with our 2011 acquisition of Vicept Therapeutics, Inc., or Vicept. The impairment charge was recognized because the carrying amount of the asset was determined to be in excess of its estimated fair value. Significant management judgment is required in the forecasts of future operating results that are used in our impairment evaluations. The estimates we have used are consistent with the plans and estimates that we use to manage our business. It is possible, however, that the plans may change and estimates used may prove to be inaccurate. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur future impairment charges. Continuing Operations Headquartered in Irvine, California, we are a multi-specialty health care company focused on developing and commercializing innovative pharmaceuticals, biologics, medical devices and over-the-counter products that enable people to live life to its full potential - to see more clearly, move more freely and express themselves more fully. We discover, develop and commercialize a diverse range of products for the ophthalmic, neurological, medical aesthetics, medical dermatology, breast aesthetics, urological and other specialty markets in more than 100 countries around the world. We are also a pioneer in specialty pharmaceutical, biologic and medical device research and development. Our research and development efforts are focused on products and technologies related to the many specialty areas in which we currently operate as well as new specialty areas where unmet medical needs are significant. We supplement our own research and development activities with our commitment to identify and obtain new technologies through in-licensing, research collaborations, joint ventures and acquisitions. At December 31, 2014, we employed approximately 10,500 persons around the world. Our principal geographic markets are the United States, Europe, Latin America and Asia Pacific. Results of Continuing Operations We operate our business on the basis of two reportable segments - specialty pharmaceuticals and medical devices. The specialty pharmaceuticals segment produces a broad range of pharmaceutical products, including: ophthalmic products for dry eye, glaucoma, inflammation, infection, allergy and retinal disease; Botox® for certain therapeutic and aesthetic indications; skin care products for acne, psoriasis, eyelash growth and other prescription and physician-dispensed skin care products; and urologics products. The medical devices segment produces a broad range of medical devices, including: breast implants for augmentation, revision and reconstructive surgery and tissue expanders; and facial aesthetics products. We provide global marketing strategy teams to coordinate the development and execution of a consistent marketing strategy for our products in all geographic regions that share similar distribution channels and customers. Management evaluates our business segments and various global product portfolios on a revenue basis, which is presented below in accordance with GAAP. We also report sales performance using the non-GAAP financial measure of constant currency sales. Constant currency sales represent current period reported sales, adjusted for the translation effect of changes in average foreign exchange rates between the current period and the corresponding period in the prior year. We calculate the currency effect by comparing adjusted current period reported sales, calculated using the monthly average foreign exchange rates for the corresponding period in the prior year, to the actual current period reported sales. We routinely evaluate our net sales performance at constant currency so that sales results can be viewed without the impact of changing foreign currency exchange rates, thereby facilitating period-to-period comparisons of our sales. Generally, when the U.S. dollar either strengthens or weakens against other currencies, the growth at constant currency rates will be higher or lower, respectively, than growth reported at actual exchange rates. The following table compares net sales by product line within each reportable segment and certain selected pharmaceutical products for the years ended December 31, 2014, 2013 and 2012: ---------- (a) Percentage change in selected product net sales is calculated on amounts reported to the nearest whole dollar. Total glaucoma products include the Alphagan® and Lumigan® franchises. Product Net Sales Product net sales increased by $928.6 million in 2014 compared to 2013 due to an increase of $673.1 million in our specialty pharmaceuticals product net sales, an increase of $213.1 million in our core medical devices product net sales, and an increase of $42.4 million of sales made pursuant to transition services agreements with Apollo Endosurgery, Inc., or Apollo, related to the disposition of our obesity intervention business unit. The increase in specialty pharmaceuticals product net sales is due to increases in product net sales of our eye care pharmaceuticals, Botox®, and skin care and other product lines. The increase in core medical devices product net sales reflects an increase in product net sales of our facial aesthetics and breast aesthetics product lines. Several of our products, including Botox® Cosmetic, Latisse®, over-the-counter artificial tears, non-prescription aesthetics skin care products, facial aesthetics and breast implant products, as well as, in emerging markets, Botox® for therapeutic use and eye care products, are purchased based on consumer choice and have limited reimbursement or are not reimbursable by government or other health care plans and are, therefore, partially or wholly paid for directly by the consumer. As such, the general economic environment and level of consumer spending have a significant effect on our sales of these products. In the United States, sales of our products that are reimbursable by government health care plans continue to be significantly impacted by the provisions of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Affordability Reconciliation Act, collectively, the PPACA, which extended Medicaid and Medicare benefits to new patient populations and increased Medicaid and Medicare rebates. Additionally, sales of our products in the United States that are reimbursed by managed care programs continue to be impacted by competitive pricing pressures. In Europe and some other international markets, sales of our products that are reimbursable by government health care plans continue to be impacted by mandatory price reductions, tenders and rebate increases. Certain of our products face generic competition and our products also compete with generic versions of some branded pharmaceutical products sold by our competitors. A generic version of Latisse®, our treatment for inadequate or insufficient eyelashes, was approved by the U.S. Food and Drug Administration, or FDA, in December 2014, and we expect to face generic competition for Latisse® in 2015. In October 2013, a generic version of Zymaxid®, our fluoroquinolone indicated for the treatment of bacterial conjunctivitis, was launched in the United States. In 2011, the U.S. patent for Tazorac®cream, indicated for psoriasis and acne, expired. The U.S. patents for Tazorac® gel expired in June 2014. The FDA has posted guidance regarding requirements for clinical bioequivalence for a generic of tazarotene cream, separately for both psoriasis and acne. We believe that this will require generic manufacturers to conduct a trial, at risk, for both indications. In 2013, the FDA published draft guidance that proposes certain approaches for demonstrating bioequivalence in abbreviated new drug applications referring to the new drug application related to Restasis®. In response to the draft guidance, we submitted a Citizen Petition to the FDA, which the FDA granted in-part and denied in-part in November 2014. In January 2014, we received a paragraph 4 Hatch-Waxman Act certification stating that Watson Laboratories, Inc., a division of Actavis plc, had submitted an abbreviated new drug application, or ANDA, to the FDA seeking approval to market a generic version of our Restasis® product. In December 2014, the U.S. District Court for the Eastern District of Texas, in relevant part, dismissed a related legal proceeding that a case or controversy was not ripe because the Watson ANDA had not been received by the FDA. Also in December 2014, we submitted a revised Citizen Petition to the FDA. There remains uncertainty as to the status of any ANDA filers with respect to Restasis®. Since the FDA’s draft guidance was published in 2013, we have obtained four additional U.S. patents covering the specific formulation and the method of using our Restasis® product. Although generic competition in the United States negatively affected our aggregate product net sales in 2014, the impact was not material. We do not currently believe that our aggregate product net sales will be materially impacted in 2015 by generic competition, but we could experience a rapid and significant decline in net sales of certain products if we are unable to successfully maintain or defend our patents and patent applications relating to such products. For a more complete discussion of the risks relating to generic competition and patent protection, see Item 1A of Part I of this report, “Risk Factors - We may be unable to obtain and maintain adequate protection for our intellectual property rights.” Eye care pharmaceuticals product net sales increased in 2014 compared to 2013 due to increases in the United States, Canada, Europe and Asia Pacific, partially offset by a decrease in sales in Latin America due primarily to the negative translation effect of average foreign currency exchange rates in effect during 2014 compared to 2013. When measured at constant currency, net sales of eye care pharmaceutical products in Latin America increased in 2014 compared to 2013. The overall increase in total sales in dollars of our eye care pharmaceutical products in 2014 compared to 2013 is primarily due to an increase in sales of Restasis®, our therapeutic treatment for chronic dry eye disease, an increase in sales of Ozurdex®, our biodegradable, sustained-release steroid implant for the treatment of certain retinal diseases, an increase in sales of Ganfort™, our Lumigan® and timolol combination for the treatment of glaucoma, an increase in sales of our glaucoma products Lumigan® 0.03%, Lumigan® 0.01%, Combigan®, Alphagan® P 0.1% and Alphagan® P 0.15%, an increase in sales of eye care products, prednisolone acetate and fluorometholone, by our generics division, Pacific Pharma, Inc., an increase in our non-steroidal anti-inflammatory drug Acular LS®, and an increase of $30.7 million in sales of our artificial tears products, primarily consisting of Refresh® and Optive™ lubricant eye drops, partially offset by a decrease in sales of our fluoroquinolone products Zymaxid® and Zymar®, a decrease in sales of Lastacaft®, our topical allergy medication for the treatment and prevention of itching associated with allergic conjunctivitis, and a decrease in sales of our older-generation anti-inflammatory drug Acular®. We increased prices on certain eye care pharmaceutical products in the United States in 2014. Effective January 1, 2014, we increased the published U.S. list price for Restasis®, Lumigan® 0.01%, Lastacaft®, Combigan®, Alphagan® P 0.1%, Alphagan® P 0.15%, Acular®, Acuvail® and Zymaxid® by seven percent. Effective July 8, 2014, we increased the published U.S. list price for Alphagan® P 0.1%, Combigan®, Lumigan® 0.01% and Restasis® by an additional three percent. These price increases had a positive net effect on our U.S. sales in 2014 compared to 2013, but the actual net effect is difficult to determine due to the various managed care sales rebate and other incentive programs in which we participate. Wholesaler buying patterns and the change in dollar value of the prescription product mix also affected our reported net sales dollars, although we are unable to determine the impact of these effects. Total sales of Botox® increased in 2014 compared to 2013 due to growth in sales for both therapeutic and cosmetic uses. Sales of Botox® for therapeutic use increased in the United States, Canada, Europe, and Asia Pacific, primarily due to strong growth in sales for the prophylactic treatment of chronic migraine and for the treatment of urinary incontinence, partially offset by a decline in sales in Latin America. Sales of Botox® for cosmetic use increased in the United States and Europe, partially offset by a decline in sales in Canada and Latin America. The decline in net sales of Botox® for both therapeutic and cosmetic use in Latin America was primarily due to decreases in sales in Venezuela related to the economic turmoil in that country and lack of foreign exchange. The decline in net sales in Canada resulted from the launches of two competitive products. The increase in sales of Botox® for cosmetic use in the United States and Europe was primarily attributable to higher unit volume. Additionally, sales of Botox® for both therapeutic and cosmetic uses in the United States were positively impacted by an increase in the U.S. list price for Botox® of three percent that was effective January 1, 2014. Based on internal information and assumptions, we estimate in 2014 that Botox® therapeutic sales accounted for approximately 55% of total consolidated Botox® sales and increased by approximately 15% compared to 2013. In 2014, Botox® Cosmetic sales accounted for approximately 45% of total consolidated Botox® sales and increased by approximately 10% compared to 2013. We believe our worldwide market share for neuromodulators, including Botox®, was approximately 75% in the third quarter of 2014, the last quarter for which market data is available. Skin care and other product net sales increased in 2014 compared to 2013 primarily due to an increase of $56.4 million in sales of Aczone®, our topical dapsone treatment for acne vulgaris, an increase of $8.3 million in SkinMedica physician dispensed aesthetic skin care products, and an increase of $2.5 million in sales of our topical tazarotene products Tazorac® and Avage®, partially offset by a $1.4 million decrease in sales of Latisse®. The increase in sales of Aczone® is primarily attributable to an increase in product sales volume and an increase in the U.S. list price. The U.S. list prices for Aczone® and our topical tazarotene products Tazorac® and Avage® were increased by five percent effective January 1, 2014, and an additional five percent effective May 3, 2014. We have a policy to attempt to maintain average U.S. wholesaler inventory levels of our specialty pharmaceuticals products at an amount less than eight weeks of our net sales. At December 31, 2014, based on available external and internal information, we believe the amount of average U.S. wholesaler inventories of our specialty pharmaceutical products was at the lower end of our stated policy levels. Breast aesthetics product net sales, which consist primarily of sales of silicone gel and saline breast implants and tissue expanders, increased in 2014 compared to 2013 due to increases in the United States, Canada, Latin America and Asia Pacific. The increase in sales of breast aesthetics products in Canada, Latin America and Asia Pacific was primarily due to higher implant unit volume. The increase in sales of breast aesthetics products in the United States was primarily due to new product sales related to the recent launch of our Seri® Surgical Scaffold product, which is indicated for use as a transitory scaffold for soft tissue support and repair, and a beneficial change in implant product mix to higher priced round and shaped silicone gel products, partially offset by lower implant volume. Total sales of tissue expanders increased $1.9 million and total sales of silicone gel and saline breast implants, accessories and Seri® Surgical Scaffold products increased $26.9 million in 2014 compared to 2013. Facial aesthetics product net sales, which consist primarily of sales of hyaluronic acid-based dermal fillers used to correct facial wrinkles, increased in 2014 compared to 2013 due to strong growth in all of our principal geographic regions. The increase in sales of facial aesthetics products in the United States was due primarily to an overall increase in unit volume due to the recent launch of Juvéderm® Voluma™. The increase in sales of facial aesthetics products in international markets was due primarily to an overall increase in unit volume of Juvéderm® Voluma™, Juvéderm® Volift™ and Juvéderm® Volbella™. Foreign currency changes decreased product net sales by $93.0 million in 2014 compared to 2013, primarily due to the weakening of the euro, Canadian dollar, Brazilian real, Argentine peso, Turkish lira and Australian dollar compared to the U.S. dollar, partially offset by the strengthening of the U.K. pound compared to the U.S. dollar. U.S. product net sales as a percentage of total product net sales increased by 1.4 percentage points to 63.4% in 2014 compared to U.S. sales of 62.0% in 2013, due primarily to higher sales growth in the U.S. market compared to our international markets for our Botox®, eye care pharmaceuticals, and facial aesthetics product lines, partially offset by higher sales growth in international markets compared to the U.S. market for our breast aesthetics product line. Product net sales increased by $648.2 million in 2013 compared to 2012 due to an increase of $554.4 million in our specialty pharmaceuticals product net sales, an increase of $90.7 million in our core medical devices product net sales, and $3.1 million of sales made pursuant to transition services agreements with Apollo related to the disposition of our obesity intervention business unit. The increase in specialty pharmaceuticals product net sales is due to increases in product net sales of our eye care pharmaceuticals, Botox®, and skin care and other product lines. The increase in core medical devices product net sales reflects an increase in product net sales of our facial aesthetics product line and a small increase in sales of breast aesthetics products. Eye care pharmaceuticals product net sales increased in 2013 compared to 2012 in all of our principal geographic markets. The overall increase in total sales in dollars of our eye care pharmaceutical products is primarily due to an increase in sales of Restasis®, an increase in sales of our glaucoma drug Lumigan® 0.01%, an increase in sales of Ozurdex®, our biodegradable, sustained-release steroid implant for the treatment of certain retinal diseases, an increase in sales of Ganfort™, our Lumigan® and timolol combination for the treatment of glaucoma, an increase in sales of Lastacaft®, our topical allergy medication for the treatment and prevention of itching associated with allergic conjunctivitis, an increase in sales of our glaucoma products Combigan®, Alphagan® P 0.1% and Alphagan® P 0.15%, and an increase of $19.3 million in sales of our artificial tears products, primarily consisting of Refresh® and Optive™ lubricant eye drops, partially offset by a decrease in sales of our older-generation glaucoma drug Lumigan® 0.03% and our fluoroquinolone product Zymaxid®. Due to the strong acceptance of Lumigan® 0.1% in the U.S. market, we ceased manufacturing Lumigan® 0.3% for the U.S. market in the fourth quarter of 2012. We increased prices on certain eye care pharmaceutical products in the United States in 2013. Effective January 5, 2013, we increased the published U.S. list price for Restasis®, Lastacaft® and Zymaxid® by five percent, Combigan® and Alphagan® P 0.1% by seven percent, Lumigan® 0.1% and Alphagan® P 0.15% by eight percent, and Acular®, Acular LS® and Acuvail® by eighteen percent. Effective May 18, 2013, we increased the published U.S. list price for Restasis®, Alphagan® P 0.1%, Alphagan® P 0.15% and Lastacaft® by an additional five percent and Zymaxid®, Acular®, Acular LS® and Acuvail® by an additional six percent. Effective November 23, 2013, we increased the published U.S. list price for Acular LS® by an additional ten percent. These price increases had a positive net effect on our U.S. sales in 2013 compared to 2012, but the actual net effect is difficult to determine due to the various managed care sales rebate and other incentive programs in which we participate. Wholesaler buying patterns and the change in dollar value of the prescription product mix also affected our reported net sales dollars, although we are unable to determine the impact of these effects. Total sales of Botox® increased in 2013 compared to 2012 due to strong growth in sales for both therapeutic and cosmetic uses. Sales of Botox® for therapeutic use increased in all of our principal geographic markets, primarily due to strong growth in sales for the prophylactic treatment of chronic migraine and an increase in sales for the treatment of urinary incontinence. Sales of Botox® for cosmetic use increased in the United States, Latin America, Europe and Asia, partially offset by a decline in sales in Canada due primarily to the introduction of competitive products in that market. Based on internal information and assumptions, we estimate in 2013 that Botox® therapeutic sales accounted for approximately 54% of total consolidated Botox® sales and increased by approximately 17% compared to 2012. In 2013, Botox® Cosmetic sales accounted for approximately 46% of total consolidated Botox® sales and increased by approximately 8% compared to 2012. In March 2012, a U.S. District Court, after conducting a full trial, ruled that Merz Pharmaceuticals and Merz Aesthetics, or, jointly, Merz, violated California's Uniform Trade Secrets Act and issued an injunction prohibiting Merz from providing, selling or soliciting purchases of Xeomin® or its Radiesse® dermal filler products, provided that Merz may sell Xeomin® in the therapeutic market to customers not identified on court mandated exclusion lists and may sell dermal filler products to certain pre-existing customers. On October 1, 2012, the Company announced that the U.S. District Court had entered an order providing that the injunction related to Xeomin® for the facial aesthetics market would remain in place until January 9, 2013. The injunction related to Xeomin® for therapeutic use and Radiesse® was in effect until November 1, 2012. Skin care and other product net sales increased in 2013 compared to 2012 primarily due to an increase of $47.5 million in sales of Aczone®, our topical dapsone treatment for acne vulgaris, new product sales of $81.7 million from a variety of physician-dispensed aesthetic skin care products acquired in our recent acquisition of SkinMedica, an increase of $29.9 million in sales of our topical tazarotene products Tazorac®, Zorac® and Avage®, and a $2.7 million increase in sales of Latisse®, our treatment for inadequate or insufficient eyelashes, partially offset by a decrease of $19.9 million in sales of our Sanctura® franchise products for the treatment of overactive bladder, or OAB, due to a decline in unit volume related to the launch of competitive generic versions of Sanctura XR® in the United States since October 2012. The increases in sales of Aczone® and our topical tazarotene products Tazorac®, Zorac® and Avage® are primarily attributable to an increase in sales volume and an increase in the U.S. list price for these products of five percent that was effective May 18, 2013. The increase in sales of Latisse® is primarily attributable to an increase in product sales volume and an increase in the U.S. wholesale list price of between six to nine percent, depending on product size, that was effective March 16, 2013. Breast aesthetics product net sales, which consist primarily of sales of silicone gel and saline breast implants and tissue expanders, increased slightly in 2013 compared to 2012 due to increases in sales in the United States and Asia, partially offset by a decrease in sales in Latin America and, to a lesser degree, Europe. The increase in sales of breast aesthetics products in the United States was primarily due to a beneficial change in implant product mix to higher priced round and shaped silicone gel products and higher tissue expander unit volume from lower priced saline products, partially offset by a small decline in implant unit volume. The increase in sales in Asia benefited from strong growth in Japan and China. The overall decrease in sales of breast aesthetics products in Latin America was primarily due to lower unit volume shipped to distributors in Mexico and Colombia where we plan to begin direct selling operations for breast aesthetics products in 2014. In Europe, sales of breast aesthetics products declined slightly in 2013 compared to 2012 due primarily to extraordinarily high sales in 2012 following a regulatory action by the French Government to shut down a manufacturer using industrial grade silicone in their breast implants. Many of the resultant revision surgeries occurred with our implants. Sales of tissue expanders increased $8.8 million and total sales of silicone gel and saline breast implants and accessories decreased $8.0 million in 2013 compared to 2012. Facial aesthetics product net sales, which consist primarily of sales of hyaluronic acid-based dermal fillers used to correct facial wrinkles, increased in 2013 compared to 2012 due to strong growth in all of our principal geographic markets. The increase in sales of facial aesthetics products in the United States was due primarily to an overall increase in unit volume due to an expansion of the dermal filler market, an increase in market share and an increase in the U.S. list price for Juvéderm® products of three percent that was effective March 4, 2013. In December 2013, we launched Juvéderm® Voluma™ XC, our dermal filler indicated for temporary correction of age-related volume loss in the mid-face, in the United States. The increase in sales of facial aesthetics products in Europe, Latin America and Asia Pacific was due primarily to recent launches of Juvéderm® Voluma™, Juvéderm® Volift™ and Juvéderm® Volbella™ in those markets. Foreign currency changes decreased product net sales by $41.1 million in 2013 compared to 2012, primarily due to the weakening of the Brazilian real, Canadian dollar, Australian dollar, Turkish lira and Indian rupee compared to the U.S. dollar, partially offset by the strengthening of the euro compared to the U.S. dollar. U.S. product net sales as a percentage of total product net sales increased by 1.1 percentage points to 62.0% in 2013 compared to U.S. sales of 60.9% in 2012, due primarily to higher sales growth in the U.S. market compared to our international markets for our Botox® product line, skin care and other products, which are highly concentrated in the United States, and breast aesthetics product line. Other Revenues Other revenues increased $8.9 million to $111.8 million in 2014 compared to $102.9 million in 2013. The increase in other revenues is primarily due to the achievement of a sales milestone related to sales of Lumigan® in Japan and an increase in royalty income from sales of Aiphagan® in Japan under a license agreement with Senju Pharmaceutical Co., Ltd., or Senju, and sales of brimonidine products in the United States under a license agreement with Alcon, Inc., or Alcon, partially offset by a decrease in royalty income from sales of Lumigan® in Japan under a license agreement with Senju, which were negatively impacted by the decline in average Japanese yen exchange rates in effect during 2014 compared to 2013. Other revenues increased $5.6 million to $102.9 million in 2013 compared to $97.3 million in 2012. The increase in other revenues is primarily due to an increase in royalty income, partially offset by a decline in substantive milestone event revenue. No substantive milestone event revenue was recorded in 2013. In 2012, other revenues included the achievement of substantive milestones related to the approval of Aiphagan® ophthalmic solution 0.1%, or Aiphagan®, in Japan and the achievement of two sales milestones related to sales of Lumigan® in Japan. The increase in royalty income in 2013 compared to 2012 is primarily due to an increase in sales of Aiphagan® in Japan under a license agreement with Senju, an increase in sales of brimonidine products in the United States under a license agreement with Alcon, and an increase in sales of Botox® for therapeutic use in Japan and China under a licensing agreement with GlaxoSmithKline, partially offset by a decrease in royalties from sales of Lumigan® in Japan under a license agreement with Senju, which were negatively impacted by the Japanese yen exchange rates in effect during 2013 compared to 2012. Income and Expenses The following table sets forth the relationship to product net sales of various items in our consolidated statements of earnings: Cost of Sales Cost of sales increased $46.6 million, or 5.9%, in 2014 to $842.4 million, or 11.8% of product net sales, compared to $795.8 million, or 12.8% of product net sales in 2013. Cost of sales in 2013 includes $8.9 million for the purchase accounting fair market value inventory adjustment rollout related to our acquisition of SkinMedica. Excluding the effect of this charge, cost of sales increased $55.5 million, or 7.1% in 2014 compared to 2013. This increase in cost of sales primarily resulted from the 15.0% increase in total product net sales, partially offset by a decrease in cost of sales as a percentage of product net sales primarily due to beneficial changes in product and geographic mix and lower royalty expenses. Cost of sales increased $44.6 million, or 5.9%, in 2013 to $795.8 million, or 12.8% of product net sales, compared to $751.2 million, or 13.5% of product net sales in 2012. Cost of sales in 2013 includes $8.9 million for the purchase accounting fair market value inventory adjustment rollout related to our acquisition of SkinMedica. Cost of sales in 2012 includes $0.3 million for the purchase accounting fair market value inventory adjustment rollout related to the purchase of our distributor's business in Russia. Excluding the effect of the charges described above, cost of sales increased $36.0 million, or 4.8%, to $786.9 million, or 12.7% of product net sales in 2013 compared to $750.9 million, or 13.5% of product net sales, in 2012. This increase in cost of sales primarily resulted from the 11.7% increase in total product net sales, partially offset by a decrease in cost of sales as a percentage of product net sales primarily due to lower royalty expenses, lower provisions for inventory reserves, and beneficial changes in standard costs, geographic mix and product mix. Selling, General and Administrative Selling, general and administrative, or SG&A, expenses increased $317.8 million, or 12.6%, to $2,837.2 million, or 39.8% of product net sales, in 2014 compared to $2,519.4 million, or 40.7% of product net sales, in 2013. SG&A expenses in 2014 include $128.0 million of expenses associated with the Allergan Board of Directors' consideration of unsolicited proposals from Valeant to acquire all of the outstanding shares of Allergan, a $37.3 million charge for estimated bad debts in Venezuela due to changes in that country's foreign currency exchange system and administration by the National Center for Foreign Commerce, or CENCOEX, which is severely limiting U.S. dollar payments for older receivables due from local customers, a $32.2 million estimated expense catch-up adjustment in accordance with final regulations issued by the IRS governing administration of the annual fee on branded prescription drug manufacturers and importers, $57.5 million of expenses related to the global restructuring announced in July 2014, $2.3 million of transaction and integration costs related to business combinations and license agreements, expenses of $6.1 million related to the January 2014 realignment of various business functions, $4.4 million of costs related to the announced Actavis transaction and pre-integration planning and $15.1 million of income related to the change in fair value of contingent consideration liabilities associated with certain business combinations. SG&A expenses in 2013 include $20.6 million of transaction and integration costs related to business combinations and license agreements, a $70.7 million charge related to the change in fair value of contingent consideration liabilities associated with certain business combinations, expenses of $1.7 million related to the realignment of various business functions and expenses of $3.1 million for external costs of stockholder derivative litigation associated with the 2010 global settlement with the U.S. Department of Justice, or DOJ, regarding our past U.S. sales and marketing practices relating to certain therapeutic uses of Botox® and other legal contingency expenses. Excluding the effect of the items described above, SG&A expenses increased $161.2 million, or 6.7%, to $2,584.5 million, or 36.3% of product net sales, in 2014 compared to $2,423.3 million, or 39.1% of product net sales in 2013. The increase in SG&A expenses in dollars, excluding the charges described above, primarily relates to increases in promotion, selling, marketing and general and administrative expenses. The increase in promotion expenses in 2014 is primarily due to an increase in direct-to-consumer advertising in the United States for Botox® for the treatment of urinary incontinence and chronic migraine, Juvéderm® Voluma™, which was recently launched in the United States, Botox® Cosmetic and Aczone®. The increase in selling expenses in 2014 compared to 2013 principally relates to increased personnel and related incentive compensation costs that support the 15.0% increase in product net sales, including sales force expansions in Europe, Africa and Middle East and Asia. The increase in marketing expenses in 2014 is primarily due to product launch support costs in the United States related to Juvéderm® Voluma™ and Seri® Surgical Scaffold products. General and administrative expenses increased in 2014 compared to 2013 primarily due to higher personnel and related incentive compensation costs, an increase in the estimated expense for our share of the annual non-deductible fee on entities that sell branded prescription drugs to specified U.S. government programs, additional costs associated with the transition services agreements with Apollo, an increase in bad debt expense and an increase in information services and finance support costs, partially offset by a decrease in legal expenses. Under the provisions of the PPACA, companies that sell branded prescription drugs or biologics to specified government programs in the United States are subject to an annual non-deductible fee based on the company's relative market share of branded prescription drugs or biologics sold to the specified government programs. We recorded SG&A expenses of approximately $64 million (including the $32 million expense catch-up adjustment) and $24 million related to the non-deductible fee in 2014 and 2013, respectively. Also under the provisions of the PPACA, we are required to pay a tax deductible excise tax of 2.3% on the sale of certain medical devices. We recorded SG&A expenses of approximately $11.5 million and $8.6 million related to the medical device excise tax in 2014 and 2013, respectively. SG&A expenses increased $326.3 million, or 14.9%, to $2,519.4 million, or 40.7% of product net sales, in 2013 compared to $2,193.1 million, or 39.5% of product net sales, in 2012. SG&A expenses in 2013 include $20.6 million of transaction and integration costs related to business combinations and license agreements, a $70.7 million charge related to the change in fair value of contingent consideration liabilities associated with certain business combinations, expenses of $1.7 million related to the realignment of various business functions and expenses of $3.1 million for external costs of stockholder derivative litigation associated with the 2010 global settlement with the DOJ discussed above and other legal contingency expenses. SG&A expenses in 2012 include aggregate expenses of $9.7 million for external costs of stockholder derivative litigation and other legal costs associated the 2010 global settlement with the DOJ discussed above and other legal contingency expenses, a $5.4 million charge related to the change in fair value of contingent consideration liabilities associated with certain business combinations, and $1.5 million of transaction and integration costs related to our acquisition of SkinMedica. Excluding the effect of the items described above, SG&A expenses increased $246.8 million, or 11.3%, to $2,423.3 million, or 39.1% of product net sales, in 2013 compared to $2,176.5 million, or 39.2% of product net sales in 2012. The increase in SG&A expenses in dollars, excluding the charges described above, primarily relates to increases in selling expenses, promotion expenses, and general and administrative expenses. The increase in selling expenses in 2013 compared to 2012 principally relates to increased personnel and related incentive compensation costs that support the 11.7% increase in product net sales, including the acquisition of the SkinMedica sales force and other sales force expansions in the United States, Europe and Asia. The increase in promotion expenses is primarily due to an increase in direct-to-consumer advertising in the United States for Aczone®, Botox® for the treatment of chronic migraine and Restasis®. The increase in general and administrative expenses primarily relates to higher personnel and related incentive compensation costs, the new medical device excise tax in the United States, an increase in bad debt expense and higher facilities, human resources, information services and finance support costs, partially offset by a decrease in legal expenses, losses from the disposal of fixed assets and a reduction in the estimated expense for our share of the annual non-deductible fee on entities that sell branded prescription drugs to specified government programs in the United States. We recorded SG&A expenses of approximately $24 million and $27 million in 2013 and 2012, respectively, related to the annual non-deductible fee imposed by the PPACA on companies that sell branded prescription drugs or biologics to specified government programs in the United States. Research and Development We believe that our future medium- and long-term revenue and cash flows are most likely to be affected by the successful development and approval of our significant late-stage research and development candidates. As of December 31, 2014, we have the following significant R&D projects in late-stage development: • SempranaTM - formerly referred to as Levadex®(U.S. - Filed/Allergan addressing FDA Complete Response Letter) for migraine • Restasis® (Europe - Phase III) for ocular surface disease • Ser-120 (U.S. - Phase III) for nocturia (in collaboration with Serenity) • Abicipar pegol - Anti-VEGF DARPin® (U.S. - advancing to Phase III) for neovascular age-related macular degeneration • Bimatoprost sustained-release implant (U.S. - Phase III) for glaucoma • Botox® (U.S. - Phase III) for juvenile cerebral palsy • Aczone® X (U.S. - Phase III) for acne vulgaris • AGN-199201 (U.S. - Phase III) for rosacea On June 30, 2014 we announced completion of the topline analysis of data from our stage 3, Phase II study of abicipar pegol (Anti-VEGF DARPin®) in neovascular, or “wet,” age-related macular degeneration. These data along with data from previous studies were reviewed with the FDA at an end of Phase II meeting where the FDA supported our decision to advance abicipar pegol to Phase III clinical trials and agreed with the proposed Phase III study plan. We expect to initiate the Phase III trials in the second quarter of 2015. On June 30, 2014, we announced completion of the review of data from our Phase II clinical trials of bimatoprost sustained-release implant for the treatment of elevated intraocular pressure and glaucoma. Patients in this trial received a bimatoprost sustained-release implant in one eye and topical bimatoprost in the contralateral eye. The data suggests that bimatoprost sustained-release implant efficacy is comparable to daily topical bimatoprost with duration of 4-6 months. Phase III clinical trials of bimatoprost sustained-release implant for the treatment of elevated intraocular pressure and glaucoma were initiated in the fourth quarter of 2014. On June 30, 2014, we announced receipt of approval from the FDA for Ozurdex® (dexamethasone intravitreal implant) 0.7 mg as a new treatment option for diabetic macular edema, or DME, in adult patients who have an artificial lens implant or who are scheduled for cataract surgery. The Ozurdex® implant uses the proprietary and innovative Novadur® solid polymer delivery system, a biodegradable implant that releases medicine over an extended period of time, to suppress inflammation, which plays a key role in the development of DME. On June 30, 2014, we announced receipt of a Complete Response Letter, or CRL, from the FDA to our New Drug Application for SempranaTM, which is being developed as an acute treatment of migraine in adults. In the CRL, the FDA acknowledged that Allergan has made improvements in the canister filling process. The two specific items listed in the CRL are related to specifications around content uniformity on the improved canister filling process and on standards for device actuation. There were no issues related to the clinical safety and efficacy of the product and we received draft labeling from the FDA for the product in June 2013. We plan to file our response to the CRL by the end of the second quarter of 2015. On September 2, 2014, we announced that the European Commission has extended the Marketing Authorization for Ozurdex® to treat adult patients with vision loss due to diabetic macular edema, or DME, who are pseudophakic (have an artificial lens implant), or who are considered insufficiently responsive to, or unsuitable for non-corticosteroid therapy. DME is a common complication with diabetes and is the leading cause of sight loss in patients with diabetes. On September 29, 2014, we announced that the FDA removed the limitations on the indication for Ozurdex® for the treatment of DME. Ozurdex® was originally approved in June as a treatment for DME in patients who are pseudophakic (have an artificial lens implant following cataract surgery) or who are phakic (have their natural lens) and are scheduled for cataract surgery. In addition to the significant R&D projects in late stage development described above, we have certain important Phase II projects including bimatoprost for scalp hair growth, Botox® for depression and Botox® for osteoarthritis pain. For management purposes, we accumulate direct costs for R&D projects, but do not allocate all indirect project costs, such as R&D administration, infrastructure and regulatory affairs costs, to specific R&D projects. Additionally, R&D expense includes upfront payments to license or purchase in-process R&D assets that have not achieved regulatory approval. Our overall R&D expenses are not materially concentrated in any specific project or stage of development. The following table sets forth direct costs for our late-stage projects (which include candidates in Phase III clinical trials) and other R&D projects, upfront payments to license or purchase in-process R&D assets and all other R&D expenses for the years ended December 31, 2014, 2013 and 2012: R&D expenses increased $149.3 million, or 14.3%, to $1,191.6 million in 2014, or 16.7% of product net sales, compared to $1,042.3 million, or 16.8% of product net sales in 2013. R&D expenses in 2014 include a $65.0 million charge for an upfront payment and an additional development milestone payment of $15.0 million associated with the in-licensing of certain neurotoxin product candidates currently in development from Medytox, Inc., that have not yet achieved regulatory approval, a $10.0 million charge for the purchase of certain dermal filler technology under development that has not yet achieved regulatory approval, $21.0 million of R&D expenses related to the global restructuring announced in July 2014 and $2.7 million of R&D expenses related to the January 2014 realignment of various business functions. R&D expenses in 2013 include $6.5 million for an upfront payment associated with the in-licensing of a technology for the treatment of ocular disease that has not yet achieved regulatory approval. Excluding the effect of these charges, R&D expenses increased $42.1 million, or 4.1%, to $1,077.9 million in 2014, or 15.1% of product net sales compared to $1,035.8 million, or 16.7% of product net sales in 2013. The increase in R&D expenses in dollars was primarily due to increased spending on next generation eye care pharmaceuticals products for the treatment of glaucoma and retinal diseases, including the DARPin® development programs, an increase in spending on the next generation of our Aczone® product for the treatment of acne, increased spending on Botox® for the treatment of movement disorders, including juvenile cerebral palsy, and for the treatment of depression, spending on the development of technology associated with the LiRIS acquisition, increased expenses associated with our collaboration with Serenity Pharmaceuticals, LLC, or Serenity, related to Ser-120 for the treatment of nocturia, and an increase in spending on development of dermal filler products using our proprietary Vycross™ technology, partially offset by a decrease in spending on our recently launched Seri® Surgical Scaffold product, a decrease in expenses for potential new treatment applications for Latisse®, a decrease in expenses for Ozurdex®, and a decrease in expenses for new technology discovery programs. R&D expenses increased $65.0 million, or 6.7%, to $1,042.3 million in 2013, or 16.8% of product net sales, compared to $977.3 million, or 17.6% of product net sales in 2012. R&D expenses in 2013 include $6.5 million for an upfront payment associated with the in-licensing of a technology for the treatment of ocular disease that has not yet achieved regulatory approval. R&D expenses in 2012 include an aggregate charge of $62.5 million for upfront payments associated with two agreements for the in-licensing of technologies for the treatment of serious ophthalmic diseases, including age-related macular degeneration, from Molecular Partners AG that have not yet achieved regulatory approval. Excluding the effect of the charges described above, R&D expenses increased by $121.0 million, or 13.2%, to $1,035.8 million in 2013, or 16.7% of product net sales, compared to $914.8 million, or 16.5% of product net sales, in 2012. The increase in R&D expenses in dollars, excluding these charges, and as a percentage of product net sales, was primarily due to increased spending on next generation eye care pharmaceuticals products for the treatment of glaucoma and retinal diseases, including the DARPin® development programs, the development of technology for the treatment of rosacea acquired in the Vicept acquisition, increased spending on Botox® for the treatment of movement disorders, including juvenile cerebral palsy, increased spending on potential new treatment applications for Latisse®, an increase in spending on the next generation of our Aczone® product for acne, an increase in costs associated with our collaboration with Serenity, related to Ser-120 for the treatment of nocturia, increased spending on the development of tissue reinforcement technonology acquired in the Serica Technologies, Inc. acquisition, new expenses for the development of SempranaTM for the acute treatment of migraine acquired in the MAP acquisition, and an increase in spending on development of dermal filler products using our proprietary Vycross™ technology, partially offset by a decrease in expenses associated with our restructured collaboration with Spectrum related to the development of apaziquone, a decrease in spending on Botox® for the treatment of crow's feet and a decrease in expenses for new technology discovery programs. Amortization of Intangible Assets Amortization of intangible assets decreased $4.3 million to $112.4 million in 2014, or 1.6% of product net sales, compared to $116.7 million, or 1.9% of product net sales in 2013. The decrease in amortization expense is primarily due to a decline in amortization expense associated with certain licensing assets that became fully amortized at the end of the first quarter of 2013 and the impairment of an intangible asset for distribution rights acquired in connection with our 2011 acquisition of Precision Light, Inc. in the fourth quarter of 2013, partially offset by an increase in the balance of intangible assets subject to amortization, including intangible assets that we acquired in connection with our March 2013 acquisition of MAP and August 2014 acquisition of LiRIS. Amortization of intangible assets increased $26.5 million to $116.7 million in 2013, or 1.9% of product net sales, compared to $90.2 million, or 1.6% of product net sales in 2012. The increase in amortization expense is primarily due to an increase in the balance of intangible assets subject to amortization, including intangible assets that we acquired in connection with our March 2013 acquisition of MAP and our December 2012 acquisition of SkinMedica, partially offset by a decline in amortization expense associated with certain licensing assets that became fully amortized at the end of the first quarter of 2013, intangible assets associated with Sanctura XR®, which became fully amortized at the end of 2012, and the impairment of an intangible asset for distribution rights acquired in connection with our 2011 acquisition of Precision Light, Inc. in the fourth quarter of 2013. Impairment of Intangible Assets and Related Costs In the fourth quarter of 2013, we recorded a pre-tax charge of $11.4 million related to the impairment of an intangible asset for distribution rights acquired in connection with our 2011 acquisition of Precision Light, Inc. as a result of our decision to discontinue the sale of products related to those distribution rights. In the fourth quarter of 2012, we recorded a pre-tax charge of $17.0 million related to the partial impairment of an indefinite-lived in-process research and development asset acquired in connection with our 2011 acquisition of Vicept. The impairment charge was recognized because the carrying amount of the asset was determined to be in excess of its estimated fair value. In the fourth quarter of 2012, we recorded an additional impairment charge of $5.3 million related to the prepaid royalty asset associated with the Sanctura® franchise due to the launch of a competitive generic version of Sanctura XR®. Restructuring Charges and Integration Costs July 2014 Restructuring Plan In July 2014, we completed a global review of our structures and processes, portfolio of research and development projects and marketed products, and our geographies in an effort to prioritize the highest value investments. As a result of this review, we initiated a restructuring of our global operations to improve efficiency and productivity. We currently estimate that we will incur total non-recurring pre-tax charges of between $325.0 million and $375.0 million in connection with the restructuring and other costs, of which $80.0 million to $90.0 million will be a non-cash charge associated with the acceleration of previously unrecognized share-based compensation costs and certain other non-cash accounting adjustments. As part of the restructuring, we will reduce our workforce by approximately 1,500 employees, or approximately 13 percent of our current global headcount, and eliminate an additional approximately 250 vacant positions. We began to record costs associated with the July 2014 restructuring plan in the third quarter of 2014 and expect to continue to recognize costs through the second quarter of 2015. The restructuring charges primarily consist of employee severance and other one-time termination benefits, facility lease and other contract termination costs and other costs, primarily consisting of relocation costs and consulting fees, associated with the restructuring plan. During 2014, we recorded restructuring charges of $219.4 million and recognized additional costs of $28.4 million related to accelerated share-based compensation, consisting of $1.0 million of cost of sales, $16.2 million in SG&A expenses and $11.2 million in R&D expenses, and $36.5 million of asset write-offs and accelerated depreciation costs, consisting of $0.3 million of cost of sales, $27.9 million in SG&A expenses and $8.3 million in R&D expenses. In addition, in 2014 we also recognized pension settlement and curtailment charges, duplicate operating expenses and other costs of $15.6 million, consisting of $0.7 million of cost of sales, $13.4 million in SG&A expenses and $1.5 million in R&D expenses. The following table presents the restructuring charges related to the July 2014 restructuring plan during the year ended December 31, 2014: January 2014 Restructuring Plan In January 2014, we initiated a restructuring plan that includes certain sales force realignments and position eliminations, certain facility relocations and closures in the United States and Europe and the realignment of certain other business support functions, which affected approximately 250 employees. We began to record costs associated with the January 2014 restructuring plan in the first quarter of 2014 and substantially completed all activities related to the restructuring plan in the fourth quarter of 2014 with the exception of certain expenses related to the relocation of a minor manufacturing facility to be incurred in 2015. The restructuring charges primarily consist of employee severance, one-time termination benefits and contract termination costs associated with the restructuring plan. During 2014, we recorded restructuring charges of $24.5 million and recognized additional costs of $11.4 million related to accelerated depreciation and share-based compensation expenses and duplicate operating expenses, consisting of $3.2 million of cost of sales, $6.0 million in SG&A expenses and $2.2 million in R&D expenses. The following table presents the restructuring charges related to the January 2014 restructuring plan during the year ended December 31, 2014: Other Restructuring Activities and Integration Costs In connection with our March 2013 acquisition of MAP, our April 2013 acquisition of Exemplar and our December 2012 acquisition of SkinMedica, Inc., we initiated restructuring activities in 2013 to integrate the operations of the acquired businesses with our operations and to capture synergies through the centralization of certain research and development, manufacturing, general and administrative and commercial functions. For the year ended December 31, 2013, we recorded $4.5 million of restructuring charges, primarily consisting of employee severance and other one-time termination benefits for approximately 111 people. In the first quarter of 2014, we recorded an additional $0.4 million of restructuring charges. Included in 2014 are $0.7 million of restructuring charges for lease terminations and employee severance and other one-time termination benefits, $0.1 million of SG&A expenses and $0.5 million of R&D expenses related to the realignment of various business functions. Included in 2013 are $1.0 million of restructuring charges for employee severance and other one-time termination benefits, $1.7 million of SG&A expenses and $1.1 million of R&D expenses related to the realignment of various business functions. Included in 2012 are $1.5 million of restructuring charges for lease terminations and employee severance and other one-time termination benefits, $1.5 million of SG&A expenses and $0.3 million of R&D expenses related to the realignment of various business functions. Included in 2014 are $2.3 million of SG&A expenses and $0.4 million of R&D expenses related to transaction and integration costs associated with the purchase of various businesses and collaboration agreements. Included in 2013 are $0.1 million of cost of sales and $20.6 million of SG&A expenses related to transaction and integration costs associated with the purchase of various businesses and collaboration agreements. The SG&A expenses for the year ended December 31, 2013 primarily consist of investment banking and legal fees. Included in 2012 are $0.1 million of cost of sales and $2.3 million of SG&A expenses related to transaction and integration costs associated with the purchase of various businesses and collaboration agreements. Operating Income Management evaluates business segment performance on an operating income basis exclusive of general and administrative expenses and other indirect costs, legal settlement expenses, impairment of intangible assets and related costs, restructuring charges, in-process research and development expenses, amortization of certain identifiable intangible assets related to business combinations and asset acquisitions and related capitalized licensing costs and certain other adjustments, which are not allocated to our business segments for performance assessment by our chief operating decision maker. Other adjustments excluded from our business segments for purposes of performance assessment represent income or expenses that do not reflect, according to established Company-defined criteria, operating income or expenses associated with our core business activities. For 2014, general and administrative expenses, other indirect costs and other adjustments not allocated to our business segments for purposes of performance assessment consisted of sales milestone revenue of $9.7 million associated with a license agreement with Senju, general and administrative expenses of $463.1 million, expenses of $80.5 million related to the global restructuring announced in July 2014, costs of $128.0 million associated with the Allergan Board of Directors’ consideration of unsolicited proposals from Valeant to acquire all of the outstanding shares of Allergan, estimated bad debt expense of $37.3 million due to changes in Venezuela’s foreign exchange system and administration by CENCOEX, an estimated expense catch-up adjustment of $32.2 million in accordance with final regulations issued by the IRS governing administration of the annual fee on branded prescription drug manufacturers and importers, an upfront licensing fee of $65.0 million and a subsequent development milestone payment of $15.0 million for technology that has not achieved regulatory approval and related transaction costs of $0.4 million, a $10.0 million expense for acquired in-process research and development technology and related transaction costs of $0.6 million, income of $15.1 million for changes in the fair value of contingent consideration liabilities, integration and transaction costs of $1.7 million associated with the purchase of various businesses, expenses of $12.0 million related to the realignment of various business functions, expenses of $4.4 million related to the announced Actavis transaction and pre-integration planning costs and other net indirect costs of $29.0 million. For 2013, general and administrative expenses, other indirect costs and other adjustments not allocated to our business segments for purposes of performance assessment consisted of general and administrative expenses of $452.9 million, aggregate charges of $3.1 million for stockholder derivative litigation costs in connection with the 2010 global settlement with the DOJ regarding our past U.S. sales and marketing practices relating to Botox® and other legal contingency expenses, charges of $70.7 million for changes in the fair value of contingent consideration liabilities, a purchase accounting fair market value inventory adjustment of $8.9 million associated with the acquisition of SkinMedica, integration and transaction costs of $20.6 million associated with the purchase of various businesses and collaboration agreements, expenses of $2.8 million related to the realignment of various business functions, an upfront licensing fee of $6.5 million for technology that has not achieved regulatory approval and related transaction costs of $0.1 million and other net indirect costs of $29.0 million. For 2012, general and administrative expenses, other indirect costs and other adjustments not allocated to our business segments for purposes of performance assessment consisted of general and administrative expenses of $424.1 million, upfront licensing fees of $62.5 million paid to Molecular Partners AG for technology that has not achieved regulatory approval and related transaction costs of $0.3 million, aggregate charges of $9.7 million for stockholder derivative and tax litigation costs in connection with the 2010 global settlement with the DOJ regarding our past U.S. sales and marketing practices relating to Botox® and other legal contingency expenses, charges of $5.4 million for changes in the fair value of contingent consideration liabilities, a purchase accounting fair market value inventory adjustment of $0.3 million associated with the purchase of our distributor's business related to our products in Russia, integration and transaction costs of $2.1 million associated with the purchase of various businesses, expenses related to the 2012 restructuring and realignment initiatives of $1.8 million and other net indirect costs of $19.1 million. The following table presents operating income for each reportable segment for the years ended December 31, 2014, 2013 and 2012 and a reconciliation of our segments’ operating income to consolidated operating income: ---------- (a) Represents amortization of certain identifiable intangible assets related to business combinations and asset acquisitions and related capitalized licensing costs, as applicable. Our consolidated operating income in 2014 was $2,009.3 million, or 28.2% of product net sales, compared to consolidated operating income of $1,809.3 million, or 29.2% of product net sales in 2013. The $200.0 million increase in consolidated operating income was due to a $928.6 million increase in product net sales, an $8.9 million increase in other revenues, a $4.3 million decrease in amortization of intangible assets and an $11.4 million decrease in the impairment of intangible assets and related costs, partially offset by a $46.6 million increase in cost of sales, a $317.8 million increase in SG&A expenses, a $149.3 million increase in R&D expenses and a $239.5 million increase in restructuring charges. Our specialty pharmaceuticals segment operating income in 2014 was $2,832.3 million, compared to operating income of $2,282.0 million in 2013. The $550.3 million increase in our specialty pharmaceuticals segment operating income was due primarily to an increase in product net sales across all product lines, partially offset by an increase in promotion expenses and an increase in R&D expenses. Our medical devices segment operating income in 2014 was $382.9 million, compared to operating income of $246.2 million in 2013. The $136.7 million increase in our medical devices segment operating income was due primarily to an increase in product net sales of our facial aesthetics and breast aesthetics product lines and a decrease in R&D expenses, partially offset by an increase in selling, promotion and marketing expenses. Our consolidated operating income in 2013 was $1,809.3 million, or 29.2% of product net sales, compared to consolidated operating income of $1,611.0 million, or 29.0% of product net sales in 2012. The $198.3 million increase in consolidated operating income was due to a $648.2 million increase in product net sales, a $5.6 million increase in other revenues and a $10.9 million decrease in the impairment of intangible assets and related costs, partially offset by a $44.6 million increase in cost of sales, a $326.3 million increase in SG&A expenses, a $65.0 million increase in R&D expenses, a $26.5 million increase in amortization of intangible assets and a $4.0 million increase in restructuring charges. Our specialty pharmaceuticals segment operating income in 2013 was $2,282.0 million, compared to operating income of $1,997.7 million in 2012. The $284.3 million increase in our specialty pharmaceuticals segment operating income was due primarily to an increase in product net sales across all product lines, partially offset by an increase in selling, promotion and R&D expenses. Our medical devices segment operating income in 2013 was $246.2 million, compared to operating income of $229.1 million in 2012. The $17.1 million increase in our medical devices segment operating income was due primarily to an increase in product net sales of our facial aesthetics product line, partially offset by an increase in selling, promotion and marketing expenses and an increase in R&D expenses. Non-Operating Income and Expenses Total net non-operating expense in 2014 was $20.0 million compared to $78.5 million in 2013. Interest income increased $0.9 million to $7.7 million in 2014 compared to $6.8 million in 2013. Interest expense decreased $5.6 million to $69.4 million in 2014 compared to $75.0 million in 2013. Interest expense decreased primarily due to a decrease in accrued statutory interest resulting from a change in estimate related to uncertain tax positions, partially offset by an increase in interest expense primarily due to the issuance in March 2013 of our 1.35% Senior Notes due 2018, or 2018 Notes, and our 2.80% Senior Notes due 2023, or 2023 Notes, and an increase in borrowings under various foreign bank facilities. Other, net income was $41.7 million in 2014, consisting primarily of $44.9 million in net gains on foreign currency derivative instruments and other foreign currency transactions and a loss of $3.1 million related to the impairment of a non-marketable third party equity investment. Other, net expense was $10.3 million in 2013, consisting primarily of $7.4 million in net losses on foreign currency derivative instruments and other foreign currency transactions and a loss of $3.7 million related to the impairment of a non-marketable third party equity investment, partially offset by a gain of $0.7 million on the sale of a third party equity investment. Total net non-operating expense in 2013 was $78.5 million compared to $80.0 million in 2012. Interest income increased $0.1 million to $6.8 million in 2013 compared to $6.7 million in 2012. Interest expense increased $11.4 million to $75.0 million in 2013 compared to $63.6 million in 2012. Interest expense increased primarily due to the issuance in March 2013 of our 2018 Notes and our 2023 Notes and an increase in accrued statutory interest resulting from a change in estimate related to uncertain tax positions. Other, net expense was $10.3 million in 2013, consisting primarily of $7.4 million in net losses on foreign currency derivative instruments and other foreign currency transactions and a loss of $3.7 million related to the impairment of a non-marketable third party equity investment, partially offset by a gain of $0.7 million on the sale of a third party equity investment. Other, net expense was $23.1 million in 2012, consisting primarily of net losses on foreign currency derivative instruments and other foreign currency transactions. Income Taxes Our effective tax rate in 2014 was 23.0% compared to the effective tax rate of 26.5% in 2013. Included in our earnings before income taxes for 2014 are a $65.0 million upfront payment for the in-licensing of in-process research and development technologies from Medytox, a $15.0 million development milestone payment associated with the technologies in-licensed from Medytox, a $10.0 million expense for the purchase of an in-process research and development asset, a $37.3 million charge for estimated bad debts in Venezuela, a loss of $3.1 million related to the impairment of a non-marketable third party equity investment, restructuring charges of $245.0 million, $80.5 million of other expenses associated with the July 2014 restructuring plan, $12.0 million of other expenses for the January 2014 realignment of certain business, $15.1 million of income related to changes in the fair value of contingent consideration associated with certain business combination agreements and $128.0 million of expenses associated with the Allergan Board of Directors' consideration of unsolicited proposals from Valeant to acquire all of the outstanding shares of Allergan. In 2014 we recorded no income tax benefits related to the upfront payment for the in-licensing of technology from Medytox, the development milestone payment associated with the technologies in-licensed from Medytox, or for the changes in the fair value of contingent consideration liabilities, $3.4 million of income tax benefits related to the expense for the purchase of an in-process research and development asset, $5.0 million of income tax benefits related to the estimated bad debts in Venezuela, $1.1 million of income tax benefits related to the impairment of a non-marketable third party equity investment, $69.5 million of estimated income tax benefits related to the restructuring charges, $24.9 million of income tax benefits related to other costs associated with the July 2014 restructuring plan, $3.9 million of income tax benefits related to other expenses associated with the January 2014 realignment of certain business functions and $45.5 million of income tax benefits related to expenses associated with the Allergan Board of Directors' consideration of unsolicited proposals from Valeant to acquire all of the outstanding shares of Allergan. In 2014, we also recorded income tax benefits of $13.3 million for changes in estimated taxes related to tax positions included in prior year filings, which resulted primarily from the re-measurement of certain transfer pricing positions. Excluding the impact of the pre-tax charges of $580.8 million and the income tax benefits of $166.6 million for the items discussed above, our adjusted effective tax rate for 2014 was 24.3%. We believe that the use of an adjusted effective tax rate provides a more meaningful measure of the impact of income taxes on our results of operations because it excludes the effect of certain items that are not included as part of our core business activities. This allows investors to better determine the effective tax rate associated with our core business activities. The calculation of our adjusted effective tax rate for 2014 is summarized below: Our effective tax rate in 2013 was 26.5% compared to the effective tax rate of 28.1% in 2012. Included in our earnings before income taxes for 2013 are charges related to changes in the fair value of contingent consideration associated with certain business combination agreements of $70.7 million, the fair market value inventory adjustment rollout related to the acquisition of SkinMedica of $8.9 million, external costs of stockholder derivative litigation associated with the 2010 global settlement with the DOJ regarding our past U.S. sales and marketing practices relating to certain therapeutic uses of Botox® and other legal contingency expenses of $3.1 million, transaction and integration costs associated with business combinations and license agreements of $20.6 million, a loss of $3.7 million related to the impairment of a non-marketable third party equity investment and restructuring charges of $5.5 million. In 2013 we recorded no income tax benefit related to the changes in the fair value of contingent consideration liabilities, $3.3 million of income tax benefits related to the fair market value inventory adjustment rollout related to the acquisition of SkinMedica, no income tax benefits related to external costs of stockholder derivative litigation associated with the 2010 global settlement with the DOJ regarding our past U.S. sales and marketing practices relating to certain therapeutic uses of Botox® and other legal contingency expenses, $4.8 million of income tax benefits related to transaction and integration costs associated with business combinations and license agreements, $1.3 million of income tax benefits related to the impairment of a non-marketable third party equity investment and $1.7 million of income tax benefits related to the restructuring charges. In 2013, we also recorded an income tax benefit of $15.1 million for the retroactive benefit of the U.S. federal research and development tax credit for the 2012 fiscal year that was signed into law on January 2, 2013. Excluding the impact of the aggregate pre-tax charges of $112.5 million and the income tax benefits of $26.2 million for the items discussed above, our adjusted effective tax rate for 2013 was 26.3%. The calculation of our adjusted effective tax rate for 2013 is summarized below: Our effective tax rate in 2012 was 28.1%. Included in our earnings before income taxes for 2012 are charges related to changes in the fair value of contingent consideration associated with certain business combination agreements of $5.4 million, upfront payments of $62.5 million associated with two agreements for the in-licensing of technologies from Molecular Partners AG, the fair market value inventory adjustment rollout and integration costs related to the purchase of a distributor's business in Russia of $0.9 million, external costs of stockholder derivative litigation and other legal costs associated with the 2010 global settlement with the DOJ regarding our past U.S. sales and marketing practices relating to certain therapeutic uses of Botox® and other legal contingency expenses of $9.7 million, $0.9 million of interest expense associated with changes in estimated taxes related to uncertain tax positions included in prior year filings, restructuring charges of $1.5 million and impairment of intangible assets and related costs of $22.3 million. In 2012 we recorded no income tax benefits related to the changes in the fair value of contingent consideration liabilities, $15.7 million of income tax benefits related to the upfront payments associated with the two agreements for the in-licensing of technologies from Molecular Partners AG, $0.1 million of income tax benefits related to the fair market value inventory adjustment rollout and integration costs related to the purchase of a distributor's business in Russia, $1.3 million of income tax benefits related to external costs of stockholder derivative litigation and other legal costs associated with the 2010 global settlement with the DOJ regarding our past U.S. sales and marketing practices relating to certain therapeutic uses of Botox® and other legal contingency expenses, income tax benefits of $0.3 million related to interest expense associated with changes in estimated taxes related to uncertain tax positions included in prior year filings, $0.6 million of income tax benefits related to the restructuring charges and $8.2 million of income tax benefits related to the impairment of intangible assets and related costs. In 2012 we also recorded an income tax provision of $7.7 million for changes in estimated taxes related to uncertain tax positions included in prior year filings. Excluding the impact of the pretax charges of $103.2 million and the net income tax benefits of $18.5 million for the items discussed above, our adjusted effective tax rate for 2012 was 27.5%. The calculation of our adjusted effective tax rate for 2012 is summarized below: The decrease in the adjusted effective tax rate to 24.3% in 2014 compared to the adjusted effective tax rate in 2013 of 26.3% is primarily attributable to beneficial changes in the mix of pre-tax earnings in the various countries in which we operate, a reduction in the valuation allowance against certain deferred tax assets and prior year provision to return adjustments. The decrease in the adjusted effective tax rate to 26.3% in 2013 compared to the adjusted effective tax rate in 2012 of 27.5% is primarily attributable to the beneficial impact of the U.S. federal research and development tax credit, which is included in our annual effective tax rate for 2013, but was not available in 2012, and other small changes in certain tax positions related to prior periods. Earnings from Continuing Operations Our earnings from continuing operations in 2014 were $1,532.6 million compared to earnings from continuing operations of $1,272.5 million in 2013. The $260.1 million increase in earnings from continuing operations was primarily the result of the increase in operating income of $200.0 million, the decrease in net non-operating expense of $58.5 million and the decrease in the provision for income taxes of $1.6 million. Our earnings from continuing operations in 2013 were $1,272.5 million compared to earnings from continuing operations of $1,100.7 million in 2012. The $171.8 million increase in earnings from continuing operations was primarily the result of the increase in operating income of $198.3 million and the decrease in net non-operating expense of $1.5 million, partially offset by the increase in the provision for income taxes of $28.0 million. Net Earnings Attributable to Noncontrolling Interest Our net earnings attributable to noncontrolling interest for our majority-owned subsidiaries were $4.6 million in 2014, $3.6 million in 2013 and $3.7 million in 2012. In November 2013, we purchased a noncontrolling interest in a subsidiary from a minority shareholder for $18.0 million. We accounted for the purchase as an equity transaction. Discontinued Operations On February 1, 2013, we formally committed to pursue a sale of our obesity intervention business unit, including the assets related to the Lap-Band® gastric band system and the Orbera™ intra-gastric balloon system. Accordingly, beginning in the first quarter of 2013, we have reported the financial results from that business unit as discontinued operations in the consolidated statements of earnings and the remaining assets related to that business unit as assets of discontinued operations in the consolidated balance sheets. On December 2, 2013, we completed the sale of the obesity intervention business to Apollo Endosurgery, Inc., or Apollo, for cash consideration of $75.0 million, subject to certain adjustments, and certain additional consideration, including a minority equity interest in Apollo with an estimated fair value of $15.0 million and contingent consideration of up to $20.0 million to be paid upon the achievement of certain regulatory and sales milestones. At the closing date, the cash consideration was reduced by the amount of inventories held outside of the United States of $7.6 million and net trade accounts receivable and payable of $19.4 million, which we retained pursuant to the sale and transition services agreements with Apollo. For the year ended December 31, 2013, we reported a total pre-tax loss of $408.2 million ($297.9 million after tax) on the disposal of the obesity intervention business unit net assets. The pre-tax loss includes transaction costs of approximately $2.6 million, consisting primarily of investment banking fees. For the year ended December 31, 2014, we recognized an additional pre-tax loss of $2.5 million ($3.8 million after tax), on the disposal of the obesity intervention business unit net assets. In connection with the sale of the obesity intervention business, we also entered into certain transitional service agreements designed to facilitate the orderly transfer of business operations to Apollo. These agreements primarily relate to administrative services in the United States and distribution services outside of the United States, all of which are generally to be provided for a period of up to 12 months. We will also manufacture and supply products to Apollo for a transitional period not to exceed 24 months in order to allow Apollo adequate time to obtain regulatory approval for licenses and manufacturing facilities. The continuing cash flows from these agreements are not significant, and we have no significant continuing involvement in the obesity intervention business. Net sales made pursuant to the manufacturing and distribution agreements are recorded as product net sales in the consolidated statements of earnings and are reflected as other medical devices product net sales. The results of operations from discontinued operations presented below include certain allocations that management believes fairly reflect the utilization of services provided to the obesity intervention business. The allocations do not include amounts related to general corporate administrative expenses or interest expense. Therefore, the results of operations from the obesity intervention business unit do not necessarily reflect what the results of operations would have been had the business operated as a stand-alone entity. The following table summarizes the results of operations from discontinued operations for the years ended December 31, 2013 and 2012, respectively: Liquidity and Capital Resources We assess our liquidity by our ability to generate cash to fund our operations. Significant factors in the management of liquidity are: funds generated by operations; levels of accounts receivable, inventories, accounts payable and capital expenditures; funds available under our credit facilities; the extent of our stock repurchase program; global economic conditions; funds required for acquisitions and other transactions; and financial flexibility to attract long-term capital on satisfactory terms. Historically, we have generated cash from operations in excess of working capital requirements. The net cash provided by operating activities was $1,927.8 million in 2014 compared to $1,695.4 million in 2013 and $1,599.9 million in 2012. Cash flow from operating activities increased in 2014 compared to 2013 primarily as a result of an increase in cash from net earnings from operations, including the effect of adjusting for non-cash items, and a decrease in cash required to fund changes in trade receivables and an increase in accrued expenses and other liabilities, partially offset by an increase in cash used to fund changes in inventories, other current assets, other non-current assets, accounts payable and income taxes. In 2014, we made upfront and milestone payments of $80.0 million related to a license agreement and an upfront payment of $10.0 million for the purchase of certain dermal filler technology under development that has not achieved regulatory approval compared to an upfront payment of $6.5 million for a license and collaboration agreement in 2013, which were included in our net earnings for the respective periods. We paid pension contributions of $51.9 million in 2014 compared to $42.3 million in 2013. Cash flow from operating activities increased in 2013 compared to 2012 primarily as a result of an increase in cash from net earnings from operations, including the effect of adjusting for non-cash items, and a decrease in cash required to fund changes in other current assets, accrued expenses and income taxes, partially offset by an increase in cash used to fund changes in trade receivables, inventories, other non-current assets and other liabilities. In September 2012, we terminated the $300.0 million notional amount interest rate swap and received $54.7 million, which included accrued interest of $3.7 million. In 2013, we made upfront payments of $6.5 million compared to $62.5 million in 2012 for various licensing and collaboration agreements, which were included in our net earnings for the respective periods. We paid pension contributions of $42.3 million in 2013 compared to $47.1 million in 2012. Net cash provided by investing activities was $182.7 million in 2014 compared to net cash used in investing activities of $1,375.3 million in 2013 and net cash used in investing activities of $589.3 million in 2012. In 2014, we received $1,815.9 million from the maturities of short-term investments and collected $1.8 million from the 2013 sale of the obesity intervention business. In 2014, we purchased $1,269.8 million of short-term investments, paid $67.5 million for the acquisition of LiRIS, paid $20.3 million for equity investments and $15.0 million for licensing and developed technology intangible assets. Additionally, we invested $243.9 million in new facilities and equipment and $19.0 million in capitalized software. We currently expect to invest between approximately $200 million and $220 million in capital expenditures for manufacturing and administrative facilities, manufacturing equipment and other property, plant and equipment during 2015. In 2013, we received $683.2 million from the maturities of short-term investments and $42.7 million from the sale of the obesity intervention business. In 2013, we purchased $1,025.6 million of short-term investments and paid $889.7 million, net of cash acquired, for the acquisitions of MAP and Exemplar, and $2.4 million for purchase price adjustments related to prior acquisitions. Additionally, we invested $171.9 million in new facilities and equipment and $11.8 million in capitalized software. In 2012, we received $784.6 million from the maturities of short-term investments and $1.8 million from the sale of property, plant and equipment. In 2012, we purchased $865.2 million of short-term investments, paid $349.2 million, net of cash acquired, for the acquisition of SkinMedica, and the purchase of our distributor’s business related to our products in Russia and paid $4.1 million for trademarks and developed technology intangible assets. Additionally, we invested $143.3 million in new facilities and equipment and $13.9 million in capitalized software. Net cash used in financing activities was $204.0 million in 2014 compared to net cash provided by financing activities of $28.2 million in 2013 and net cash used in financing activities of $717.5 million in 2012. In 2014, we repurchased approximately 6.1 million shares of our common stock for $839.2 million, paid $59.6 million in dividends to stockholders and paid contingent consideration of $10.2 million. This use of cash was partially offset by $16.5 million in net borrowings of notes payable, $521.0 million received from the sale of stock to employees and $167.5 million in excess tax benefits from share-based compensation. On March 12, 2013, we issued concurrently in a registered offering $250.0 million in aggregate principal amount of our 2018 Notes and $350.0 million in aggregate principal amount of our 2023 Notes, and received total proceeds of $598.5 million, net of original discounts. Additionally, in 2013, we received $6.8 million in net borrowings of notes payable, $179.3 million from the sale of stock to employees and $37.7 million in excess tax benefits from share-based compensation. These amounts were partially reduced by the repurchase of approximately 6.1 million shares of our common stock for $650.7 million, a cash payment of $4.8 million for offering fees related to the issuance of the 2018 Notes and the 2023 Notes, $59.4 million in dividends paid to stockholders, payments of contingent consideration of $61.2 million and the purchase of a noncontrolling interest in a subsidiary from a minority shareholder of $18.0 million. In 2012, we repurchased approximately 10.0 million shares of our common stock for $909.0 million, paid $60.4 million in dividends to stockholders, made net repayments of notes payable of $35.1 million and paid contingent consideration of $5.1 million. This use of cash was partially offset by $246.4 million received from the sale of stock to employees and $45.7 million in excess tax benefits from share-based compensation. As of December 31, 2014, $3,194.5 million of our existing cash and equivalents and short-term investments are held by non-U.S. subsidiaries. We currently plan to use these funds indefinitely in our operations outside the United States. Withholding and U.S. taxes have not been provided for unremitted earnings of certain non-U.S. subsidiaries because we have reinvested these earnings indefinitely in such operations. At December 31, 2014, we had approximately $4,485.3 million in unremitted earnings outside the United States for which withholding and U.S. taxes were not provided. Tax costs would be incurred if these earnings were remitted to the United States. Debt Outstanding and Borrowing Capacity Our 5.75% Senior Notes due 2016, or 2016 Notes, were sold at 99.717% of par value with an effective interest rate of 5.79%, pay interest semi-annually on the principal amount of the notes at a rate of 5.75% per annum, and are redeemable at any time at our option, subject to a make-whole provision based on the present value of remaining interest payments at the time of the redemption. The aggregate outstanding principal amount of the 2016 Notes will be due and payable on April 1, 2016, unless earlier redeemed by us. In September 2012, we terminated the $300.0 million notional amount interest rate swap related to the 2016 Notes and received $54.7 million, which included accrued interest of $3.7 million. Upon termination of the interest rate swap, we added the net fair value received of $51.0 million to the carrying value of the 2016 Notes. The amount received for the termination of the interest rate swap is being amortized as a reduction to interest expense over the remaining life of the debt, which effectively fixes the interest rate for the remaining term of the 2016 Notes at 3.94%. Our 2018 Notes, which were sold at 99.793% of par value with an effective interest rate of 1.39%, are unsecured and pay interest semi-annually on the principal amount of the notes at a rate of 1.35% per annum, and are redeemable at any time at our option, subject to a make-whole provision based on the present value of remaining interest payments at the time of the redemption. The aggregate outstanding principal amount of the 2018 Notes will be due and payable on March 15, 2018, unless earlier redeemed by us. Our 3.375% Senior Notes due 2020, or 2020 Notes, which were sold at 99.697% of par value with an effective interest rate of 3.41%, are unsecured and pay interest semi-annually on the principal amount of the notes at a rate of 3.375% per annum, and are redeemable at any time at our option, subject to a make-whole provision based on the present value of remaining interest payments at the time of the redemption. The aggregate outstanding principal amount of the 2020 Notes will be due and payable on September 15, 2020, unless earlier redeemed by us. Our 2023 Notes, which were sold at 99.714% of par value with an effective interest rate of 2.83%, are unsecured and pay interest semi-annually on the principal amount of the notes at a rate of 2.80% per annum, and are redeemable at any time at our option, subject to a make-whole provision based on the present value of remaining interest payments at the time of the redemption, if the redemption occurs prior to December 15, 2022 (three months prior to the maturity of the 2023 Notes). If the redemption occurs on or after December 15, 2022, then such redemption is not subject to the make-whole provision.The aggregate outstanding principal amount of the 2023 Notes will be due and payable on March 15, 2023, unless earlier redeemed by us. At December 31, 2014, we had a committed long-term credit facility, a commercial paper program, a shelf registration statement that allows us to issue additional securities, including debt securities, in one or more offerings from time to time, a real estate mortgage and various foreign bank facilities. Our committed long-term credit facility will expire in October 2016. The termination date can be further extended from time to time upon our request and acceptance by the issuer of the facility for a period of one year from the last scheduled termination date for each request accepted. The committed long-term credit facility allows for borrowings of up to $800.0 million. The commercial paper program also provides for up to $800.0 million in borrowings. However, our combined borrowings under our committed long-term credit facility and our commercial paper program may not exceed $800.0 million in the aggregate. Borrowings under the committed long-term credit facility are subject to certain financial and operating covenants that include, among other provisions, maximum leverage ratios. Certain covenants also limit subsidiary debt. We believe we were in compliance with these covenants at December 31, 2014. At December 31, 2014, we had no borrowings under our committed long-term credit facility, $20.0 million in borrowings outstanding under the real estate mortgage, $72.1 million in borrowings outstanding under various foreign bank facilities and no borrowings under the commercial paper program. Commercial paper, when outstanding, is issued at current short-term interest rates. Additionally, any future borrowings that are outstanding under the long-term credit facility may be subject to a floating interest rate. We may from time to time seek to retire or purchase our outstanding debt. Dividends and Stock Repurchase Program Effective February 2, 2015, our Board of Directors declared a cash dividend of $0.05 per share, payable March 20, 2015 to stockholders of record on February 27, 2015. We maintain an evergreen stock repurchase program. Our evergreen stock repurchase program authorizes us to repurchase our common stock for the primary purpose of funding our stock-based benefit plans. Under the stock repurchase program, we may maintain up to 18.4 million repurchased shares in our treasury account at any one time. At December 31, 2014, we held approximately 8.4 million treasury shares under this program. Pursuant to our evergreen stock repurchase program, we entered into certain stock repurchase plans that authorized our brokers to purchase our common stock traded in the open market. The terms of the plans set forth an aggregate maximum limit of 6.0 million shares to be repurchased in the first half of 2014, and the aggregate maximum limit of the plans has been satisfied. Trade Receivables Supplemental Information We sell products to public and semi-public hospitals in Italy and Spain, which are wholly or partially funded by their respective sovereign governments. The following table provides information related to trade receivables outstanding as of December 31, 2014 from product net sales in Italy and Spain: We believe the reserves established against these trade receivables are sufficient to cover the amounts that will ultimately be uncollectible. However, the economic stability in these countries is unpredictable and we cannot provide assurance that additional allowances will not be necessary if current economic conditions in these countries continue to decline. Negative changes in the amount of allowances for doubtful accounts could adversely affect our future results of operations. As of December 31, 2014, we have no significant trade accounts receivable from customers in Greece or Portugal that are primarily funded by their respective sovereign governments. In the third quarter of 2014, we recorded an estimated bad debt charge of $37.3 million related to certain U.S. dollar denominated trade receivables from local customers in Venezuela. The estimated charge for bad debts was based on an analysis at that time of our U.S. dollar denominated trade receivable payment and non-payment trends over the last 12 months in relation to currency exchange controls administered by the National Center for Foreign Commerce, or CENCOEX, a Venezuela government body, and our review of other relevant communications by CENCOEX and economic data regarding the current state of Venezuela’s economy. Based on our analysis, we concluded that the likelihood of a bad debt loss for our U.S. dollar denominated trade receivables generated prior to October 2013 was probable. Trade receivables generated from product sales in Venezuela subsequent to September 2013 have generally been paid on a regular basis by CENCOEX at the published preferred exchange rate for pharmaceutical products, so we are continuing to supply certain products to our one major distributor, a sizeable multinational corporation, within self-imposed credit limits, under the assumption that CENCOEX will continue to allow U.S. dollar denominated trade receivables, which are properly registered with CENCOEX, to be paid within normal trade terms. We are continuing to make efforts to collect the outstanding older trade receivables that have been reserved, and any future recovery will be recorded when realized. As of December 31, 2014, we had net trade receivables from the distributor in Venezuela of approximately $15.5 million, which are subject to currency exchange controls administered by CENCOEX. The payment of our trade receivables is required to be approved through CENCOEX’s administration of monthly allocations of foreign currency provided by the Central Bank of Venezuela. We have experienced a lower amount of payments from CENCOEX for trade receivables from this distributor in the fourth quarter of 2014 compared to payments received in the prior three quarters of 2014. Our trade receivables are subject to future potential currency devaluation actions that could be taken by the Venezuelan government, which have occurred several times in the past. The agreement with our distributor contains certain terms that limit our exposure to devaluation risk, but because of the unpredictable economic stability in Venezuela, our trade receivables in Venezuela may become subject to a material devaluation. Acquisitions and Collaborations On August 13, 2014, we completed the acquisition of LiRIS for an upfront payment of $67.5 million plus up to an aggregate of $295.0 million in payments contingent upon achieving certain future development milestones and up to an aggregate of $225.0 million in payments contingent upon achieving certain commercial milestones. The estimated fair value of the contingent consideration as of the acquisition date was $170.5 million. On September 25, 2013, we announced that we had entered into a license agreement with Medytox, Inc., or Medytox, contingent on obtaining certain government approvals. In January 2014, we closed the transaction. Under the terms of the agreement, we made an upfront payment to Medytox of $65.0 million in January 2014 and Medytox granted us exclusive rights, worldwide outside of Korea with co-exclusive rights in Japan, to develop and, if approved, commercialize certain neurotoxin product candidates currently in development, including a potential liquid-injectable product. The terms of the agreement also include potential future development milestone payments of up to $116.5 million and potential future sales milestone payments of up to $180.5 million, as well as potential future royalty payments. In the third quarter of 2014, we made a development milestone payment to Medytox of $15.0 million. Other Liquidity Matters As part of an ongoing effort to improve efficiency and productivity which will further increase stockholder value, in July 2014 we completed a global review of our structures and processes, portfolio of research and development projects and marketed products, and our geographies in an effort to prioritize the highest value investments. As a result of this review, we initiated a restructuring of our global operations that we estimate will deliver annual pre-tax savings exceeding $475 million in calendar year 2015. We currently estimate that we will incur total non-recurring pre-tax charges of between $325.0 million and $375.0 million in connection with the restructuring and other costs, of which $80.0 million and $90.0 million will be a non-cash charge. We began to incur these non-recurring charges in the third quarter of 2014 and expect to continue to incur them through the second quarter of 2015. A generic version of Zymaxid® was launched in the United States in October 2013. A generic version of Latisse® was approved by the FDA in December 2014, and we expect to face generic competition for Latisse® in 2015. In addition, our products compete with generic versions of some branded pharmaceutical products sold by our competitors. We do not believe that our liquidity will be materially impacted in 2015 by generic competition. At December 31, 2014, we had net pension and postretirement benefit obligations totaling $317.0 million. Future funding requirements are subject to change depending on the actual return on net assets in our funded pension plans and changes in actuarial assumptions. In 2015, we expect to pay pension contributions of between $10.0 million and $15.0 million for our U.S. and non-U.S. pension plans and between $1.0 million and $2.0 million for our other postretirement plan. Additionally, in 2014 we initiated and completed a program to offer voluntary lump-sum pension payouts to terminated vested participants of our U.S. qualified defined benefit pension plan. The program provided participants with a one-time choice of electing to receive a lump-sum settlement of their remaining pension benefit. As part of this voluntary lump-sum program, we paid approximately $63.6 million from our pension assets with a corresponding reduction in pension obligations and recognized an associated $13.0 million settlement charge. We believe that the net cash provided by operating activities, supplemented as necessary with borrowings available under our existing credit facilities and existing cash and equivalents and short-term investments, will provide us with sufficient resources to meet our current expected obligations, working capital requirements, debt service and other cash needs over the next year. Inflation Although at reduced levels in recent years and at the end of 2014, inflation continues to apply upward pressure on the cost of goods and services that we use. The competitive and regulatory environments in many markets substantially limit our ability to fully recover these higher costs through increased selling prices. We continually seek to mitigate the adverse effects of inflation through cost containment and improved productivity and manufacturing processes. Foreign Currency Fluctuations Approximately 36.6% of our product net sales in 2014 were derived from operations outside the United States, and a portion of our international cost structure is denominated in currencies other than the U.S. dollar. As a result, we are subject to fluctuations in sales and earnings reported in U.S. dollars due to changing currency exchange rates. We routinely monitor our transaction exposure to currency rates and implement certain economic hedging strategies to limit such exposure, as we deem appropriate. The net impact of foreign currency fluctuations on our sales was a decrease of $93.0 million and $41.1 million in 2014 and 2013, respectively. The 2014 sales decrease included $18.4 million related to the euro, $17.1 million related to the Brazilian real, $9.1 million related to the Australian dollar, $18.9 million related to the Canadian dollar, $13.5 million related to the Turkish lira, $12.4 million related to the Argentine peso and $12.9 million related to other currencies, partially offset by an increase of $9.3 million related to the U.K. pound. The 2013 sales decrease included $20.1 million related to the Brazilian real, $9.5 million related to the Australian dollar, $7.5 million related to the Canadian dollar, $5.0 million related to the Turkish lira, $4.4 million related to the Indian rupee, $2.3 million related to the U.K. pound and $7.8 million related to other currencies, partially offset by an increase of $15.5 million related to the euro. See Note 1, “Summary of Significant Accounting Policies,” in the notes to the consolidated financial statements listed under Item 15 of Part IV of this report, “Exhibits and Financial Statement Schedules,” for a description of our accounting policy on foreign currency translation. Contractual Obligations and Commitments The table below presents information about our contractual obligations and commitments at December 31, 2014: ---------- (a) Debt obligations include expected principal and interest obligations, but exclude an unamortized amount related to a terminated interest rate swap of $17.8 million at December 31, 2014. (b) For purposes of this table, we assume that we will be required to fund our U.S. and non-U.S. funded pension plans based on the minimum funding required by applicable regulations. In determining the minimum required funding, we utilize current actuarial assumptions and exchange rates to forecast estimates of amounts that may be payable for up to five years in the future. In management’s judgment, minimum funding estimates beyond a five year time horizon cannot be reliably estimated. Where minimum funding as determined for each individual plan would not achieve a funded status to the level of local statutory requirements, additional discretionary funding may be provided from available cash resources. (c) Other obligations include contingent consideration liabilities, deferred executive compensation liabilities and certain other long-term obligations.

<s>[INST] This financial review presents our operating results for each of the three years in the period ended December 31, 2014, and our financial condition at December 31, 2014. Except for the historical information contained herein, the following discussion contains forwardlooking statements which are subject to known and unknown risks, uncertainties and other factors that may cause our actual results to differ materially from those expressed or implied by such forwardlooking statements. We discuss such risks, uncertainties and other factors throughout this report and specifically under Item 1A of Part I of this report, “Risk Factors.” In addition, the following review should be read in connection with the information presented in our consolidated financial statements and the related notes to our consolidated financial statements. Critical Accounting Policies, Estimates and Assumptions The preparation and presentation of financial statements in conformity with accounting principles generally accepted in the United States, or GAAP, requires us to establish policies and to make estimates and assumptions that affect the amounts reported in our consolidated financial statements. In our judgment, the accounting policies, estimates and assumptions described below have the greatest potential impact on our consolidated financial statements. Accounting assumptions and estimates are inherently uncertain and actual results may differ materially from our estimates. Revenue Recognition We recognize revenue from product sales when goods are shipped and title and risk of loss transfer to our customers. A substantial portion of our revenue is generated by the sale of specialty pharmaceutical products (primarily eye care pharmaceuticals and skin care and other products) to wholesalers within the United States, and we have a policy to attempt to maintain average U.S. wholesaler inventory levels at an amount less than eight weeks of our net sales. A portion of our revenue is generated from consigned inventory of breast implants maintained at physician, hospital and clinic locations. These customers are contractually obligated to maintain a specific level of inventory and to notify us upon the use of consigned inventory. Revenue for consigned inventory is recognized at the time we are notified by the customer that the product has been used. Notification is usually through the replenishing of the inventory, and we periodically review consignment inventories to confirm the accuracy of customer reporting. We generally offer cash discounts to customers for the early payment of receivables. Those discounts are recorded as a reduction of revenue and accounts receivable in the same period that the related sale is recorded. The amounts reserved for cash discounts were $7.5 million and $6.3 million at December 31, 2014 and 2013, respectively. Provisions for cash discounts deducted from consolidated sales in 2014, 2013 and 2012 were $87.2 million, $76.9 million and $69.2 million, respectively. We permit returns of product from most product lines by any class of customer if such product is returned in a timely manner, in good condition and from normal distribution channels. Return policies in certain international markets and for certain medical device products, primarily breast implants, provide for more stringent guidelines in accordance with the terms of contractual agreements with customers. Our estimates for sales returns are based upon the historical patterns of product returns matched against sales, and management’s evaluation of specific factors that may increase the risk of product returns. The amount of allowances for sales returns recognized in our consolidated balance sheets at December 31, 2014 and 2013 were $83.4 million and $84.4 million, respectively, and are recorded in “Other accrued expenses” and “Trade receivables, net” in our consolidated balance sheets. See Note 5, “Composition of Certain Financial Statement Captions” in the notes to our consolidated financial statements listed under Item 15 of Part IV of this report, “Exhibits and Financial Statement Schedules.” Provisions for sales returns deducted from consolidated sales were $447.5 million, $465.0 million and $408.3 million in 2014, 2013 and 2012, respectively. The decrease in the provisions for sales returns in 2014 compared to 2013 is primarily due to a decrease in estimated product sales return rates for our breast aesthetics products, partially offset by increased [/INST] Positive. </s>

PDC ENERGY, INC.

2015-02-19

2014-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis, as well as other sections in this report, should be read in conjunction with our consolidated financial statements and related notes to consolidated financial statements included elsewhere in this report. Further, we encourage you to revisit the Special Note Regarding Forward-Looking Statements in Part I of this report. EXECUTIVE SUMMARY 2014 Financial Overview Crude oil, natural gas and NGLs sales from continuing operations increased in 2014 by $130.6 million, or 38%, compared to 2013. The growth in crude oil, natural gas and NGLs sales was the result of increased production. For the month ended December 31, 2014, we maintained an average production rate of 30 MBoe per day. Production of 9.3 MMboe from continuing operations for the year ended December 31, 2014 represents an increase of 42% as compared to the year ended December 31, 2013, primarily attributable to our successful horizontal Niobrara and Codell drilling program in the Wattenberg Field. Crude oil production from continuing operations increased 49% in 2014, while NGLs production from continuing operations increased 68%. Our liquids percentage of total production from continuing operations was 65% in 2014. Natural gas production from continuing operations increased 25% in 2014 compared to 2013. Higher natural gas index prices at derivatives settlement during 2014 were the primary reason for negative net settlements on derivative positions of $0.8 million in 2014 compared to positive net settlements of $11.2 million in 2013. Crude oil, natural gas and NGLs sales, including the impact of net settlements on derivatives, was $470.6 million in 2014 compared to $352.0 million in 2013. This represents an increase of 34% in 2014 compared to 2013. Other significant changes impacting our 2014 results of operations include the following: • Positive net change in the fair value of unsettled derivatives in 2014 was $311.1 million compared to a negative net change in the fair value of unsettled derivative positions of $35.1 million in 2013, as the crude oil and natural gas forward curves shifted significantly lower during the later months of 2014; • Impairment of crude oil and natural gas properties increased to $163.5 million in 2014 compared to $52.5 million in 2013, primarily related to the $158.3 million write-down of our Utica Shale producing and non-producing crude oil and natural gas properties to their estimated fair value, $112.6 million of which was for proved producing properties and $45.7 million for unproved properties; • General and administrative expense increased to $115.9 million in 2014 compared to $60.0 million in 2013, primarily attributable to $40.3 million recorded in 2014 in connection with settlement of certain partnership-related class action litigation and litigation arising from bankruptcy proceedings of certain affiliated partnerships; • Depreciation, depletion and amortization expense increased to $192.5 million compared to $115.6 million in 2013, mainly due to the increase in production; and • Gain on sale of properties and equipment classified as discontinued operations increased to $76.5 million compared to a loss on sale of properties and equipment classified as discontinued operations of $1.7 million in 2013. Available liquidity as of December 31, 2014 was $398.4 million compared to $647.0 million as of December 31, 2013. Available liquidity is comprised of $16.1 million of cash and cash equivalents and $382.3 million available for borrowing under our revolving credit facility. In addition to our currently elected commitment of $450 million, we have an additional $250 million of borrowing base availability under our revolving credit facility, subject to certain terms and conditions of the agreement. Considering the additional $250 million, our liquidity position as of December 31, 2014 would have been $648.3 million. With our current derivative position, available liquidity and expected cash flows from operations, we believe we have sufficient liquidity to allow us to execute our expected capital program through 2015. Operational Overview Drilling Activities. During 2014, we continued to execute our strategic plan of increasing production, reserves and cash flows from drilling operations in the Wattenberg Field in Colorado and the Utica Shale play in southeastern Ohio. In the Wattenberg Field, we are currently running five drilling rigs. In 2014, we spudded 116 horizontal wells in the Wattenberg Field, turned-in-line 86 horizontal wells and participated in 84 gross, 18.7 net, horizontal non-operated drilling projects. We spudded 11 horizontal Utica wells in 2014 and turned-in-line eight horizontal wells. Divestiture of Appalachian Marcellus Shale Assets. In October 2014, we completed the sale of our entire 50% ownership interest in PDCM to an unrelated third-party for aggregate consideration, after our share of PDCM's debt repayment and other working capital adjustments, of approximately $192 million, comprised of approximately $153 million in net cash proceeds and a promissory note due in 2020 of approximately $39 million. The transaction included the buyer's assumption of our share of the firm transportation commitment related to the assets owned by PDCM, as well as our share of PDCM's natural gas hedging positions for the years 2014 through 2017. The divestiture resulted in a pre-tax gain of $76.3 million. Proceeds from the divestiture were used to reduce outstanding borrowings on our revolving credit facility and to fund a portion of our 2014 capital budget. 2015 Operational Outlook We expect our production for 2015 to range between 13.5 MMBoe to 14.5 MMBoe and that our production rate will average approximately 38,400 Boe per day at the mid-point of that range. Our projected expenditures for our 2015 capital program has been reduced to approximately $473 million. The updated 2015 capital program maintains our five-rig drilling program in the Wattenberg Field, but has been adjusted for anticipated service cost reductions and lower non-operated spending, partially offset by increased working interests on certain planned 2015 wells. Our 2015 capital program forecast is expected to be directed primarily to development drilling in the Wattenberg Field, completion of a four-well pad in the Utica Shale and for other miscellaneous projects. Our 2015 capital program forecast includes $435 million of development capital and $38 million for lease acquisition and other capital expenditures. A further deterioration of commodity prices could negatively impact our financial condition and results of operations. We may further revise our capital program forecast during the year as a result of, among other things, commodity prices, acquisitions or dispositions of assets, drilling results, changes in our borrowing capacity and/or significant changes in cash flows. Wattenberg Field. We expect to invest approximately $435 million in the Wattenberg Field in 2015, continuing with a five-rig drilling program. The capital program forecast is expected to consist of $379 million for our operated drilling program and $56 million for non-operated projects. We expect to spud approximately 119 and turn-in-line 109 horizontal Niobrara or Codell wells, of which 40% are expected to be extended length laterals of approximately 6,500 feet to 7,000 feet. Approximately 60% of the wells are expected to target the Niobrara formation, with the remainder targeting the Codell formation. We expect to participate in approximately 85 gross, 14.2 net, non-operated horizontal opportunities in 2015. Utica Shale. Based on current low commodity prices and large natural gas price differentials in Appalachia, we have elected to temporarily cease drilling in the Utica Shale in favor of allocating more of our 2015 capital program to our higher return projects in the Wattenberg inner and middle core areas. In 2015, we plan to invest a total of $35 million in the Utica Shale to complete and turn-in-line the four-well Cole pad that was in-process as of December 31, 2014 and for lease acquisitions and other capital expenditures. We expect to resume our Utica Shale drilling program when commodity prices and net-back realizations rebound. Non-U.S. GAAP Financial Measures We use "adjusted cash flows from operations," "adjusted net income (loss)," "adjusted EBITDA" and "PV-10," non-U.S. GAAP financial measures, for internal management reporting, when evaluating period-to-period changes and, in some cases, providing public guidance on possible future results. These measures are not measures of financial performance under U.S. GAAP and should be considered in addition to, not as a substitute for, net income (loss) or cash flows from operations, investing or financing activities, or standardized measure, as applicable, and should not be viewed as liquidity measures or indicators of cash flows reported in accordance with U.S. GAAP. The non-U.S. GAAP financial measures that we use may not be comparable to similarly titled measures reported by other companies. Also, in the future, we may disclose different non-U.S. GAAP financial measures in order to help our investors more meaningfully evaluate and compare our future results of operations to our previously reported results of operations. We strongly encourage investors to review our financial statements and publicly filed reports in their entirety and to not rely on any single financial measure. See Reconciliation of Non-U.S. GAAP Financial Measures for a detailed description of these measures, as well as a reconciliation of each to the most comparable U.S. GAAP measure. Results of Operations Summary Operating Results The following table presents selected information regarding our operating results from continuing operations: * Percentage change is not meaningful or equal to or greater than 300%. Amounts may not recalculate due to rounding. ______________ (1) Production is net and determined by multiplying the gross production volume of properties in which we have an interest by our ownership percentage. For total production volume, including discontinued operations, see Part I, Item 6, Selected Financial Data. (2) One Bbl of crude oil or NGL equals six Mcf of natural gas. (3) Represents net settlements on derivatives related to crude oil and natural gas sales, which do not include net settlements on derivatives related to natural gas marketing. (4) Represents sales from natural gas marketing, net of costs of natural gas marketing, including net settlements and net change in fair value of unsettled derivatives related to natural gas marketing activities. Crude Oil, Natural Gas and NGLs Sales The following tables present crude oil, natural gas and NGLs production and weighted-average sales price for continuing operations: * Percentage change is not meaningful or equal to or greater than 300%. Amounts may not recalculate due to rounding. * Percentage change is not meaningful or equal to or greater than 300%. Amounts may not recalculate due to rounding. The year-over-year change in crude oil, natural gas and NGLs sales revenue were primarily due to the following: Crude oil, natural gas and NGLs sales in 2014 increased 38% compared to 2013. The increase was primarily attributable to significantly higher volumes sold, in particular liquids, which resulted in a liquids percentage of total production of approximately 65% in 2014. Our average daily sales volumes increased to 25 MBoe per day in 2014 compared to 18 MBoe per day in 2013, primarily due to the success of the horizontal Niobrara and Codell drilling program in the Wattenberg Field. Contributing to the increase in crude oil, natural gas and NGLs sales was a 19% increase in the average price of natural gas in 2014 over 2013. Crude oil, natural gas and NGLs sales in 2013 increased 49% compared to 2012. The increase was primarily attributable to an increase in volumes sold, in particular liquids, which resulted in a liquids percentage of total production of approximately 61% in 2013. Our average daily sales volumes increased to 18 MBoe per day in 2013 compared to 13 MBoe per day in 2012. The increase in crude oil, natural gas and NGLs sales was also due to increases in the average price of natural gas, crude oil and NGLs of 26%, 3% and 2%, respectively, in 2013. As expected, we experienced higher than normal gathering system pressures in the Wattenberg Field by our primary third-party midstream provider during 2014 and we had previously factored in these higher line pressures into our production estimates for the year. The line pressures in 2014 were within our expectations and lower than they were in 2012 and the first three quarters of 2013, primarily due to the commissioning of the O’Connor gas plant in the fall of 2013, the startup of an additional compressor station in 2014 and relatively mild summer temperatures in 2014. Ongoing industry drilling activity in the area has continued to increase volumes on the gathering system and pressures remained at 2014 summer levels through the end of 2014. We believe our midstream service provider will be challenged to keep pace with industry drilling activity with new midstream infrastructure at least until the new Lucerne II plant is completed in mid-2015. This project should result in a significant increase in processing capacity and we anticipate that it will address system pressure issues until well into 2016, when the next significant midstream infrastructure projects are projected to be completed. We and other operators in the field are working with the midstream service provider, who continues to implement a multi-year facility expansion program that will significantly increase the long-term gathering and processing capacity of the system. Like most producers, we rely on our third-party midstream service providers to construct compression, gathering and processing facilities to keep pace with our production growth. As a result, the timing and availability of additional facilities going forward is beyond our control. Crude Oil, Natural Gas and NGLs Pricing. Our results of operations depend upon many factors, particularly the price of crude oil, natural gas and NGLs and our ability to market our production effectively. Crude oil, natural gas and NGLs prices are among the most volatile of all commodity prices. The price of crude oil and natural gas weakened significantly in the second half of 2014 due to a combination of factors including increased U.S. supply, global economic concerns and a decision by the Organization of the Petroleum Exporting Countries not to reduce supply. These price variations can have a material impact on our financial results and capital expenditures. Crude oil pricing is predominately driven by the physical market, supply and demand, financial markets and national and international politics. In the Wattenberg Field, crude oil is sold under various purchase contracts with monthly pricing provisions based on NYMEX pricing, adjusted for differentials. We are currently pursuing various alternatives with respect to oil transportation, particularly in the Wattenberg Field, with a view toward improving pricing and takeaway capacity. We recently reached agreement to commit a significant portion of our Wattenberg Field crude oil production to White Cliffs Pipeline, LLC, which will allow crude oil to be transported via pipeline to the Cushing, Oklahoma market starting in May of 2015. In addition, we have signed a long-term agreement for gathering of crude oil at the wellhead by pipeline from several of our wells and transported to at least one central point in the Wattenberg Field, with a view toward reducing costs and minimizing truck traffic and overall physical footprint. In the Utica Shale, crude oil and condensate is sold to local purchasers at each individual well site based on NYMEX pricing, adjusted for differentials. Natural gas prices vary by region and locality, depending upon the distance to markets, availability of pipeline capacity and supply and demand relationships in that region or locality. The price we receive for our natural gas produced in the Wattenberg Field is based on CIG prices, adjusted for certain deductions, while natural gas produced in the Utica Shale has been based on TETCO M-2 and Dominion pricing, adjusted for certain deductions. Starting in 2015, all of our Utica Shale gas has access to the TETCO M-2 pipeline. The differentials at our sales points for the Utica Shale widened substantially in 2014, primarily due to an oversupply of gas in the Appalachian region. We have been able to sell a portion of our Utica gas to a Midwest market which has helped to mitigate the impact of these differentials. We anticipate that the widened Appalachian differentials will continue at least through the remainder of 2015. Our price for NGLs produced in the Wattenberg Field is based on a combination of prices from the Conway hub in Kansas and Mt. Belvieu in Texas where this production is marketed. The NGLs produced in the Utica Shale are sold based on month-to-month pricing to various markets. We currently use the "net-back" method of accounting for crude oil, natural gas and NGLs production from the Wattenberg Field and crude oil from the Utica Shale as the majority of the purchasers of these commodities also provide transportation, gathering and processing services. We sell our commodities at the wellhead and collect a price and recognize revenues based on the wellhead sales price as transportation and processing costs downstream of the wellhead are incurred by the purchaser and reflected in the wellhead price. The net-back method results in the recognition of a sales price that is below the indices for which the production is based. Natural gas and NGLs sales related to production from the Utica Shale are recognized based on gross prices as the purchasers do not provide transportation, gathering or processing services and we recognize expenses relating to those services as production costs. Production Costs Production costs include lease operating expenses, production taxes, transportation and gathering expense and certain production and engineering staff-related overhead costs as follows: Lease operating expenses. Lease operating expenses per Boe were $4.36, $4.78 and $4.57 for 2014, 2013 and 2012, respectively. The $9.3 million increase in lease operating expenses in 2014 as compared to 2013 was primarily due to an increase of $2.9 million to mitigate high line pressures in the Wattenberg Field, including costs for the rental of additional compressors, as well as additional well maintenance incurred in order to increase the operating efficiency of older vertical wells, $1.1 million for workover and maintenance related projects, including additional costs incurred for the plugging of older vertical wells, $1.9 million for environmental compliance and remediation projects, $1.9 million for lease operating expenses incurred on the increasing number of non-operated wells and $1.0 million in additional wages and benefits due to increased headcount. The $9.0 million increase in lease operating expenses in 2013 as compared to 2012 was due to an increase of $3.5 million for workover, compliance and maintenance related projects, an increase of $2.1 million for the rental of additional compressors used to mitigate high line pressures in the Wattenberg Field, an increase of $1.2 million in additional wages and employee benefits due to increased headcount and $0.9 million of expenses for wells impacted by the September 2013 Colorado flood. Production taxes. Production taxes are directly related to crude oil, natural gas and NGLs sales. The $3.8 million, or 17%, increase in production taxes for 2014 compared to 2013 is primarily related to the 38% increase in crude oil, natural gas and NGLs sales. Similarly, the $7.9 million, or 57%, increase in production taxes for 2013 compared to 2012 is primarily related to the 49% increase in crude oil, natural gas and NGLs sales. Transportation, gathering and processing expenses. The $0.6 million, or 12%, decrease in transportation, gathering and processing expenses for 2014 compared to 2013 was primarily attributable to a $2.5 million reduction in our unutilized takeaway capacity and other transportation costs resulting from the divestiture of our shallow Upper Devonian (non-Marcellus Shale) Appalachian Basin producing properties and a $0.4 million decrease in compressor and refrigeration unit rentals in the Utica Shale, offset by a $2.3 million net increase in transportation and processing expenses due to higher production levels, primarily in the Utica Shale region. The $2.4 million, or 86%, increase in transportation, gathering and processing expenses for 2013 compared to 2012 was primarily attributable to an increase in unutilized takeaway capacity costs in our shallow Upper Devonian (non-Marcellus Shale) Appalachian Basin producing properties. Overhead and other production expenses. Overhead and other production expenses increased $6.2 million in 2014 compared to 2013 mainly attributable to a $3.2 million increase in wages and employee benefits, mostly attributable to moving Utica Shale employee costs to production expense from exploration expense, and an increase of $2.9 million for the write-off of costs due to changes in our capital and future development plan. The decrease of $3.8 million in 2013 compared to 2012 was mainly the result of $3.2 million of expense recognized in 2012 related to the sale of crude oil inventory that had been acquired at fair market value in the Merit Acquisition. Commodity Price Risk Management, Net We use various derivative instruments to manage fluctuations in natural gas and crude oil prices. We have in place a variety of collars, fixed-price swaps and basis swaps on a portion of our estimated natural gas and crude oil production. Because we sell all of our natural gas and crude oil production at prices similar to the indexes inherent in our derivative instruments, adjusted for certain fees and surcharges stipulated in the applicable sales agreements, we ultimately realize a price, before contract fees, related to our collars of no less than the floor and no more than the ceiling and, for our commodity swaps, we ultimately realize the fixed price related to our swaps. See Note 4, Derivative Financial Instruments, to our consolidated financial statements included elsewhere in this report and Item 7A, Quantitative and Qualitative Disclosures About Market Risk, for a discussion of how each derivative type impacts our cash flows and a detailed presentation of our derivative positions as of December 31, 2014. Commodity price risk management, net, includes cash settlements upon maturity of our derivative instruments and the change in fair value of unsettled derivatives related to our crude oil and natural gas production. Commodity price risk management, net, does not include derivative transactions related to our natural gas marketing, which are included in sales from and cost of natural gas marketing. See Note 3, Fair Value of Financial Instruments, and Note 4, Derivative Financial Instruments, to our consolidated financial statements included elsewhere in this report for additional details of our derivative financial instruments. Net settlements are primarily the result of crude oil and natural gas index prices at maturity of our derivative instruments compared to the respective strike prices. Net change in fair value of unsettled derivatives is comprised of the net asset increase or decrease in the beginning-of-period fair value of derivative instruments that settled during the period and the net change in fair value of unsettled derivatives during the period. The corresponding impact of settlement of the derivative instruments that settled during the period is included in net settlements for the period as discussed above. Net change in fair value of unsettled derivatives during the period is primarily related to shifts in the crude oil and natural gas forward curves and changes in certain differentials. See Note 4, Derivative Financial Instruments, to our consolidated financial statements included elsewhere in this report for a detailed description of net settlements on our various derivatives. The following table presents net settlements and net change in fair value of unsettled derivatives included in commodity price risk management, net: Natural Gas Marketing Fluctuations in our natural gas marketing's income contribution are primarily due to fluctuations in commodity prices, cash settlements upon maturity of derivative instruments and the change in fair value of unsettled derivatives, and volumes sold and purchased. The following table presents the components of sales from and costs of natural gas marketing: The increase in natural gas sales revenue and costs of natural gas purchases in 2014 compared to 2013 is primarily attributable to a 7.5% increase in volumes slightly offset by a 2.8% decrease in the average natural gas price. The increase in natural gas sales revenue and costs of natural gas purchases in 2013 compared to 2012 is primarily attributable to a 30% increase in the average natural gas price and a 14% increase in volumes. Derivative instruments related to natural gas marketing include both physical and cash-settled derivatives. We offer fixed-price derivative contracts for the purchase or sale of physical natural gas and enter into cash-settled derivative positions with counterparties in order to offset those same physical positions. See Note 4, Derivative Financial Instruments, to our consolidated financial statements included elsewhere in this report and Item 7A, Quantitative and Qualitative Disclosures About Market Risk, for a discussion of how each derivative type impacts our cash flows and detailed presentation of our derivative positions as of December 31, 2014. Exploration Expense The following table presents the major components of exploration expense: Exploratory dry hole costs. There were no exploratory dry holes in 2014 and 2013. In 2012, two vertical stratigraphic test wells in southeastern Ohio were expensed at a cost of $12.2 million. The remaining 2012 expense relates to the unsuccessful testing of an exploratory zone in two existing wells in the Wattenberg Field and three Rose Run test wells in Ohio that were determined to have found noncommercial quantities of hydrocarbons. Geological and geophysical costs. Geological and geophysical costs in 2013 and 2012 were primarily related to costs associated with reservoir studies in the Utica Shale. Operating, personnel and other. The $4.7 million decrease in 2014 compared to 2013 is primarily related to a reduction in personnel costs in the Utica Shale resulting from the reassignment of former exploration department personnel to production departments and to general and administrative expense. The $2.6 million increase in 2013 compared to 2012 was mainly attributable to an increase in payroll and employee benefits in the exploration division as a result of increased employee headcount in the Utica Shale. Impairment of Crude Oil and Natural Gas Properties The following table sets forth the major components of our impairments of crude oil and natural gas properties expense: Impairment of proved properties. In 2014, we recognized an impairment charge of $112.6 million to write-down certain capitalized well costs on our Utica Shale proved producing properties. The impairment charge represented the amount by which the carrying value of the Utica Shale proved producing properties exceeded the estimated fair value due to the current low commodity prices, large natural gas price differentials in the Appalachian Basin and changes in our Utica Shale drilling plans. The estimated fair value was determined based on estimated future discounted net cash flows, a Level 3 input, using estimated production and prices at which we reasonably expect the crude oil and natural gas will be sold. A significant decrease in future expected crude oil and natural gas prices could result in further impairments of these properties.The impairment charge was included in the consolidated statements of operations line item impairment of crude oil and natural gas properties. In 2013, we recognized an impairment charge of approximately $48.8 million related to all of our shallow Upper Devonian (non-Marcellus Shale) Appalachian Basin producing properties located in West Virginia and Pennsylvania previously owned directly by us, as well as through our proportionate share of PDCM. The impairment charge represented the excess of the carrying value of the assets over the estimated fair value, less the cost to sell. The fair value of the assets was determined based upon estimated future cash flows from unrelated third-party bids, a Level 3 input. See Note 14, Assets Held for Sale, Divestitures and Discontinued Operations, to our consolidated financial statements included elsewhere in this report for additional details related to the sale of these properties. Impairment of unproved properties. In 2014, we also recognized an impairment charge of $45.7 million to write-down certain capitalized leasehold costs on our Utica Shale unproved properties. The impairment was due to the current low commodity prices, large natural gas price differentials in the Appalachian Basin and changes in our Utica Shale drilling plans. The $0.5 million decrease in 2013 compared to 2012 is primarily related to two significant leases that were written off in 2012 in the Wattenberg Field for $1.0 million compared to a single lease in non-Utica Ohio acreage written off in 2013 for $0.5 million. General and Administrative Expense General and administrative expense increased $55.9 million, or 93.2%, in 2014 compared to 2013. The increase was mainly attributable to $40.3 million recorded in 2014 in connection with settlement of certain partnership-related class action litigation and litigation arising from bankruptcy proceedings of certain affiliated partnerships. Additional increases were an $8.8 million increase in payroll and employee benefits, of which $3.9 million was related to stock-based compensation, and a $4.6 million increase in legal fees, primarily related to the aforementioned partnership-related class action litigation, consulting and other professional services. General and administrative expense increased $5.1 million, or 9.4%, in 2013 compared to 2012. The increase was primarily due to a $4.9 million increase in payroll, employee benefits and stock-based compensation and a $1.5 million increase in other general and administrative expenses. These increases were offset in part by a decrease in professional and consulting fees of $1.3 million. Depreciation, Depletion and Amortization Crude oil and natural gas properties. DD&A expense related to crude oil and natural gas properties is directly related to proved reserves and production volumes. DD&A expense related to crude oil and natural gas properties was $188.5 million in 2014 compared to $111.6 million in 2013. The increase in 2014 compared to 2013 was comprised of $48.9 million due to higher production and $28.0 million due to a higher weighted-average DD&A expense rate. The following table presents our DD&A expense rates for crude oil and natural gas properties: The decrease in the Wattenberg Field DD&A rate in 2013 was the result of the property acquisition costs of the Merit Acquisition being depleted over our entire proved reserves, whereas the majority of our DD&A expense is depleted over our proved developed reserves. The increase in the Utica Shale DD&A expense rate in 2014 compared to 2013 was mainly the result of depleting the entire capitalized well costs of a Utica Shale horizontal well that experienced a mechanical failure during the year. Non-crude oil and natural gas properties. Depreciation expense for non-crude oil and natural gas properties was $4.1 million for 2014 compared to $4.0 million for 2013 and $4.8 million for 2012. Accretion of Asset Retirement Obligations Accretion of asset retirement obligations ("ARO") for 2014 decreased by $1.2 million, or 25.2%, compared to 2013. The decrease in 2014 is primarily attributable to the sale of our shallow Upper Devonian (non-Marcellus Shale) Appalachian Basin producing properties in 2013. Accretion of ARO for 2013 increased by $0.9 million, or 24.4%, compared to 2012. The increase in 2013 is primarily attributable to the properties acquired in the Merit Acquisition in 2012. Gain (Loss) on Sale of Properties and Equipment The loss on sale of properties and equipment of $0.5 million in 2014 primarily relates to the sale of certain affiliate partnership wells and various drilling equipment. The gain on sale of properties and equipment of $2.0 million in 2013 primarily relates to the sale of our shallow Upper Devonian (non-Marcellus Shale) Appalachian Basin producing properties. The gain on sale of properties and equipment in 2012 was not material. Interest Expense Interest expense decreased by approximately $2.3 million in 2014 compared to 2013. The decrease is primarily comprised of a $1.8 million decrease attributable to an increase in the interest expense capitalized in 2014. Interest expense increased by approximately $2.6 million in 2013 compared to 2012. The increase is primarily related to $39.6 million of interest expense resulting from the issuance of $500 million of 7.75% senior notes due 2022 in October 2012. Partially offsetting this increase were decreases of $31.1 million related to the November 2012 redemption of previously-outstanding 12% senior notes due 2018 and $5.3 million as a result of lower average borrowings on our revolving credit facility during 2013 as compared to 2012. Interest costs capitalized in 2014, 2013 and 2012 were $3.5 million, $1.7 million and $0.9 million, respectively. Loss on Extinguishment of Debt The $23.3 million loss on extinguishment of debt in 2012 related to the redemption of the previously-outstanding 12% senior notes due 2018 in October 2012. The pre-tax loss consisted of an $18.9 million make-whole premium and the write-off of both unamortized debt discount of $1.5 million and unamortized debt issuance costs of $2.9 million. Provision for Income Taxes For 2014, the effective tax rate (the "rate") of 39.5% on income from continuing operations differs from the statutory tax rate of 35% primarily due to state income taxes. For 2013, the rate of 36.0% on loss from continuing operations differs from the statutory tax rate primarily due to state income taxes and nondeductible executive compensation, partially offset by the percentage depletion deduction. The 2012 rate of 36.9% on loss from continuing operations differs from the statutory tax rate primarily due to the percentage depletion deduction. See Note 7, Income Taxes, to our consolidated financial statements included elsewhere in this report for our rate reconciliation for each of the years in the three-year period ended December 31, 2014. We are current with our income tax filings in all applicable state jurisdictions and are not currently under examination. We continue voluntary participation in the Internal Revenue Service’s (the "IRS") Compliance Assurance Program (the "CAP Program") for the 2014 and 2015 tax years. We have received a full acceptance “no change” notice from the IRS for our filed 2013 federal tax return. Discontinued Operations Appalachian Marcellus Shale Assets. In October 2014, we completed the sale of our entire 50% ownership interest in PDCM to an unrelated third-party for aggregate consideration, after our share of PDCM's debt repayment and other working capital adjustments, of approximately $192 million, comprised of approximately $153 million in net cash proceeds and a promissory note due in 2020 of approximately $39 million. The transaction included the buyer's assumption of our share of the firm transportation commitment related to the assets owned by PDCM, as well as our share of PDCM's natural gas hedging positions for the years 2014 through 2017. The divestiture resulted in a pre-tax gain of $76.3 million. The divestiture represents a strategic shift in our operations. Accordingly, our proportionate share of PDCM's Marcellus Shale results of operations have been separately reported as discontinued operations in the consolidated statements of operations for all periods presented. Piceance Basin and NECO. In June 2013, we divested our Piceance Basin, NECO and certain other non-core Colorado oil and gas properties, leasehold mineral interests and related assets for total consideration of approximately $177.6 million, with an additional $17.0 million paid to our non-affiliated investor partners in our affiliated partnerships. Following the sale, we do not have significant continuing involvement in the operations of, or cash flows from, the Piceance Basin and NECO oil and gas properties. Accordingly, the results of operations related to these assets have been reported as discontinued operations for all periods presented in the accompanying consolidated statements of operations included in this report. For operating results related to our discontinued operations, see Note 14, Assets Held for Sale, Divestitures and Discontinued Operations, to our consolidated financial statements included elsewhere in this report. Net Income (Loss)/Adjusted Net Income (Loss) The changes in net income in 2014 compared to net loss in 2013 and 2012 are discussed above. These same reasons similarly impacted adjusted net income (loss), a non-U.S. GAAP financial measure, with the exception of the net change in fair value of unsettled derivatives, adjusted for taxes, of $193.1 million, $22.8 million and $10.6 million in 2014, 2013 and 2012, respectively. Adjusted net loss, a non-U.S. GAAP financial measure, was $37.7 million and $120.1 million in 2014 and 2012, respectively, compared to an adjusted net income of $0.5 million in 2013. See Reconciliation of Non-U.S. GAAP Financial Measures, below, for a more detailed discussion of this non-U.S. GAAP financial measure. Financial Condition, Liquidity and Capital Resources Historically, our primary sources of liquidity have been cash flows from operating activities, our revolving credit facility, proceeds raised in debt and equity market transactions and asset sales. In 2014, our primary sources of liquidity were net cash flows from operating activities of $236.7 million, net cash proceeds received from the sale of our entire 50% ownership interest in PDCM of approximately $152.8 million, net borrowings under our revolving credit facility of $63.8 million and the remaining proceeds from the August 2013 equity transaction. Our primary source of cash flows from operating activities is the sale of crude oil, natural gas and NGLs. Fluctuations in our operating cash flows are substantially driven by commodity prices and changes in our production volumes. Commodity prices have historically been volatile and we manage this volatility through our use of derivatives. We enter into commodity derivative instruments with maturities of no greater than five years from the date of the instrument. For instruments that mature in three years or less, our debt covenants restrict us from entering into hedges that would exceed 85% of our expected future production from total proved reserves for such related time period (proved developed producing, proved developed non-producing and proved undeveloped). For instruments that mature later than three years, but no more than our designated maximum maturity, our debt covenants limit us from entering into hedges that would exceed 85% of our expected future production from proved developed producing properties during that time period. In addition, we may not hedge the maximum amounts permitted under our covenants. Therefore, we may still have significant fluctuations in our cash flows from operating activities due to the remaining non-hedged portion of our future production. Given the depressed commodity prices entering 2015 relative to our 2015 hedge prices, we expect that positive net settlements on our derivative positions will be a significant positive component of our 2015 cash flows from operations. Our working capital fluctuates for various reasons, including, but not limited to, changes in the fair value of our commodity derivative instruments and changes in our cash and cash equivalents due to our practice of utilizing excess cash to reduce the outstanding borrowings under our revolving credit facility. At December 31, 2014, we had a working capital surplus of $30.3 million compared to a surplus of $112.4 million at December 31, 2013. The reduction in working capital is due to our utilization of the 2013 year-end cash balance to fund our 2014 capital program and an increase in current deferred tax liability, partially offset by a significant increase in the fair value of unsettled derivatives. We ended 2014 with cash and cash equivalents of $16.1 million and availability under our revolving credit facility of $382.3 million, for a total liquidity position of $398.4 million, compared to $647.0 million at December 31, 2013. The decrease in liquidity of $248.6 million, or 38.4%, was primarily attributable to capital expenditures of $628.6 million during 2014, offset in part by cash flows provided by operating activities of $236.7 million and $154.5 million received from the sale of our entire 50% ownership interest in PDCM and other properties and equipment. In addition to our currently elected commitment of $450 million, we have an additional $250 million of borrowing base availability under our revolving credit facility, subject to certain terms and conditions of the agreement. Our forecast estimates our adjusted cash flows from operations will range from $350 million to $375 million in 2015, based on estimated NYMEX crude oil and natural gas prices of $51.72 per barrel and $2.86 per Mcf, respectively, before the effects of differentials or hedges. Due to the derivative hedges in place as of December 31, 2014, a $10 per barrel change in the price of crude oil would change our estimated adjusted cash flows from operations by approximately $20 million to $25 million. Based on our current commodity mix and hedge position, we estimate that a decline in the price of natural gas will not have a material impact on our adjusted cash flows from operations in 2015. With our current derivative position, liquidity position and expected cash flows from operations, we believe that we have sufficient capital to fund our planned drilling operations in 2015. In recent periods, we have been able to access borrowings under our revolving credit facility and to obtain proceeds from the issuance of debt and equity securities. We cannot, however, assure this will continue to be the case in the future. In light of recent weakened commodity prices, we continue to monitor market conditions and their potential impact on each of our revolving credit facility lenders, many of which are counterparties in our derivative transactions. Our revolving credit facility borrowing base is subject to a redetermination each May and November, based upon a quantification of our proved reserves at each June 30 and December 31, respectively. In September 2014, the semi-annual redetermination of our revolving credit facility's borrowing base was completed, resulting in an increase in the borrowing base from $450 million to $700 million. However, we have elected to maintain the aggregate commitment at $450 million. We had $56.0 million outstanding under our revolving credit facility as of December 31, 2014. Our next scheduled redetermination is in May 2015, and recent declines in commodity prices increase the risk of a reduction in our borrowing base. While we have added and expect to continue to add producing reserves through our drilling operations, these reserve additions could be offset by other factors including, among other things, a prolonged decrease in commodity prices. In January 2012, we filed an automatic shelf registration statement on Form S-3 with the SEC, pursuant to which we sold 5.2 million shares of our common stock in August 2013 in an underwritten public offering at a price to us of $53.37 per share. That registration statement has since expired, and we intend to file a new automatic shelf registration on Form S-3 with the SEC in the first half of 2015. Our revolving credit facility contains financial maintenance covenants. The covenants require that we maintain: (i) total debt of less than 4.25 times earnings before interest, taxes, depreciation, depletion and amortization, change in fair value of unsettled derivatives, exploration expense, gains (losses) on sales of assets and other non-cash, extraordinary or non-recurring gains (losses) ("EBITDAX") and (ii) an adjusted current ratio of at least 1.0 to 1.0. Our adjusted current ratio is adjusted by eliminating the impact on our current assets and liabilities of recording the fair value of crude oil and natural gas derivative instruments. Additionally, available borrowings under our revolving credit facility are added to the current asset calculation and the current portion of our revolving credit facility debt is eliminated from the current liabilities calculation. At December 31, 2014, we were in compliance with all debt covenants with a 2.1 times debt to EBITDAX ratio and a 1.7 to 1.0 current ratio. We expect to remain in compliance throughout the next year, taking into account the current pricing environment. The indenture governing our 7.75% senior notes due 2022 contains customary restrictive covenants that, among other things, limit our ability and the ability of our restricted subsidiaries to: (a) incur additional debt, (b) make certain investments or pay dividends or distributions on our capital stock or purchase, redeem or retire capital stock, (c) sell assets, including capital stock of our restricted subsidiaries, (d) restrict the payment of dividends or other payments by restricted subsidiaries to us, (e) create liens that secure debt, (f) enter into transactions with affiliates and (g) merge or consolidate with another company. At December 31, 2014, we were in compliance with all covenants and expect to remain in compliance throughout the next year. The conversion rights on our Convertible Notes could be triggered prior to the maturity date. We have initially elected a net-settlement method to satisfy our conversion obligation, which allows us to settle the principal amount of the Convertible Notes in cash and to settle the excess conversion value in shares, as well as cash in lieu of fractional shares. In the event that a holder elects to convert its note, we expect to fund the cash settlement of any such conversion from working capital and/or borrowings under our revolving credit facility. We expect to utilize the net-settlement method to satisfy our conversion obligation upon the maturity of the Convertible Notes in May 2016. The conversion right is not expected to have a material impact on our financial position. The Convertible Notes were not convertible at the option of holders as of December 31, 2014. See Part II, Item 7A, Quantitative and Qualitative Disclosures about Market Risk, for our discussion of credit risk. Cash Flows Operating Activities. Our net cash flows from operating activities are primarily impacted by commodity prices, production volumes, net settlements from our derivative positions, operating costs and general and administrative expenses. Cash flows provided by operating activities increased in 2014 compared to 2013. The $77.5 million increase was mainly attributable to the increase in crude oil, natural gas and NGLs sales of $130.6 million and the decrease in changes in assets and liabilities of $35.1 million related to the timing of cash payments and receipts. These increases were offset in part by increases in general and administrative expense of $55.9 million, production costs of $15.8 million, net of prepaid well cost write-offs of $2.9 million, and the decrease in net settlements on derivative positions of $15.1 million. Cash flows provided by operating activities decreased in 2013 compared to 2012. The $15.6 million decrease was mainly attributable to changes in assets and liabilities of $59.4 million related to the timing of cash payments and receipts, the decrease in net settlements on derivative positions of $36.5 million and increases in production costs, net of inventory adjustments and prepaid well cost write-offs, of $26.2 million, general and administrative expense of $5.2 million and interest expense of $3.6 million. The decrease was offset in part by the increase in crude oil, natural gas and NGLs sales of $121.0 million. The key components for the changes in our cash flows provided by operating activities are described in more detail in Results of Operations above. Adjusted cash flows from operations, a non-U.S. GAAP financial measure, increased by $42.4 million in 2014 and $43.9 million in 2013 when compared to the respective prior years. These changes were primarily due to the same factors mentioned above for changes in cash flows provided by operating activities, without regard to timing of cash payments and/or receipts of our assets and liabilities of $13.5 million and $48.6 million in 2014 and 2013, respectively. Adjusted EBITDA, a non-U.S. GAAP financial measure, increased by $120.0 million in 2014 from 2013, primarily due to a $130.6 million increase in crude oil, natural gas and NGLs sales and a $72.3 million increase in contribution margins related to divested crude oil and natural gas assets, offset in part by a $55.9 million increase in general and administrative expense, a $18.7 million increase in production costs and a $12.1 million decrease in net settlements on derivatives. Adjusted EBITDA increased by $44.1 million in 2013 from 2012, primarily due to a $112.8 million increase in crude oil, natural gas and NGLs sales, offset in part by a $32.4 million decrease in net settlements on derivatives, a $26.1 million decrease in contribution margins related to divested crude oil and natural gas assets and a $15.5 million increase in production costs. See Reconciliation of Non-U.S. GAAP Financial Measures, below, for a more detailed discussion of non-U.S. GAAP financial measures. Investing Activities. Because crude oil and natural gas production from a well declines rapidly in the first few years of production, we need to continue to commit significant amounts of capital in order to maintain and grow our production and replace our reserves. If capital is not available or is constrained in the future, we will be limited to our cash flows from operations and liquidity under our revolving credit facility as the sources for funding our capital expenditures. We would not be able to maintain our current level of crude oil, natural gas and NGLs production and cash flows from operating activities if capital markets were unavailable, commodity prices were to become depressed and/or the borrowing base under our revolving credit facility was significantly reduced. The occurrence of such an event may result in our election to defer a substantial portion of our planned capital expenditures and could have a material negative impact on our operations in the future. Cash flows from investing activities primarily consist of the acquisition, exploration and development of crude oil and natural gas properties, net of dispositions of crude oil and natural gas properties. In 2014, our drilling program consisted of five drilling rigs operating in the horizontal Niobrara and Codell plays in our Wattenberg Field and one drilling rig in the Utica Shale. See Part I, Properties - Drilling Activities, for additional details on our drilling activities. Net cash used in investing activities of $474.1 million during 2014 was primarily related to cash utilized for our drilling operations of $628.6 million, offset in part by the $152.8 million net cash proceeds received from the sale of our entire 50% ownership interest in PDCM. Net cash used in investing activities of $217.1 million during 2013 was primarily related to cash utilized for our drilling operations of $394.9 million, offset in part by the $187.5 million received from the sale of properties and equipment, including acquisition adjustments. In 2013, we also paid approximately $9.7 million for the acquisition of crude oil and natural gas properties. In 2012, net cash used in investing activities was primarily related to the $304.6 million expended in June 2012 for the Merit Acquisition and $347.7 million for our drilling operations and acquisition of Utica Shale acreage, offset in part by $189.2 million received from the divestiture of our Permian assets in February 2012 and $28.9 million received related to title defects discovered from PDCM's Seneca-Upshur acquisition in October 2011, of which $14.5 million represented our share. Financing Activities. Net cash from financing activities in 2014 were primarily comprised of net borrowings under our revolving credit facility of $63.8 million to execute our capital budget. Net cash from financing activities in 2013 was primarily related to the $275.8 million received from the issuance of our common stock in August 2013, partially offset by net payments of approximately $23.3 million to pay down amounts borrowed under revolving credit facilities. Net cash from financing activities in 2012 includes gross proceeds of $500 million from our October 2012 issuance of the 7.75% senior notes due 2022 and $164.5 million from our May 2012 sale of common stock. The net proceeds from the issuance of the 7.75% senior notes due 2022 were used to fund the redemption of our previously-outstanding 12% senior notes due 2018 for a total redemption price of approximately $222 million and to repay a portion of amounts outstanding under our revolving credit facility. The proceeds from the sale of common stock in May 2012 were used to finance a portion of the Merit Acquisition. Contractual Obligations and Contingent Commitments The following table presents our contractual obligations and contingent commitments as of December 31, 2014: __________ (1) Table does not include deferred income tax liability to taxing authorities of $125.7 million, due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. (2) Amount presented does not agree with the consolidated balance sheets in that it excludes $6.1 million in unamortized debt discount. See Note 8, Long-Term Debt, to our consolidated financial statements included elsewhere in this report. (3) Represents our gross liability related to the fair value of derivative positions. (4) Includes deferred compensation to former executive officers and deferred payments related to firm transportation agreements. (5) Table does not include an undrawn $11.7 million irrevocable standby letter of credit pending issuance to a transportation service provider. See Note 8, Long-Term Debt, to our consolidated financial statements included elsewhere in this report. Additionally, the table does not include the annual repurchase obligations to investing partners or termination benefits related to employment agreements with our executive officers, due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. See Note 11, Commitments and Contingencies - Partnership Repurchase Provision; Employment Agreements with Executive Officers, to our consolidated financial statements included elsewhere in this report. (6) Amounts presented include $301.9 million to the holders of our 7.75% senior notes due 2022 and $5.1 million payable to the holders of our 3.25% convertible senior notes due 2016. Amounts also include $12.1 million payable to the participating banks in our revolving credit facility, of which interest of $4.9 million is related to unutilized commitments at a rate of .38% per annum, $7.1 million related to the outstanding borrowings on our revolving credit facility of $56.0 million and $0.1 million related to our undrawn letters of credit. (7) Represents our gross commitment. See Note 11, Commitments and Contingencies - Firm Transportation, Processing and Sales Agreements, to our consolidated financial statements included elsewhere in this report. As the managing general partner of affiliated partnerships, we have liability for potential casualty losses in excess of the partnership assets and insurance. We believe that the casualty insurance coverage we and our subcontractors carry is adequate to meet this potential liability. For information regarding our legal proceedings, see Note 11, Commitments and Contingencies - Litigation, to our consolidated financial statements included elsewhere in this report. From time to time, we are a party to various other legal proceedings in the ordinary course of business. We are not currently a party to any litigation that we believe would have a materially adverse effect on our business, financial condition, results of operations or liquidity. Critical Accounting Policies and Estimates We have identified the following policies as critical to business operations and the understanding of our results of operations. This is not a comprehensive list of all of the accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP, with no need for our judgment in the application. There are also areas in which our judgment in selecting available alternatives would not produce a materially different result. However, certain of our accounting policies are particularly important to the portrayal of our financial position and results of operations and we may use significant judgment in the application. As a result, they are subject to an inherent degree of uncertainty. In applying those policies, we use our judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on historical experience, observation of trends in the industry and information available from other outside sources, as appropriate. For a more detailed discussion on the application of these and other accounting policies, see Note 2, Summary of Significant Accounting Policies, to our consolidated financial statements included elsewhere in this report. Crude Oil and Natural Gas Properties. We account for our crude oil and natural gas properties under the successful efforts method of accounting. Costs of proved developed producing properties, successful exploratory wells and developmental dry hole costs are capitalized and depreciated or depleted by the unit-of-production method based on estimated proved developed producing reserves. Property acquisition costs are depreciated or depleted on the unit-of-production method based on estimated proved reserves. Annually, we engage independent petroleum engineers to prepare reserve and economic evaluations of all our properties on a well-by-well basis as of December 31. We adjust our crude oil and natural gas reserves for major acquisitions, new drilling and divestitures during the year as needed. The process of estimating and evaluating crude oil and natural gas reserves is complex, requiring significant decisions in the evaluation of available geological, geophysical, engineering and economic data. The data for a given property may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and a continual reassessment of the viability of production under changing economic conditions. As a result, revisions in existing reserve estimates occur. Although every reasonable effort is made to ensure that reserve estimates reported represent our most accurate assessments possible, the subjective decisions and variances in available data for various properties increase the likelihood of significant changes in these estimates over time. Because estimates of reserves significantly affect our DD&A expense, a change in our estimated reserves could have an effect on our net income. Exploration costs, including geological and geophysical expenses, and delay rentals, are charged to expense as incurred. Exploratory well drilling costs, including the cost of stratigraphic test wells, are initially capitalized, but are charged to expense if the well is determined to be nonproductive. The status of each in-progress well is reviewed quarterly to determine the proper accounting treatment under the successful efforts method of accounting. Exploratory well costs continue to be capitalized as long as the well has found a sufficient quantity of reserves to justify completion as a producing well and we are making sufficient progress assessing our reserves and economic and operating viability. If an in-progress exploratory well is found to be unsuccessful prior to the issuance of the financial statements, the costs incurred prior to the end of the reporting period are charged to exploration expense. If we are unable to make a final determination about the productive status of a well prior to issuance of the financial statements, the well is classified as "suspended well costs" until we have had sufficient time to conduct additional completion or testing operations to evaluate the pertinent geological and engineering data obtained. At the time when we are able to make a final determination of a well’s productive status, the well is removed from the suspended well status and the proper accounting treatment is applied. The acquisition costs of unproved properties are capitalized when incurred, until such properties are transferred to proved properties or charged to expense when expired, impaired or amortized. Unproved crude oil and natural gas properties with individually significant acquisition costs are periodically assessed, and any impairment in value is charged to impairment of crude oil and natural gas properties. The amount of impairment recognized on unproved properties which are not individually significant is determined by amortizing the costs of such properties within appropriate fields based on our historical experience, acquisition dates and average lease terms, with the amortization recognized in impairment of crude oil and natural gas properties. The valuation of unproved properties is subjective and requires us to make estimates and assumptions which, with the passage of time, may prove to be materially different from actual realizable values. We assess our crude oil and natural gas properties for possible impairment upon a triggering event by comparing net capitalized costs to estimated undiscounted future net cash flows on a field-by-field basis using estimated production based upon prices at which we reasonably estimate the commodity to be sold. Any impairment in value is charged to impairment of crude oil and natural gas properties. The estimates of future prices may differ from current market prices of crude oil and natural gas. Any downward revisions in estimates to our reserve quantities, expectations of falling commodity prices or rising operating costs could result in a triggering event, and therefore, a reduction in undiscounted future net cash flows and an impairment of our crude oil and natural gas properties. Although our cash flow estimates are based on the relevant information available at the time the estimates are made, estimates of future cash flows are, by nature, highly uncertain and may vary significantly from actual results. Crude Oil, Natural Gas and NGLs Sales Revenue Recognition. Crude oil, natural gas and NGLs sales are recognized when production is sold to a purchaser at a determinable price, delivery has occurred, rights and responsibility of ownership have transferred and collection of revenue is reasonably assured. We record sales revenue based on an estimate of the volumes delivered at estimated prices as determined by the applicable sales agreement. We estimate our sales volumes based on company-measured volume readings. We then adjust our crude oil, natural gas and NGLs sales in subsequent periods based on the data received from our purchasers that reflects actual volumes and prices received. We receive payment for sales from one to two months after actual delivery has occurred. The differences in sales estimates and actual sales are recorded two months later. Historically, these differences have been immaterial. Fair Value of Financial Instruments. Our fair value measurements are estimated pursuant to a fair value hierarchy that requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date, giving the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable data (Level 3). In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The lowest level input that is significant to a fair value measurement in its entirety determines the applicable level in the fair value hierarchy. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability, and may affect the valuation of the assets and liabilities and their placement within the fair value hierarchy levels. The three levels of inputs that may be used to measure fair value are defined as: Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability and inputs that are derived from observable market data by correlation or other means. Level 3 - Unobservable inputs for the asset or liability, including situations where there is little, if any, market activity. Derivative Financial Instruments. We measure the fair value of our derivative instruments based on a pricing model that utilizes market-based inputs, including but not limited to the contractual price of the underlying position, current market prices, natural gas and crude oil forward curves, discount rates such as the LIBOR curve for a similar duration of each outstanding position, volatility factors and nonperformance risk. Nonperformance risk considers the effect of our credit standing on the fair value of derivative liabilities and the effect of our counterparties' credit standings on the fair value of derivative assets. Both inputs to the model are based on published credit default swap rates and the duration of each outstanding derivative position. We validate our fair value measurement through the review of counterparty statements and other supporting documentation, the determination that the source of the inputs is valid, the corroboration of the original source of inputs through access to multiple quotes, if available, or other information and monitoring changes in valuation methods and assumptions. While we use common industry practices to develop our valuation techniques, changes in our pricing methodologies or the underlying assumptions could result in significantly different fair values. While we believe our valuation method is appropriate and consistent with those used by other market participants, the use of a different methodology or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value. Net settlements on our derivative instruments are initially recorded to accounts receivable or payable, as applicable, and may not be received from or paid to counterparties to our derivative contracts within the same accounting period. Such settlements typically occur the month following the maturity of the derivative instrument. We have evaluated the credit risk of the counterparties holding our derivative assets, which are primarily financial institutions who are also major lenders in our revolving credit facility, giving consideration to amounts outstanding for each counterparty and the duration of each outstanding derivative position. Based on our evaluation, we have determined that the potential impact of nonperformance of our counterparties on the fair value of our derivative instruments is not significant. Deferred Income Tax Asset Valuation Allowance. Deferred income tax assets are recognized for deductible temporary differences, net operating loss carry-forwards and credit carry-forwards if it is more likely than not that the tax benefits will be realized. To the extent a deferred tax asset is not expected to be realized under the preceding criteria, we establish a valuation allowance. The factors which we consider in assessing whether we will realize the value of deferred income tax assets involve judgments and estimates of both amount and timing, which could differ from actual results, achieved in future periods. The judgments used in applying these policies are based on our evaluation of the relevant facts and circumstances as of the date of the financial statements. Actual results may differ from those estimates. Accounting for Acquisitions Using Purchase Accounting. We utilize the purchase method to account for acquisitions. Pursuant to purchase method accounting, we allocate the cost of the acquisition to assets acquired and liabilities assumed based on fair values as of the acquisition date. The purchase price allocations are based on appraisals, discounted cash flows, quoted market prices and estimates by management. When appropriate, we review comparable purchases and sales of crude oil and natural gas properties within the same regions and use that data as a basis for fair market value; for example, the amount at which a willing buyer and seller would enter into an exchange for such properties. In estimating the fair values of assets acquired and liabilities assumed, we make various assumptions. The most significant assumptions relate to the estimated fair values assigned to proved developed producing, proved developed non-producing, proved undeveloped, unproved crude oil and natural gas properties and other non-crude oil and natural gas properties. To estimate the fair values of these properties, we prepare estimates of crude oil and natural gas reserves. We estimate future prices by using the applicable forward pricing strip to apply to our estimate of reserve quantities acquired, and estimates of future operating and development costs, to arrive at an estimate of future net revenues. For estimated proved reserves, the future net revenues are discounted using a market-based weighted-average cost of capital rate determined appropriate at the time of the acquisition. The market-based weighted-average cost of capital rate is subject to additional project-specific risking factors. To compensate for the inherent risk of estimating and valuing unproved properties, we reduce the discounted future net revenues of probable and possible reserves by additional risk-weighting factors. We record deferred taxes for any differences between the assigned values and tax basis of assets and liabilities. Estimated deferred taxes are based on available information concerning the tax basis of assets acquired and liabilities assumed and loss carryforwards at the acquisition date, although such estimates may change in the future as additional information becomes known. Recent Accounting Standards See Note 2, Summary of Significant Accounting Policies - Recent Accounting Standards, to our consolidated financial statements included elsewhere in this report. Reconciliation of Non-U.S. GAAP Financial Measures Adjusted cash flows from operations. We define adjusted cash flows from operations as the cash flows earned or incurred from operating activities, without regard to changes in operating assets and liabilities. We believe it is important to consider adjusted cash flows from operations, as well as cash flows from operations, as we believe it often provides more transparency into what drives the changes in our operating trends, such as production, prices, operating costs and related operational factors, without regard to whether the related asset or liability was received or paid during the same period. We also use this measure because the timing of cash received from our assets, cash paid to obtain an asset or payment of our obligations has been only a timing issue from one period to the next as we have not had accounts receivable collection problems, nor been unable to purchase assets or pay our obligations. See the Consolidated Statements of Cash Flows included elsewhere in this report. Adjusted net income (loss). We define adjusted net income (loss) as net income (loss), plus loss on commodity derivatives, less gain on commodity derivatives and net settlements on commodity derivatives, each adjusted for tax effect. We believe it is important to consider adjusted net income (loss), as well as net income (loss). We believe this measure often provides more transparency into our operating trends, such as production, prices, operating costs, net settlements from derivatives and related factors, without regard to changes in our net income (loss) from our mark-to-market adjustments resulting from net changes in the fair value of unsettled derivatives. Adjusted EBITDA. We define adjusted EBITDA as net income (loss), plus loss on commodity derivatives, interest expense, net of interest income, income taxes, impairment of crude oil and natural gas properties, depreciation, depletion and amortization, accretion of asset retirement obligations and loss on debt extinguishment, less gain on commodity derivatives and net settlements on commodity derivatives. Adjusted EBITDA is not a measure of financial performance or liquidity under U.S. GAAP and should be considered in addition to, not as a substitute for, net income (loss), nor as an indicator of cash flows reported in accordance with U.S. GAAP. Adjusted EBITDA includes certain non-cash costs incurred by us and does not take into account changes in operating assets and liabilities. Other companies in our industry may calculate adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure. We believe adjusted EBITDA is relevant because it is a measure of our operational and financial performance, as well as a measure of our liquidity, and is used by our management, investors, commercial banks, research analysts and others to analyze such things as: • operating performance and return on capital as compared to our peers; • financial performance of our assets and our valuation without regard to financing methods, capital structure or historical cost basis; • ability to generate sufficient cash to service our debt obligations; and • viability of acquisition opportunities and capital expenditure projects, including the related rate of return. PV-10. We define PV-10 as the estimated present value of the future net cash flows from our proved reserves before income taxes, discounted using a 10% discount rate. We believe that PV-10 provides useful information to investors as it is widely used by professional analysts and sophisticated investors when evaluating oil and gas companies. We believe that PV-10 is relevant and useful for evaluating the relative monetary significance of our reserves. Professional analysts and sophisticated investors may utilize the measure as a basis for comparison of the relative size and value of our reserves to other companies' reserves. Because there are many unique factors that can impact an individual company when estimating the amount of future income taxes to be paid, we believe the use of a pre-tax measure is valuable in evaluating us and our reserves. PV-10 is not intended to represent the current market value of our estimated reserves. The following table presents a reconciliation of our non-U.S. GAAP financial measures to its most comparable U.S. GAAP measure: Amounts above include results from continuing and discontinued operations.

<s>[INST] EXECUTIVE SUMMARY 2014 Financial Overview Crude oil, natural gas and NGLs sales from continuing operations increased in 2014 by $130.6 million, or 38%, compared to 2013. The growth in crude oil, natural gas and NGLs sales was the result of increased production. For the month ended December 31, 2014, we maintained an average production rate of 30 MBoe per day. Production of 9.3 MMboe from continuing operations for the year ended December 31, 2014 represents an increase of 42% as compared to the year ended December 31, 2013, primarily attributable to our successful horizontal Niobrara and Codell drilling program in the Wattenberg Field. Crude oil production from continuing operations increased 49% in 2014, while NGLs production from continuing operations increased 68%. Our liquids percentage of total production from continuing operations was 65% in 2014. Natural gas production from continuing operations increased 25% in 2014 compared to 2013. Higher natural gas index prices at derivatives settlement during 2014 were the primary reason for negative net settlements on derivative positions of $0.8 million in 2014 compared to positive net settlements of $11.2 million in 2013. Crude oil, natural gas and NGLs sales, including the impact of net settlements on derivatives, was $470.6 million in 2014 compared to $352.0 million in 2013. This represents an increase of 34% in 2014 compared to 2013. Other significant changes impacting our 2014 results of operations include the following: Positive net change in the fair value of unsettled derivatives in 2014 was $311.1 million compared to a negative net change in the fair value of unsettled derivative positions of $35.1 million in 2013, as the crude oil and natural gas forward curves shifted significantly lower during the later months of 2014; Impairment of crude oil and natural gas properties increased to $163.5 million in 2014 compared to $52.5 million in 2013, primarily related to the $158.3 million writedown of our Utica Shale producing and nonproducing crude oil and natural gas properties to their estimated fair value, $112.6 million of which was for proved producing properties and $45.7 million for unproved properties; General and administrative expense increased to $115.9 million in 2014 compared to $60.0 million in 2013, primarily attributable to $40.3 million recorded in 2014 in connection with settlement of certain partnershiprelated class action litigation and litigation arising from bankruptcy proceedings of certain affiliated partnerships; Depreciation, depletion and amortization expense increased to $192.5 million compared to $115.6 million in 2013, mainly due to the increase in production; and Gain on sale of properties and equipment classified as discontinued operations increased to $76.5 million compared to a loss on sale of properties and equipment classified as discontinued operations of $1.7 million in 2013. Available liquidity as of December 31, 2014 was $398.4 million compared to $647.0 million as of December 31, 2013. Available liquidity is comprised of $16.1 million of cash and cash equivalents and $382.3 million available for borrowing under our revolving credit facility. In addition to our currently elected commitment of $450 million, we have an additional $250 million of borrowing base availability under our revolving credit facility, subject to certain terms and conditions of the agreement. Considering the additional $250 million, our liquidity position as of December 31, 2014 would have been $648.3 million. With our current derivative position, available liquidity and expected cash flows from operations, we believe we have sufficient liquidity to allow us to execute [/INST] Positive. </s>

PDC ENERGY, INC.

2016-02-22

2015-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis, as well as other sections in this report, should be read in conjunction with our consolidated financial statements and related notes to consolidated financial statements included elsewhere in this report. Further, we encourage you to revisit the Special Note Regarding Forward-Looking Statements in Part I of this report. EXECUTIVE SUMMARY 2015 Financial Overview Production volumes from continuing operations increased substantially to 15.4 MMboe in 2015 compared to 9.3 MMboe in 2014, representing an increase of 65%. The increase in production volumes was primarily attributable to our successful horizontal Niobrara and Codell drilling program in the Wattenberg Field. Crude oil production from continuing operations increased 62% in 2015, while NGL production from continuing operations increased 61%. Crude oil production comprised approximately 45% of total production from continuing operations in 2015. Natural gas production from continuing operations increased 73% in 2015 compared to 2014 as we shifted our focus to the higher rate of return drilling projects located in the higher gas to oil ratio inner and middle core areas of the Wattenberg Field. For the month ended December 31, 2015, we maintained an average production rate of 52 MBoe per day, up from 30 MBoe per day for the month ended December 31, 2014. Crude oil, natural gas and NGLs sales from continuing operations, coupled with the impact of settlement of derivatives, increased in 2015. Increased production and positive net settlements on derivative positions more than offset the effect of declines in commodity prices during the year. Lower crude oil and natural gas index prices in 2015 were the primary reason for significant positive net settlements of $238.9 million on derivative positions compared to negative net settlements of $0.8 million in 2014. Crude oil, natural gas and NGLs sales, including the impact of net settlements on derivatives, was $617.6 million in 2015 compared to $470.6 million in 2014. This represents an increase of 31% in 2015 compared to 2014. Other significant changes impacting our 2015 results of operations include the following: • Crude oil, natural gas and NGLs sales decreased to $378.7 million in 2015 compared to $471.4 million in 2014, due to a 51% decrease in the weighted-average realized prices of crude oil, natural gas and NGLs, offset in part by a 65% increase in production; • Negative net change in the fair value of unsettled derivative positions in 2015 was $35.8 million compared to a positive net change in the fair value of unsettled derivative positions of $311.1 million in 2014, primarily attributable to crude oil and natural gas derivatives that settled in 2015; • General and administrative expense decreased to $90.0 million in 2015 compared to $123.6 million in 2014, primarily attributable to $40.3 million recorded in 2014 in connection with certain partnership-related class action litigation and estimates relating to litigation arising from bankruptcy proceedings of certain affiliated partnerships; • Impairment of crude oil and natural gas properties was $161.6 million in 2015 compared to $166.8 million in 2014, both primarily related to the write-down of our Utica Shale producing and non-producing crude oil and natural gas properties; and • Depreciation, depletion and amortization expense increased to $303.3 million in 2015 compared to $192.5 million in 2014, primarily due to increased production, offset in part by lower weighted-average depreciation, depletion and amortization rates. Available liquidity as of December 31, 2015 was $402.2 million compared to $398.4 million as of December 31, 2014. Available liquidity as of December 31, 2015 is comprised of $0.9 million of cash and cash equivalents and $401.3 million available for borrowing under our revolving credit facility. These amounts exclude an additional $250 million available under our revolving credit facility, subject to certain terms and conditions of the agreement. In September 2015, we completed the semi-annual redetermination of the borrowing base under our revolving credit facility, which resulted in the reaffirmation of the borrowing base at $700 million. We have elected to maintain the aggregate commitment level at $450 million. In March 2015, we completed a public offering of 4,002,000 shares of our common stock for net proceeds of approximately $203 million, after deducting offering expenses and underwriting discounts. We used a portion of the proceeds of the offering to repay all amounts then outstanding on our revolving credit facility, and used the remaining amounts to fund a portion of our capital program. With our current derivative position, available liquidity and expected cash flows from operations, we believe we have sufficient liquidity to allow us to execute our expected capital program through 2016. 2015 Operational Overview During 2015, we continued to execute our strategic plan of increasing production, reserves and cash flows from drilling operations in the Wattenberg Field in Colorado and from completion activities in the Utica Shale play in southeastern Ohio. In the Wattenberg Field, we reduced our rig count in December to four automated drilling rigs from five due to the increases in our drilling rig efficiencies. In 2015, we spud 174 horizontal wells in the Wattenberg Field and turned-in-line 136 horizontal wells. We also participated in 54 gross, 8.1 net, horizontal non-operated wells that were spud and 58 gross, 9.3 net, horizontal non-operated wells which were turned-in-line. We began implementing several horizontal well-recovery enhancements in 2015, including tighter spacing between frac intervals on all wells and by drilling 40% of our wells with extended reach laterals of 6,500 feet to 7,000 feet. We have been able to improve our drilling time due to several factors, including the use of automated drilling rigs that minimize downtime, improved drilling team cohesion and utilizing analytics to improve drilling efficiencies. In the Utica Shale, we completed and turned-in-line a four-well pad during the first half of 2015. As a result of the turn-in-line of a four-well pad in late 2014 and a four-well pad in the second quarter of 2015, production volumes from the Utica Shale increased 41% in 2015 compared to 2014. 2016 Operational Outlook We expect our production for 2016 to range between 20.0 MMBoe to 22.0 MMBoe and that our production rate will average approximately 55,000 to 60,000 Boe per day. Our 2016 capital forecast of approximately $435 million at the midpoint is focused on continuing to provide value-driven production growth by exploiting our extensive inventory of reasonable rate-of-return projects in the Wattenberg Field. Capital spending is expected to be weighted to the front half of 2016 as we complete Wattenberg Field in-process wells spud in 2015 and execute our Utica Shale drilling program. Wattenberg Field. The 2016 capital forecast anticipates a four-rig drilling program in the Wattenberg Field based on our December 2015 outlook for future commodity prices. Approximately $400 million of our 2016 capital forecast is expected to be spent on development activities in the Wattenberg Field, comprised of approximately $350 million for our operated drilling program and approximately $35 million for non-operated projects. The remainder of the Wattenberg Field capital forecast is expected to be used for leasing, workover projects and other capital improvements, including the remodeling of our Greeley, Colorado, field operating facilities. We plan to spud 135 and turn-in-line 160 horizontal Niobrara or Codell wells and participate in approximately 35.0 gross, 7.0 net, non-operated horizontal opportunities in 2016. Utica Shale. Based on the production results from recently drilled wells and decreases in well costs, in 2016 we plan on executing a modest drilling operation in the condensate and wet natural gas window of the play. Early in 2016, we plan to spend approximately $35 million in the Utica Shale to drill, complete and turn-in-line five wells, all of which are at least 6,000 foot laterals. The planned activity will focus on further delineation of our southern acreage, determining the impact of well-orientation on productivity and testing improved capital efficiency of a 10,000 foot lateral well. 2016 Operational Flexibility In December 2015, the Board of Directors approved our 2016 development plan as described above. This plan, which primarily focuses on a four-rig drilling program in the Wattenberg Field, was based upon our December 2015 internal outlook for crude oil and natural gas prices, favorable debt metrics and the strength of our balance sheet, including our strong hedge position for 2016. In 2016, our goal continues to be preserving this balance sheet strength by managing our capital spending to approximate our cash flows from operations. Since approving our 2016 development plan in December 2015, future commodity prices have continued to decline. Concurrently, capital costs to drill and complete Wattenberg Field wells have decreased, while crude oil differentials in the field have improved. We expect that our capital forecast of $420 million to $450 million will fund the same level of drilling and completions activity as projected prior to the aforementioned changes. Moreover, despite commodity prices decreasing in early 2016, we are anticipating reasonable rates of return in our middle core acreage in the Wattenberg Field. The Company maintains significant operational flexibility in 2016 to reduce the pace of our capital spending. We will continue to monitor future commodity prices throughout 2016, and should prices remain depressed or continue to further deteriorate, we believe an adjustment to our development plan would be appropriate. We have ample opportunities to reduce capital spending, including but not limited to: working with our vendors to achieve further cost reductions; reducing the number of rigs being utilized in our drilling program; and/or managing our completion schedule. The production impact of reduced 2016 capital spending would be felt primarily in 2017 and thereafter, as our anticipated long-term production growth would likely be reduced. This operational flexibility is maintained with little exposure to incurring additional costs, given that all of our acreage in the Wattenberg Field is held by production, a reduction in rigs would not cause us to incur substantial idling costs as our rig commitments are short term (30 to 90 days), and we do not anticipate having additional material unfulfilled transportation commitment fees. Further, throughout 2016, such a reduction would be consistent with maintaining compliance well within the limits of our debt covenants. As we go through 2016, our priority remains ensuring ample liquidity and protecting the strength of our balance sheet, and we will adjust our development plans as necessary to this end. We remain in close contact with the banks in our credit facility and are evaluating the increased risk that lenders may seek to reduce our borrowing base due to regulatory pressure to reduce their exposure to the energy industry or for other reasons. Further, we continue to monitor debt, equity and hedging markets for opportunities to strengthen our liquidity position. Results of Operations Summary Operating Results The following table presents selected information regarding our operating results from continuing operations: * Percentage change is not meaningful or equal to or greater than 300%. Amounts may not recalculate due to rounding. ______________ (1) Production is net and determined by multiplying the gross production volume of properties in which we have an interest by our ownership percentage. For total production volume, including discontinued operations, see Part I, Item 6, Selected Financial Data. (2) One Bbl of crude oil or NGL equals six Mcf of natural gas. (3) Represents net settlements on derivatives related to crude oil and natural gas sales, which do not include net settlements on derivatives related to natural gas marketing. (4) Represents lease operating expenses, exclusive of production taxes, on a per unit basis. (5) Represents sales from natural gas marketing, net of costs of natural gas marketing, including net settlements and net change in fair value of unsettled derivatives related to natural gas marketing activities. Crude Oil, Natural Gas and NGLs Sales The following tables present crude oil, natural gas and NGLs production and weighted-average sales price for continuing operations: * Percentage change is not meaningful or equal to or greater than 300%. Amounts may not recalculate due to rounding. * Percentage change is not meaningful or equal to or greater than 300%. Amounts may not recalculate due to rounding. The year-over-year change in crude oil, natural gas and NGLs sales revenue were primarily due to the following: Crude oil, natural gas and NGLs sales in 2015 decreased 20% compared to 2014. The decrease was primarily attributable to a significant decrease in commodity prices, resulting in a 51% decline in the price of a barrel of crude oil equivalent in 2015 compared to 2014. The decrease was offset in part by higher volumes sold in 2015 of 15.4 million Boe, up from 9.3 million Boe in 2014. Our average daily sales volumes increased to 42 MBoe per day in 2015 compared to 25 MBoe per day in 2014, as a result of continued drilling and completion activities as discussed in Operational Overview. Crude oil, natural gas and NGLs sales in 2014 increased 38% compared to 2013. The increase was primarily attributable to significantly higher volumes sold, in particular liquids, which resulted in a liquids percentage of total production of approximately 65% in 2014. Our average daily sales volumes increased to 25 MBoe per day in 2014 compared to 18 MBoe per day in 2013, primarily due to the success of the horizontal Niobrara and Codell drilling program in the Wattenberg Field. Contributing to the increase in crude oil, natural gas and NGLs sales was a 19% increase in the average price of natural gas in 2014 over 2013. We continued to experience high line pressures on the midstream system in the Wattenberg Field in the first half of 2015, but the Lucerne II processing plant and additional new compressor stations on the gathering system began initial operations in June 2015, resulting in immediate reductions in line pressures. We have experienced further line pressure reductions in the fourth quarter of 2015, particularly in December of 2015 when our primary service provider, DCP Midstream, completed its Grand Parkway gas gathering project. As a result of the reductions in line pressures during the second half of 2015, production from our Wattenberg Field vertical wells increased by 35% in the second half of 2015 when compared to the first half. Further, we expect sustained relief of gathering system pressure on our primary gatherer's system through 2016, depending upon the impact of reduced drilling activity in the field going forward. Our secondary midstream service provider, which currently gathers and processes approximately 30% of our Wattenberg Field gas, has indicated it will have limitations on its capital program in 2016, which may result in a curtailment of certain of our projected 2016 volumes. We rely on our third-party midstream service providers to construct compression, gathering and processing facilities to keep pace with our production growth. As a result, the timing and availability of additional facilities going forward is beyond our control. Falling commodity prices have resulted in reduced investment in midstream facilities by some third parties, increasing the risk that sufficient midstream infrastructure will not be available in future periods. Crude Oil, Natural Gas and NGLs Pricing. Our results of operations depend upon many factors, particularly the price of crude oil, natural gas and NGLs and our ability to market our production effectively. Crude oil, natural gas and NGLs prices are among the most volatile of all commodity prices. The price of crude oil decreased during the second half of 2015 compared to the first half of 2015 amid continuing concerns regarding high U.S. inventories and slowing global demand for crude oil. Natural gas prices in 2015 were at significantly lower levels than the comparable periods of 2014. NGL prices declined significantly during 2015 and, while they have stabilized somewhat, also remain at low levels relative to those experienced in 2014. See Item 1 and 2. Business and Properties - Business Segments - Oil and Gas Exploration and Production for additional information regarding the marketing and pricing provisions of our crude oil, natural gas and NGLs. Our crude oil, natural gas and NGLs sales are recorded under either the “net-back” or "gross" method of accounting, depending upon the related purchase agreement. We use the "net-back" method of accounting for natural gas and NGLs, as well as a portion of our crude oil production, from the Wattenberg Field and for crude oil from the Utica Shale as the majority of the purchasers of these commodities also provide transportation, gathering and processing services. We sell our commodities at the wellhead and collect a price and recognize revenues based on the wellhead sales price as transportation and processing costs downstream of the wellhead are incurred by the purchaser and reflected in the wellhead price. The net-back method results in the recognition of a sales price that is below the indices for which the production is based. We use the "gross" method of accounting for Wattenberg Field crude oil delivered through the White Cliffs pipeline and for natural gas and NGLs sales related to production from the Utica Shale as the purchasers do not provide transportation, gathering or processing services. Under this method, we recognize revenues based on the gross selling price and recognize transportation, gathering and processing expenses as a component of production costs. As a result of the White Cliffs agreement, our Wattenberg Field crude oil average sales price increased approximately $1.28 per barrel in 2015 attributable to recognizing these costs for transportation on the White Cliffs pipeline as an increase in transportation expense, rather than a deduction from revenues. Lease Operating Expenses Lease operating expenses were $57.0 million in 2015 compared to $42.4 million in 2014. The $14.6 million increase in lease operating expenses in 2015 as compared to 2014 was primarily due to an increase of $4.2 million for environmental remediation and regulatory compliance projects, an increase of $3.4 million for additional wages and employee benefits, including costs for additional contract labor, $2.0 million for workover and maintenance related projects, $1.4 million to mitigate high line pressures in the Wattenberg Field, including costs for the rental of additional compressors, $1.0 million for the increasing number of non-operated wells in the Wattenberg Field and $0.9 million for additional costs pertaining to water hauling and disposal. Lease operating expenses per Boe were $3.71 and $4.56 for 2015 and 2014, respectively. Lease operating expenses were $42.4 million in 2014 compared to $33.8 million in 2013. The $8.6 million increase in lease operating expenses in 2014 as compared to 2013 was primarily due to an increase of $2.9 million to mitigate high line pressures in the Wattenberg Field, including costs for the rental of additional compressors, as well as additional well maintenance incurred in order to increase the operating efficiency of older vertical wells, $1.1 million for workover and maintenance related projects, including additional costs incurred for the plugging of older vertical wells, $1.9 million for environmental compliance and remediation projects, $1.9 million for lease operating expenses incurred on the increasing number of non-operated wells and $1.0 million in additional wages and benefits due to increased headcount. Lease operating expenses per Boe were $4.56 and $5.18 for 2014 and 2013, respectively. Production Taxes Production taxes are directly related to crude oil, natural gas and NGLs sales. The $7.2 million, or 28%, decrease in production taxes for 2015 compared to 2014 is primarily related to the 20% decrease in crude oil, natural gas and NGLs sales and lower production tax rates. Similarly, the $3.9 million, or 18%, increase in production taxes for 2014 compared to 2013 is primarily related to the 38% increase in crude oil, natural gas and NGLs sales. Transportation, Gathering and Processing Expenses The $5.6 million, or 121%, increase in transportation, gathering and processing expenses for 2015 compared to 2014 was mainly attributable to oil transportation cost on the White Cliffs pipeline in the Wattenberg Field as we began delivering crude oil to the pipeline at the beginning of July 2015. We expect to continue to incur these oil transportation costs pursuant to our long-term firm transportation agreement. The $0.6 million, or 11%, decrease in transportation, gathering and processing expenses for 2014 compared to 2013 was primarily attributable to a $2.5 million reduction in our unutilized takeaway capacity and other transportation costs resulting from the divestiture of our shallow Upper Devonian (non-Marcellus Shale) Appalachian Basin producing properties and a $0.4 million decrease in compressor and refrigeration unit rentals in the Utica Shale, offset by a $2.3 million net increase in transportation and processing expenses due to higher production levels, primarily in the Utica Shale region. Commodity Price Risk Management, Net We use various derivative instruments to manage fluctuations in natural gas and crude oil prices. We have in place a variety of collars, fixed-price swaps and basis swaps on a portion of our estimated natural gas and crude oil production. Because we sell all of our natural gas and crude oil production at prices similar to the indexes inherent in our derivative instruments, adjusted for certain fees and surcharges stipulated in the applicable sales agreements, we ultimately realize a price, before contract fees, related to our collars of no less than the floor and no more than the ceiling and, for our commodity swaps, we ultimately realize the fixed price related to our swaps, less deductions. See Note 4, Derivative Financial Instruments, to our consolidated financial statements included elsewhere in this report and Item 7A, Quantitative and Qualitative Disclosures About Market Risk, for a discussion of how each derivative type impacts our cash flows and a detailed presentation of our derivative positions as of December 31, 2015. Commodity price risk management, net, includes cash settlements upon maturity of our derivative instruments and the change in fair value of unsettled derivatives related to our crude oil and natural gas production. Commodity price risk management, net, does not include derivative transactions related to our natural gas marketing, which are included in sales from and cost of natural gas marketing. See Note 3, Fair Value of Financial Instruments, and Note 4, Derivative Financial Instruments, to our consolidated financial statements included elsewhere in this report for additional details of our derivative financial instruments. Net settlements are primarily the result of crude oil and natural gas index prices at maturity of our derivative instruments compared to the respective strike prices. Net change in fair value of unsettled derivatives is comprised of the net asset increase or decrease in the beginning-of-period fair value of derivative instruments that settled during the period and the net change in fair value of unsettled derivatives during the period. The corresponding impact of settlement of the derivative instruments that settled during the period is included in net settlements for the period as discussed above. Net change in fair value of unsettled derivatives during the period is primarily related to shifts in the crude oil and natural gas forward curves and changes in certain differentials. See Note 4, Derivative Financial Instruments, to our consolidated financial statements included elsewhere in this report for a detailed description of net settlements on our various derivatives. The following table presents net settlements and net change in fair value of unsettled derivatives included in commodity price risk management, net: Natural Gas Marketing Fluctuations in our natural gas marketing's income contribution are primarily due to fluctuations in commodity prices, cash settlements upon maturity of derivative instruments and the change in fair value of unsettled derivatives, and volumes sold and purchased. The following table presents the components of sales from and costs of natural gas marketing: Natural gas sales revenue and cost of natural gas purchases decreased in 2015 compared to 2014 as our Gas Marketing segment markets less natural gas following the divestiture of our Appalachian Basin natural gas properties and due to the significant decrease in natural gas prices. Our Gas Marketing segment sold approximately 4.4 Bcf of natural gas at an average price of $1.37 per Mcf in 2015, compared to approximately 19.8 Bcf of natural gas at an average price of $3.39 per Mcf in 2014. Our Gas Marketing segment sold approximately 18.4 Bcf of natural gas at an average price of $3.48 per Mcf in 2013. Derivative instruments related to natural gas marketing include both physical and cash-settled derivatives. We offer fixed-price derivative contracts for the purchase or sale of physical natural gas and enter into cash-settled derivative positions with counterparties in order to offset those same physical positions. See Note 4, Derivative Financial Instruments, to our consolidated financial statements included elsewhere in this report and Item 7A, Quantitative and Qualitative Disclosures About Market Risk, for a discussion of how each derivative type impacts our cash flows and a detailed presentation of our derivative positions as of December 31, 2015. As natural gas prices continue to remain depressed, certain third-party producers under our Gas Marketing segment have begun and may continue to experience financial distress, which has led to certain contractual defaults and litigation. To date, we have had no material counterparty default losses; however, we expect continued deterioration in the financial condition of some counterparties. In 2015, we recorded an allowance for doubtful accounts of approximately $0.5 million. We have initiated several legal actions for collection against some of the third-party producers, which have resulted in no collections and some of the third-party producers shutting-in their wells. As a result, we expect RNG's expenses to exceed its revenues by approximately $1 million to $2 million per year through 2022, assuming a continuation of current economic conditions. Although some third-party producers have defaulted on their firm transportation fees owed to us, RNG remains obligated to fulfill this commitment regardless of whether or not our third-party producers meet their commitments. As of December 31, 2015, the dollar commitment over the next several years related to this long-term firm transportation, sales and processing agreement was approximately $20.6 million. Exploration Expense The following table presents the major components of exploration expense: Geological and geophysical costs. Geological and geophysical costs in 2013 were primarily related to costs associated with reservoir studies in the Utica Shale. Operating, personnel and other. The $4.7 million decrease in 2014 compared to 2013 is primarily related to a reduction in personnel costs in the Utica Shale resulting from the reassignment of former exploration department personnel to production departments and to general and administrative expense. Impairment of Crude Oil and Natural Gas Properties The following table sets forth the major components of our impairments of crude oil and natural gas properties expense: Impairment of proved and unproved properties. Due to a significant decline in commodity prices and a decrease in net-back realizations, we experienced a triggering event that required us to assess our crude oil and natural gas properties for possible impairment during the third quarter of 2015. As a result of our assessment, we recorded an impairment charge of $150.3 million to write-down our Utica Shale proved and unproved properties. Of this impairment charge, $24.7 million was recorded to write-down certain capitalized well costs on our Utica Shale proved producing properties. The impairment charge represented the amount by which the carrying value of these crude oil and natural gas properties exceeded the estimated fair value. The estimated fair value of approximately $27.9 million was determined based on estimated future discounted net cash flows, a Level 3 input, using estimated production and prices at which we reasonably expect the crude oil and natural gas will be sold. Additionally, as a result of the current outlook for future commodity prices, we recorded an impairment charge of $125.6 million to write-down all of our Utica Shale lease acquisition costs and pad development costs for pads not in production. Further deterioration of commodity prices could result in additional impairment charges to our crude oil and natural gas properties. In 2014, we recognized an impairment charge of $112.6 million to write-down certain capitalized well costs on our Utica Shale proved producing properties. The impairment charge represented the amount by which the carrying value of the Utica Shale proved producing properties exceeded the estimated fair value due to low commodity prices, large natural gas price differentials in the Appalachian Basin and changes in our Utica Shale drilling plans. The estimated fair value was determined based on estimated future discounted net cash flows, a Level 3 input, using estimated production and prices at which we reasonably expected the crude oil and natural gas would be sold. The impairment charge was included in the consolidated statements of operations line item impairment of crude oil and natural gas properties. In 2014, we also recognized an impairment charge of $45.7 million to write-down certain capitalized leasehold costs on our Utica Shale unproved properties. The impairment was due to low commodity prices, large natural gas price differentials in the Appalachian Basin and changes in our Utica Shale drilling plans. In 2013, we recognized an impairment charge of approximately $48.8 million related to all of our shallow Upper Devonian (non-Marcellus Shale) Appalachian Basin producing properties located in West Virginia and Pennsylvania previously owned directly by us, as well as through our proportionate share of PDCM. The impairment charge represented the excess of the carrying value of the assets over the estimated fair value, less the cost to sell. The fair value of the assets was determined based upon estimated future cash flows from unrelated third-party bids, a Level 3 input. See Note 15, Assets Held for Sale, Divestitures and Discontinued Operations, to our consolidated financial statements included elsewhere in this report for additional details related to the sale of these properties. Amortization of individually insignificant unproved properties. The increase in 2015 compared to 2014 was primarily related to a higher number of insignificant leases that were subject to amortization, primarily in the Utica Shale where we have altered drilling plans due to lower commodity prices and, as a result, expect certain leases to expire. General and Administrative Expense General and administrative expense decreased $33.6 million, or 27%, in 2015 compared to 2014. The decrease was primarily attributable to $40.3 million recorded in 2014 in connection with certain partnership-related class action litigation and estimates relating to litigation arising from bankruptcy proceedings of certain affiliated partnerships and a $1.8 million decrease in costs for legal and other professional services in 2015. The decreases were offset in part by an $8.2 million increase in payroll and employee benefits in 2015, of which $3.3 million was related to stock-based compensation. General and administrative expense increased $59.8 million, or 94%, in 2014 compared to 2013. The increase was mainly attributable to $40.3 million recorded in 2014 in connection with settlement of certain partnership-related class action litigation and litigation arising from bankruptcy proceedings of certain affiliated partnerships. Additional increases were an $13.0 million increase in payroll and employee benefits, of which $4.0 million was related to stock-based compensation, and a $4.6 million increase in legal fees, primarily related to the aforementioned partnership-related class action litigation, consulting and other professional services. Depreciation, Depletion and Amortization Crude oil and natural gas properties. DD&A expense related to crude oil and natural gas properties is directly related to proved reserves and production volumes. DD&A expense related to crude oil and natural gas properties was $298.8 million, $188.5 million and $111.6 million in 2015, 2014 and 2013, respectively. The year-over-year change in DD&A expense related to crude oil and natural gas properties were primarily due to the following: The following table presents our DD&A expense rates for crude oil and natural gas properties: The decrease in the Utica Shale DD&A expense rate in 2015 compared to 2014 was primarily due to the effect of impairments recorded in December 2014 and September 2015 to write-down certain capitalized well costs on our Utica Shale proved producing properties, which lowered the net book value of the properties by approximately $137.3 million. As a result of the decrease in proved developed reserves in 2015 as compared to 2014, we expect the weighted-average DD&A expense rate in 2016 to increase as compared to 2015. The increase in the Utica Shale DD&A expense rate in 2014 compared to 2013 was mainly the result of depleting the entire capitalized well costs of a Utica Shale horizontal well that experienced a mechanical failure in 2014. Non-crude oil and natural gas properties. Depreciation expense for non-crude oil and natural gas properties was $4.5 million for 2015 compared to $4.1 million for 2014 and $4.0 million for 2013. Accretion of Asset Retirement Obligations Accretion of asset retirement obligations ("ARO") for 2015 increased by $2.9 million, or 84%, compared to 2014. The increase in 2015 is primarily attributable to a decrease in the estimated useful life of certain vertical wells in the Wattenberg Field and increased plugging and abandonment of these wells to allow for horizontal drilling. As a result of the upward revision in estimated cash flows during 2015, we expect an increase in accretion expense for ARO in 2016 as compared to 2015. Accretion of ARO for 2014 decreased by $1.2 million, or 25%, compared to 2013. The decrease in 2014 is primarily attributable to the sale of our shallow Upper Devonian (non-Marcellus Shale) Appalachian Basin producing properties in 2013. Interest Expense Interest expense decreased by approximately $0.3 million in 2015 compared to 2014. The decrease is primarily comprised of a $1.6 million decrease attributable to an increase in capitalized interest, offset in part by a $0.9 million increase due to higher average borrowings on our revolving credit facility in 2015. Interest expense decreased by approximately $2.3 million in 2014 compared to 2013. The decrease is primarily comprised of a $1.8 million decrease attributable to an increase in capitalized interest in 2014. Interest costs capitalized in 2015, 2014 and 2013 were $5.1 million, $3.5 million and $1.7 million, respectively. Provision for Income Taxes For 2015, the effective tax rate (the "rate") of 35.9% on loss from continuing operations differs from the statutory tax rate of 35% primarily due to state taxes, percentage depletion and domestic production deduction, partially offset by nondeductible expenses that consist primarily of officers' compensation and government lobbying expenses. For 2014, the rate of 39.5% on income from continuing operations differs from the statutory tax rate of 35% primarily due to state income taxes. The 2013 rate of 36.0% on loss from continuing operations differs from the statutory tax rate primarily due to state income taxes and the percentage depletion deduction, partially offset by nondeductible executive compensation. See Note 7, Income Taxes, to our consolidated financial statements included elsewhere in this report for our rate reconciliation for each of the years in the three-year period ended December 31, 2015. As of the date of this report, we are current with our income tax filings in all applicable state jurisdictions and are not currently under any state income tax examinations. We continue voluntary participation in the Internal Revenue Service’s ("IRS") Compliance Assurance Program (the "CAP Program") for the 2014, 2015 and 2016 tax years. We have received a partial acceptance notice from the IRS for our filed 2014 federal tax return and the IRS's post filing review is continuing. Discontinued Operations Appalachian Marcellus Shale Assets. In October 2014, we completed the sale of our entire 50% ownership interest in PDCM to an unrelated third-party for aggregate consideration, after our share of PDCM's debt repayment and other working capital adjustments, of approximately $192 million, comprised of approximately $153 million in net cash proceeds and a promissory note due in 2020 of approximately $39 million. The transaction included the buyer's assumption of our share of the firm transportation commitment related to the assets owned by PDCM, as well as our share of PDCM's natural gas hedging positions for the years 2014 through 2017. The divestiture resulted in a pre-tax gain of $76.3 million. The divestiture represented a strategic shift in our operations. Accordingly, our proportionate share of PDCM's Marcellus Shale results of operations have been separately reported as discontinued operations in the consolidated statements of operations for all periods presented. Piceance Basin and NECO. In June 2013, we divested our Piceance Basin, NECO and certain other non-core Colorado oil and gas properties, leasehold mineral interests and related assets for total consideration of approximately $177.6 million, with an additional $17.0 million paid to our non-affiliated investor partners in our affiliated partnerships. Following the sale, we do not have significant continuing involvement in the operations of, or cash flows from, the Piceance Basin and NECO oil and gas properties. Accordingly, the results of operations related to these assets have been reported as discontinued operations for all periods presented in the accompanying consolidated statements of operations included in this report. For operating results related to our discontinued operations, see Note 15, Assets Held for Sale, Divestitures and Discontinued Operations, to our consolidated financial statements included elsewhere in this report. Net Income (Loss)/Adjusted Net Income (Loss) The factors resulting in changes in net loss in 2015 and 2013 compared to net income in 2014 are discussed above. These same reasons similarly impacted adjusted net income (loss), a non-U.S. GAAP financial measure, with the exception of the net change in fair value of unsettled derivatives, adjusted for taxes, of $22.2 million, $193.1 million and $22.8 million in 2015, 2014 and 2013, respectively. Adjusted net loss, a non-U.S. GAAP financial measure, was $46.1 million and $37.7 million in 2015 and 2014, respectively, compared to an adjusted net income of $0.5 million in 2013. See Reconciliation of Non-U.S. GAAP Financial Measures, below, for a more detailed discussion of this non-U.S. GAAP financial measure. Financial Condition, Liquidity and Capital Resources Historically, our primary sources of liquidity have been cash flows from operating activities, our revolving credit facility, proceeds raised in debt and equity market transactions and asset sales. In 2015, our primary sources of liquidity were net cash flows from operating activities of $411.1 million and the proceeds received from the March 2015 public offering of our common stock of approximately $203 million. We used a portion of the proceeds of the offering to repay all amounts then outstanding on our revolving credit facility and used the remaining amounts to fund a portion of our capital program. Our primary source of cash flows from operating activities is the sale of crude oil, natural gas and NGLs. Fluctuations in our operating cash flows are substantially driven by commodity prices and changes in our production volumes. Commodity prices have historically been volatile and we manage this volatility through our use of derivatives. We enter into commodity derivative instruments with maturities of no greater than five years from the date of the instrument. For instruments that mature in three years or less, our debt covenants restrict us from entering into hedges that would exceed 85% of our expected future production from total proved reserves for such related time period (proved developed producing, proved developed non-producing and proved undeveloped). For instruments that mature later than three years, but no more than our designated maximum maturity, our debt covenants limit us from entering into hedges that would exceed 85% of our expected future production from proved developed producing properties during that time period. In addition, we may choose not to hedge the maximum amounts permitted under our covenants. Therefore, we may still have significant fluctuations in our cash flows from operating activities due to the remaining non-hedged portion of our future production. Given current commodity prices and our hedge position, we expect that positive net settlements on our derivative positions will continue to be a significant positive component of our 2016 cash flows from operations. Our working capital fluctuates for various reasons, including, but not limited to, changes in the fair value of our commodity derivative instruments and changes in our cash and cash equivalents due to our practice of utilizing excess cash to reduce the outstanding borrowings under our revolving credit facility. At December 31, 2015, we had a working capital surplus of $30.7 million compared to a surplus of $89.5 million at December 31, 2014. The reduction in working capital is primarily the result of classifying as a current liability the carrying value of the Convertible Notes, net of discount, as the stated maturity of the Convertible Notes is May 2016, offset in part by an decrease in accounts payable and an increase in the fair value of unsettled derivatives. We ended 2015 with cash and cash equivalents of $0.9 million and availability under our revolving credit facility of $401.3 million, for a total liquidity position of $402.2 million, compared to $398.4 million at December 31, 2014. These amounts exclude an additional $250 million available under our revolving credit facility, subject to certain terms and conditions of the agreement. The increase in liquidity of $3.8 million, or 0.9%, was primarily attributable to net cash flows from operating activities of $411.1 million, and the proceeds received from the March 2015 public offering of our common stock of approximately $203 million, offset in part by capital expenditures of $604.7 million during 2015. Our liquidity position will be reduced by the cash payment of approximately $115 million upon the maturity of our Convertible Notes. With our current derivative position, liquidity position and expected cash flows from operations, we believe that we have sufficient capital to fund our planned drilling operations in 2016. In March 2015, we filed an automatic shelf registration statement on Form S-3 with the SEC. Effective upon filing, the shelf provides for the potential sale of an unspecified amount of debt securities, common stock or preferred stock, either separately or represented by depository shares, warrants or purchase contracts, as well as units that may include any of these securities or securities of other entities. The shelf registration statement is intended to allow us to be proactive in our ability to raise capital and to have the flexibility to raise such funds in one or more offerings should we perceive market conditions to be favorable. Pursuant to this shelf registration, we sold approximately four million shares of our common stock in March 2015 in an underwritten public offering at a price to us of approximately $50.73 per share. In recent periods, including the year ended December 31, 2015, we have been able to access borrowings under our revolving credit facility and to obtain proceeds from the issuance of securities. We cannot, however, assure this will continue to be the case in the future. In light of recent weakened commodity prices, we continue to monitor market conditions and their potential impact on each of our revolving credit facility lenders, many of which are counterparties in our derivative transactions. In addition, we expect that some commercial lenders may look to reduce their exposure to exploration and production companies due to regulatory pressures they face and/or independent business considerations. This could adversely affect our liquidity and our ability to refinance our debt. Our revolving credit facility borrowing base is subject to a redetermination each May and November, based upon a quantification of our proved reserves at each June 30 and December 31, respectively. In September 2015, we completed the semi-annual redetermination of our revolving credit facility, which resulted in the reaffirmation of our borrowing base at $700 million. Further, we entered into a Second Amendment to Third Amended and Restated Credit Agreement that extended the maturity date of our revolving credit facility to May 2020. However, we have elected to maintain the aggregate commitment level at $450 million. We had $37.0 million outstanding on our revolving credit facility as of December 31, 2015. While we have added and expect to continue to add producing reserves through our drilling operations, the effect of any such reserve additions on our borrowing base could be offset by other factors including, among other things, a prolonged period of depressed commodity prices or regulatory pressure on lenders to reduce their exposure to exploration and production companies. Our revolving credit facility contains financial maintenance covenants. The covenants require that we maintain: (i) total debt of less than 4.25 times the trailing 12 months earnings before interest, taxes, depreciation, depletion and amortization, change in fair value of unsettled derivatives, exploration expense, gains (losses) on sales of assets and other non-cash, extraordinary or non-recurring gains (losses) ("EBITDAX") and (ii) an adjusted current ratio of at least 1.0 to 1.0. Our adjusted current ratio is adjusted by eliminating the impact on our current assets and liabilities of recording the fair value of crude oil and natural gas derivative instruments. Additionally, available borrowings under our revolving credit facility are added to the current asset calculation and the current portion of our revolving credit facility debt is eliminated from the current liabilities calculation. At December 31, 2015, we were in compliance with all debt covenants with a 1.4 times debt to EBITDAX ratio and a 1.7 to 1.0 current ratio. We expect to remain in compliance throughout the next year. The indenture governing our 7.75% senior notes due 2022 contains customary restrictive covenants that, among other things, limit our ability and the ability of our restricted subsidiaries to: (a) incur additional debt, (b) make certain investments or pay dividends or distributions on our capital stock or purchase, redeem or retire capital stock, (c) sell assets, including capital stock of our restricted subsidiaries, (d) restrict the payment of dividends or other payments by restricted subsidiaries to us, (e) create liens that secure debt, (f) enter into transactions with affiliates and (g) merge or consolidate with another company. At December 31, 2015, we were in compliance with all covenants and expect to remain in compliance throughout the next year. Pursuant to the indenture governing the Convertible Notes, the conversion rights on our Convertible Notes were triggered on November 15, 2015. We have elected to settle the $115 million principal amount of the notes in cash and issue common stock for the excess conversion value upon maturity in May 2016. We expect to fund the cash settlement of any such conversion from working capital and/or borrowings under our revolving credit facility. See Part II, Item 7A, Quantitative and Qualitative Disclosures about Market Risk, for our discussion of credit risk. Cash Flows Operating Activities. Our net cash flows from operating activities are primarily impacted by commodity prices, production volumes, net settlements from our derivative positions, operating costs and general and administrative expenses. Cash flows provided by operating activities increased in 2015 compared to 2014. The $174.4 million increase in cash provided by operating activities was primarily due to the increase in net settlements from our derivative positions of $241.0 million and a decrease in general and administrative expense of $33.6 million and production taxes of $7.2 million. The increase was partially offset by the decrease in crude oil, natural gas and NGLs sales of $92.7 million and an increase in lease operating costs of $14.6 million. Cash flows provided by operating activities increased in 2014 compared to 2013. The $77.5 million increase was mainly attributable to the increase in crude oil, natural gas and NGLs sales of $130.6 million and the decrease in changes in assets and liabilities of $35.1 million related to the timing of cash payments and receipts. These increases were offset in part by increases in general and administrative expense of $59.8 million, lease operating costs of $8.6 million and the decrease in net settlements on derivative positions of $15.1 million. The key components for the changes in our cash flows provided by operating activities are described in more detail in Results of Operations above. Adjusted cash flows from operations, a non-U.S. GAAP financial measure, increased by $170.6 million in 2015 and $42.4 million in 2014 when compared to the respective prior years. These changes were primarily due to the same factors mentioned above for changes in cash flows provided by operating activities, without regard to timing of cash payments and/or receipts of our assets and liabilities of $9.7 million and $13.5 million in 2015 and 2014, respectively. Adjusted EBITDA, a non-U.S. GAAP financial measure, increased by $78.9 million in 2015 from 2014, primarily as a result of the increase in net settlements from our derivative positions of $241.0 million and a decrease in general and administrative expense of $33.6 million. The increase was partially offset by the decrease in crude oil, natural gas and NGLs sales of $92.7 million, an $88.8 million decrease in contribution margins from discontinued operations and a $14.6 million increase in lease operating costs. Adjusted EBITDA increased by $122.9 million in 2014 from 2013, primarily due to a $130.6 million increase in crude oil, natural gas and NGLs sales and a $72.3 million increase in contribution margins related to divested crude oil and natural gas assets, offset in part by a $59.8 million increase in general and administrative expense, an $8.6 million increase in lease operating costs and a $12.1 million decrease in net settlements on derivatives. See Reconciliation of Non-U.S. GAAP Financial Measures, below, for a more detailed discussion of non-U.S. GAAP financial measures. Investing Activities. Because crude oil and natural gas production from a well declines rapidly in the first few years of production, we need to continue to commit significant amounts of capital in order to maintain and grow our production and replace our reserves. If capital markets are not available in the future, we will be limited to our cash flows from operations and liquidity under our revolving credit facility as the sources for funding our capital expenditures. We would not be able to maintain our current level of crude oil, natural gas and NGLs production and cash flows from operating activities if capital markets were unavailable, commodity prices were to become depressed for a prolonged period and/or the borrowing base under our revolving credit facility was significantly reduced. The occurrence of such an event may result in our election to defer a substantial portion of our planned capital expenditures and could have a material negative impact on our operations in the future. Cash flows from investing activities primarily consist of the acquisition, exploration and development of crude oil and natural gas properties, net of dispositions of crude oil and natural gas properties. Our drilling program during the majority of 2015 consisted of five automated drilling rigs operating in the horizontal Niobrara and Codell plays in our Wattenberg Field. We reduced our rig count to four automated drilling rigs in December 2015. See Part I, Items 1 and 2, Business and Properties - Properties - Drilling Activities, for additional details on our drilling activities. Net cash used in investing activities of $604.3 million during 2015 was primarily related to cash utilized for our drilling operations. Net cash used in investing activities of $474.1 million during 2014 was primarily related to cash utilized for our drilling operations of $628.6 million, offset in part by the $152.8 million net cash proceeds received from the sale of our entire 50% ownership interest in PDCM. Net cash used in investing activities of $217.1 million during 2013 was primarily related to cash utilized for our drilling operations of $394.9 million, offset in part by the $187.5 million received from the sale of properties and equipment, including acquisition adjustments. In 2013, we also paid approximately $9.7 million for the acquisition of crude oil and natural gas properties. Financing Activities. Net cash from financing activities in 2015 was primarily related to the $202.9 million received from the issuance of our common stock in March 2015, partially offset by net payments of approximately $19.0 million to pay down amounts borrowed under our revolving credit facility. Net cash from financing activities in 2014 were primarily comprised of net borrowings under our revolving credit facility of $63.8 million to execute our capital budget. Net cash from financing activities in 2013 was primarily related to the $275.8 million received from the issuance of our common stock in August 2013, partially offset by net payments of approximately $23.3 million to pay down amounts borrowed under revolving credit facilities. Contractual Obligations and Contingent Commitments The following table presents our contractual obligations and contingent commitments as of December 31, 2015: __________ (1) Table does not include deferred income tax liability to taxing authorities of $143.5 million, due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. (2) Amount presented does not agree with the consolidated balance sheets in that it excludes $1.9 million of unamortized debt discount and $7.8 million of unamortized debt issuance costs. See Note 8, Long-Term Debt, to our consolidated financial statements included elsewhere in this report. (3) Represents our gross liability related to the fair value of derivative positions. (4) Short-term capital lease obligations are included in other accrued expenses on the consolidated balance sheets. Long-term capital lease obligations are included in other liabilities on the consolidated balance sheets. (5) Includes deferred compensation to former executive officers and deferred payments related to firm transportation agreements. (6) Table does not include an undrawn $11.7 million irrevocable standby letter of credit pending issuance to a transportation service provider. See Note 8, Long-Term Debt, to our consolidated financial statements included elsewhere in this report. Additionally, the table does not include the annual repurchase obligations to investing partners or termination benefits related to employment agreements with our executive officers, due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. See Note 12, Commitments and Contingencies - Partnership Repurchase Provision; Employment Agreements with Executive Officers, to our consolidated financial statements included elsewhere in this report. (7) Amounts presented include $263.2 million to the holders of our 7.75% senior notes due 2022 and $1.4 million payable to the holders of our 3.25% convertible senior notes due 2016. Amounts also include $11.0 million payable to the participating banks in our revolving credit facility, of which interest of $6.6 million is related to unutilized commitments at a rate of 0.38% per annum, $4.3 million related to the outstanding borrowings on our revolving credit facility of $37.0 million and $0.2 million related to our undrawn letters of credit. (8) Represents our gross commitment. See Note 12, Commitments and Contingencies - Firm Transportation, Processing and Sales Agreements, to our consolidated financial statements included elsewhere in this report. As the managing general partner of affiliated partnerships, we have liability for potential casualty losses in excess of the partnership assets and insurance. We believe that the casualty insurance coverage we and our subcontractors carry is adequate to meet this potential liability. For information regarding our legal proceedings, see Note 12, Commitments and Contingencies - Litigation, to our consolidated financial statements included elsewhere in this report. From time to time, we are a party to various other legal proceedings in the ordinary course of business. We are not currently a party to any litigation that we believe would have a materially adverse effect on our business, financial condition, results of operations or liquidity. Critical Accounting Policies and Estimates We have identified the following policies as critical to business operations and the understanding of our results of operations. This is not a comprehensive list of all of the accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP, with no need for our judgment in the application. There are also areas in which our judgment in selecting available alternatives would not produce a materially different result. However, certain of our accounting policies are particularly important to the portrayal of our financial position and results of operations and we may use significant judgment in the application. As a result, they are subject to an inherent degree of uncertainty. In applying those policies, we use our judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on historical experience, observation of trends in the industry and information available from other outside sources, as appropriate. For a more detailed discussion on the application of these and other accounting policies, see Note 2, Summary of Significant Accounting Policies, to our consolidated financial statements included elsewhere in this report. Crude Oil and Natural Gas Properties. We account for our crude oil and natural gas properties under the successful efforts method of accounting. Costs of proved developed producing properties, successful exploratory wells and developmental dry hole costs are capitalized and depreciated or depleted by the unit-of-production method based on estimated proved developed producing reserves. Property acquisition costs are depreciated or depleted on the unit-of-production method based on estimated proved reserves. Annually, we engage independent petroleum engineers to prepare reserve and economic evaluations of all our properties on a well-by-well basis as of December 31. We adjust our crude oil and natural gas reserves for major acquisitions, new drilling and divestitures during the year as needed. The process of estimating and evaluating crude oil and natural gas reserves is complex, requiring significant decisions in the evaluation of available geological, geophysical, engineering and economic data. The data for a given property may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and a continual reassessment of the viability of production under changing economic conditions. As a result, revisions in existing reserve estimates occur. Although every reasonable effort is made to ensure that reserve estimates reported represent our most accurate assessments possible, the subjective decisions and variances in available data for various properties increase the likelihood of significant changes in these estimates over time. Because estimates of reserves significantly affect our DD&A expense, a change in our estimated reserves could have an effect on our net income. Exploration costs, including geological and geophysical expenses, and delay rentals, are charged to expense as incurred. Exploratory well drilling costs, including the cost of stratigraphic test wells, are initially capitalized, but are charged to expense if the well is determined to be nonproductive. The status of each in-progress well is reviewed quarterly to determine the proper accounting treatment under the successful efforts method of accounting. Exploratory well costs continue to be capitalized as long as the well has found a sufficient quantity of reserves to justify completion as a producing well and we are making sufficient progress assessing our reserves and economic and operating viability. If an in-progress exploratory well is found to be unsuccessful prior to the issuance of the financial statements, the costs incurred prior to the end of the reporting period are charged to exploration expense. If we are unable to make a final determination about the productive status of a well prior to issuance of the financial statements, the well is classified as "suspended well costs" until we have had sufficient time to conduct additional completion or testing operations to evaluate the pertinent geological and engineering data obtained. At the time when we are able to make a final determination of a well’s productive status, the well is removed from the suspended well status and the proper accounting treatment is applied. The acquisition costs of unproved properties are capitalized when incurred, until such properties are transferred to proved properties or charged to expense when expired, impaired or amortized. Unproved crude oil and natural gas properties with individually significant acquisition costs are periodically assessed, and any impairment in value is charged to impairment of crude oil and natural gas properties. The amount of impairment recognized on unproved properties which are not individually significant is determined by amortizing the costs of such properties within appropriate fields based on our historical experience, acquisition dates and average lease terms, with the amortization recognized in impairment of crude oil and natural gas properties. The valuation of unproved properties is subjective and requires us to make estimates and assumptions which, with the passage of time, may prove to be materially different from actual realizable values. We assess our crude oil and natural gas properties for possible impairment upon a triggering event by comparing net capitalized costs to estimated undiscounted future net cash flows on a field-by-field basis using estimated production based upon prices at which we reasonably estimate the commodity to be sold. Any impairment in value is charged to impairment of crude oil and natural gas properties. The estimates of future prices may differ from current market prices of crude oil and natural gas. Any downward revisions in estimates to our reserve quantities, expectations of falling commodity prices or rising operating costs could result in a triggering event, and therefore, a reduction in undiscounted future net cash flows and an impairment of our crude oil and natural gas properties. Although our cash flow estimates are based on the relevant information available at the time the estimates are made, estimates of future cash flows are, by nature, highly uncertain and may vary significantly from actual results. Crude Oil, Natural Gas and NGLs Sales Revenue Recognition. Crude oil, natural gas and NGLs sales are recognized when production is sold to a purchaser at a determinable price, delivery has occurred, rights and responsibility of ownership have transferred and collection of revenue is reasonably assured. We record sales revenue based on an estimate of the volumes delivered at estimated prices as determined by the applicable sales agreement. We estimate our sales volumes based on company-measured volume readings. We then adjust our crude oil, natural gas and NGLs sales in subsequent periods based on the data received from our purchasers that reflects actual volumes and prices received. We receive payment for sales from one to two months after actual delivery has occurred. The differences in sales estimates and actual sales are recorded two months later. Historically, these differences have been immaterial. Fair Value of Financial Instruments. Our fair value measurements are estimated pursuant to a fair value hierarchy that requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date, giving the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable data (Level 3). In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The lowest level input that is significant to a fair value measurement in its entirety determines the applicable level in the fair value hierarchy. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability, and may affect the valuation of the assets and liabilities and their placement within the fair value hierarchy levels. The three levels of inputs that may be used to measure fair value are defined as: Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability and inputs that are derived from observable market data by correlation or other means. Level 3 - Unobservable inputs for the asset or liability, including situations where there is little, if any, market activity. Derivative Financial Instruments. We measure the fair value of our derivative instruments based on a pricing model that utilizes market-based inputs, including but not limited to the contractual price of the underlying position, current market prices, natural gas and crude oil forward curves, discount rates such as the LIBOR curve for a similar duration of each outstanding position, volatility factors and nonperformance risk. Nonperformance risk considers the effect of our credit standing on the fair value of derivative liabilities and the effect of our counterparties' credit standings on the fair value of derivative assets. Both inputs to the model are based on published credit default swap rates and the duration of each outstanding derivative position. We validate our fair value measurement through the review of counterparty statements and other supporting documentation, the determination that the source of the inputs is valid, the corroboration of the original source of inputs through access to multiple quotes, if available, or other information and monitoring changes in valuation methods and assumptions. While we use common industry practices to develop our valuation techniques, changes in our pricing methodologies or the underlying assumptions could result in significantly different fair values. While we believe our valuation method is appropriate and consistent with those used by other market participants, the use of a different methodology or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value. Net settlements on our derivative instruments are initially recorded to accounts receivable or payable, as applicable, and may not be received from or paid to counterparties to our derivative contracts within the same accounting period. Such settlements typically occur the month following the maturity of the derivative instrument. We have evaluated the credit risk of the counterparties holding our derivative assets, which are primarily financial institutions who are also major lenders in our revolving credit facility, giving consideration to amounts outstanding for each counterparty and the duration of each outstanding derivative position. Based on our evaluation, we have determined that the potential impact of nonperformance of our counterparties on the fair value of our derivative instruments is not significant. Deferred Income Tax Asset Valuation Allowance. Deferred income tax assets are recognized for deductible temporary differences, net operating loss carry-forwards and credit carry-forwards if it is more likely than not that the tax benefits will be realized. To the extent a deferred tax asset is not expected to be realized under the preceding criteria, we establish a valuation allowance. The factors which we consider in assessing whether we will realize the value of deferred income tax assets involve judgments and estimates of both amount and timing, which could differ from actual results, achieved in future periods. The judgments used in applying these policies are based on our evaluation of the relevant facts and circumstances as of the date of the financial statements. Actual results may differ from those estimates. Accounting for Acquisitions Using Purchase Accounting. We utilize the purchase method to account for acquisitions. Pursuant to purchase method accounting, we allocate the cost of the acquisition to assets acquired and liabilities assumed based on fair values as of the acquisition date. The purchase price allocations are based on appraisals, discounted cash flows, quoted market prices and estimates by management. When appropriate, we review comparable purchases and sales of crude oil and natural gas properties within the same regions and use that data as a basis for fair market value; for example, the amount at which a willing buyer and seller would enter into an exchange for such properties. In estimating the fair values of assets acquired and liabilities assumed, we make various assumptions. The most significant assumptions relate to the estimated fair values assigned to proved developed producing, proved developed non-producing, proved undeveloped, unproved crude oil and natural gas properties and other non-crude oil and natural gas properties. To estimate the fair values of these properties, we prepare estimates of crude oil and natural gas reserves. We estimate future prices by using the applicable forward pricing strip to apply to our estimate of reserve quantities acquired, and estimates of future operating and development costs, to arrive at an estimate of future net revenues. For estimated proved reserves, the future net revenues are discounted using a market-based weighted-average cost of capital rate determined appropriate at the time of the acquisition. The market-based weighted-average cost of capital rate is subject to additional project-specific risking factors. To compensate for the inherent risk of estimating and valuing unproved properties, we reduce the discounted future net revenues of probable and possible reserves by additional risk-weighting factors. We record deferred taxes for any differences between the assigned values and tax basis of assets and liabilities. Estimated deferred taxes are based on available information concerning the tax basis of assets acquired and liabilities assumed and loss carryforwards at the acquisition date, although such estimates may change in the future as additional information becomes known. Recent Accounting Standards See Note 2, Summary of Significant Accounting Policies - Recently Adopted Accounting Standards, to our consolidated financial statements included elsewhere in this report. Reconciliation of Non-U.S. GAAP Financial Measures Adjusted cash flows from operations. We define adjusted cash flows from operations as the cash flows earned or incurred from operating activities, without regard to changes in operating assets and liabilities. We believe it is important to consider adjusted cash flows from operations, as well as cash flows from operations, as we believe it often provides more transparency into what drives the changes in our operating trends, such as production, prices, operating costs and related operational factors, without regard to whether the related asset or liability was received or paid during the same period. We also use this measure because the timing of cash received from our assets, cash paid to obtain an asset or payment of our obligations has been only a timing issue from one period to the next as we have not had accounts receivable collection problems, nor been unable to purchase assets or pay our obligations. See the Consolidated Statements of Cash Flows included elsewhere in this report. Adjusted net income (loss). We define adjusted net income (loss) as net income (loss), plus loss on commodity derivatives, less gain on commodity derivatives and net settlements on commodity derivatives, each adjusted for tax effect. We believe it is important to consider adjusted net income (loss), as well as net income (loss). We believe this measure often provides more transparency into our operating trends, such as production, prices, operating costs, net settlements from derivatives and related factors, without regard to changes in our net income (loss) from our mark-to-market adjustments resulting from net changes in the fair value of unsettled derivatives. Adjusted EBITDA. We define adjusted EBITDA as net income (loss), plus loss on commodity derivatives, interest expense, net of interest income, income taxes, impairment of crude oil and natural gas properties, depreciation, depletion and amortization, accretion of asset retirement obligations and loss on debt extinguishment, less gain on commodity derivatives and net settlements on commodity derivatives. Adjusted EBITDA is not a measure of financial performance or liquidity under U.S. GAAP and should be considered in addition to, not as a substitute for, net income (loss), nor as an indicator of cash flows reported in accordance with U.S. GAAP. Adjusted EBITDA includes certain non-cash costs incurred by us and does not take into account changes in operating assets and liabilities. Other companies in our industry may calculate adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure. We believe adjusted EBITDA is relevant because it is a measure of our operational and financial performance, as well as a measure of our liquidity, and is used by our management, investors, commercial banks, research analysts and others to analyze such things as: • operating performance and return on capital as compared to our peers; • financial performance of our assets and our valuation without regard to financing methods, capital structure or historical cost basis; • ability to generate sufficient cash to service our debt obligations; and • viability of acquisition opportunities and capital expenditure projects, including the related rate of return. PV-10. We define PV-10 as the estimated present value of the future net cash flows from our proved reserves before income taxes, discounted using a 10% discount rate. We believe that PV-10 provides useful information to investors as it is widely used by professional analysts and sophisticated investors when evaluating oil and gas companies. We believe that PV-10 is relevant and useful for evaluating the relative monetary significance of our reserves. Professional analysts and sophisticated investors may utilize the measure as a basis for comparison of the relative size and value of our reserves to other companies' reserves. Because there are many unique factors that can impact an individual company when estimating the amount of future income taxes to be paid, we believe the use of a pre-tax measure is valuable in evaluating us and our reserves. PV-10 is not intended to represent the current market value of our estimated reserves. The following table presents a reconciliation of our non-U.S. GAAP financial measures to its most comparable U.S. GAAP measure: Amounts above include results from continuing and discontinued operations.

<s>[INST] EXECUTIVE SUMMARY 2015 Financial Overview Production volumes from continuing operations increased substantially to 15.4 MMboe in 2015 compared to 9.3 MMboe in 2014, representing an increase of 65%. The increase in production volumes was primarily attributable to our successful horizontal Niobrara and Codell drilling program in the Wattenberg Field. Crude oil production from continuing operations increased 62% in 2015, while NGL production from continuing operations increased 61%. Crude oil production comprised approximately 45% of total production from continuing operations in 2015. Natural gas production from continuing operations increased 73% in 2015 compared to 2014 as we shifted our focus to the higher rate of return drilling projects located in the higher gas to oil ratio inner and middle core areas of the Wattenberg Field. For the month ended December 31, 2015, we maintained an average production rate of 52 MBoe per day, up from 30 MBoe per day for the month ended December 31, 2014. Crude oil, natural gas and NGLs sales from continuing operations, coupled with the impact of settlement of derivatives, increased in 2015. Increased production and positive net settlements on derivative positions more than offset the effect of declines in commodity prices during the year. Lower crude oil and natural gas index prices in 2015 were the primary reason for significant positive net settlements of $238.9 million on derivative positions compared to negative net settlements of $0.8 million in 2014. Crude oil, natural gas and NGLs sales, including the impact of net settlements on derivatives, was $617.6 million in 2015 compared to $470.6 million in 2014. This represents an increase of 31% in 2015 compared to 2014. Other significant changes impacting our 2015 results of operations include the following: Crude oil, natural gas and NGLs sales decreased to $378.7 million in 2015 compared to $471.4 million in 2014, due to a 51% decrease in the weightedaverage realized prices of crude oil, natural gas and NGLs, offset in part by a 65% increase in production; Negative net change in the fair value of unsettled derivative positions in 2015 was $35.8 million compared to a positive net change in the fair value of unsettled derivative positions of $311.1 million in 2014, primarily attributable to crude oil and natural gas derivatives that settled in 2015; General and administrative expense decreased to $90.0 million in 2015 compared to $123.6 million in 2014, primarily attributable to $40.3 million recorded in 2014 in connection with certain partnershiprelated class action litigation and estimates relating to litigation arising from bankruptcy proceedings of certain affiliated partnerships; Impairment of crude oil and natural gas properties was $161.6 million in 2015 compared to $166.8 million in 2014, both primarily related to the writedown of our Utica Shale producing and nonproducing crude oil and natural gas properties; and Depreciation, depletion and amortization expense increased to $303.3 million in 2015 compared to $192.5 million in 2014, primarily due to increased production, offset in part by lower weightedaverage depreciation, depletion and amortization rates. Available liquidity as of December 31, 2015 was $402.2 million compared to $398.4 million as of December 31, 2014. Available liquidity as of December 31, 2015 is comprised of $0.9 million of cash and cash equivalents and $401.3 million available for borrowing under our revolving credit facility. These amounts exclude an additional $250 million available under our revolving credit facility, subject to certain terms and conditions of the agreement. [/INST] Positive. </s>

PDC ENERGY, INC.

2017-02-28

2016-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis, as well as other sections in this report, should be read in conjunction with our consolidated financial statements and related notes to consolidated financial statements included elsewhere in this report. Further, we encourage you to revisit the Special Note Regarding Forward-Looking Statements in Part I of this report. SUMMARY 2016 Financial Overview of Operations and Liquidity Production volumes increased to 22.2 MMBoe in 2016, including 0.2 MMBoe from our recent acquisitions in the Delaware Basin, compared to 15.4 MMBoe in 2015, representing an increase of 44 percent. The increase in production volumes was primarily attributable to our successful horizontal Niobrara and Codell drilling program in the Wattenberg Field. Crude oil production increased 25 percent in 2016, which comprised approximately 39 percent of total production. Natural gas production increased 55 percent and NGLs increased 70 percent in 2016 compared to 2015. These increases were the result of our shift in focus to the higher rate of return drilling projects located in the higher gas to oil ratio inner and middle core areas of the Wattenberg Field during the first half of 2016. On a combined basis, total liquids production of crude oil and NGLs comprised 61 percent of production in 2016 compared to 64 percent of production in 2015, a decrease of four percent. For the month ended December 31, 2016, we maintained an average production rate of 73 MBoe per day, up from 52 MBoe per day for the month ended December 31, 2015. Crude oil, natural gas, and NGLs sales increased to $497.4 million in 2016 compared to $378.7 million in 2015, due to a 44 percent increase in production, offset in part by a nine percent decrease in the weighted-average realized prices of crude oil, natural gas, and NGLs, driven by lower commodity prices and changes in commodity mix. Crude oil, natural gas, and NGLs sales, coupled with the impact of positive net settlements of derivatives, also increased in 2016 as compared to 2015. When combining the physical commodity sales and the net settlements received on our commodity derivative instruments, the total net revenues increased 14 percent to $705.4 million in 2016 from $617.6 million in 2015. The low crude oil and natural gas index prices in 2016 and 2015 were the primary reason for the positive net settlements of $208.1 million and $238.9 million on commodity derivatives in 2016 and 2015, respectively. In 2016, we generated a net loss of $245.9 million, or $5.01 per diluted share. In the same period we generated $435.6 million of adjusted EBITDA, a non-U.S. GAAP financial measure, and invested $396.4 million in the development and exploration of our oil and natural gas properties, which is net of the change in accounts payable related to capital expenditures. Our cash flow from operations was $486.3 million and our adjusted cash flow from operations was $466.8 million in 2016. Adjusted EBITDA and adjusted cash flow from operations are non-U.S. GAAP financial measures as defined and more fully described later in this section. Other significant changes impacting our 2016 results of operations include the following: • The net change in the fair value of unsettled derivative positions in 2016 was a loss of $333.8 million compared to a loss of $35.8 million in 2015. The decrease in the fair value of unsettled derivative positions is largely driven by the normal monthly settlements of the commodity derivative instruments in 2016. Additionally, the change in fair value was attributable to hedging positions entered into in 2016 at lower strike prices and the upward shift in the crude oil and natural gas forward curves that occurred during 2016 versus a downward shift in 2015. • Production tax expense increased to $31.4 million in 2016 from $18.4 million in 2015 due to increased production of 44 percent and higher overall sales proceeds. Additionally, we had a higher effective production tax rate in 2016 primarily from a reduction in ad valorem credits from the prior year to offset current year severance taxes due. • Impairment of crude oil and natural gas properties was $10.0 million in 2016 compared to $161.6 million in 2015. The 2016 impairments are a result of the write-off of certain leases that were no longer part of our development plan and to reflect the fair value of other land and buildings that are held for sale. The Utica Shale was the largest component of the 2015 write-down which included both producing and non-producing crude oil and natural gas properties. • General and administrative expense increased to $112.5 million in 2016 compared to $90.0 million in 2015. The increase was attributable to professional and transaction fees related to the Delaware Basin acquisitions and increases in payroll and employee benefits, as we increased our staff by nine percent over the course of 2016. • Depreciation, depletion, and amortization expense increased to $416.9 million in 2016 compared to $303.3 million in 2015, due to the increase in production volumes from year to year. • We recorded a provision for uncollectible notes receivable of $44.0 million in the first quarter of 2016 to impair a note receivable. • Interest expense increased to $62.0 million in 2016 from $47.6 million in 2015. The increase was primarily attributable to a $9.3 million charge for the bridge loan commitment related to our initial Delaware Basin acquisition, a $7.4 million increase in interest expense resulting from the issuance of our 2024 Senior Notes, and a $2.9 million increase in interest expense for the issuance of our 2021 Convertible Notes in September 2016. The increases were partially offset by a $5.1 million decrease in interest expense resulting from the net settlement of our 2016 Convertible Notes in May 2016. Available liquidity as of December 31, 2016 was $932.4 million compared to $402.2 million as of December 31, 2015. Available liquidity as of December 31, 2016 is comprised of $244.1 million of cash and cash equivalents and $688.3 million available for borrowing under our revolving credit facility. In December 2016, pursuant to an amendment to our credit facility and in conjunction with the closing of the acquisitions of the Delaware Basin properties, we increased the aggregate commitment under our revolving credit facility from $450 million to $700 million. In March 2016, we completed a public offering of 5.9 million shares of our common stock at a price to us of $50.11 per share. Net proceeds of the offering were $296.6 million, after deducting offering expenses and underwriting discounts. We used the net proceeds of the offering to repay all amounts then outstanding on our revolving credit facility, the principal and interest owed upon the maturity of the $115 million face value of 2016 Convertible Notes in May 2016 and for general corporate purposes. We settled the 2016 Convertible Notes with a combination of cash and stock, paying the aggregate principal amount, plus cash for fractional shares, totaling approximately $115 million. The conversion price for the 2016 Convertible Notes was $42.40 per share, resulting in the issuance of 792,406 shares of common stock for the excess conversion value. In June 2016, we entered into definitive agreements with Noble Energy Inc. and certain of its subsidiaries ("Noble") to consolidate certain acreage positions in the core Wattenberg Field. In September 2016, we closed the acreage exchange transaction. Pursuant to the transaction, we exchanged leasehold acreage and, to a lesser extent, interests in certain development wells. Upon closing, we received approximately 13,500 net acres in exchange for approximately 11,700 net acres, with no cash exchanged between the parties. The difference in net acres was primarily due to variances in leasehold net revenue interests and third-party mid-stream contracts. This acreage trade has resulted in opportunities for longer length horizontal laterals with increased working interests, while minimizing potential surface impact. In September 2016, we sold 9.1 million shares of common stock for net proceeds of $558.5 million, we issued the 2024 Senior Notes for net proceeds of $392.2 million, and we issued the 2021 Convertible Senior Notes convertible at 11.7113 shares of common stock per $1,000 principal amount for net proceeds of $193.9 million (collectively, the "Securities Issuances"). The total net proceeds of $1.1 billion from the Securities Issuances were used to fund a portion of the purchase price of the acquisitions of the Delaware Basin properties, pay related fees and expenses, and for general corporate purposes. We intend to continue to manage our liquidity position by a variety of means, including through the generation of cash flow from our operations, investment in projects with attractive rates of return, protection of cash flows on a portion of our anticipated sales through the use of an active commodity derivative program, utilization of our borrowing capacity under our revolving credit facility, and the pursuit of capital markets transactions from time to time. Delaware Basin Acquisitions Through a deliberate and disciplined process of searching for, and evaluating, a large-scale acquisition in a U.S. onshore basin that diversifies our operations and is capable of creating material long-term value-added growth, we recently acquired proved and unproved leasehold in the Delaware Basin in Reeves and Culberson Counties in Texas. The acquisition criteria focused on four key attributes: • top-tier acreage in core geologic positions; • significant drilling inventory with additional expansion through down spacing; • portfolio optionality for capital allocation and diversification; and • the ability to deliver long-term corporate accretion. We believe the Delaware Basin acquisitions met these criteria. We completed two acquisition transactions associated with the Delaware Basin. The first acquisition closed in early December 2016, and we acquired acreage, approximately 30 producing wells and related midstream infrastructure in Reeves and Culberson Counties, Texas, for an aggregate consideration to the sellers of approximately $1.64 billion, which was comprised of approximately $952.1 million in cash (including the repayment of $40.0 million of debt from the seller at closing) and 9.4 million shares of our common stock valued at approximately $690.7 million at the time the acquisition closed. The total purchase price remains subject to certain post-closing adjustments as of the date of this report and we expect that it may take into mid-2017 until all post-closing adjustments are settled. The acquisitions were accounted for under the acquisition method. Accordingly, we conducted assessments of net assets acquired and recognized amounts for identifiable assets acquired and liabilities assumed at their estimated acquisition date fair values, while transaction and integration costs associated with the acquisition were expensed as incurred. The details of the purchase price and the preliminary allocation of the purchase price for the first transaction are presented below (in thousands): The 2016 results of operations of the acquired properties in the first transaction had a loss from operations of $1.7 million, which is included in our consolidated statements of operations for 2016. The second transaction closed at the end of December 2016. In this transaction, we acquired primarily unproved acreage for cash consideration of $120.6 million. This acquisition is also subject to final settlement as there were some limited producing assets. The final settlement is not expected to be completed until mid-2017. 2016 Drilling Overview During 2016, we continued to execute our strategic plan to grow production while preserving our financial strength and liquidity. Through July 2016, we ran four automated drilling rigs in the Wattenberg Field. In August 2016, we decreased the number of automated drilling rigs to three in anticipation of higher working interests in wells drilled resulting from the acreage exchange. During 2016, we spud 128 gross horizontal, (109.4 net), wells and turned-in-line 140 gross, (109.7 net), horizontal wells in the Wattenberg Field. Also in the Wattenberg Field, we participated in 17 gross (3.6 net) horizontal non-operated wells that were spud and 24 gross (5.0 net) horizontal non-operated wells which were turned-in-line. In the Utica Shale, we completed five gross horizontal (4.5 net) wells, all of which were turned-in-line in 2016. Following the closing of our acquisitions in the Delaware Basin, we spud one well (0.9 net), and turned-in-line another well (1.0 net) prior to the end of 2016. The following table summarizes our 2016 drilling and completion activity: Our in-process wells represent wells that are in the process of being drilled and/or have been drilled and are waiting to be fractured and/or for gas pipeline connection. We do not have a practice of inventorying our drilled but uncompleted wells. The majority of these in-process wells at each year end are drilled, but not completed as we do not begin the completion process until the entire well pad is drilled. All costs incurred through the end of the period have been capitalized or accrued to capital, while the capital investment to complete the wells will be incurred in the following year. The cost of completing these wells is included in our 2017 capital forecast. 2017 Operational Outlook We expect our production for 2017 to range between 30.0 MMBoe to 33.0 MMBoe and we estimate that our production rate will average approximately 82,200 to 90,400 Boe per day. We expect that 41 percent to 43 percent of our 2017 production will be comprised of crude oil and 20 percent to 22 percent will be NGLs, for total liquids of 61 percent to 65 percent of our total 2017 production. Our previously-announced 2017 capital forecast of between $725 million and $775 million is focused on continued development in the core Wattenberg Field and the integration of the core Delaware Basin assets. Due to recent cost escalation for services and the modification of our drilling schedule in the Delaware Basin, where we have accelerated the deployment of an additional drilling rig, we currently expect that our 2017 capital investment will be at or near the high end of the range. These changes to our capital investment outlook are not expected to impact our expected 2017 production as the incremental wells drilled are contemplated to be turned-in-line to sales late in the year. Wattenberg Field. The 2017 investment outlook of approximately $470 million in the Wattenberg Field anticipates a three to four-rig drilling program based on our current commodity price outlook. Approximately $460 million of our 2017 capital investment program is expected to be allocated to development activities, comprised of approximately $440 million for our operated drilling program and approximately $20 million for wells drilled and operated by others. The remainder of the Wattenberg Field capital investment program is expected to be used for miscellaneous workover and capital projects. Wells in the Wattenberg Field typically have productive horizons at a depth of approximately 6,500 to 7,500 feet below the surface. In 2017, to help manage our priorities, we now anticipate spudding 137 and turning-in-line approximately 139 horizontal operated wells with lateral lengths of 5,000 to 10,000 feet. Delaware Basin. Our 2017 investment outlook contemplates operating a two-rig to four-rig program in the Delaware Basin from time to time during the year. Total capital investment in the Delaware Basin is estimated to be $300 million, of which approximately $235 million is allocated to spud 31 and turn-in-line an estimated 26 wells. Of the the 26 planned turn-in-lines, 14 are expected to have laterals of approximately 10,000 horizontal feet with an estimated 70 to 75 completion stages per well. Similarly spaced completion stages are anticipated for the remaining 12 turn-in-lines. Wells in the Delaware Basin typically have productive horizons at a depth of approximately 9,000 to 11,000 feet below the surface. Based on the timing of our operations and the requirements to hold acreage, we may adapt our capital investment program to drill wells in addition to those currently anticipated, as we are continuing to analyze terms of the leaseholds related to our recent acquisitions of properties in the basin. We plan to invest approximately $35 million for leasing, seismic, and technical studies with an additional $30 million for midstream-related projects including gas connections, salt water disposal wells, and surface location infrastructure. Utica Shale. At this time, we are currently evaluating all of our strategic alternatives with respect to our Utica Shale position. As a result of such evaluation, we are deferring our 2017 planned expenditure of $18 million to drill, complete, and turn-in-line two wells in Guernsey County. In 2017, our capital investment program for the Utica Shale is expected to include between $2 million to $3 million for additional leasing. Such leasing may be necessary to complete certain drilling operations if we decide to continue development of our existing position in the northern portion of our acreage. Results of Operations Summary Operating Results The following table presents selected information regarding our operating results from continuing operations: * Percentage change is not meaningful or equal to or greater than 300% or not applicable. Amounts may not recalculate due to rounding. ______________ (1) Represents net settlements on derivatives related to crude oil and natural gas sales, which do not include net settlements on derivatives related to gas marketing. (2) Represents sales from gas marketing, net of costs of gas marketing, including net settlements and net change in fair value of unsettled derivatives related to gas marketing activities. Crude Oil, Natural Gas and NGLs Sales The following tables present crude oil, natural gas, and NGLs production and weighted-average sales price for continuing operations: (1) Reflects the Delaware Basin acquisitions that occurred in December 2016. * Percentage change is not meaningful or equal to or greater than 300%. Amounts may not recalculate due to rounding. (1) Reflects the Delaware Basin acquisitions that occurred in December 2016. * Percentage change is not meaningful or equal to or greater than 300%. Amounts may not recalculate due to rounding. The year-over-year change in crude oil, natural gas, and NGLs sales revenue were primarily due to the following: Production volumes increased 44 percent in 2016 compared to 2015. Crude oil production increased 25 percent in 2016, which comprised approximately 39 percent of total production. Natural gas production increased 55 percent and NGLs increased 70 percent in 2016 compared to 2015. The increases in crude oil are different from the comparative period because of our shift in focus to the higher rate of return drilling projects located in the higher gas to oil ratio inner and middle core areas of the Wattenberg Field during the first half of 2016. On a combined basis, total liquids production of crude oil and NGLs comprised 61 percent of production in 2016 compared to 64 percent of production in 2015, a decrease of four percent. Production volumes increased 65 percent in 2015 compared to 2014. Production of crude oil, natural gas and NGLs was relatively consistent across commodities at 62 percent, 73 percent, and 61 percent, respectively, as we focused our 2015 and 2014 drilling on the middle and outer core areas of the Wattenberg Field. We currently expect our 2017 individual commodity growth and overall production growth to be similar. Crude oil, natural gas, and NGLs sales in 2016 increased 31 percent compared to 2015. The increase was primarily attributable to higher volumes sold in 2016 of 22.2 MMBoe, up from 15.4 MMBoe in 2015. This was offset in part by a decrease in commodity prices and modest changes in the commodity mix, which resulted in a nine percent decline in the average realized price on a barrel of oil equivalent basis in 2016 compared to 2015. The higher volumes were primarily contributed from turning in-line to sales 140 new gross wells in the Wattenberg Field that delivered significant production volumes. Included in the 22.2 MMBoe is production of 0.2 MMBoe from our acquisitions of producing properties in the Delaware Basin. Our average daily sales volumes increased to 60.6 MBoe per day in 2016 compared to 42.1 MBoe per day in 2015 as a result of continued drilling and completion activities. The average NYMEX crude oil and natural gas prices decreased by 11 percent and eight percent in 2016 compared to 2015. For crude oil the change was to $43.32 per barrel in 2016 from $48.80 per barrel in 2015, and we were able to offset the majority of the decrease in the NYMEX sales prices through actions that decreased our contractual deductions to $4.39 per barrel in 2016 from $9.95 per barrel in 2015. The natural gas realized sales price decreased more than the decrease in the NYMEX price because a portion of our deductions for natural gas are based on fixed price elements and have a more pronounced effect at lower prices. Crude oil, natural gas, and NGLs sales in 2015 decreased 20 percent compared to 2014. The decrease was primarily attributable to a significant decrease in commodity prices, resulting in a 51 percent decline in the price of a barrel of crude oil equivalent in 2015 compared to 2014. The decrease was offset in part by the higher volumes sold in 2015 of 15.4 MMBoe, up from 9.3 MMBoe in 2014. Our average daily sales volumes increased to 42.1 MMBoe per day in 2015 compared to 25.5 MMBoe per day in 2014. The average NYMEX crude oil and natural gas prices decreased by 47 percent and 40 percent in 2015 and 2014, respectively. During various times between 2012 and the summer of 2015, our production had been adversely affected by high line pressures in the natural gas gathering facilities in the Wattenberg Field. Such pressures did not materially affect our production during 2016 due to the investment in the midstream capabilities by our midstream providers and a decrease in development activity by certain producers in the Wattenberg Field resulting in more relative capacity being available to deliver our production. In 2016, approximately 90 percent of our production in the Wattenberg Field was delivered from horizontal wells, with the remaining 10 percent coming from vertical wells. The horizontal wells are less prone to issues than the vertical wells in that they are newer and have greater producing capacity and higher formation pressures and therefore tend to be more resilient from periodic gas system pressure issues. We rely on our third-party midstream service providers to construct compression, gathering and processing facilities to keep pace with our, and the overall field's, production growth. We anticipate gathering system pressures to vary throughout the year, with increases coinciding with the warmer summer months. We, along with other operators in the Wattenberg Field, continue to work closely with our third-party midstream providers in an effort to ensure adequate system capacity going forward as evidenced by a recent commitment of DCP to build additional gathering and processing in the field. This expansion of gathering and processing facilities is expected to improve natural gas gathering pipelines and processing facilities and assist in the control of line pressures in the Wattenberg Field. However, the timing and availability of adequate infrastructure is not within our control and if our midstream provider's construction projects are delayed, we could experience higher line pressures that may negatively impact our ability to fulfill our growth plans. Total system infrastructure needs may also be affected by a number of factors, including potential increases in production from the Wattenberg Field and warmer than expected weather. Crude Oil, Natural Gas, and NGLs Pricing. Our results of operations depend upon many factors, particularly the price of crude oil, natural gas, and NGLs, and our ability to market our production effectively. Crude oil, natural gas, and NGL prices have a high degree of volatility. While the price of crude oil decreased during the first half of 2016 compared to 2015, prices increased during the second half of 2016 as compared to the first half of the year as the number of U.S. crude oil rigs and inventories declined in the last half of 2015 and into early 2016. Natural gas prices decreased during 2016 compared to 2015, primarily due to domestic oversupply driven by a lack of a normal winter withdrawal cycle in the winter of 2015-2016. We experienced improved NGL pricing towards the end of 2016; however, due to an oversupply of nearly all domestic NGLs products, our average realized sales price for NGLs during most of 2016 reflected the same depressed levels seen during 2015. With the initiation of ethane exports and increased domestic demand for NGLs driven by the completion of petrochemical processing plants, the industry is beginning to see NGL prices trend upward, including in the near term forward market. Crude Oil. Crude oil pricing is predominately driven by the physical market, supply and demand, the relative strength of the U.S. dollar, financial markets, and national and international politics. In the Wattenberg Field, our crude oil is sold under various purchase contracts with monthly and longer term transportation provisions based on NYMEX pricing, adjusted for differentials. We have entered into commitments ranging in term from one month to over three years to deliver crude oil to competitive markets, resulting in improved overall average deductions in 2016, as noted previously. We continue to pursue various alternatives with respect to oil transportation, particularly in the Wattenberg Field, with a view toward further improving pricing and limiting our use of trucking through delivering greater quantities of our crude oil via pipeline to liquid markets. We began delivering crude oil in accordance with our long term commitment to the White Cliffs pipeline in July 2015. The White Cliffs agreement is one of several we have entered into to facilitate deliveries of a portion of our crude oil to the Cushing, Oklahoma market. In addition, to the White Cliffs agreement described above, we have signed a long-term agreement with Saddle Butte Rockies Midstream, LLC for gathering of crude oil at the wellhead by pipeline from several of our producing pads in the Wattenberg Field, with a view toward minimizing truck traffic, increasing reliability, reducing the overall physical footprint of our well pads, and reducing emissions. We began delivering crude oil into this pipeline during the fourth quarter of 2015 and continued to grow these volumes during 2016. In the Delaware Basin, our crude oil production is sold at the wellhead and transported via trucks to pipelines that deliver the oil to the Midland, Texas, crude oil market. Given the increased level of activity in the form of acquisitions, leasing, and the increases in rig count in the Delaware Basin over the last six months, we expect the balance between production and pipeline takeaway capacity to tighten during 2017. At the current time, there are pipeline, truck and rail pathways out of the basin, all of which are available to us. We are evaluating near-term and longer-term solutions that contemplate the increased activity levels we expect, as well as our anticipated future production. These may include longer-term sales agreements. In the Utica Shale, crude oil and condensate is sold to local purchasers at each individual pad based on NYMEX pricing, adjusted for differentials, and is typically transported by the purchasers via truck to local refineries, rail facilities, or barge loading terminals on the Ohio River. To date, we have not experienced any issues with takeaway capacity in this region for our crude oil. Natural Gas. Natural gas prices vary quite significantly by region and locality, depending upon the distance to markets, availability of pipeline capacity, and supply and demand relationships in that region or locality. The price we receive for our natural gas produced in the Wattenberg Field is based on CIG pricing provisions or local distribution company monthly/daily pricing provisions, adjusted for certain deductions. Our natural gas from the Delaware Basin is sold into the Waha hub and El Paso index markets. Natural gas produced in the Utica Shale is sold based on TETCO M-2 pricing. Natural Gas Liquids. Our NGL sales are priced based upon the components of the product and are correlated to the price of crude oil. Our price for NGLs produced in the Wattenberg Field is based on a combination of prices from the Conway hub in Kansas and Mt. Belvieu in Texas where this production is marketed. While NGL prices remained low during the majority of 2016, we realized improvements in NGL pricing during the fourth quarter of 2016 and are seeing this improvement continue in early 2017. Given the lack of liquidity in the forward markets, it is unclear if this trend will continue. Delaware Basin NGLs sales are indexed to NYMEX and sold into the Mt. Belvieu, Texas market. The NGLs produced in the Utica Shale are sold based on month-to-month pricing to various markets. Our crude oil, natural gas, and NGLs sales are recorded under either the “net-back” or "gross" method of accounting, depending upon the related purchase agreement. We use the "net-back" method of accounting for natural gas and NGLs, as well as the majority of our crude oil production from the Wattenberg Field, for all commodities in the Delaware Basin, and for crude oil from the Utica Shale as the majority of the purchasers of these commodities also provide transportation, gathering, and processing services. In these situations, the purchaser pays us proceeds based on a percent of the proceeds, or have fixed our sales price at index less a specified deduction. We sell our commodities at the wellhead or what is tantamount to the wellhead in situations where we gather multiple wells into larger pads, and collect a price and recognize revenues based on the wellhead sales price as transportation and processing costs downstream of the wellhead are incurred by the purchaser and therefore embedded in the wellhead price. The "net-back" method results in the recognition of a net sales price that is lower than the indices for which the production is based because the operating costs and profit of the midstream facilities are embedded in the net price we earn. We use the "gross" method of accounting for Wattenberg Field crude oil delivered through the White Cliffs and Saddle Butte pipelines, and for natural gas and NGLs sales related to production from the Utica Shale as the purchasers do not provide transportation, gathering or processing services as a function of the price we earn. Rather, we contract separately with the midstream provider for the applicable transport and processing based on a per unit basis. Under this method, we recognize revenues based on the gross selling price and recognize transportation, gathering, and processing expenses. As a result of the White Cliffs and Saddle Butte agreements, during 2016 and 2015, our Wattenberg Field crude oil average sales price increased approximately $1.60 and $0.73, respectively, per barrel, relative to the benchmark price because we recognized the costs for transportation on the White Cliffs and Saddle Butte pipelines as an increase in revenues and transportation expense, rather than as a deduction from revenues. Lease Operating Expenses Lease operating expenses were $60.0 million in 2016 compared to $57.0 million in 2015. Due to newer and more horizontal well completions that deliver larger volumes of production per well than older vertical wells, we are seeing the lease operating costs spread over more volume, resulting in lower lease operating cost per Boe. This is reflected in the fact that our per Boe lease operating expense decreased by 27 percent to $2.70 for 2016 from $3.71 for 2015. The $3.0 million increase in the total lease operating expenses in 2016 as compared to 2015 was primarily due to an increase of $3.7 million for increases in wages and employee benefits related to an increase in headcount, including costs for additional contract labor, $1.8 million for additional leased compressors to address line pressures, and an increase of $1.5 million related to lease operating expenses for the acquisitions in the Delaware Basin. These increases were partially offset by a decrease in environmental remediation and regulatory compliance projects of $3.2 million due to a reduction in new remediation projects, and a decrease of $1.4 million related to fewer workover and maintenance related projects. With our entry into the Delaware Basin, we anticipate that our per Boe lease operating cost will be higher initially as we have limited wells and production over which to apply our lease operating costs. With time, we expect that the lease operating costs per Boe in the Delaware Basin will improve. Lease operating expenses were $57.0 million in 2015 compared to $42.4 million in 2014. The $14.6 million increase in lease operating expenses in 2015 as compared to 2014 was primarily due to an increase of $4.2 million for environmental remediation and regulatory compliance projects due to increases in the number of projects and an increase in per project expenses, an increase of $3.4 million for additional wages and employee benefits primarily due to additional headcount, including costs for additional contract labor, $2.0 million for additional workover and maintenance related projects, $1.4 million for additional compressors to correct high line pressures in the Wattenberg Field, $1.0 million for the increasing number of non-operated wells in the Wattenberg Field, and $0.9 million for additional costs pertaining to water hauling and disposal. Lease operating expenses per Boe decreased significantly to $3.71 for 2015 from $4.56 in 2014, as a result of increased production. Production Taxes Production taxes are directly related to crude oil, natural gas, and NGLs sales. Production taxes are comprised of both statutory severance tax rates as well as ad valorem tax rates for the applicable production periods. There are a number of adjustments to the statutory rates based on certain credits that are determined based on activity levels and relative commodity prices from year-to-year. The $13.0 million, or 70 percent, increase in production taxes for 2016 compared to 2015 is primarily related to the 31 percent increase in crude oil, natural gas, and NGLs sales, higher ad valorem mill rates, and an overall higher effective tax rate resulting from a decrease in ad valorem tax credits available from the prior year to offset current year severance taxes, driven by the relatively depressed commodity pricing in 2015. These items resulted in effective production tax rates of 6.3 percent and 4.9 percent in 2016 and 2015, respectively. Similarly, the $7.2 million, or 28 percent, decrease in production taxes for 2015 compared to 2014 is primarily related to the 20 percent decrease in crude oil, natural gas, and NGLs sales. On a per Boe basis, the increase in rates in 2016 impacted the production tax expense, which increased to $1.42 for 2016 compared to $1.20 for 2015 due to the higher effective tax rate noted above. With the decrease in commodity pricing for 2015, production taxes per Boe decreased to $1.20 for 2015 compared to $2.76 for 2014. These items resulted in effective production tax rates of 4.9 percent and 5.4 percent in 2015 and 2014, respectively. Transportation, Gathering and Processing Expenses The $8.3 million, or 81 percent, increase in transportation, gathering, and processing expenses for 2016 compared to 2015 was mainly attributable to the costs associated with the White Cliffs and Saddle Butte pipelines in the Wattenberg Field as we began delivering crude oil on these pipelines in July 2015 and December 2015, respectively. We expect to continue to incur these oil transportation costs pursuant to our long-term firm transportation agreement for 6,600 gross barrels per day. The $5.6 million, or 121 percent, increase in transportation, gathering, and processing expenses for 2015 compared to 2014 was mainly attributable to costs associated with the White Cliffs pipeline. Transportation, gathering, and processing expenses per Boe increased to $0.83 for 2016 compared to $0.66 for 2015 and $0.49 for 2014. By using these pipelines and having the pipelines be able to deliver product to the Cushing, Oklahoma market, we benefit from the liquidity associated with the purchasers’ delivery point. Commodity Price Risk Management, Net We use commodity derivative instruments to manage fluctuations in crude oil and natural gas prices. We have in place a variety of collars, fixed-price swaps, and basis swaps on a portion of our estimated crude oil and natural gas production. Because we sell all of our crude oil and natural gas production at prices related to the indexes inherent in our underlying derivative instruments, we ultimately realize value related to our collars of no less than the floor and no more than the ceiling and, for our commodity swaps, we ultimately realize the fixed price value related to our swaps. Commodity price risk management, net, includes cash settlements upon maturity of our derivative instruments and the change in fair value of unsettled derivatives related to our crude oil and natural gas production. Commodity price risk management, net, does not include derivative transactions related to our gas marketing, which are included in sales from and cost of gas marketing. Net settlements of commodity derivative instruments are based on the difference between the crude oil, natural gas and natural gas index prices at the settlement date of our commodity derivative instruments compared to the respective strike prices contracted for the settlement months that were established at the time we entered into the commodity derivative transaction. The net change in fair value of unsettled commodity derivatives is comprised of the net value increase or decrease in the beginning-of-period fair value of commodity derivative instruments that settled during the period, and the net change in fair value of unsettled commodity derivatives during the period or from inception of any new contracts entered into during the applicable period. The corresponding impact of settlement of the commodity derivative instruments during the period is included in net settlements for the period as discussed above. The net change in fair value of unsettled commodity derivatives during the period is primarily related to shifts in the crude oil and natural gas forward curves and changes in certain differentials. The following table presents net settlements and net change in fair value of unsettled commodity derivatives included in commodity price risk management, net: Exploration Expense The following table presents the major components of exploration expense: Geological and geophysical costs. Geological and geophysical costs in 2016 were primarily related to the portion of the purchase of seismic data related to unproved acreage in the Delaware Basin. Impairment of Properties and Equipment The following table sets forth the major components of our impairments of properties and equipment expense: Due to a significant decline in commodity prices and decreases in our net realized sales prices, we experienced triggering events during 2015 and 2014 that required us to assess our crude oil and natural gas properties for possible impairment. As a result of our assessments, we recorded impairment charges of $150.3 million and $158.3 million in 2015 and 2014, respectively, to write-down our Utica Shale proved and unproved properties. Of these impairment charges, $24.7 million and $112.6 million were recorded in 2015 and 2014, respectively, to write-down certain capitalized well costs on our Utica Shale proved producing properties. In 2015 and 2014, we also recorded impairment charges of $125.6 million and $45.7 million to write-down our Utica Shale lease acquisition costs. The impairment charges, which are included in the consolidated statements of operations line item impairment of properties and equipment, represented the amount by which the carrying value of these crude oil and natural gas properties exceeded the estimated fair values. We continued to monitor whether any further impairments were triggered and required measurement throughout 2016 given the continued volatility of commodity prices and the continued capital investment in the development and acquisition of oil and gas properties. No such triggering events occurred during 2016. Impairment charges in 2016 relate to the retirement of certain leases that were no longer part of our development plan and to reflect the fair value of other property and equipment that was held for sale as of December 31, 2016. Future deterioration of commodity prices or other operating circumstances could result in additional impairment charges to our properties and equipment. Amortization of individually insignificant unproved properties. The decrease in 2016 as compared to 2015 is due to the impairment of leases in 2015, which significantly reduced total lease costs. The increase in 2015 as compared to 2014 was primarily related to a higher number of insignificant leases that were subject to amortization in 2015, primarily in the Utica Shale. Land and buildings. The impairment charge for 2016 represents the excess of the carrying value over the estimated fair value, less the cost to sell, of a field operating facility in Greeley, Colorado, and 12 acres of land located adjacent to our Bridgeport, West Virginia, regional headquarters. The fair values of these assets were determined based upon estimated future cash flows from unrelated third-party bids. General and Administrative Expense General and administrative expense increased $22.5 million, or 25 percent, in 2016 compared to 2015. The increase in cash based general and administrative costs was primarily attributable to $12.2 million of legal and professional fees related to the acquisitions in the Delaware Basin, a $7.7 million increase in payroll and employee benefits due to per capita increases in wages and increases in headcount given the increase in our personnel by nine percent over the course of 2016. Stock-based compensation expense in 2016 and 2015 was $19.5 million and $20.1 million, respectively. General and administrative expense decreased $33.6 million, or 27 percent, in 2015 compared to 2014. The decrease was primarily attributable to $40.3 million recorded in 2014 in connection with certain partnership-related class action litigation and estimates relating to litigation arising from bankruptcy proceedings of certain affiliated partnerships and a $1.8 million decrease in costs for legal and other professional services in 2015. The decreases were offset in part by an $8.2 million increase in payroll and employee benefits in 2015, of which $3.3 million was related to stock-based compensation. Stock-based compensation expense in 2015 and 2014 was $20.1 million and $17.5 million, respectively. Depreciation, Depletion, and Amortization Crude oil and natural gas properties. During 2016, 2015, and 2014, we invested $396.4 million, $554.3 million and $663.4 million, which is net of the change in accounts payable related to capital expenditures, in the development of our oil and natural gas properties, respectively. We also incurred $1.76 billion to acquire proved reserves during 2016. We did not invest in any acquisitions of proved reserves in 2015 or 2014. DD&A expense related to crude oil and natural gas properties is directly related to proved reserves and production volumes. DD&A expense related to crude oil and natural gas properties was $413.1 million, $298.8 million, and $188.5 million in 2016, 2015, and 2014, respectively. The year-over-year change in DD&A expense related to crude oil and natural gas properties were primarily due to the following: The following table presents our DD&A expense rates for crude oil and natural gas properties: The 2016 rate for the Delaware Basin is related to our acquisitions in the Delaware Basin. The slight decrease in the Wattenberg Field rate for 2016 as compared to 2015 was primarily due to the impact of our 2016 year-end reserves. The decrease in the Utica Shale DD&A expense rates in 2015 relative to 2014 was primarily due to the effect of impairments recorded in 2015 and 2014 to write-down certain capitalized well costs on our Utica Shale proved producing properties. Provision for Uncollectible Notes Receivable In the first quarter of 2016, we recorded a provision for uncollectible notes receivable of $44.7 million to impair two third-party notes receivable whose collection was not reasonably assured. Later in 2016, we collected a $0.7 million promissory note and reversed the related provision and allowance for uncollectible notes receivable. Accretion of Asset Retirement Obligations Accretion of asset retirement obligations ("ARO") for 2016 increased by $0.8 million, or 13 percent, compared to 2015, and increased by $2.9 million, or 84 percent, in 2015 compared to 2014. The increase in 2016 was due to adding new wells and the associated increase in amortization expense. The increase in 2015 was primarily attributable to decreases in the estimated useful life of certain vertical wells in the Wattenberg Field. Interest Expense Interest expense increased by approximately $14.4 million in 2016 compared to 2015. The increase is primarily attributable to a $9.3 million charge for the bridge loan commitment related to acquisitions of properties in the Delaware Basin, a $7.4 million increase in interest for the issuance of our 2024 Senior Notes, and a $2.9 million increase in interest expense for the issuance of our 2021 Convertible Notes in September 2016. The increases were partially offset by a $5.1 million decrease in interest expense resulting from the net settlement of our 2016 Convertible Notes in May 2016. The entire $9.3 million of interest expense attributed to the bridge loan facility was expensed in 2016 as the bridge loan was replaced with equity and longer term debt financing. Interest expense decreased by approximately $0.3 million in 2015 compared to 2014. The decrease is primarily comprised of a $1.6 million decrease attributable to an increase in capitalized interest, offset in part by a $0.9 million increase due to higher average borrowings on our revolving credit facility in 2015. Interest costs capitalized in 2016, 2015, and 2014 were $4.5 million, $5.1 million, and $3.5 million, respectively. Provision for Income Taxes The current income tax benefit (expense) in 2016, 2015, and 2014 was $9.9 million, $(3.1) million, and $(0.5) million, respectively. Current income taxes generally relate to the cash that is paid or recovered for income taxes associated with the applicable period. The remaining portion of the total income tax expense is comprised of deferred income tax expense (benefit), which is a result of differences in the timing of deductions for our GAAP presentation of financial statements and the income tax regulations. For 2016, 2015, and 2014, the effective income tax rate (the "rate") of 37.4 percent, 35.9 percent, and 39.5 percent on income (loss) from operations differs from the federal statutory tax rate of 35 percent primarily due to state taxes and excess stock compensation benefits, offset by nondeductible expenses that consist primarily of officers' compensation cost and government lobbying expenses. As of the date of this report, we are current with our income tax filings in all applicable state jurisdictions. We continue to voluntarily participate in the Internal Revenue Service’s ("IRS") Compliance Assurance Program (the "CAP Program") for the 2015, 2016, and 2017 tax years. We have received a full acceptance notice from the IRS for our filed 2015 federal tax return and the IRS's post filing review is complete. We acquired a net deferred tax liability of $379.9 million in 2016 associated with a lack of tax basis relative to the purchase price of one of the Delaware Basin acquisitions. This has resulted in a material increase in our deferred tax liability on the balance sheet as of December 31, 2016. There has been increased discussion by the federal government of a potential reduction of the corporate income tax rate and corresponding changes to the tax code. In the event of a change in federal or state income tax rates, the impact of the rate change will be required to be recorded through deferred income tax expense. Should statutory income tax rates decrease, our deferred tax liability would decrease, resulting in deferred tax benefit for the period. If the statutory income tax rates increase, our deferred tax liability would increase resulting in a deferred tax expense. Discontinued Operations Appalachian Marcellus Shale Assets. In October 2014, we completed the sale of our entire 50 percent ownership interest in PDCM to an unrelated third-party for aggregate consideration, after our share of PDCM's debt repayment and other working capital adjustments, of approximately $192.0 million, comprised of approximately $152.8 million in net cash proceeds and a promissory note due in 2020 of approximately $39.0 million. The transaction included the buyer's assumption of our share of the firm transportation commitment related to the assets owned by PDCM, as well as our share of PDCM's natural gas hedging positions in effect at the time. The divestiture resulted in a pre-tax gain of $76.3 million. The divestiture represented a strategic shift in our operations. Accordingly, our proportionate share of PDCM's Marcellus Shale results of operations have been separately reported as discontinued operations in the consolidated statements of operations for 2014 and prior periods in the Selected Financial Information disclosures. Net Income (Loss)/Adjusted Net Income (Loss) The factors resulting in changes in net loss in 2016 and 2015 compared to net income in 2014 are discussed above. These same reasons similarly impacted adjusted net income (loss), a non-U.S. GAAP financial measure, with the exception of the net change in fair value of unsettled derivatives, adjusted for taxes, of $208.9 million, $22.2 million, and $193.1 million in 2016, 2015, and 2014, respectively. Adjusted net loss, a non-U.S. GAAP financial measure, was $37.0 million, $46.1 million, and $37.7 million in 2016, 2015, and 2014 respectively. See Reconciliation of Non-U.S. GAAP Financial Measures, below, for a more detailed discussion of this non-U.S. GAAP financial measure. Financial Condition, Liquidity and Capital Resources Historically, our primary sources of liquidity have been cash flows from operating activities, our revolving credit facility, proceeds raised in debt, and equity capital market transactions and asset sales. In 2016, our primary sources of liquidity were net cash flows from operating activities of $486.3 million, the net proceeds received from the March 2016 public offering of our common stock of approximately $296.6 million, and the net proceeds from the Securities Issuances of approximately $1.1 billion. We used a portion of the net proceeds from the March 2016 common stock offering to repay all amounts then outstanding on our revolving credit facility and the principal amount owed upon the maturity of the 2016 Convertible Notes in May 2016 and the remainder for general corporate purposes. The net proceeds from the Securities Issuances were used to fund a portion of the purchase price and related fees for acquisitions in the Delaware Basin and for general corporate purposes. Our primary source of cash flows from operating activities is the sale of crude oil, natural gas, and NGLs. Fluctuations in our operating cash flows are substantially driven by commodity prices and changes in our production volumes. Commodity prices have historically been volatile and we partially manage this volatility through our use of commodity derivative instruments. In 2016 and 2015, net settled commodity derivatives comprised approximately 43 percent and 58 percent, respectively, of our cash flows from operating activities. Based upon our hedge position and assuming year-end forward strip pricing, in 2017 and thereafter our derivatives may not be a significant source of cash flow, and may result in cash outflows in 2017 and 2018. As of December 31, 2016, the fair value of our derivatives was a net liability of $70.0 million. Based on the forward pricing strip at December 31, 2016, we would expect negative net settlements totaling approximately $45 million during 2017. The covenants under our revolving credit agreement limit the volume of our expected future production that we may hedge. However, we may enter into commodity derivative instruments with future settlement periods of up to sixty months from the date of issuance of the commodity derivative instrument. We do not have minimum hedging requirements associated with our revolving credit facility. Our net working capital fluctuates for various reasons, including, but not limited to, changes in the fair value of our commodity derivative instruments and changes in our cash and cash equivalents due to our historical practice of utilizing excess cash to reduce the outstanding borrowings under our revolving credit facility when we have borrowings outstanding. At December 31, 2016, we had a working capital surplus of $129.2 million compared to a surplus of $30.7 million at December 31, 2015. The increase in working capital is primarily the result of an increase of $243.3 million in cash and cash equivalents, the $112.9 million reduction in the current portion of long-term debt due to the settlement of our 2016 Convertible Notes in May 2016, and no current amounts outstanding under our revolving credit facility as of December 31, 2016, partially offset by a negative change in the fair value of our commodity derivative instruments of $264.9 million from 2015 to 2016. The net cash position was a result of the Securities Issuances and our desire to have cash available to fund the portion of the 2017 capital investment program that is expected to exceed operating cash flows. We ended 2016 with cash and cash equivalents of $244.1 million and availability under our revolving credit facility of $688.3 million, providing for a total liquidity position of $932.4 million, compared to $402.2 million at December 31, 2015. The change in liquidity of $530.2 million, or 131.8 percent, was primarily attributable to: •net cash flows from operating activities of $486.3 million; •net proceeds received from the March 2016 public offering of our common stock of approximately $296.6 million; •net proceeds from the Securities Issuances of approximately $1.1 billion; offset in part by, •cash outflows for capital investments associated with development, exploration, and acquisition activity of $1.76 billion during 2016; and •cash payment of approximately $115 million upon the maturity of our Convertible Notes in May 2016. Based on our expectations of cash flows from operations, our cash and cash equivalent balance and availability under our revolving credit facility, we believe that we have sufficient capital to fund our planned activities during 2017. In March 2015, we filed an automatic shelf registration statement on Form S-3 with the SEC. Effective upon filing, the shelf provides for the potential sale of an unspecified amount of debt securities, common stock or preferred stock, either separately or represented by depository shares, warrants or purchase contracts, as well as units that may include any of these securities or securities of other entities. The shelf registration statement is intended to allow us to be proactive in our ability to raise capital and to have the flexibility to raise such funds in one or more offerings should we perceive market conditions to be favorable. We have utilized the shelf registration statement to raise capital from time to time, and we may utilize the facility in the future to raise additional capital. Our revolving credit facility is a borrowing base facility and availability under the facility is subject to redetermination each May and November, based upon a quantification of our proved reserves at each June 30 and December 31, respectively. In September 2016, we entered into a Third Amendment to the Third Amended and Restated Credit Agreement. The amendment, among other things, amended the revolving credit facility to permit the completion of acquisitions in the Delaware Basin and, effective upon closing of the acquisitions, adjusted the interest rate payable on amounts borrowed under the facility, increased the aggregate commitments under the facility from $450 million to $700 million, and reduced our maximum leverage ratio to 4.00:1.00 times as described in more detail below. The maturity date of our revolving credit facility is May 2020. In October 2016, we entered into the Fourth Amendment to the Third Amended and Restated Credit Agreement. The amendment, among other things, reaffirmed our borrowing base at $700 million and, increased the percentage of our future production that we are permitted to hedge. Our borrowing base availability under the revolving credit facility is limited under our 2022 Senior Notes to the greater of $700 million or the calculated value under an Adjusted Consolidated Tangible Net Asset test, as defined. Our borrowings bear interest at either the LIBOR or prime rate plus an applicable margin, depending on the percentage of the commitment that has been utilized as of December 31, 2016, the applicable margin is 1.25%, and the unused commitment fee is 0.50%. We had no balance outstanding on our revolving credit facility as of December 31, 2016. As of December 31, 2016, RNG had issued an irrevocable standby letter of credit of approximately $11.7 million in favor of a third-party transportation service provider to secure firm transportation of the natural gas produced by third-party producers for whom we market production in the Appalachian Basin. The letter of credit expires in September 2017 and is automatically extended annually in accordance with the letter of credit's terms and conditions. The letter of credit reduces the amount of available funds under our revolving credit facility by an amount equal to the letter of credit. While we have added and expect to continue to add producing reserves through our drilling operations, the effect of any such reserve additions on our borrowing base could be offset by other factors including, among other things, a prolonged period of depressed commodity prices or regulatory pressure on lenders to reduce their exposure to exploration and production companies. Our revolving credit facility contains financial maintenance covenants. The covenants require that we maintain: (i) total debt of less than 4.00 times the trailing 12 months earnings before interest, taxes, depreciation, depletion and amortization, change in fair value of unsettled commodity derivatives, exploration expense, gains (losses) on sales of assets and other non-cash, gains (losses) ("EBITDAX"), and (ii) an adjusted current ratio of at least 1.00:1.00. Our adjusted current ratio is adjusted by eliminating the impact on our current assets and liabilities of recording the fair value of crude oil and natural gas commodity derivative instruments. Additionally, available borrowings under our revolving credit facility are added to the current asset calculation and the current portion of our revolving credit facility debt is eliminated from the current liabilities calculation. At December 31, 2016, we were in compliance with all debt covenants with a 2.10 times debt to EBITDAX ratio and a 5.00:1.00 current ratio. We expect to remain in compliance into the foreseeable future. The indentures governing our 2024 Senior Notes and 2022 Senior Notes contain customary restrictive covenants that, among other things, limit our ability and the ability of our restricted subsidiaries to: (a) incur additional debt including limitations as to availability under our revolving credit facility, (b) make certain investments or pay dividends or distributions on our capital stock or purchase, redeem, or retire capital stock, (c) sell assets, including capital stock of our restricted subsidiaries, (d) restrict the payment of dividends or other payments by restricted subsidiaries to us, (e) create liens that secure debt, (f) enter into transactions with affiliates, and (g) merge or consolidate with another company. At December 31, 2016, we were in compliance with all covenants and expect to remain in compliance into the foreseeable future. In January 2017, pursuant to the filing of the supplemental indentures for the 1.25% convertible senior notes due in 2021 ("2021 Convertible Senior Notes"), the 2024 Senior Notes, and the 2022 Senior Notes, our subsidiary PDC Permian, Inc., became a guarantor of the notes. Cash Flows Operating Activities. Our net cash flows from operating activities are primarily impacted by commodity prices, production volumes, net settlements from our commodity derivative positions, operating costs, and general and administrative expenses. Cash flows provided by operating activities increased in 2016 compared to 2015. The $75.2 million increase was primarily due to the increase in crude oil, natural gas, and NGLs sales of $118.7 million. We also realized an increase in the change of funds held for future distribution of $36.5 million, and an increase in the deferral of income taxes of $13.1 million. The increases were partially offset by a decrease in monthly derivative commodity settlements of $30.8 million, and increases in general and administrative expense of $22.5 million, interest expense of $14.4 million, production taxes of $13.0 million and transportation, gathering, and processing expenses of $8.3 million. Cash flows provided by operating activities increased in 2015 compared to 2014. The $174.4 million increase was primarily due to the increase in normal monthly derivative commodity settlements of $241.0 million and a decrease in general and administrative expense of $33.6 million and production taxes of $7.2 million. The increase was offset by the decrease in crude oil, natural gas, and NGLs sales of $92.7 million and an increase in lease operating costs of $14.6 million. Adjusted cash flows from operations, a non-U.S. GAAP financial measure, increased by $46.0 million in 2016 to $466.8 million, and $170.6 million to $420.8 million in 2015, when compared to the respective prior years. These changes were primarily due to the same factors mentioned above for changes in cash flows provided by operating activities, without regard to timing of cash payments and/or receipts of our assets and liabilities of $19.5 million and $9.7 million in 2016 and 2015, respectively. Adjusted EBITDA, a non-U.S. GAAP financial measure, decreased by $7.6 million in 2016 to $435.6 million from $443.2 million in 2015, primarily as a result of the provision for uncollectible notes receivable of $44.0 million, the decrease in net settlements from our monthly derivative commodity settlements of $30.8 million, an increase in general and administrative expense of $22.5 million, and a $27.8 million increase in production and exploration expense. The decrease was partially offset by the increase in crude oil, natural gas, and NGLs sales of $118.7 million. Adjusted EBITDA increased by $78.9 million in 2015 from 2014, primarily as a result of the increase in normal monthly derivative commodity settlements of $241.0 million and a decrease in general and administrative expense of $33.6 million. The increase was partially offset by the decrease in crude oil, natural gas, and NGLs sales of $92.7 million, and an $88.8 million decrease in contribution margins from discontinued operations and a $14.6 million increase in lease operating costs. Investing Activities. Because crude oil and natural gas production from a well declines rapidly in the first few years of production, we need to continue to invest significant amounts of capital in order to maintain and grow our production and replace our reserves. If capital markets are not available in the future, we will be limited to our cash flows from operations and liquidity under our revolving credit facility as the sources for funding our capital investments. Cash flows from investing activities primarily consist of the acquisition, exploration and development of crude oil and natural gas properties, net of dispositions of crude oil and natural gas properties. During 2016, our acquisitions in the Delaware Basin comprised the majority of our cash flows used in investing activities. Net cash used in the Delaware Basin acquisitions was $1.1 billion and we used cash of $436.9 million for our oil and gas operations. Our total cash used in investing activities during 2016 was approximately $1.5 billion. Through July 2016, we ran four automated drilling rigs in the Wattenberg Field. In August 2016, we decreased the number of automated drilling rigs to three in anticipation of higher working interests in wells drilled resulting from an acreage exchange. In the Utica Shale, we drilled and completed five gross (4.5 net) wells, all of which were turned-in-line to sales in 2016. With the closing of our acquisitions in the Delaware Basin, we completed the drilling of two wells that were in-process at closing, spud an additional well, and turned-in-line one well prior to the end of 2016. Net cash used in investing activities of $604.3 million during 2015 was primarily related to cash utilized for our drilling operations. Net cash used in investing activities of $474.1 million during 2014 was primarily related to cash utilized for our drilling operations of $623.8 million, offset in part by the $152.8 million net cash proceeds received from the sale of our entire 50 percent ownership interest in PDCM. Financing Activities. Net cash from financing activities in 2016 was primarily related to the $855.1 million of net proceeds received from the issuance of 9.4 million shares of our common stock, $392.2 million of net proceeds from issuance of the 2024 Senior Notes and $193.9 million of net proceeds from issuance of the 2021 Convertible Notes, partially offset by the $115 million payment owed upon the maturity of the 2016 Convertible Notes and net payments of approximately $37.0 million to pay down amounts borrowed under our revolving credit facility. Net cash from financing activities in 2015 was primarily related to $202.9 million of net proceeds received from the issuance of our common stock in March 2015, partially offset by net payments of approximately $19.0 million to pay down amounts borrowed under our revolving credit facility. Net cash from financing activities in 2014 were primarily comprised of net borrowings under our revolving credit facility of $63.8 million to execute our capital budget. Contractual Obligations and Contingent Commitments The following table presents our contractual obligations and contingent commitments as of December 31, 2016: __________ (1) Table does not include deferred income tax liability to taxing authorities of $143.5 million, due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. (2) Amount presented does not agree with the consolidated balance sheets in that it excludes $37.5 million of unamortized debt discount and $18.6 million of unamortized debt issuance costs. (3) Represents our gross liability related to the fair value of derivative positions. (4) Short-term capital lease obligations are included in other accrued expenses on the consolidated balance sheets. Long-term capital lease obligations are included in other liabilities on the consolidated balance sheets. (5) Includes deferred compensation to former executive officers and deferred payments related to firm transportation agreements. (6) Table does not include an undrawn $11.7 million irrevocable standby letter of credit pending issuance to a transportation service provider. Additionally, the table does not include the annual repurchase obligations to investing partners or termination benefits related to employment agreements with our executive officers, due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. (7) Amounts presented include $224.4 million to the holders of our 2022 Senior Notes, $188.7 million to the holders of our 2024 Senior Notes, and $115.2 million payable to the holders of our 2021 Convertible Notes. Amounts also include $11.0 million payable to the participating banks in our revolving credit facility, of which interest of $9.0 million is related to unutilized commitments at a rate of 0.38% per annum, and $0.2 million is related to our undrawn letters of credit. (8) Represents our gross commitment which includes volumes produced by us, purchased from third parties and produced by our affiliated partnerships and other third-party working, royalty and overriding royalty interest owners whose volumes we market on their behalf. This includes anticipated and estimated commitments associated with a new gas processing facility by our primary mid-stream provider. The timing of such payments has been estimated and is subject to change based on the completion of construction and the commencing of operations by the midstream provider. As the managing general partner of affiliated partnerships, we have liability for potential casualty losses in excess of the partnership assets and insurance. We believe that the casualty insurance coverage we and our subcontractors carry is adequate to meet this potential liability. From time to time, we are a party to various legal proceedings in the ordinary course of business. We are not currently a party to any litigation that we believe would have a materially adverse effect on our business, financial condition, results of operations, or liquidity. Critical Accounting Policies and Estimates We have identified the following policies as critical to business operations and the understanding of our results of operations. This is not a comprehensive list of all of the accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP, with no need for our judgment in the application. There are also areas in which our judgment in selecting available alternatives would not produce a materially different result. However, certain of our accounting policies are particularly important to the presentation of our financial position and results of operations and we may use significant judgment in the application. As a result, they are subject to an inherent degree of uncertainty. In applying those policies, we use our judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on historical experience, observation of trends in the industry and information available from other outside sources, as appropriate. For a more detailed discussion on the application of these and other accounting policies, see the footnote titled Summary of Significant Accounting Policies to our consolidated financial statements included elsewhere in this report. Crude Oil and Natural Gas Properties. We account for our crude oil and natural gas properties under the successful efforts method of accounting. Costs of proved developed producing properties, successful exploratory wells and developmental dry hole costs are capitalized and depreciated or depleted by the unit-of-production method based on estimated proved developed producing reserves. Property acquisition costs are depreciated or depleted on the unit-of-production method based on estimated proved reserves. Annually, we engage independent petroleum engineers to prepare reserve and economic evaluations of all our properties on a well-by-well basis as of December 31. We adjust our crude oil and natural gas reserves for major acquisitions, new drilling, and divestitures during the year as needed. The process of estimating and evaluating crude oil and natural gas reserves is complex, requiring significant decisions in the evaluation of available geological, geophysical, engineering, and economic data. The data for a given property may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and a continual reassessment of the viability of production under changing economic conditions. As a result, revisions in existing reserve estimates occur. Although every reasonable effort is made to ensure that reserve estimates reported represent our most accurate assessments possible, the subjective decisions and variances in available data for various properties increase the likelihood of significant changes in these estimates over time. Because estimates of reserves significantly affect our DD&A expense, a change in our estimated reserves could have an effect on our net income (loss). Exploration costs, including geological and geophysical expenses, the acquisition of seismic data covering unproved acreage, and delay rentals, are charged to expense as incurred. Exploratory well drilling costs, including the cost of stratigraphic test wells, are initially capitalized, but are charged to expense if the well is determined to be nonproductive. The status of each in-progress well is reviewed quarterly to determine the proper accounting treatment under the successful efforts method of accounting. Exploratory well costs continue to be capitalized as long as the well has found a sufficient quantity of reserves to justify completion as a producing well and we are making sufficient progress assessing our reserves and economic and operating viability. If an in-progress exploratory well is found to be unsuccessful prior to the issuance of the financial statements, the costs incurred prior to the end of the reporting period are charged to exploration expense. If we are unable to make a final determination about the productive status of a well prior to issuance of the financial statements, the well is classified as "suspended well costs" until we have had sufficient time to conduct additional completion or testing operations to evaluate the pertinent geological and engineering data obtained. At the time when we are able to make a final determination of a well’s productive status, the well is removed from the suspended well status and the proper accounting treatment is applied. The acquisition costs of unproved properties are capitalized when incurred, until such properties are transferred to proved properties or charged to expense when expired, impaired, or amortized. Unproved crude oil and natural gas properties with individually significant acquisition costs are periodically assessed, and any impairment in value is charged to impairment of crude oil and natural gas properties. The amount of impairment recognized on unproved properties which are not individually significant is determined by amortizing the costs of such properties within appropriate fields based on our historical experience, acquisition dates and average lease terms, with the amortization recognized in impairment of crude oil and natural gas properties. The valuation of unproved properties is subjective and requires us to make estimates and assumptions which, with the passage of time, may prove to be materially different from actual realizable values. We assess our crude oil and natural gas properties for possible impairment upon a triggering event or when circumstances warrant by comparing net capitalized costs to estimated undiscounted future net cash flows on a field-by-field basis using estimated production based upon prices at which we reasonably estimate the commodity to be sold. Any impairment in value is charged to impairment of properties and equipment. The estimates of future prices may differ from current market prices of crude oil and natural gas. Any downward revisions in estimates to our reserve quantities, expectations of falling commodity prices, or rising operating costs could result in a triggering event, and therefore, a reduction in undiscounted future net cash flows and an impairment of our crude oil and natural gas properties. Although our cash flow estimates are based on the relevant information available at the time the estimates are made, estimates of future cash flows are, by nature, highly uncertain and may vary significantly from actual results. Crude Oil, Natural Gas, and NGLs Sales Revenue Recognition. Crude oil, natural gas, and NGLs sales are recognized when production is sold to a purchaser at a determinable price, delivery has occurred, rights and responsibility of ownership have transferred and collection of revenue is reasonably assured. We record sales revenue based on an estimate of the volumes delivered at estimated prices as determined by the applicable sales agreement. We estimate our sales volumes based on company-measured volume readings. We then adjust our crude oil, natural gas, and NGLs sales in subsequent periods based on the data received from our purchasers that reflects actual volumes and prices received. We receive payment for sales from one to two months after actual delivery has occurred. The differences in sales estimates and actual sales are recorded one to two months later. Historically, these differences have been immaterial. If a sale is deemed uncollectible, an allowance for doubtful collection is recorded. Fair Value of Financial Instruments. Our fair value measurements are estimated pursuant to a fair value hierarchy that requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date, giving the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable data (Level 3). In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The lowest level input that is significant to a fair value measurement in its entirety determines the applicable level in the fair value hierarchy. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability, and may affect the valuation of the assets and liabilities and their placement within the fair value hierarchy levels. The three levels of inputs that may be used to measure fair value are defined as: Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability, and inputs that are derived from observable market data by correlation or other means. Level 3 - Unobservable inputs for the asset or liability, including situations where there is little, if any, market activity. Commodity Derivative Financial Instruments. We measure the fair value of our commodity derivative instruments based on a pricing model that utilizes market-based inputs, including but not limited to the contractual price of the underlying position, current market prices, natural gas, and crude oil forward curves, discount rates such as the LIBOR curve for a similar duration of each outstanding position, volatility factors and nonperformance risk. Nonperformance risk considers the effect of our credit standing on the fair value of commodity derivative liabilities and the effect of our counterparties' credit standings on the fair value of commodity derivative assets. Both inputs to the model are based on published credit default swap rates and the duration of each outstanding commodity derivative position. We validate our fair value measurement through the review of counterparty statements and other supporting documentation, the determination that the source of the inputs is valid, the corroboration of the original source of inputs through access to multiple quotes, if available, or other information and monitoring changes in valuation methods and assumptions. While we use common industry practices to develop our valuation techniques, changes in our pricing methodologies or the underlying assumptions could result in significantly different fair values. While we believe our valuation method is appropriate and consistent with those used by other market participants, the use of a different methodology, or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value. Net settlements on our commodity derivative instruments are initially recorded to accounts receivable or payable, as applicable, and may not be received from or paid to counterparties to our commodity derivative contracts within the same accounting period. Such settlements typically occur the month following the maturity of the commodity derivative instrument. We have evaluated the credit risk of the counterparties holding our commodity derivative assets, which are primarily financial institutions who are also major lenders in our revolving credit facility, giving consideration to amounts outstanding for each counterparty and the duration of each outstanding commodity derivative position. Based on our evaluation, we have determined that the potential impact of nonperformance of our counterparties on the fair value of our commodity derivative instruments is not significant. Deferred Income Tax Asset Valuation Allowance. Deferred income tax assets are recognized for deductible temporary differences, net operating loss carry-forwards and credit carry-forwards if it is more likely than not that the tax benefits will be realized. To the extent a deferred tax asset is not expected to be realized under the preceding criteria, we establish a valuation allowance. The factors which we consider in assessing whether we will realize the value of deferred income tax assets involve judgments and estimates of both amount and timing. The judgments used in applying these policies are based on our evaluation of the relevant facts and circumstances as of the date of the financial statements. Actual results may differ from those estimates. Accounting for Business Combinations. We utilize the purchase method to account for acquisitions of businesses and assets. The value of the purchase consideration takes into account the degree to which the consideration is objective and measurable such as cash consideration paid to a seller. With the issuance of equity, restrictions upon the sale of the issued stock are taken into consideration. Pursuant to purchase method accounting, we allocate the cost of the acquisition to assets acquired and liabilities assumed based on fair values as of the acquisition date. The purchase price allocations are based on appraisals, discounted cash flows, quoted market prices, and estimates by management. When appropriate, we review comparable purchases and sales of crude oil and natural gas properties within the same regions and use that data as a basis for fair market value as such sales represent the amount at which a willing buyer and seller would enter into an exchange for such properties. In estimating the fair values of assets acquired and liabilities assumed, we make various assumptions. The most significant assumptions relate to the estimated fair values assigned to proved developed producing, proved developed non-producing, proved undeveloped and unproved crude oil and natural gas properties, and other non-crude oil and natural gas properties. To estimate the fair values of these properties, we prepare estimates of crude oil and natural gas reserves. When appropriate, we review comparable purchases and sales of crude oil and natural gas properties within the same regions and use that data as a basis for fair market value; for example, the amount at which a willing buyer and seller would enter into an exchange for such properties. We estimate future prices by using the applicable forward pricing strip to apply to our estimate of reserve quantities acquired, and estimates of future operating and development costs, to arrive at an estimate of future net revenues. For estimated proved reserves, the future net revenues are discounted using a market-based weighted-average cost of capital rate determined appropriate at the time of the acquisition. The market-based weighted-average cost of capital rate is subject to additional project-specific risking factors. To compensate for the inherent risk of estimating and valuing unproved properties, we reduce the discounted future net revenues of probable and possible reserves by additional risk-weighting factors. We record deferred taxes for any differences between the assigned values and tax basis of assets and liabilities. Estimated deferred taxes are based on available information concerning the tax basis of assets acquired and liabilities assumed and loss carryforwards at the acquisition date, although such estimates may change in the future as additional information becomes known. Recent Accounting Standards See the footnote titled Summary of Significant Accounting Policies - Recently Adopted Accounting Standards to our consolidated financial statements included elsewhere in this report. Reconciliation of Non-U.S. GAAP Financial Measures Adjusted cash flows from operations. We define adjusted cash flows from operations as the cash flows earned or incurred from operating activities, without regard to changes in operating assets and liabilities. We believe it is important to consider adjusted cash flows from operations, as well as cash flows from operations, as we believe it often provides more transparency into what drives the changes in our operating trends, such as production, prices, operating costs, and related operational factors, without regard to whether the related asset or liability was received or paid during the same period. We also use this measure because the timing of cash received from our assets, cash paid to obtain an asset or payment of our obligations has been only a timing issue from one period to the next as we have not had accounts receivable collection problems, nor been unable to purchase assets or pay our obligations. Adjusted net income (loss). We define adjusted net income (loss) as net income (loss), plus loss on commodity derivatives, less gain on commodity derivatives and net settlements on commodity derivatives, each adjusted for tax effects. We believe it is important to consider adjusted net income (loss), as well as net income (loss). We believe this measure often provides more transparency into our operating trends, such as production, prices, operating costs, net settlements from derivatives and related factors, without regard to changes in our net income (loss) from mark-to-market adjustments resulting from net changes in the fair value of unsettled derivatives. Additionally, other items which we believe are not indicative of future results may be excluded to clearly identify operating trends. Adjusted EBITDA. We define adjusted EBITDA as net income (loss), plus loss on commodity derivatives, interest expense, net of interest income, income taxes, impairment of properties and equipment, depreciation, depletion, and amortization and accretion of asset retirement obligations, less gain on commodity derivatives and net settlements on commodity derivatives. Adjusted EBITDA is not a measure of financial performance or liquidity under U.S. GAAP and should be considered in addition to, not as a substitute for, net income (loss), nor as an indicator of cash flows reported in accordance with U.S. GAAP. Adjusted EBITDA includes certain non-cash costs incurred by us and does not take into account changes in operating assets and liabilities. Other companies in our industry may calculate adjusted EBITDA differently than we do, limiting its usefulness as a comparative measure. We believe adjusted EBITDA is relevant because it is a measure of our operational and financial performance, as well as a measure of our liquidity, and is used by our management, investors, commercial banks, research analysts, and others that utilize our financial statements to analyze such things as: • operating performance and return on capital as compared to our peers; • financial performance of our assets and our valuation without regard to financing methods, capital structure, or historical cost basis; • ability to generate sufficient cash to service our debt obligations and commitments; and • viability of acquisition opportunities and capital investment projects, including the related rate of return. PV-10. We define PV-10 as the estimated present value of the future net cash flows from our proved reserves before income taxes, discounted using a 10 percent discount rate. We believe that PV-10 provides useful information to investors as it is widely used by professional analysts and sophisticated investors when evaluating oil and gas companies. We believe that PV-10 is relevant and useful for evaluating the relative monetary significance of our reserves. Professional analysts, investors, and other users of our financial statements may utilize the measure as a basis for comparison of the relative size and value of our reserves to other companies' reserves. Because there are many unique factors that can impact an individual company when estimating the amount of future income taxes to be paid, we believe the use of a pre-tax measure is valuable in evaluating us and our reserves. PV-10 is not intended to represent the current market value of our estimated reserves. The following table presents a reconciliation of our non-U.S. GAAP financial measures to its most comparable U.S. GAAP measure: Amounts above include results from continuing and discontinued operations.

<s>[INST] SUMMARY 2016 Financial Overview of Operations and Liquidity Production volumes increased to 22.2 MMBoe in 2016, including 0.2 MMBoe from our recent acquisitions in the Delaware Basin, compared to 15.4 MMBoe in 2015, representing an increase of 44 percent. The increase in production volumes was primarily attributable to our successful horizontal Niobrara and Codell drilling program in the Wattenberg Field. Crude oil production increased 25 percent in 2016, which comprised approximately 39 percent of total production. Natural gas production increased 55 percent and NGLs increased 70 percent in 2016 compared to 2015. These increases were the result of our shift in focus to the higher rate of return drilling projects located in the higher gas to oil ratio inner and middle core areas of the Wattenberg Field during the first half of 2016. On a combined basis, total liquids production of crude oil and NGLs comprised 61 percent of production in 2016 compared to 64 percent of production in 2015, a decrease of four percent. For the month ended December 31, 2016, we maintained an average production rate of 73 MBoe per day, up from 52 MBoe per day for the month ended December 31, 2015. Crude oil, natural gas, and NGLs sales increased to $497.4 million in 2016 compared to $378.7 million in 2015, due to a 44 percent increase in production, offset in part by a nine percent decrease in the weightedaverage realized prices of crude oil, natural gas, and NGLs, driven by lower commodity prices and changes in commodity mix. Crude oil, natural gas, and NGLs sales, coupled with the impact of positive net settlements of derivatives, also increased in 2016 as compared to 2015. When combining the physical commodity sales and the net settlements received on our commodity derivative instruments, the total net revenues increased 14 percent to $705.4 million in 2016 from $617.6 million in 2015. The low crude oil and natural gas index prices in 2016 and 2015 were the primary reason for the positive net settlements of $208.1 million and $238.9 million on commodity derivatives in 2016 and 2015, respectively. In 2016, we generated a net loss of $245.9 million, or $5.01 per diluted share. In the same period we generated $435.6 million of adjusted EBITDA, a nonU.S. GAAP financial measure, and invested $396.4 million in the development and exploration of our oil and natural gas properties, which is net of the change in accounts payable related to capital expenditures. Our cash flow from operations was $486.3 million and our adjusted cash flow from operations was $466.8 million in 2016. Adjusted EBITDA and adjusted cash flow from operations are nonU.S. GAAP financial measures as defined and more fully described later in this section. Other significant changes impacting our 2016 results of operations include the following: The net change in the fair value of unsettled derivative positions in 2016 was a loss of $333.8 million compared to a loss of $35.8 million in 2015. The decrease in the fair value of unsettled derivative positions is largely driven by the normal monthly settlements of the commodity derivative instruments in 2016. Additionally, the change in fair value was attributable to hedging positions entered into in 2016 at lower strike prices and the upward shift in the crude oil and natural gas forward curves that occurred during 2016 versus a downward shift in 2015. Production tax expense increased to $31.4 million in 2016 from $18.4 million in 2015 due to increased production of 44 percent and higher overall sales proceeds. Additionally, we had a higher [/INST] Negative. </s>

PDC ENERGY, INC.

2018-02-27

2017-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes thereto included elsewhere in this report. Further, we encourage you to revisit the Special Note Regarding Forward-Looking Statements in Part I of this report. SUMMARY 2017 Financial Overview of Operations and Liquidity Production volumes increased 44 percent to 31.8 MMBoe in 2017 compared to 2016, including 4.2 MMBoe contributed from the Delaware Basin assets that we acquired in December 2016. The increase in production volumes was primarily attributable to the continued success of our horizontal Niobrara and Codell drilling program in the Wattenberg Field and growing production from our horizontal Wolfcamp drilling program in our Delaware Basin properties. Crude oil production increased 48 percent in 2017, which comprised approximately 41 percent of our total production. Natural gas production increased 39 percent and NGLs increased 45 percent in 2017 compared to 2016. On a combined basis, total liquids production of crude oil and NGLs comprised 62 percent of production in 2017. For the month ended December 31, 2017, we maintained an average production rate of approximately 97,000 Boe per day, including approximately 18,000 Boe per day from the Delaware Basin, up from approximately 73,200 Boe per day, including approximately 6,000 Boe per day from the Delaware Basin, for the month ended December 31, 2016. Crude oil, natural gas, and NGLs sales increased to $913.1 million in 2017 compared to $497.4 million in 2016, due to a 44 percent increase in production, combined with a 28 percent increase in the weighted average realized commodity prices. Crude oil, natural gas, and NGLs sales increased 31 percent in 2016 as compared to 2015 due to a 44 percent increase in production, partially offset by a nine percent decrease in average realized commodity prices. We had positive net settlements from our commodity derivative contracts of $13.3 million for 2017, $208.1 million for 2016, and $238.9 million for 2015. We entered into agreements for the derivative instruments that settled throughout 2016 and 2015 prior to commodity prices becoming depressed in late 2014. Substantially all of these higher-value derivatives settled by the end of 2016. Net settlements for 2017 reflect derivative instruments entered into since 2015, which more closely approximate recent realized prices. See Results of Operations - Commodity Price Risk Management, Net for further details of our settlements of derivatives and changes in the fair value of unsettled derivatives. The combined revenue from crude oil, natural gas, and NGLs sales and net settlements received on our commodity derivative instruments increased 31 percent to $926.4 million in 2017 from $705.5 million in 2016. Such combined revenue of $705.5 million in 2016 increased 14 percent from $617.6 million in 2015. During 2017, we recorded exploratory dry hole well expense of $41.3 million and an unproved and proved property impairment charge of $285.5 million, and we impaired all of the goodwill associated with the assets acquired in the Delaware Basin, which resulted in an impairment charge of $75.1 million. The majority of these charges are a result of our western Culberson County acreage not meeting our performance expectations. In addition, we recorded a loss on extinguishment of debt of $24.7 million related to the redemption of our 2022 Senior Notes. For more information regarding these expenses and charges see Results of Operations - Exploration, Geologic, and Geophysical Expense, Results of Operations - Impairments of Properties, Results of Operations - Impairment of Goodwill, and Results of Operations - Loss on Extinguishment of Debt. In December 2017, the President of the United States signed into law the 2017 Tax Cuts and Jobs Act (the "2017 Tax Act"). We recorded the effects of changes in tax law in the period of enactment. The 2017 Tax Act reduces the corporate tax rate from 35 percent to 21 percent effective January 1, 2018. Consequently, we have decreased our deferred tax assets and deferred tax liabilities as of December 31, 2017. Since we are in a net deferred liability position at 2017 year end, the tax rate change resulted in a deferred tax benefit and corresponding reduction of our net deferred tax liability of approximately $114 million in 2017. In 2017, we generated a net loss of $127.5 million or $1.94 per diluted share. Our net income was negatively impacted by the aforementioned impairment charges, expensing of exploratory dry hole well costs, and extinguishment of debt. During the same period, our adjusted EBITDAX, a non-U.S. GAAP financial measure, was $682.1 million, up 48 percent relative to 2016. The increase in our 2017 adjusted EBITDAX as compared to 2016 was primarily the result of the increase in crude oil, natural gas, and NGLs sales of $415.7 million, as well as the recording of a provision for a note receivable in 2016 of $44.0 million and the subsequent sale of the note in 2017 to a third-party for $40.2 million. These increases were partially offset by a decrease in derivative commodity settlements of $194.8 million and increases in operating costs of $81.7 million and interest expense of $16.7 million. Beginning in 2017, we have included non-cash stock-based compensation and exploration, geologic, and geophysical expense in our reconciliation of adjusted EBITDAX. In prior periods, we reported adjusted EBITDA, a non-U.S. GAAP financial measure that did not include these adjustments. All prior periods have been conformed for comparability of this updated EBITDAX presentation. In 2016 and 2015, our net loss per diluted share was $5.01 and $1.74, respectively, and our adjusted EBITDAX was $459.8 million and $464.3 million, respectively. Our net cash flows from operating activities in 2017, 2016, and 2015 were $588.6 million, $486.3 million, and $411.1 million, respectively, and our adjusted cash flow from operations, a non-U.S. GAAP financial measure, were $582.1 million, $466.8 million, and $420.8 million, respectively. See Reconciliation of Non-U.S. GAAP Financial Measures, below, for a more detailed discussion of these non-U.S. GAAP financial measures and a reconciliation of these measures to the most comparable U.S. GAAP measures. Liquidity Available liquidity as of December 31, 2017 was $880.7 million, which was comprised of $180.7 million of cash and cash equivalents and $700.0 million available for borrowing under our revolving credit facility at our current commitment level. In October 2017, we entered into a Sixth Amendment to the Third Amended and Restated Credit Agreement. The amendment allowed the borrowing base to be set above the $1.0 billion borrowing capacity of the facility. The borrowing base for our November 2017 redetermination was confirmed at $1.1 billion and we elected to maintain a $700 million commitment level. Assuming that the Bayswater Acquisition had closed in December 2017, our liquidity position as of December 31, 2017, would have been approximately $700 million. In November 2017, we issued $600 million principal amount of our 2026 Senior Notes. The net proceeds from the offering were used to fund the redemption of our $500 million 2022 Senior Notes and a portion of the purchase price of the January 2018 Bayswater Acquisition, and for general corporate purposes. We intend to continue to manage our liquidity position by a variety of means, including through the generation of cash flows from operations, investment in projects with attractive rates of return, protection of cash flows on a portion of our anticipated sales through the use of an active commodity derivative hedging program, potential utilization of our borrowing capacity under our revolving credit facility, and if warranted, capital markets transactions from time to time. Acquisition On January 5, 2018, we closed the Bayswater Acquisition for approximately $186 million, subject to certain customary post-closing adjustments. In addition to the approximately $186 million of cash paid at closing, we invested approximately $15 million during 2017 to complete certain DUCs acquired in the transaction. Acreage Exchanges In 2017, we completed two significant acreage exchanges that consolidated certain acreage positions in the core area of the Wattenberg Field. Both transactions involved the exchange of leasehold acreage with a limited number of wells that were in the process of being drilled and completed. Upon closing the transactions, we received an aggregate of approximately 15,900 net acres in exchange for an aggregate of approximately 16,200 net acres. The difference in net acres is primarily due to variances in working and net revenue interests and midstream contracts. 2017 Drilling Overview During the year ended December 31, 2017, we continued to execute our strategic plan to grow production while preserving our financial strength and liquidity. Our drilling efficiency in the Wattenberg Field over the last year has resulted in shorter drill times; as a result, we decreased our rig count from four to three in the fourth quarter of 2017. Due to the decreased drill times, the impact of the reduced rig count on our expected turn-in-line count in the Wattenberg Field was minimal in 2017. During the three months ended December 31, 2017, we briefly ran four rigs in the Delaware Basin as we swapped out rigs to focus on improving drill times. During the fourth quarter of 2017, we turned-in-line 19 wells in the Wattenberg Field and five wells in the Delaware Basin. We did not complete or turn-in-line any wells in the Utica Shale during 2017. The following tables summarizes our drilling and completion activity for the year ended December 31, 2017: Our in-process wells represent wells that are in the process of being drilled and/or have been drilled and are waiting to be fractured and/or for gas pipeline connection. Our DUCs are generally completed and turned-in-line within three to nine months of drilling. The majority of the PDC-operated in-process wells at each period end are DUCs, as we do not begin the completion process until the entire well pad is drilled. All appropriate costs incurred through the end of the period have been capitalized, while the capital investment to complete the wells will be incurred in the period in which the wells are completed. 2018 Operational and Financial Outlook We expect our production for 2018 to range between 38 MMBoe to 42 MMBoe, or approximately 104,000 Boe to 115,000 Boe per day for the year. We expect that approximately 42 to 45 percent of our 2018 production will be comprised of crude oil and approximately 19 to 22 percent will be NGLs, for total liquids of approximately 64 to 67 percent. Our 2018 capital forecast of between $850 million and $920 million is focused on continued execution in the Wattenberg Field and Delaware Basin with three drilling rigs and one completion crew in each basin throughout the year. We believe that we maintain significant operational flexibility to control the pace of our capital spending. As we execute our capital investment program, we continually monitor, among other things, commodity prices, development costs, midstream capacity, and offset and continuous drilling obligations. Should commodity pricing or the operating environment deteriorate, we may determine that an adjustment to our development plan is appropriate. We believe we have ample opportunities to reduce capital spending in order to stay within the range of our capital investment plan, including but not limited to reducing the number of rigs being utilized in our drilling program and/or managing our completion schedule. This flexibility is more limited in the Delaware Basin given leasehold maintenance requirements. Wattenberg Field. We are drilling in the Niobrara and Codell plays within the field and anticipate spudding and turning-in-line between approximately 135 to 150 operated wells in 2018. Our 2018 capital investment program is estimated to be approximately $470 million to $500 million in the Wattenberg Field, of which approximately 90 percent is anticipated to be invested in operated drilling and completion activity. The remainder of the Wattenberg Field capital investment program is expected to be used for non-operated wells and miscellaneous workover and capital projects. Delaware Basin. Total capital investment in the Delaware Basin in 2018 is estimated to be approximately $380 million to $420 million, of which approximately 75 percent is allocated to both spud and turn-in-line approximately 25 to 30 operated wells targeting the Wolfcamp formation. Based on the timing of our operations and requirements to hold acreage, we may adapt our capital investment program to drill wells different from or in addition to those currently anticipated, as we are continuing to analyze the terms of the relevant leases. We plan to invest approximately 10 percent of our capital in leasing, non-operated capital, seismic, and technical studies with an additional approximately 15 percent for midstream related projects including oil and gas gathering systems and water supply and disposal systems. Utica Shale. In 2017, as part of plans to divest the Utica Shale properties, we engaged an investment banking firm and began actively marketing the properties for sale; therefore, these properties are classified as held-for-sale as of December 31, 2017. In February 2018, we entered into a definitive PSA to sell these properties for net cash proceeds of approximately $40.0 million. The transaction is expected to close in the first quarter of 2018, subject to certain customary closing conditions. Financial Guidance. Based on our current production forecast for 2018 and assuming averages of approximately $57.50 NYMEX crude oil price for the year and a $3.00 NYMEX natural gas price, we expect 2018 capital investments to exceed our 2018 cash flows from operations by approximately less than $90 million. We anticipate that the proceeds received from the sale of our Utica Shale assets and a midstream dedication agreement (see the footnote titled Subsequent Events to the consolidated financial statements included elsewhere in this report), will fund approximately two-thirds of this outspend. We expect this capital investment outspend to occur during the first half of 2018, with cash flows exceeding capital investment during the second half of the year. Our leverage ratio, as defined in our revolving credit facility agreement, is expected to decrease in 2018 to 1.4 based on production and operational cash flow growth. The following table provides projected financial guidance for 2018: Results of Operations Summary Operating Results The following table presents selected information regarding our operating results from continuing operations: * Percentage change is not meaningful or equal to or greater than 300% or not applicable. Amounts may not recalculate due to rounding. ______________ (1) In February 2018, we entered into a PSA to sell the Utica Shale properties. Crude Oil, Natural Gas, and NGLs Sales The year-over-year change in crude oil, natural gas, and NGLs sales revenue were primarily due to the following: Crude Oil, Natural Gas, and NGLs Production The following tables present crude oil, natural gas, and NGLs production. Our acquisition of assets in the Delaware Basin closed in December 2016; therefore, there is no comparative data for 2015. *Percentage change is not meaningful or equal to or greater than 300%. Amounts may not recalculate due to rounding. ______________ (1) In February 2018, we entered into a PSA to sell the Utica Shale properties. In the Wattenberg Field, we rely on third-party midstream service providers to construct gathering, compression, and processing facilities to keep pace with our and the overall field's natural gas production growth. In 2017 and during 2018, our production has been adversely affected by high line pressures on the gas gathering facilities, primarily due to increases in field-wide production volumes. As a result, we experienced some production curtailments during the second half of 2017. The gathering system of our primary midstream service provider, DCP Midstream, LP ("DCP"), is currently at capacity. We believe that our 2018 production guidance range appropriately reflects the impact of anticipated gathering system line pressures and the resulting temporary limitations on the gathering system’s capacity, but curtailments may be greater than anticipated. For 2017, 94 percent of our production in the Wattenberg Field was delivered from horizontal wells, with the remaining six percent coming from vertical wells. The horizontal wells are less prone to curtailments than the vertical wells because they are newer and have greater producing capacity and higher formation pressures and therefore tend to be more resilient to gas system pressure issues; however, all of our wells in the field are currently experiencing some impact. We expect to continue to operate in a constrained environment into the third quarter of 2018, at which time additional processing capacity is scheduled to be brought into operation by DCP. We continue to work closely with our third-party midstream providers in an effort to ensure that adequate midstream system capacity is available going forward in the Wattenberg Field. We, along with other operators, have made a commitment with DCP to support its construction of two additional processing facilities with associated gathering pipe and compression in the field. These expansions are expected to increase DCP's system capacity, assist in the control of line pressures on its natural gas gathering facilities, and reduce production curtailments in the field. We will be bound to the incremental volume requirements in these agreements on the first day of the calendar month after the actual in-service dates of the plants for a period of seven years, which are currently scheduled to occur in the third quarter of 2018 and in the second quarter of 2019, respectively. The agreements impose a baseline volume commitment and guarantee a certain target profit margin to DCP on those volumes during the initial three years of the contracts. Under our current drilling plans, we expect to meet both the baseline and incremental volume commitments, and we believe that the contractual target profit margin will be achieved without additional payment from us. See the footnote titled Commitments and Contingencies to our consolidated financial statements included elsewhere in this report for additional details regarding the agreements. In addition, we have begun early discussions with DCP with respect to further increasing its processing facilities in the Wattenberg Field. We also continue to work with all of our midstream service providers in the field in an effort to ensure all of the existing infrastructure is fully utilized and that all options for system expansions are evaluated and implemented, where possible. The ultimate timing and availability of adequate infrastructure is not within our control and if our midstream service providers' construction projects are delayed, we could experience higher gathering line pressures that would negatively impact our ability to meet our production targets. Crude Oil, Natural Gas, and NGLs Pricing Our results of operations depend upon many factors. Key factors include the price of crude oil, natural gas, and NGLs and our ability to market our production effectively. Crude oil, natural gas, and NGL prices have a high degree of volatility and our realizations can change substantially. Our sales prices for crude oil, natural gas, and NGLs increased during 2017 compared to 2016. NYMEX crude oil prices increased 18 percent and NYMEX natural gas prices increased 26 percent as compared to 2016. Our sales prices for crude oil and natural gas decreased and prices for NGLs increased during 2016 compared to 2015. NYMEX crude oil prices decreased 12 percent and NYMEX natural gas prices decreased 8 percent as compared to 2015. The majority of our NGL prices in the Wattenberg Field are reflected in the tables below, net of the processing and transport costs that are embedded in the applicable percent-of-proceeds contracts. The following tables present weighted-average sales prices of crude oil, natural gas, and NGLs for the periods presented. Our acquisition of assets in the Delaware Basin closed in December 2016; therefore, there is no comparative data for 2015: * Percentage change is not meaningful or equal to or greater than 300%. Amounts may not recalculate due to rounding. ______________ (1) In February 2018, we entered into a PSA to sell the Utica Shale properties. Our crude oil, natural gas, and NGLs sales are recorded using either the “net-back” or "gross" method of accounting, depending upon the related purchase agreement. We use the net-back method when the purchasers of these commodities also provide transportation, gathering, or processing services. In these situations, the purchaser pays us proceeds based on a percent of the proceeds or have fixed our sales price at index less specified deductions. The net-back method results in the recognition of a net sales price that is lower than the indices for which the production is based because the operating costs and profit of the midstream facilities are embedded in the net price we are paid. We use the gross method of accounting when the purchasers do not provide transportation, gathering, or processing services as a function of the price we receive. Rather, we contract separately with midstream providers for the applicable transport and processing on a per unit basis. Under this method, we recognize revenues based on the gross selling price and recognize transportation, gathering, and processing expenses. The following table summarizes how we recognize revenue related to the sales of our crude oil, natural gas, and NGLs: As discussed above, we enter into agreements for the sale, transportation, gathering, and processing of our production. The terms of these agreements can result in variances in the per unit realized prices that we receive for our crude oil, natural gas and NGLs. Information related to the components and classifications in the consolidated statements of operations is shown below. For crude oil, the average NYMEX prices shown below are based upon average daily prices throughout each month and our natural gas average NYMEX pricing is based upon first-of-the-month index prices as this is how the majority of each of these commodities are sold pursuant to terms of the respective sales agreements. For NGLs, we use the NYMEX crude oil price as a reference for presentation purposes. For NGLs, the average realized price both before and after transportation, gathering, and processing expenses shown in the table below represents our approximate composite per barrel price. We adopted a new revenue recognition accounting standard effective January 1, 2018. Under the guidance of the new revenue recognition standard, certain crude oil sales in the Wattenberg Field that were recognized using the gross method prior to the adoption of the new revenue standard will be recognized using the net-back method and in the Delaware Basin certain crude oil and natural gas sales that were recognized using the gross method prior to the adoption of the new revenue standard will be recognized using the net-back method. If we had adopted the standard on January 1, 2017, we estimate that the average realization percentage before transportation, gathering, and processing expenses would have been 94 percent, 70 percent, 36 percent, and 73 percent for crude oil, natural gas, NGLs, and crude oil equivalent, respectively, as $11.3 million in expenses currently recorded in transportation, gathering, and processing on our consolidated statements of operations would, in that case, have been reflected as a reduction to the sales price. However, the net realized price would remain unchanged. Commodity Price Risk Management, Net We use commodity derivative instruments to manage fluctuations in crude oil and natural gas prices. We have in place a variety of collars, fixed-price swaps, and basis swaps on a portion of our estimated crude oil, natural gas, and propane production. Because we sell all of our crude oil, natural gas, and NGLs production at prices related to the indexes inherent in our underlying derivative instruments, we ultimately realize value related to our collars of no less than the floor and no more than the ceiling. For our commodity swaps, we ultimately realize the fixed price value related to our swaps. See the footnote titled Commodity Derivative Financial Instruments for a detailed presentation of our derivative positions as of December 31, 2017. Commodity price risk management, net, includes cash settlements upon maturity of our derivative instruments, as well as the change in fair value of unsettled commodity derivatives related to our crude oil, natural gas, and propane production. Commodity price risk management, net, does not include derivative transactions related to our gas marketing, which are included in other income and other expenses. Net settlements of commodity derivative instruments are based on the difference between the crude oil, natural gas, and propane index prices at the settlement date of our commodity derivative instruments compared to the respective strike prices. The net change in fair value of unsettled commodity derivatives is comprised of the net value increase or decrease in the beginning-of-period fair value of commodity derivative instruments that settled during the period, and the net change in fair value of unsettled commodity derivatives during the period or from inception of any new contracts entered into during the applicable period. The net change in fair value of unsettled commodity derivatives during the period is primarily related to shifts in the crude oil, natural gas, and NGLs forward curves and changes in certain differentials. The following table presents net settlements and net change in fair value of unsettled commodity derivatives included in commodity price risk management, net: Lease Operating Expenses Lease operating expenses were $89.6 million in 2017 compared to $60.0 million in 2016. Aggregate lease operating expenses during 2017 increased $29.6 million, of which $20.1 million related to our properties in the Delaware Basin. The $29.6 million increase in the total lease operating expenses in 2017 as compared to 2016 was primarily due to increases of $9.4 million for payroll and employee benefits related to increases in headcount, $5.6 million for produced water disposal, $5.6 million for increased workover projects, $3.9 million related to additional compressor rentals, and $2.2 million for equipment rentals. The increases were slightly offset by a $1.5 million decrease in environmental remediation costs. Lease operating expense per Boe increased by four percent to $2.82 for 2017 from $2.70 for 2016, primarily due to expected higher per Boe costs in the Delaware Basin compared to our other areas of operation. Lease operating expenses were $60.0 million in 2016 compared to $57.0 million in 2015. The $3.0 million increase in lease operating expenses in 2016 as compared to 2015 was primarily due to an increase of $3.7 million for increases in wages and employee benefits related to an increase in headcount, including costs for additional contract labor, $1.8 million for additional leased compressors to address line pressures, and an increase of $1.5 million related to lease operating expenses for the acquisition in the Delaware Basin. These increases were partially offset by a decrease in environmental remediation and regulatory compliance projects of $3.2 million due to a reduction in new remediation projects, and a decrease of $1.4 million related to fewer workover and maintenance related projects. Lease operating expenses per Boe decreased significantly to $2.70 for 2016 from $3.71 in 2015 as a result of increased production. Production Taxes Production taxes were $60.7 million, $31.4 million, and $18.4 million in 2017, 2016, and 2015, respectively. Production taxes are comprised mainly of severance tax and ad valorem tax and are directly related to crude oil, natural gas, and NGLs sales as the taxes are generally assessed as a percentage of net revenues. From time to time, there are adjustments to the statutory rates for these taxes based upon certain credits that are determined based upon activity levels and relative commodity prices from year to year. The $29.3 million and $13.0 million increases in production taxes during 2017 and 2016, respectively, were primarily related to the 84 percent and 31 percent increases in crude oil, natural gas, and NGLs sales in 2017 and 2016, respectively, and to a lesser extent, an increase in tax rates. Our overall production tax rates were 6.6 percent, 6.3 percent, and 4.9 percent in 2017, 2016, and 2015, respectively. Transportation, Gathering and Processing Expenses Transportation expenses were $33.2 million in 2017 compared to $18.4 million in 2016. The increase was mainly attributable to a $5.0 million increase in oil transportation costs due to additional volumes delivered through pipelines in the Wattenberg Field and an increase of $9.7 million related to natural gas gathering and transportation operations in the Delaware Basin. Transportation expenses were $18.4 million in 2016 compared to $10.2 million in 2015. The increase was mainly attributable to the costs associated with certain pipelines in the Wattenberg Field as we began delivering crude oil on these pipelines in July and December 2015, respectively. Transportation, gathering, and processing expenses per Boe increased to $1.04 for 2017 compared to $0.83 for 2016 and $0.66 for 2015. As discussed in - Crude Oil, Natural Gas, and NGLs Pricing, whether transportation, gathering, and processing costs are presented separately or are reflected as a reduction to net revenue is a function of the terms of the relevant marketing contract. The tables at the end of that section show our net realized prices for the periods shown after the relevant costs are deducted, regardless of where those costs appear on our income statement (see in particular the columns titled “Average Realized Price After Transportation, Gathering and Processing Expenses” and “Average Realization Percentage After Transportation, Gathering and Processing Expenses”). We expect that our transportation, gathering, and processing expenses will decrease beginning in 2018 with the adoption of a new revenue recognition standard as a portion of our current transportation, gathering, and processing expense will be recorded as a reduction to the sales price. Exploration, Geologic, and Geophysical Expense The following table presents the major components of exploration, geologic, and geophysical expense: Exploratory dry hole costs. During 2017, two exploratory dry hole wells, associated lease costs, and related infrastructure assets in the Delaware Basin were expensed at a cost of $41.3 million. The conclusion to expense these items was based on our determination that the acreage on which these wells were drilled was exploratory in nature and, following drilling, that the hydrocarbon production was insufficient for the wells to be deemed economically viable. Geological and geophysical costs. Geological and geophysical costs in 2017 and 2016 were primarily related to the portion of the purchase of seismic data related to unproved acreage in the Delaware Basin. Impairment of Properties and Equipment The following table sets forth the major components of our impairments of properties and equipment expense: Impairment of proved and unproved properties. Amounts represent the retirement or expiration of certain leases that are no longer part of our development plan or that we do not plan to extend and will allow to expire. Deterioration of commodity prices or other operating circumstances could result in additional impairment charges. During 2017, we recorded a charge related to two exploratory dry holes we had drilled in the western area of our Culberson County acreage in the Delaware Basin, as referenced previously. We then assessed the impact of the dry holes and various factors related thereto, including (i) the operational and geologic data obtained, (ii) the current increased cost environment for drilling and completion services in the Delaware Basin, (iii) our future commodity price outlook, and (iv) the terms of the related lease agreements. Based on the results of this assessment, we concluded that the underlying geologic risk and the challenged economics of future capital expenditures reduced the likelihood that we would perform future development in this area over the remaining lease term for this acreage. Accordingly, we recorded an impairment of $251.6 million covering approximately 13,400 acres during 2017. The amount of the impairment was based on the value assigned to individual lease acres in the final purchase price allocation of our Delaware Basin acquisition. This allocation included the consideration paid to the sellers, including the effect of the non-cash impact from the deferred tax liability created at the time of the acquisition. We recorded approximately $29 million of additional lease impairments in the Delaware Basin and an impairment charge of $2.1 million related to the Utica Shale properties that are classified as held-for-sale during 2017. Due to the aforementioned events and circumstances, we also evaluated our proved property for possible impairment and concluded that no further impairments were necessary at this time. During 2015, due to a significant decline in commodity prices and decreases in our net realized sales prices, we experienced triggering events that required us to assess our crude oil and natural gas properties for possible impairment. As a result of our assessments, we recorded impairment charges of $150.3 million in 2015 to write-down our Utica Shale proved and unproved properties. Of these impairment charges, $24.7 million were recorded in 2015 to write-down certain capitalized well costs on our Utica Shale proved producing properties. In 2015, we also recorded impairment charges of $125.6 million to write-down our Utica Shale lease acquisition costs. The impairment charges, which are included in the consolidated statements of operations line item impairment of properties and equipment, represented the amount by which the carrying value of these crude oil and natural gas properties exceeded the estimated fair values. Amortization of individually insignificant unproved properties. The decrease in 2016 as compared to 2015 is due to the impairment of leases in the Utica Shale in 2015. Impairment of Goodwill The final goodwill that resulted from the purchase price allocation of the assets acquired in the Delaware Basin was determined to be $75.1 million. With the creation of goodwill from this transaction, we expected to perform our evaluation of goodwill for impairment annually in the fourth quarter. However, primarily due to a combination of increases in per well development and operational costs and our drilling of two exploratory dry holes in the Delaware Basin subsequent to the acquisition, in conjunction with our lower future commodity price outlook, we determined that a triggering event had occurred in the quarter ended September 30, 2017. In addition to the factors mentioned above, we also considered our recent impairments of certain unproven leasehold costs and the impact of these items on our internal expectations for acceptable rates of return. We evaluated goodwill for impairment by performing a quantitative test, which involves comparing the estimated fair value of the goodwill reporting unit, which we define as the Delaware Basin, to the carrying value. We determined the fair value of the goodwill at September 30, 2017 by using an estimated after-tax future discounted cash flow analysis, along with a combination of market-based pricing factors for similar acreage, reserve valuation techniques, and other fair value considerations. The discounted cash flow analysis used to estimate fair value was based on known or knowable information at the interim measurement date. Fair value determinations require considerable judgment and are sensitive to changes in underlying assumptions and factors. The quantitative test resulted in a determination that a full impairment charge of $75.1 million was required; therefore, the charge was recorded in third quarter of 2017. General and Administrative Expense General and administrative expense increased $7.9 million, or seven percent, in 2017 compared to 2016. The increase was primarily attributable to an $8.1 million increase in payroll and employee benefits due to an increase in headcount in 2017 as compared to 2016, $4.4 million related to professional services, $4.2 million related to legal expenses, $1.4 million related to software license and maintenance agreements, and $1.3 million for the rental of additional office space. The increases were partially offset by the $12.2 million of legal and professional fees related to the acquisition in the Delaware Basin that were incurred in 2016. General and administrative expense increased $22.5 million, or 25 percent, in 2016 compared to 2015. The increase in cash based general and administrative costs was primarily attributable to $12.2 million of legal and professional fees related to the acquisition in the Delaware Basin and a $7.7 million increase in payroll and employee benefits due to increases in wages and increases in headcount. Depreciation, Depletion, and Amortization Crude oil and natural gas properties. During 2017, 2016, and 2015, we invested $788.0 million, $396.4 million, and $554.3 million, net of changes in accounts payable related to capital expenditures, in the development of our crude oil and natural gas properties, respectively. We also incurred $1.76 billion to acquire reserves during 2016 in the Delaware Basin. We did not invest in any acquisitions of proved reserves in 2015. DD&A expense related to crude oil and natural gas properties is directly related to proved reserves and production volumes. DD&A expense related to crude oil and natural gas properties was $462.5 million, $413.1 million, and $298.8 million in 2017, 2016, and 2015, respectively. The year-over-year changes in DD&A expense related to crude oil and natural gas properties were primarily due to the following: The following table presents our DD&A expense rates for crude oil and natural gas properties: ____________ (1) The 2016 Delaware Basin rate represents one month of DD&A expense. Accordingly, the comparison of the 2017 rate to the 2016 rate is not meaningful. (2) In February 2018, we entered into a PSA to sell the Utica Shale properties. The 2017 rate in the Wattenberg Field decreased as compared to the 2016 rate due to a decrease in per well development costs, and an increase in 2017 year-end reserves. The slight decrease in the Wattenberg Field rate for 2016 as compared to 2015 was primarily due to the impact of our 2016 year-end reserves. Provision for Uncollectible Notes Receivable In 2016, we recorded a provision for uncollectible notes receivable of $44.0 million to impair two third-party notes receivable whose collection was not reasonably assured. As described in the footnote titled Note Receivable included elsewhere in this report, in April 2017, we signed a definitive agreement and simultaneously closed on the sale of one of the associated notes receivable to an unrelated third-party for $40.2 million. Accordingly, we reversed $40.2 million of the provision for uncollectible notes receivable during 2017. Accretion of Asset Retirement Obligations Accretion of asset retirement obligations for 2017 decreased by $0.8 million, or 11 percent, compared to 2016, and increased by $0.8 million, or 13 percent, in 2016 compared to 2015. The decrease in 2017 was due to the replacement of vertical wells that have been plugged and abandoned with horizontal wells, which have a longer expected life. The increase in 2016 was due to adding new wells and the associated increase in amortization expense. Interest Expense Interest expense increased by $16.7 million in 2017 compared to 2016. The increase is primarily attributable to an $18.0 million increase in interest for the issuance of our 2024 Senior Notes, a $7.4 million increase in interest expense for the issuance of $200 million principal amount of our 1.125% convertible notes due 2021 (the "2021 Convertible Notes") in September 2016, a $3.1 million increase in interest expense for the issuance of our 2026 Notes in November 2017, and a $3.0 million increase in the utilization fee of our revolving credit facility. The increases were partially offset by a $9.3 million charge for a bridge loan commitment related to the 2016 acquisition of properties in the Delaware Basin, a $3.5 million decrease in interest expense resulting from the net settlement of our 2016 Convertible Notes in May 2016, and a $1.8 million decrease in interest expense resulting from the net settlement of our 2022 Notes in December 2017. Interest expense increased by approximately $14.4 million in 2016 compared to 2015. The increase is primarily attributable to a $9.3 million charge for the bridge loan commitment related to the acquisition of properties in the Delaware Basin, a $7.4 million increase in interest for the issuance of our 2024 Senior Notes, and a $2.9 million increase in interest expense for the issuance of our 2021 Convertible Notes in September 2016. The increases were partially offset by a $5.1 million decrease in interest expense resulting from the net settlement of our 2016 Convertible Notes in May 2016. The entire $9.3 million of interest expense attributed to the bridge loan facility was expensed in 2016 as the bridge loan was not used. Interest costs capitalized in 2017, 2016, and 2015 were $5.0 million, $4.5 million, and $5.1 million, respectively. Loss on Extinguishment of Debt The $24.7 million pre-tax loss on extinguishment of debt relates to the redemption of the 2022 Senior Notes during the fourth quarter of 2017. The pretax loss consists of a $19.4 million make-whole premium and the write-off of unamortized debt issuance costs of $5.4 million. Provision for Income Taxes Current income tax (expense) benefit in 2017, 2016, and 2015 was $8.2 million, $9.9 million, and $(3.1) million, respectively. Current income taxes generally relate to the cash that is paid or recovered for income taxes associated with the applicable period. The remaining portion of the total income tax provision is comprised of deferred income taxes, which are a result of differences in the timing of deductions from our U.S. GAAP presentation of financial statements and the income tax regulations. Our effective income tax rates for 2017, 2016, and 2015 were 62.4 percent, 37.4 percent, and 35.9 percent, respectively, on income (loss) from operations. The 2017 rate differs from the statutory rate of 35 percent primarily due to the reduction in the federal corporate income tax rate resulting from the 2017 Tax Act increasing the tax rate on our 2017 loss from operations by 33.7 percent. Additionally, the nondeductible goodwill impairment charge in 2017 reduced the 2017 rate by 7.7 percent. The 2017 rate was also impacted by state taxes. The 2016 and 2015 rates differ from the federal statutory tax rate primarily due to state taxes and excess stock compensation benefits, offset by nondeductible expenses that consist primarily of officers' compensation cost and government lobbying expenses. In 2016, we recorded a net deferred tax liability of $379.9 million due to book versus tax accounting basis differences of assets acquired and deferred tax liabilities assumed from the acquisition in the Delaware Basin, resulting in a material increase in our deferred tax liability on the balance sheet as of December 31, 2016. In 2017, the deferred tax liability was reduced by $94.1 million as a result of recording an impairment charge related to a portion of these Delaware Basin assets. As of the date of this report, we are current with our income tax filings in all applicable state jurisdictions. We continue to voluntarily participate in the Internal Revenue Service’s ("IRS") Compliance Assurance Program (the "CAP Program") for the 2016 through 2018 tax years. We have received a partial acceptance notice from the IRS for our filed 2016 federal tax return and the IRS's post filing review is currently ongoing. Net Income (Loss)/Adjusted Net Income (Loss) The factors resulting in changes in net loss in 2017, 2016, and 2015 are discussed above. These same reasons similarly impacted adjusted net income (loss), a non-U.S. GAAP financial measure, with the exception of the net change in fair value of unsettled derivatives, adjusted for taxes, of $13.1 million, $208.9 million, and $22.2 million in 2017, 2016, and 2015, respectively. Adjusted net loss, a non-U.S. GAAP financial measure, was $114.4 million, $37.0 million, and $46.2 million in 2017, 2016, and 2015 respectively. See Reconciliation of Non-U.S. GAAP Financial Measures, below, for a more detailed discussion of this non-U.S. GAAP financial measure. Financial Condition, Liquidity and Capital Resources Historically, our primary sources of liquidity have been cash flows from operating activities, our revolving credit facility, proceeds from debt and equity capital market transactions, and asset sales. In 2017, our primary sources of liquidity were net cash flows from operating activities of $588.6 million, net proceeds from issuance of the 2026 Senior Notes of approximately $592.4 million, and $40.2 million of proceeds from the sale of a promissory note. We used a portion of the net proceeds from the 2026 Senior Notes to fund the redemption our 2022 Senior Notes and a portion of the purchase price of the Bayswater Acquisition in early 2018, and for general corporate purposes. Our primary source of cash flows from operating activities is the sale of crude oil, natural gas, and NGLs. Fluctuations in our operating cash flows are principally driven by commodity prices and changes in our production volumes. Commodity prices have historically been volatile and we manage a portion of this volatility through our use of derivative instruments. We enter into commodity derivative instruments with maturities of no greater than five years from the date of the instrument. Our revolving credit facility imposes limits on the amount of our production we can hedge, and we may choose not to hedge the maximum amounts permitted. Therefore, we may still have fluctuations in our cash flows from operating activities due to the remaining non-hedged portion of our future production. Based upon our hedge position and assuming forward strip pricing as of December 31, 2017, our derivatives are not expected to be a significant source of cash flow in the near term. Our working capital fluctuates for various reasons, including, but not limited to, changes in the fair value of our commodity derivative instruments and changes in our cash and cash equivalents due to our practice of utilizing excess cash to reduce the outstanding borrowings under our revolving credit facility. At December 31, 2017, we had a working capital deficit of $16.4 million compared to working capital of $129.2 million at December 31, 2016. The decrease in working capital as of December 31, 2017 is primarily the result of a decrease in cash and cash equivalents of $63.4 million related to capital investment exceeding operating cash flows, an increase in accounts payable of $83.7 million related to increased development and exploration activity, and a decrease in the net fair value of our unsettled commodity derivatives of $20.2 million, which was partially offset by an increase in our net accounts receivable balance of $54.2 million. Our cash and cash equivalents were $180.7 million at December 31, 2017 and availability under our revolving credit facility was $700.0 million, providing for total liquidity of $880.7 million as of December 31, 2017. Our liquidity was augmented in 2017 by the net proceeds from the 2026 Senior Notes and the proceeds from the sale of a promissory note, described previously. Based on our expectations of cash flows from operations, our cash and cash equivalent balance and availability under our revolving credit facility, we believe that we have sufficient capital to fund our planned activities through the 12-month period following the filing of this report. Our revolving credit facility is a borrowing base facility and availability under the facility is subject to redetermination generally each May and November, based upon a quantification of our proved reserves at each December 31 and June 30, respectively. The maturity date of our revolving credit facility is May 2020. In May and October 2017, we entered into the Fifth and Sixth Amendments, respectively, to the Third Amended and Restated Credit Agreement to amend the revolving credit facility to reflect increases in the borrowing base. The Fifth amendment reflected an increase of the borrowing base from $700 million to $950 million and the Sixth Amendment amended the revolving credit facility to allow the borrowing base to increase above the borrowing capacity of $1.0 billion. In addition, the Fifth Amendment made changes to certain of the covenants in the existing agreement as well as other administrative changes. We elected to increase the borrowing base to $1.1 billion for our November 2017 borrowing base redetermination and have elected to maintain a $700 million commitment level as of the date of this report. Amounts borrowed under the revolving credit facility bear interest at either an alternate base rate option or a LIBOR option as defined in the revolving credit facility plus an applicable margin, depending on the percentage of the commitment that has been utilized. As of December 31, 2017, the applicable margin is 1.25 percent for the alternate base rate option or 2.25 percent for the LIBOR option, and the unused commitment fee is 0.5 percent. We had no amounts outstanding under our revolving credit facility as of December 31, 2017. In May 2017, we replaced our $11.7 million irrevocable standby letter of credit that we held in favor of a third-party transportation service provider to secure a firm transportation obligation with a $9.3 million deposit, which is classified as restricted cash and is included in other assets on the consolidated balance sheet. As of December 31, 2017, the available funds under our revolving credit facility were $700 million based on our elected commitment level. Our revolving credit facility contains financial maintenance covenants. The covenants require that we maintain (i) a leverage ratio defined as total debt of less than 4.0 times the trailing 12 months earnings before interest, taxes, depreciation, depletion and amortization, change in fair value of unsettled commodity derivatives, exploration expense, gains (losses) on sales of assets and other non-cash gains (losses) and (ii) an adjusted current ratio of at least 1.0:1.0. Our adjusted current ratio is adjusted by eliminating the impact on our current assets and liabilities of recording the fair value of crude oil and natural gas commodity derivative instruments. Additionally, available borrowings under our revolving credit facility are added to the current asset calculation and the current portion of our revolving credit facility debt is eliminated from the current liabilities calculation. At December 31, 2017, we were in compliance with all debt covenants, as defined by the revolving credit agreement, with a leverage ratio of 1.9 and a current ratio of 3.2. We expect to remain in compliance throughout the 12-month period following the filing of this report. The indentures governing our 2024 Senior Notes and 2026 Senior Notes contain customary restrictive covenants that, among other things, limit our ability and the ability of our restricted subsidiaries to: (a) incur additional debt including under our revolving credit facility, (b) make certain investments or pay dividends or distributions on our capital stock or purchase, redeem, or retire capital stock, (c) sell assets, including capital stock of our restricted subsidiaries, (d) restrict the payment of dividends or other payments by restricted subsidiaries to us, (e) create liens that secure debt, (f) enter into transactions with affiliates, and (g) merge or consolidate with another company. At December 31, 2017, we were in compliance with all covenants and expect to remain in compliance throughout the next 12-month period. In January 2017, pursuant to the filing of the supplemental indentures for the 2021 Convertible Senior Notes and the 2024 Senior Notes, our subsidiary PDC Permian, Inc. became a guarantor of the notes. PDC Permian, Inc. is also the guarantor of our 2026 Senior Notes issued in November 2017. Cash Flows Operating Activities. Our net cash flows from operating activities are primarily impacted by commodity prices, production volumes, net settlements from our commodity derivative positions, operating costs, and general and administrative expenses. Cash flows provided by operating activities increased in 2017 as compared to 2016. The $102.3 million increase was primarily due to the increase in crude oil, natural gas, and NGLs sales of $415.7 million. The increase was partially offset by a decrease in derivative commodity settlements of $194.8 million and increases in lease operating expenses of $29.7 million, production taxes of $29.3 million, interest expense of $16.7 million, transportation, gathering, and processing expenses of $14.8 million, and increases in general and administrative expense of $7.9 million as well as a decrease in the changes in assets and liabilities of $13.0 million. Cash flows provided by operating activities increased in 2016 compared to 2015. The $75.2 million increase was primarily due to the increase in crude oil, natural gas, and NGLs sales of $118.7 million. We also realized an increase in the change of funds held for distribution of $36.5 million, and an increase in the deferral of income taxes of $13.1 million. The increases were partially offset by a decrease in derivative commodity settlements of $30.8 million, and increases in general and administrative expense of $22.5 million, interest expense of $14.4 million, production taxes of $13.0 million and transportation, gathering, and processing expenses of $8.3 million. Adjusted cash flows from operations, a non-U.S. GAAP financial measure, increased by $115.3 million in 2017 to $582.1 million, and $46.0 million to $466.8 million in 2016, when compared to the respective prior years. These changes were primarily due to the same factors mentioned above for changes in cash flows provided by operating activities, without regard to changes in assets and liabilities. Adjusted EBITDAX, a non-U.S. GAAP financial measure, increased by $222.3 million in 2017 to $682.1 million from $459.8 million in 2016, primarily as the result of the increase in crude oil, natural gas, and NGLs sales of $415.7 million, as well as the recording of a provision for a note receivable in 2016 of $44.0 million, and the subsequent sale of the note in 2017 to a third-party for $40.2 million. The increase was partially offset by a decrease in derivative commodity settlements of $194.8 million, and increases in lease operating expenses of $29.7 million, production taxes of $29.3 million, interest expense of $16.7 million, transportation, gathering, and processing expenses of $14.8 million, and general and administrative expense of $7.9 million. Adjusted EBITDAX, a non-U.S. GAAP financial measure, decreased by $4.5 million in 2016 to $459.8 million from $464.3 million in 2015, primarily as a result of the provision for uncollectible notes receivable of $44.0 million, the decrease in net settlements from our monthly derivative commodity settlements of $30.8 million, an increase in general and administrative expense of $22.5 million, and a $13.0 million increase in production taxes. The decrease was partially offset by the increase in crude oil, natural gas, and NGLs sales of $118.7 million. See Item 7. Reconciliation of Non-U.S. GAAP Financial Measures for a reconciliation of our U.S. GAAP to non-U.S. GAAP financial measures. Investing Activities. Because crude oil and natural gas production from a well declines rapidly in the first few years of production, we continue to invest significant amounts of capital in order to maintain and grow our production and replace our reserves. If capital markets are not available in the future, we will be limited to our cash flows from operations and liquidity under our revolving credit facility as the sources for funding our capital investments. Cash flows from investing activities primarily consist of the acquisition, exploration, and development of crude oil and natural gas properties, net of dispositions of crude oil and natural gas properties. Net cash used in investing activities of $717.0 million during 2017 was primarily related to cash utilized for our drilling operations, including completion activities of $737.2 million, a $21.0 million deposit toward the Bayswater Acquisition, purchases of short-term investments of $49.9 million, and a $9.3 million deposit with a third-party transportation service provider for surety of an existing firm transportation obligation. Partially offsetting these investments was the receipt of approximately $49.9 million related to the sale of short-term investments, $40.2 million from the sale of a promissory note, and $5.4 million related to post-closing settlements of properties acquired in 2016. During 2016, our acquisition in the Delaware Basin comprised the majority of our cash flows used in investing activities. Net cash used in the Delaware Basin acquisition was $1.1 billion and we used cash of $436.9 million for our crude oil and gas operations. Our total cash used in investing activities during 2016 was approximately $1.5 billion. Financing Activities. Net cash from financing activities in 2017 was primarily related to $592.4 million of net proceeds from issuance of the 2026 Senior Notes, partially offset by the $519.4 million used to redeem our 2022 Senior Notes. Net cash from financing activities in 2016 was primarily related to the $855.1 million of net proceeds received from the issuance of 9.4 million shares of our common stock, $392.2 million of net proceeds from issuance of the 2024 Senior Notes, and $193.9 million of net proceeds from issuance of the 2021 Convertible Notes, partially offset by the $115.0 million payment upon the maturity of the 2016 Convertible Notes and net payments of approximately $37.0 million to pay down amounts borrowed under our revolving credit facility. Contractual Obligations and Contingent Commitments The following table presents our contractual obligations and contingent commitments as of December 31, 2017: __________ (1) Table does not include deferred income tax liability to taxing authorities of $192.0 million due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. (2) Amount presented does not agree with the consolidated balance sheets in that it excludes $30.3 million of unamortized debt discount and $17.7 million of unamortized debt issuance costs. (3) Represents our gross liability related to the fair value of derivative positions. (4) Short-term capital lease obligations are included in other accrued expenses on the consolidated balance sheets. Long-term capital lease obligations are included in other liabilities on the consolidated balance sheets. (5) Includes deferred compensation to former executive officers and deferred payments related to firm transportation agreements. (6) The table does not include termination benefits related to employment agreements with our executive officers, due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. (7) Amounts presented include $288.9 million to the holders of our 2026 Senior Notes, $164.2 million to the holders of our 2024 Senior Notes, and $90.7 million payable to the holders of our 2021 Convertible Notes. Amounts also include interest of $8.4 million related to unutilized commitments at a rate of 0.50 percent per annum. (8) Represents our gross commitment which includes volumes produced by us, purchased from third parties and produced by our affiliated partnerships and other third-party working, royalty and overriding royalty interest owners whose volumes we market on their behalf. This includes anticipated and estimated commitments associated with two new gas processing facilities by our primary mid-stream provider. The timing of such payments has been estimated and is subject to change based on the completion of construction and the commencement of operations by the midstream provider. From time to time, we are a party to various legal proceedings in the ordinary course of business. We are not currently a party to any litigation that we believe would have a materially adverse effect on our business, financial condition, results of operations, or liquidity. Information regarding our legal proceedings can found in the footnote titled Commitments and Contingencies - Litigation and Legal Items to our consolidated financial statements included elsewhere in this report. Critical Accounting Policies and Estimates We have identified the following policies as critical to business operations and the understanding of our results of operations. This is not a comprehensive list of all of the accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP, with no need for our judgment in the application. There are also areas in which our judgment in selecting available alternatives would not produce a materially different result. However, certain of our accounting policies are particularly important to the presentation of our financial position and results of operations and we may use significant judgment in their application. As a result, they are subject to an inherent degree of uncertainty. In applying those policies, we use our judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on historical experience, observation of trends in the industry and information available from other outside sources, as appropriate. For a more detailed discussion on the application of these and other accounting policies, see the footnote titled Summary of Significant Accounting Policies to our consolidated financial statements included elsewhere in this report. Crude Oil and Natural Gas Properties. We account for our crude oil and natural gas properties under the successful efforts method of accounting. Costs of proved developed producing properties, successful exploratory wells and developmental dry hole costs are capitalized and depreciated or depleted by the unit-of-production method based on estimated proved developed producing reserves. Property acquisition costs are depreciated or depleted on the unit-of-production method based on estimated proved reserves. Annually, we engage independent petroleum engineers to prepare reserve and economic evaluations of all our properties on a well-by-well basis as of December 31. We adjust our crude oil and natural gas reserves for major acquisitions, new drilling, and divestitures during the year as needed. The process of estimating and evaluating crude oil and natural gas reserves is complex, requiring significant decisions in the evaluation of available geological, geophysical, engineering, and economic data. The data for a given property may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and a continual reassessment of the viability of production under changing economic conditions. As a result, revisions in existing reserve estimates occur. Although every reasonable effort is made to ensure that reserve estimates reported represent our most accurate assessments possible, the subjective decisions and variances in available data for various properties increase the likelihood of significant changes in these estimates over time. Because estimates of reserves significantly affect our DD&A expense, a change in our estimated reserves could have an effect on our net income (loss). Exploration costs, including geological and geophysical expenses, the acquisition of seismic data covering unproved acreage, and delay rentals, are charged to expense as incurred. Exploratory well drilling costs, including the cost of stratigraphic test wells, are initially capitalized, but are charged to expense if the well is determined to be nonproductive. The status of each in-progress well is reviewed quarterly to determine the proper accounting treatment under the successful efforts method of accounting. Exploratory well costs continue to be capitalized as long as the well has found a sufficient quantity of reserves to justify completion as a producing well and we are making sufficient progress assessing our reserves and economic and operating viability. If an in-progress exploratory well is found to be unsuccessful prior to the issuance of the financial statements, the costs incurred prior to the end of the reporting period are charged to exploration expense. If we are unable to make a final determination about the productive status of a well prior to issuance of the financial statements, the well is classified as a "suspended well" until we have had sufficient time to conduct additional completion or testing operations to evaluate the pertinent geological and engineering data obtained. At the time when we are able to make a final determination of a well’s productive status, the well is removed from suspended well status and the proper accounting treatment is applied. The acquisition costs of unproved properties are capitalized when incurred until such properties are transferred to proved properties or charged to expense when expired, impaired, or amortized. Unproved crude oil and natural gas properties with individually significant acquisition costs are periodically assessed, and any impairment in value is charged to impairment of crude oil and natural gas properties. The amount of impairment recognized on unproved properties which are not individually significant is determined by amortizing the costs of such properties within appropriate fields based on our historical experience, acquisition dates and average lease terms, with the amortization recognized in impairment of crude oil and natural gas properties. The valuation of unproved properties is subjective and requires us to make estimates and assumptions which, with the passage of time, may prove to be materially different from actual realizable values. We assess our crude oil and natural gas properties for possible impairment upon a triggering event, including when general industry conditions warrant, by comparing net capitalized costs to estimated undiscounted future net cash flows on a field-by-field basis using estimated production based upon prices at which we reasonably estimate the commodity will be sold. Any impairment in value is charged to impairment of properties and equipment. The estimates of future prices may differ from current market prices of crude oil and natural gas. Any downward revisions in estimates to our reserve quantities, expectations of falling commodity prices, or rising operating costs could result in a triggering event, and therefore, a reduction in undiscounted future net cash flows and an impairment of our crude oil and natural gas properties. Although our cash flow estimates are based on the relevant information available at the time the estimates are made, estimates of future cash flows are, by nature, highly uncertain and may vary significantly from actual results. Crude Oil, Natural Gas, and NGLs Sales Revenue Recognition. Crude oil, natural gas, and NGLs sales are recognized when production is sold to a purchaser at a determinable price, delivery has occurred, rights and responsibility of ownership have transferred and collection of revenue is reasonably assured. We record sales revenue based on an estimate of the volumes delivered at estimated prices as determined by the applicable sales agreement. We estimate our sales volumes based on company-measured volume readings. We then adjust our crude oil, natural gas, and NGLs sales in subsequent periods based on the data received from our purchasers that reflects actual volumes and prices received. We receive payment for sales from one to two months after actual delivery has occurred. The differences in sales estimates and actual sales are recorded one to two months later. Historically, these differences have been immaterial. If a sale is deemed uncollectible, an allowance for doubtful collection is recorded. There is a new revenue standard effective for annual reporting periods beginning after December 15, 2017. See the footnote titled Summary of Significant Accounting Policies - Recently Issued Accounting Standards. Fair Value of Financial Instruments. Our fair value measurements are estimated pursuant to a fair value hierarchy that requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date, giving the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable data (Level 3). In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The lowest level input that is significant to a fair value measurement in its entirety determines the applicable level in the fair value hierarchy. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability, and may affect the valuation of the assets and liabilities and their placement within the fair value hierarchy levels. The three levels of inputs that may be used to measure fair value are defined as: Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability, and inputs that are derived from observable market data by correlation or other means. Level 3 - Unobservable inputs for the asset or liability, including situations where there is little, if any, market activity. Commodity Derivative Financial Instruments. We measure the fair value of our commodity derivative instruments based on a pricing model that utilizes market-based inputs, including but not limited to the contractual price of the underlying position, current market prices, natural gas, and crude oil forward curves, discount rates such as the LIBOR curve for a similar duration of each outstanding position, volatility factors and nonperformance risk. Nonperformance risk considers the effect of our credit standing on the fair value of commodity derivative liabilities and the effect of our counterparties' credit standings on the fair value of commodity derivative assets. Both inputs to the model are based on published credit default swap rates and the duration of each outstanding commodity derivative position. We validate our fair value measurement through the review of counterparty statements and other supporting documentation, the determination that the source of the inputs is valid, the corroboration of the original source of inputs through access to multiple quotes, if available, or other information and monitoring changes in valuation methods and assumptions. While we use common industry practices to develop our valuation techniques, changes in our pricing methodologies or the underlying assumptions could result in significantly different fair values. While we believe our valuation method is appropriate and consistent with those used by other market participants, the use of a different methodology, or assumptions to determine the fair value of certain financial instruments could result in a different estimate of fair value. Net settlements on our commodity derivative instruments are initially recorded to accounts receivable or payable, as applicable, and may not be received from or paid to counterparties to our commodity derivative contracts within the same accounting period. Such settlements typically occur the month following the maturity of the commodity derivative instrument. We have evaluated the credit risk of the counterparties holding our commodity derivative assets, which are primarily financial institutions who are also major lenders in our revolving credit facility, giving consideration to amounts outstanding for each counterparty and the duration of each outstanding commodity derivative position. Based on our evaluation, we have determined that the potential impact of nonperformance of our counterparties on the fair value of our commodity derivative instruments is not significant. Deferred Income Tax Asset Valuation Allowance. Deferred income tax assets are recognized for deductible temporary differences, net operating loss carry-forwards and credit carry-forwards if it is more likely than not that the tax benefits will be realized. To the extent a deferred tax asset is not expected to be realized under the preceding criteria, we establish a valuation allowance. The factors which we consider in assessing whether we will realize the value of deferred income tax assets involve judgments and estimates of both amount and timing. The judgments used in applying these policies are based on our evaluation of the relevant facts and circumstances as of the date of the financial statements. Actual results may differ from those estimates. Accounting for Business Combinations. We utilize the purchase method to account for acquisitions of businesses and assets. The value of the purchase consideration takes into account the degree to which the consideration is objective and measurable such as cash consideration paid to a seller. With the issuance of equity, restrictions upon the sale of the issued stock are taken into consideration. Pursuant to purchase method accounting, we allocate the cost of the acquisition to assets acquired and liabilities assumed based on fair values as of the acquisition date. The purchase price allocations are based on appraisals, discounted cash flows, quoted market prices, and estimates by management. When appropriate, we review comparable purchases and sales of crude oil and natural gas properties within the same regions and use that data as a basis for fair market value as such sales represent the amount at which a willing buyer and seller would enter into an exchange for such properties. In estimating the fair values of assets acquired and liabilities assumed, we make various assumptions. The most significant assumptions relate to the estimated fair values assigned to proved developed producing, proved developed non-producing, proved undeveloped and unproved crude oil and natural gas properties, and other non-crude oil and natural gas properties. To estimate the fair values of these properties, we prepare estimates of crude oil and natural gas reserves. When appropriate, we review comparable purchases and sales of crude oil and natural gas properties within the same regions and use that data as a basis for fair market value; for example, the amount at which a willing buyer and seller would enter into an exchange for such properties. We estimate future prices by using the applicable forward pricing strip to apply to our estimate of reserve quantities acquired, and estimates of future operating and development costs, to arrive at an estimate of future net revenues. For estimated proved reserves, the future net revenues are discounted using a market-based weighted-average cost of capital rate determined appropriate at the time of the acquisition. The market-based weighted-average cost of capital rate is subject to additional project-specific risking factors. To compensate for the inherent risk of estimating and valuing unproved properties, we reduce the discounted future net revenues of probable and possible reserves by additional risk-weighting factors. We record deferred taxes for any differences between the assigned values and tax basis of assets and liabilities. Estimated deferred taxes are based on available information concerning the tax basis of assets acquired and liabilities assumed and loss carryforwards at the acquisition date, although such estimates may change in the future as additional information becomes known. Recent Accounting Standards See the footnote titled Summary of Significant Accounting Policies - Recently Adopted Accounting Standards to our consolidated financial statements included elsewhere in this report. Reconciliation of Non-U.S. GAAP Financial Measures We use "adjusted cash flows from operations," "adjusted net income (loss)" and "adjusted EBITDAX," non-U.S. GAAP financial measures, for internal management reporting, when evaluating period-to-period changes and, in some cases, providing public guidance on possible future results. Beginning in 2017, we have included non-cash stock-based compensation and exploration, geologic and geophysical expense in our reconciliation of adjusted EBITDAX calculation. In prior periods, we disclosed adjusted EBITDA, a non-U.S. GAAP financial measure that did not include these adjustments. We have elected to disclose Adjusted EBITDAX rather than Adjusted EBITDA in this report and other public disclosures because we believe it is more comparable to similar metrics presented by others in the industry. All prior periods have been conformed for comparability of this information. These measures are not measures of financial performance under U.S. GAAP and should be considered in addition to, not as a substitute for, net income (loss) or cash flows from operations, investing or financing activities, and should not be viewed as liquidity measures or indicators of cash flows reported in accordance with U.S. GAAP. The non-U.S. GAAP financial measures that we use may not be comparable to similarly titled measures reported by other companies. Also, in the future, we may disclose different non-U.S. GAAP financial measures in order to help our investors more meaningfully evaluate and compare our future results of operations to our previously reported results of operations. We strongly encourage investors to review our financial statements and publicly filed reports in their entirety and not rely on any single financial measure. Adjusted cash flows from operations. We define adjusted cash flows from operations as the cash flows earned or incurred from operating activities, without regard to changes in operating assets and liabilities. We believe it is important to consider adjusted cash flows from operations, as well as cash flows from operations, as we believe it often provides more transparency into what drives the changes in our operating trends, such as production, prices, operating costs, and related operational factors, without regard to whether the related asset or liability was received or paid during the same period. We also use this measure because the timing of cash received from our assets, cash paid to obtain an asset or payment of our obligations has generally been a timing issue from one period to the next as we have not had significant accounts receivable collection problems, nor been unable to purchase assets or pay our obligations. Adjusted net income (loss). We define adjusted net income (loss) as net income (loss), plus loss on commodity derivatives, less gain on commodity derivatives, and net settlements on commodity derivatives, each adjusted for tax effect. We believe it is important to consider adjusted net income (loss), as well as net income (loss). We believe this measure often provides more transparency into our operating trends, such as production, prices, operating costs, net settlements from derivatives, and related factors, without regard to changes in our net income (loss) from our mark-to-market adjustments resulting from net changes in the fair value of unsettled derivatives. Additionally, other items which are not indicative of future results may be excluded to clearly identify operating trends. Adjusted EBITDAX. We define adjusted EBITDAX as net income (loss), plus loss on commodity derivatives, interest expense, net of interest income, income taxes, impairment of properties and equipment, exploration, geologic, and geophysical expense, depreciation, depletion and amortization expense, accretion of asset retirement obligations, and non-cash stock-based compensation, less gain on commodity derivatives and net settlements on commodity derivatives. Adjusted EBITDAX is not a measure of financial performance or liquidity under U.S. GAAP and should be considered in addition to, not as a substitute for, net income (loss), and should not be considered an indicator of cash flows reported in accordance with U.S. GAAP. Adjusted EBITDAX includes certain non-cash costs incurred by us and does not take into account changes in operating assets and liabilities. Other companies in our industry may calculate adjusted EBITDAX differently than we do, limiting its usefulness as a comparative measure. We believe adjusted EBITDAX is relevant because it is a measure of our operational and financial performance, as well as a measure of our liquidity, and is used by our management, investors, commercial banks, research analysts, and others to analyze such things as: • operating performance and return on capital as compared to our peers; • financial performance of our assets and our valuation without regard to financing methods, capital structure, or historical cost basis; • our ability to generate sufficient cash to service our debt obligations; and • the viability of acquisition opportunities and capital expenditure projects, including the related rate of return. PV-10. We define PV-10 as the estimated present value of the future net cash flows from our proved reserves before income taxes, discounted using a 10 percent discount rate. We believe that PV-10 provides useful information to investors as it is widely used by professional analysts and sophisticated investors when evaluating oil and gas companies. We believe that PV-10 is relevant and useful for evaluating the relative monetary significance of our reserves. Professional analysts, investors, and other users of our financial statements may utilize the measure as a basis for comparison of the relative size and value of our reserves to other companies' reserves. Because there are many unique factors that can impact an individual company when estimating the amount of future income taxes to be paid, we believe the use of a pre-tax measure is valuable in evaluating us and our reserves. PV-10 is not intended to represent the current market value of our estimated reserves. The following table presents a reconciliation of our non-U.S. GAAP financial measures to its most comparable U.S. GAAP measure: Amounts above include results from continuing and discontinued operations.

<s>[INST] SUMMARY 2017 Financial Overview of Operations and Liquidity Production volumes increased 44 percent to 31.8 MMBoe in 2017 compared to 2016, including 4.2 MMBoe contributed from the Delaware Basin assets that we acquired in December 2016. The increase in production volumes was primarily attributable to the continued success of our horizontal Niobrara and Codell drilling program in the Wattenberg Field and growing production from our horizontal Wolfcamp drilling program in our Delaware Basin properties. Crude oil production increased 48 percent in 2017, which comprised approximately 41 percent of our total production. Natural gas production increased 39 percent and NGLs increased 45 percent in 2017 compared to 2016. On a combined basis, total liquids production of crude oil and NGLs comprised 62 percent of production in 2017. For the month ended December 31, 2017, we maintained an average production rate of approximately 97,000 Boe per day, including approximately 18,000 Boe per day from the Delaware Basin, up from approximately 73,200 Boe per day, including approximately 6,000 Boe per day from the Delaware Basin, for the month ended December 31, 2016. Crude oil, natural gas, and NGLs sales increased to $913.1 million in 2017 compared to $497.4 million in 2016, due to a 44 percent increase in production, combined with a 28 percent increase in the weighted average realized commodity prices. Crude oil, natural gas, and NGLs sales increased 31 percent in 2016 as compared to 2015 due to a 44 percent increase in production, partially offset by a nine percent decrease in average realized commodity prices. We had positive net settlements from our commodity derivative contracts of $13.3 million for 2017, $208.1 million for 2016, and $238.9 million for 2015. We entered into agreements for the derivative instruments that settled throughout 2016 and 2015 prior to commodity prices becoming depressed in late 2014. Substantially all of these highervalue derivatives settled by the end of 2016. Net settlements for 2017 reflect derivative instruments entered into since 2015, which more closely approximate recent realized prices. See Results of Operations Commodity Price Risk Management, Net for further details of our settlements of derivatives and changes in the fair value of unsettled derivatives. The combined revenue from crude oil, natural gas, and NGLs sales and net settlements received on our commodity derivative instruments increased 31 percent to $926.4 million in 2017 from $705.5 million in 2016. Such combined revenue of $705.5 million in 2016 increased 14 percent from $617.6 million in 2015. During 2017, we recorded exploratory dry hole well expense of $41.3 million and an unproved and proved property impairment charge of $285.5 million, and we impaired all of the goodwill associated with the assets acquired in the Delaware Basin, which resulted in an impairment charge of $75.1 million. The majority of these charges are a result of our western Culberson County acreage not meeting our performance expectations. In addition, we recorded a loss on extinguishment of debt of $24.7 million related to the redemption of our 2022 Senior Notes. For more information regarding these expenses and charges see Results of Operations Exploration, Geologic, and Geophysical Expense, Results of Operations Impairments of Properties, Results of Operations Impairment of Goodwill, and Results of Operations Loss on Extinguishment of Debt. In December 2017, the President of the United States signed into law the 2017 Tax Cuts and Jobs Act (the "2017 Tax Act"). We [/INST] Negative. </s>

PDC ENERGY, INC.

2019-02-28

2018-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes thereto included elsewhere in this report. Further, we encourage you to revisit the Special Note Regarding Forward-Looking Statements in Part I of this report. SUMMARY 2018 Financial Overview of Operations and Liquidity Production volumes increased 26 percent to 40.2 MMBoe in 2018 compared to 2017. The increase in production volumes was primarily attributable to the continued success of our horizontal Niobrara and Codell drilling program in the Wattenberg Field and growing production from our horizontal Wolfcamp drilling program in our Delaware Basin properties. Crude oil production increased 32 percent in 2018 and comprised approximately 42 percent of our total production. Natural gas production increased 23 percent and NGLs production increased 22 percent in 2018 compared to 2017. On a combined basis, total liquids production of crude oil and NGLs comprised 63 percent of production in 2018. For the month ended December 31, 2018, we maintained an average production rate of approximately 129,000 Boe per day, up from approximately 97,000 Boe per day for the month ended December 31, 2017. Crude oil, natural gas and NGLs sales increased to $1.4 billion in 2018 compared to $913.1 million in 2017, due to a 26 percent increase in production, combined with a 21 percent increase in weighted average realized commodity prices. Crude oil, natural gas and NGLs sales increased 84 percent in 2017 as compared to 2016 due to a 44 percent increase in production, combined with a 28 percent increase in average realized commodity prices. We had negative net settlements from our commodity derivative contracts of $115.5 million for 2018 as compared to positive net settlements of $13.3 million and $208.1 million for 2017 and 2016, respectively. See Results of Operations - Commodity Price Risk Management, Net for further details of our settlements of derivatives and changes in the fair value of unsettled derivatives. The combined revenue from crude oil, natural gas and NGLs sales and net settlements received on our commodity derivative instruments increased 38 percent to $1.3 billion in 2018 from $926.4 million in 2017. Such combined revenue of $926.4 million in 2017 represented an increase of 31 percent from $705.5 million in 2016. During 2018, we recorded unproved and proved property impairment charges of $458.4 million, primarily resulting from identified current and anticipated near-term leasehold expirations within our non-focus areas of the Delaware Basin and our determination that we would no longer pursue plans to develop these properties. For more information regarding these charges see Results of Operations - Impairments of Properties. In 2018, we generated a net income of $2.0 million or $0.03 per diluted share. Our net income was most negatively impacted by the aforementioned impairment charges. During the same period, our adjusted EBITDAX, a non-U.S. GAAP financial measure, was $868.3 million, up 27 percent relative to 2017. See Reconciliation of Non-U.S. GAAP Financial Measures, below, for a more detailed discussion of adjusted EBITDAX and a reconciliation of adjusted EBITDAX to net income and cash from operating activities. The increase in our 2018 adjusted EBITDAX as compared to 2017 was primarily the result of the increase in crude oil, natural gas and NGLs sales of $476.9 million. This increase was partially offset by a decrease in derivative commodity settlements of $128.9 million, an increase in operating costs of $125.3 million and the reversal of a provision for uncollectible notes receivable of $40.2 million in 2017. In 2017 and 2016, our net loss per diluted share was $1.94 and $5.01, respectively, and our adjusted EBITDAX was $682.1 million and $459.8 million, respectively. Our net cash flows from operating activities in 2018, 2017 and 2016 were $889.3 million, $597.8 million and $486.3 million, respectively, and our adjusted cash flows from operations, a non-U.S. GAAP financial measure, were $808.4 million, $582.1 million and $466.8 million, respectively. Liquidity Available liquidity as of December 31, 2018 was $1.3 billion, which was comprised of $1.4 million of cash and cash equivalents and $1.3 billion available for borrowing under our revolving credit facility at our current commitment level. We increased the commitment level on our revolving credit facility to $1.3 billion in October 2018. We maintain a significant capital investment program to execute our development plans, which requires capital expenditures to be made in periods prior to initial production from newly-developed wells. Further, we use our available liquidity for other working capital requirements, acquisitions, support for letters of credit and for general corporate purposes. From time to time, these activities may result in a working capital deficit; however, we do not believe that our working capital deficit as of December 31, 2018 is an indication of a lack of liquidity. We intend to continue to manage our liquidity position by a variety of means, including through the generation of cash flows from operations, investment in projects with attractive rates of return, protection of cash flows on a portion of our anticipated sales through the use of an active commodity derivative hedging program, utilization of our borrowing capacity under our revolving credit facility and, if warranted, capital markets transactions from time to time. Acquisitions We closed the Bayswater Asset Acquisition in January 2018, acquiring approximately 7,400 net acres, 24 operated horizontal wells that were either DUCs or in-process wells at the time of closing and approximately 220 gross drilling locations. See the footnote titled Business Combination to our consolidated financial statements included elsewhere in this report for further details. Acreage Exchanges During 2018, we completed two acreage exchanges that consolidated our position in the core area of the Wattenberg Field, resulting in us acquiring approximately 14,800 net acres in exchange for 15,500 net acres. 2018 Drilling Overview During the year ended December 31, 2018, we continued to execute our strategic plan to grow production while preserving our financial strength and liquidity. During 2018, we ran three drilling rigs in each of the Wattenberg Field and Delaware Basin. The following tables summarizes our drilling and completion activity for the year ended December 31, 2018: _______________ (1) Represents DUCs and completed wells that had not been turned-in-line that we acquired with the Bayswater Asset Acquisition in January 2018. Our in-process wells represent wells that are in the process of being drilled and/or have been drilled and are waiting to be fractured and/or for gas pipeline connection. Our DUCs are generally completed and turned-in-line within a year of drilling. 2019 Operational and Financial Outlook We anticipate that our production for 2019 will range between 46 MMBoe to 50 MMBoe, or approximately 126,000 Boe to 137,000 Boe per day for the year. We expect that approximately 41 to 45 percent of our 2019 production will be comprised of crude oil and approximately 21 to 23 percent will be NGLs, for total liquids of approximately 62 to 68 percent. Our planned 2019 capital investments in crude oil and natural gas properties, which we expect to be between $810 million and $870 million, are focused on continued execution of our development plans in the Wattenberg Field and Delaware Basin. In 2019, we also expect to spend approximately $20 million for corporate capital, the majority of which is related to the implementation of an ERP system to replace our existing operating and financial systems. This long-planned investment is being made to enhance maintenance of our financial records, improve operational functionality and provide timely information to our management team related to the operation of the business. We believe that we maintain a degree of operational flexibility to control the pace of our capital spending. As we execute our capital investment program, we continually monitor, among other things, expected rates of return, the political environment and our remaining inventory in order to best meet our short- and long-term corporate strategy. Should commodity pricing or the operating environment deteriorate, we may determine that an adjustment to our development plan is appropriate. Wattenberg Field. We are drilling in the horizontal Niobrara and Codell plays in the rural areas of the core Wattenberg Field, which is further delineated between the Kersey, Prairie and Plains development areas. Our 2019 capital investment program for the Wattenberg Field is approximately 60 percent of our total capital investments in crude oil and natural gas properties, of which approximately 90 percent is expected to be invested in operated drilling and completion activity. We plan to drill standard-reach lateral (“SRL”), mid-reach lateral (“MRL”) and extended-reach lateral (“XRL”) wells in 2019, the majority of which will be in the Kersey area of the field. In 2019, we anticipate spudding approximately 135 to 150 operated wells and turning-in-line approximately 110 to 125 operated wells. We expect to drill at a three-rig pace in 2019 with an average development cost per well of between $3 million and $5 million, depending upon the lateral length of the well. The remainder of the Wattenberg Field capital investment program is expected to be used for non-operated drilling, land, capital workovers and facilities projects. Delaware Basin. Our 2019 capital investment program for the Delaware Basin contemplates operating between a two- and three-rig pace throughout the year. Total capital investments in crude oil and natural gas properties in the Delaware Basin for 2019 are expected to be approximately 40 percent of our total capital investments in crude oil and natural gas properties, of which approximately 80 percent is allocated to spud approximately 25 to 30 operated wells and turn-in-line approximately 20 to 25 operated wells. We plan to drill MRL and XRL wells in 2019 with an expected average development cost per well of between $11.5 million and $13 million, depending upon the lateral length of the well. We do not plan to drill any SRL wells in the Delaware Basin in 2019. Based on the timing of our operations and requirements to hold acreage, we may elect to drill wells different from or in addition to those currently anticipated as we are continuing to analyze the terms of the relevant leases. We plan to use approximately 20 percent of our budgeted capital for midstream assets, leasing, non-operated capital, seismic and technical studies and facilities. We are in the process of actively marketing our Delaware Basin crude oil gathering, natural gas gathering and produced water gathering and disposal assets for sale and currently expect to execute agreements for the sales of these assets in the first half of 2019. We anticipate making capital investments for midstream assets of approximately $40 million in 2019, a portion of which would be made prior to such sales depending on the timing of the divestitures. Such expenditures are included in the Delaware Basin capital investment amounts noted above. We expect that we would recover a portion of these expenditures upon settlement of the final sale prices. Financial Guidance. We are committed to our disciplined approach to managing our development plans and expect that cash flows from operations in 2019 will exceed our capital investments in crude oil and natural gas properties assuming an average NYMEX crude oil price of at least $50.00. Based on our current production forecast for 2019 and our average 2019 price assumptions of $55.00 for NYMEX crude oil and $3.00 for NYMEX natural gas, we expect 2019 cash flows from operations to exceed our capital investments in crude oil and natural gas properties by approximately $65.0 million. Assuming a NYMEX crude oil price of $50.00, we expect cash flows from operations to exceed our capital investments in crude oil and natural gas properties by approximately $25.0 million. We anticipate that capital investments will exceed cash flows from operations during the first half of 2019 and expect cash flows from operations to exceed capital investment during the remainder of the year. Assuming a NYMEX crude oil price of $45.00, we expect cash flows from operations to approximate our capital investments in crude oil and natural gas properties. A significant decline in NYMEX crude oil prices below approximately $45.00 per barrel would negatively impact our results of operations, financial condition and future development plans. Our leverage ratio, as defined in our revolving credit facility agreement, is expected to decrease from 1.4 as of the end of 2018 to approximately 1.3 by the end of 2019 based on anticipated production and $50.00 to $55.00 NYMEX crude oil prices. We may revise our 2019 capital investment program during the year as a result of, among other things, changes in commodity prices or our internal long-term outlook for commodity prices, requirements to hold acreage, the cost of services for drilling and well completion activities, drilling results, changes in our borrowing capacity, a significant change in cash flows, regulatory issues, requirements to maintain continuous activity on leaseholds or acquisition and/or divestiture opportunities. We currently expect similar levels of financial performance and growth in 2020 as we anticipate experiencing in 2019. Based upon similar pricing assumptions used in our 2019 outlook and our focus on capital investment discipline, we currently anticipate increasing free cash flow in 2020. The following table provides projected financial guidance for 2019: Results of Operations Summary Operating Results The following table presents selected information regarding our operating results: * Percentage change is not meaningful or equal to or greater than 300% or not applicable. Amounts may not recalculate due to rounding. ______________ (1) In March 2018, we completed the disposition of our Utica Shale properties. Crude Oil, Natural Gas and NGLs Sales The year-over-year change in crude oil, natural gas and NGLs sales revenue were primarily due to the following: Crude Oil, Natural Gas and NGLs Production The following table presents crude oil, natural gas and NGLs production. * Percentage change is not meaningful or equal to or greater than 300 percent. Amounts may not recalculate due to rounding. (1) In March 2018, we completed the disposition of our Utica Shale properties. The following table presents our crude oil, natural gas and NGLs production ratio by operating region: ______________ (1) In March 2018, we completed the disposition of our Utica Shale properties. Midstream Capacity Our ability to market our production depends substantially on the availability, proximity and capacity of gathering systems, pipelines and processing facilities owned and operated by third parties. If adequate midstream facilities and services are not available to us on a timely basis and at acceptable costs, our production and results of operations could be adversely affected. Both of our current areas of operation have seen substantial development in recent years, and this has made it more difficult for providers of midstream infrastructure and services to keep pace with the corresponding increases in field-wide production. The ultimate timing and availability of adequate infrastructure is not within our control and we could experience capacity constraints for extended periods of time that would negatively impact our ability to meet our production targets. Weather, regulatory developments and other factors also affect the adequacy of midstream infrastructure. Wattenberg Field. Elevated line pressures on gas gathering facilities have adversely affected production from the Wattenberg Field from time to time, most recently beginning in mid-2017 and continuing into the fourth quarter of 2018. DCP completed its Mewbourn 3 Plant in August of 2018. This project, along with associated new compression, resulted in significant incremental capacity being added to the DCP system. System pressures began to decrease as these projects were started and reached full capacity during the third and fourth quarters of 2018. Concurrently, additional residue pipeline capacity became available as pipeline expansion projects were completed and commissioned in November 2018. As a result, system pressures have recently been maintained at a lower level than during the latter part of 2017. These lower pressures, along with the system improvements implemented by DCP to prevent freezes, combined with relatively mild weather in late 2018, resulted in a significant reduction in line freezes compared to those experienced during late 2017. DCP continues to make progress on construction of its O’Conner 2 Plant, which we expect to be completed by the end of the second quarter of 2019. We expect that the start-up of the O’Conner 2 Plant will further reduce the line pressures on the system, while providing additional processing capacity for incremental production associated with our ongoing drilling program. This is the second plant that includes baseline volume commitments for us and the other operators and guarantees a specified profit margin to DCP for a three-year period, beginning on the initial start-up date of the plant. Under our current drilling plans and in the current commodity pricing environment, we currently expect to satisfy the volume commitment and profit margin requirements with minimal payment from us. See the footnote titled Commitments and Contingencies to our consolidated financial statements included elsewhere in this report for additional details regarding these agreements. We have been engaged with DCP in planning for further incremental increases to the processing capacity in the field and it is currently our expectation that an additional plant will be constructed and commissioned on DCP’s system in mid-2020. We also continue to work with our other midstream service providers in the field in an effort to ensure all of the existing infrastructure is fully utilized and that all options for system expansion are evaluated and implemented to the extent possible. Additional residue and NGL takeaway pipeline expansions/conversions are expected to be completed in the third and fourth quarters of 2019 to help ensure that all products associated with additional processing capacity will be transported to market. NGL fractionation on the Gulf Coast and Conway is running at full capacity and this could potentially impact the operation of gas plants in the Wattenberg Field. While our Wattenberg Field operations are not currently being impacted by NGL fractionation capacity constraints, the limitation on NGL fractionation capacity did limit the throughput of some gas processing plants in the field for a portion of the fourth quarter of 2018. Limitations on downstream fractionation capacity could limit the ability of our service providers to adjust ethane and propane recoveries to optimize the plant product mix to maximize revenue. Additional fractionation capacity is scheduled to come online later in 2019 and in 2020. Delaware Basin. Like other producers, we from time to time enter into volume commitments with midstream providers in order to induce them to provide increased capacity. If our production falls below the level required under these agreements, we could be subject to substantial penalties. In the second quarter of 2018, we entered into firm sales and pipeline agreements for portions of our Delaware Basin crude oil and natural gas production, respectively. The crude oil agreement runs through December 2023 and provides for firm physical takeaway for all of our forecasted 2019 Delaware Basin crude oil volumes. This agreement provides us with price diversification through realization of export market pricing that includes access to a Corpus Christi terminal and exposure to Brent-weighted prices. As a result of this agreement, we expect to realize approximately 94 percent of West Texas Intermediate ("WTI") crude oil pricing for our total Delaware Basin production in 2019, after deducting transportation and other related marketing expenses. Our actual realization for Delaware Basin production for 2018 was 95 percent of WTI crude oil pricing. We are currently not producing sufficient volumes to satisfy this volume commitment in the Delaware Basin; although at current commodity prices we have been able to profitably satisfy our obligations under the agreement with volumes purchased from third parties, this may not continue to be the case. Our Delaware Basin natural gas sales agreements run through December 2021 and provide for firm physical takeaway of amounts that vary between 50,000 MMbtu and 115,000 MMbtu per day of our natural gas volumes from the basin during the term of the agreements. We installed additional compression in the Central area of the basin during the third quarter of 2018, which allowed us to move our Central area natural gas volumes with minimal flaring. Our production from the Delaware Basin was not materially affected by midstream or downstream capacity constraints during 2018. However, natural gas takeaway capacity downstream of in-field gathering and processing facilities in the basin is operating close to capacity, and near-term production constraints are possible. As discussed above, NGL fractionation on the Gulf Coast and Conway is running at full capacity, and this could potentially impact the operation of gas plants in the Delaware Basin. In addition, residue pipeline and downstream crude oil pipelines in the Delaware Basin are operating at high utilization rates. We expect additional residue gas and crude oil pipelines to be available in early 2020, and additional NGL fractionation infrastructure to be available starting in mid-2019, with more projects scheduled to be completed in 2020. See Item 1A. Risk Factors - The marketability of our production is dependent upon transportation and processing facilities, the capacity and operation of which we do not control. Market conditions or operational impediments affecting midstream facilities and services could hinder our access to crude oil, natural gas and NGL markets, increase our costs or delay production. Our efforts to address midstream issues may not be successful. Crude Oil, Natural Gas and NGLs Pricing Our results of operations depend upon many factors. Key factors include the price of crude oil, natural gas and NGLs and our ability to market our production effectively. Crude oil, natural gas and NGL prices have a high degree of volatility and our realizations can change substantially. Our realized sales prices for crude oil and NGLs increased and our realized prices for natural gas decreased during 2018 as compared to 2017. NYMEX average daily crude oil prices increased 27 percent and NYMEX first-of-the-month natural gas prices decreased slightly as compared to 2017. Our realized sales prices for crude oil, natural gas and NGLs increased during 2017 compared to 2016. NYMEX crude oil prices increased 18 percent and NYMEX natural gas prices increased 26 percent as compared to 2016. The following tables present weighted-average sales prices of crude oil, natural gas and NGLs for the periods presented. * Percentage change is not meaningful or equal to or greater than 300 percent. Amounts may not recalculate due to rounding. (1) In March 2018, we completed the disposition of our Utica Shale properties. Crude oil, natural gas and NGLs revenues are recognized when we have transferred control of crude oil, natural gas or NGLs production to the purchaser. We consider the transfer of control to have occurred when the purchaser has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the crude oil, natural gas or NGLs production. We record sales revenue based on an estimate of the volumes delivered at estimated prices as determined by the applicable sales agreement. We estimate our sales volumes based on company-measured volume readings. We then adjust our crude oil, natural gas and NGLs sales in subsequent periods based on the data received from our purchasers that reflects actual volumes delivered and actual prices received. Our crude oil, natural gas and NGLs sales are recorded using either the “net-back” or "gross" method of accounting, depending upon the related purchase agreement. We use the net-back method when control of the crude oil, natural gas or NGLs has been transferred to the purchasers of these commodities that are providing transportation, gathering or processing services. In these situations, the purchaser pays us proceeds based on a percent of the proceeds or have fixed our sales price at index less specified deductions. The net-back method results in the recognition of a net sales price that is lower than the indices for which the production is based because the operating costs and profit of the midstream facilities are embedded in the net price we are paid. We use the gross method of accounting when control of the crude oil, natural gas or NGLs is not transferred to the purchasers and the purchaser does not provide transportation, gathering or processing services as a function of the price we receive. Rather, we contract separately with midstream providers for the applicable transport and processing on a per unit basis. Under this method, we recognize revenues based on the gross selling price and recognize transportation, gathering and processing expenses. Under the New Revenue Standard, certain crude oil and natural gas sales that were recognized using the gross method prior to the adoption of the New Revenue Standard are recognized using the net-back method. If we had adopted the New Revenue Standard on January 1, 2017, we estimate that the average realization percentages before transportation, gathering and processing expenses for 2017 would not have differed materially from the average realization percentages shown for the periods shown below. Further, the net realized price after transportation, gathering and processing expenses would not have changed. See the footnote titled Revenue Recognition to our consolidated financial statements included elsewhere in this report for a more detailed discussion. As discussed above, we enter into agreements for the sale and transportation, gathering and processing of our production, the terms of which can result in variances in the per unit realized prices that we receive for our crude oil, natural gas and NGLs. Information related to the components and classifications in the consolidated statements of operations is shown below. For crude oil, the average NYMEX prices shown below are based upon average daily prices throughout each month and, for natural gas, the average NYMEX pricing is based upon first-of-the-month index prices, as in each case this is the method used to sell the majority of these commodities pursuant to terms of the respective sales agreements. For NGLs, we use the NYMEX crude oil price as a reference for presentation purposes. The average realized price both before and after transportation, gathering and processing expenses shown in the table below represents our approximate composite per barrel price for NGLs. Our average realization percentages for crude oil and NGLs for 2018 are consistent with those for 2017. The realization percentage for our natural gas sales has decreased as compared to 2017, primarily due to the widening of the basis between NYMEX and the indices upon which we sell our natural gas production. Commodity Price Risk Management, Net We use commodity derivative instruments to manage fluctuations in crude oil, natural gas and NGLs prices, including collars, fixed-price swaps and basis swaps on a portion of our estimated crude oil, natural gas and propane production. For our commodity swaps, we ultimately realize the fixed price value related to the swaps. See the footnote titled Commodity Derivative Financial Instruments to our consolidated financial statements included elsewhere in this report for a detailed presentation of our derivative positions as of December 31, 2018. Commodity price risk management, net, includes cash settlements upon maturity of our derivative instruments, as well as the change in the fair value of unsettled commodity derivatives related to our crude oil, natural gas and propane production. Commodity price risk management, net, does not include derivative transactions related to our gas marketing, which are included in other income and other expenses. Net settlements of commodity derivative instruments are based on the difference between the crude oil, natural gas and propane index prices at the settlement date of our commodity derivative instruments compared to the respective strike prices contracted for the settlements months that were established at the time we entered into the commodity derivative transaction. The net change in fair value of unsettled commodity derivatives is comprised of the net value increase or decrease in the beginning-of-period fair value of commodity derivative instruments that settled during the period, and the net change in fair value of unsettled commodity derivatives during the period or from inception of any new contracts entered into during the applicable period. The net change in fair value of unsettled commodity derivatives during the period is primarily related to shifts in the crude oil, natural gas and NGLs forward curves and changes in certain differentials. The following table presents net settlements and net change in fair value of unsettled commodity derivatives included in commodity price risk management, net: Lease Operating Expenses Lease operating expenses increased 46 percent to $131.0 million in 2018 compared to $89.6 million in 2017. The increase was primarily due to increases of $8.3 million for workover projects related to increased costs to plug and abandon wells in the Wattenberg Field, $5.7 million related to additional compressor and equipment rentals to combat high line pressures, $5.4 million in environmental remediation expense, $4.9 million related to midstream expense in the Delaware Basin, $4.9 million for payroll and employee benefits related to increases in headcount, $2.6 million related to produced water disposal expense and $1.2 million related to expense for non-operated wells. Lease operating expense per Boe increased by 16 percent to $3.26 for 2018 from $2.82 for 2017. Lease operating expenses were $89.6 million in 2017 compared to $60.0 million in 2016. The $29.6 million increase in lease operating expenses in 2017 as compared to 2016 was primarily due to increases of $9.4 million for payroll and employee benefits related to increases in headcount, $5.6 million for produced water disposal, $5.6 million for increased workover projects, $3.9 million related to additional compressor rentals and $2.2 million for equipment rentals. The increases were slightly offset by a $1.5 million decrease in environmental remediation costs. Lease operating expense per Boe increased by four percent to $2.82 for 2017 from $2.70 for 2016. Production Taxes Production taxes are comprised mainly of severance tax and ad valorem tax, are directly related to crude oil, natural gas and NGLs sales and are generally assessed as a percentage of net revenues. From time to time, there are adjustments to the statutory rates for these taxes based upon activity levels and relative commodity prices from year-to-year. Production taxes increased 49 percent to $90.4 million in 2018 compared to $60.7 million in 2017, primarily due to the 52 percent increase in crude oil, natural gas and NGLs sales for 2018 compared to 2017, as well as an increase in the ad valorem tax rate in the Delaware Basin related to an increase in assessed property values. Production taxes increased 93 percent to $60.7 million in 2017 compared to $31.4 million in 2016, primarily due to the 84 percent increase in crude oil, natural gas and NGLs sales for 2017 compared to 2016, as well as an increase in tax rates. Transportation, Gathering and Processing Expenses Transportation, gathering and processing expenses increased 13 percent to $37.4 million in 2018 compared to 2017 and increased 80 percent in 2017 to $33.2 million compared to 2016. Transportation, gathering and processing expenses are primarily impacted by the volumes delivered through pipelines and for natural gas gathering and transportation operations. The change in 2018 as compared to 2017 is further impacted by decreases resulting from the adoption of the New Revenue Standard and the disposition of the Utica Shale properties. As discussed in Crude Oil, Natural Gas and NGLs Pricing, whether transportation, gathering and processing costs are presented separately or are reflected as a reduction to net revenue is a function of the terms of the relevant marketing contract. Exploration, Geologic and Geophysical Expense The following table presents the major components of exploration, geologic and geophysical expense: Exploratory dry hole costs. During 2017, two exploratory dry holes, associated lease costs and related infrastructure assets in the Delaware Basin were expensed at a cost of $41.3 million. The conclusion to expense these items was based on our determination that the acreage on which these wells was drilled was exploratory in nature and, following drilling, that the hydrocarbon production was insufficient for the wells to be deemed economically viable. Geological and geophysical costs. Geological and geophysical costs in 2018, 2017 and 2016 were primarily related to the portion of the purchase of seismic data related to unproved acreage in the Delaware Basin. Impairment of Properties and Equipment The following table sets forth the major components of our impairments of properties and equipment expense: Impairment of proved and unproved properties. Amounts represent the retirement or expiration of certain leases that are no longer part of our development plan or that we do not plan to extend and will allow to expire. Deterioration of commodity prices or other operating circumstances could result in additional impairment charges. During 2018, we recorded impairment charges totaling $458.4 million as we identified current and anticipated leasehold expirations within the Western Culberson County area of the Delaware Basin and made the determination that we would no longer pursue plans to develop these properties. The impaired non-focus leaseholds typically have a higher gas to oil ratio and a greater degree of geologic complexity than our other Delaware Basin properties. In 2019, we expect that we will allow approximately 18,300 gross (17,900 net) acres of our leaseholds in the Delaware Basin to expire. Of these leaseholds, we expect that approximately 9,500 gross and net acres and 8,600 gross (8,000 net) acres will expire in the first and third quarters, respectively, of 2019. Taking all expected 2019 expirations into account, we anticipate ending 2019 with approximately 40,100 gross (33,500 net) acres in the Delaware Basin. In 2020, we expect that we will allow approximately 3,400 gross (1,800 net) acres of our leaseholds in the Delaware Basin to expire. We are currently exploring strategic alternatives with respect to the acres expected to expire in 2019 and 2020 and believe that we may be able to monetize a portion of this acreage. During 2017, we recorded a charge related to two exploratory dry holes we had drilled in the western area of our Culberson County acreage in the Delaware Basin, as referenced previously. We then assessed the impact of the dry holes and various factors related thereto, including the operational and geologic data obtained, the current increased cost environment for drilling and completion services in the Delaware Basin, our future commodity price outlook and the terms of the related lease agreements. Based on the results of this assessment, we concluded that the underlying geologic risk and the challenged economics of future capital expenditures reduced the likelihood that we would perform future development in this area over the remaining lease term for this acreage. Accordingly, we recorded an impairment of $251.6 million covering approximately 13,400 acres during 2017. The amount of the impairment was based on the value assigned to individual lease acres in the final purchase price allocation of our Delaware Basin acquisition. This allocation included the consideration paid to the sellers, including the effect of the non-cash impact from the deferred tax liability created at the time of the acquisition. We recorded approximately $29 million of additional lease impairments in the Delaware Basin and an impairment charge of $2.1 million related to the Utica Shale Divestiture. Due to the aforementioned events and circumstances, we also evaluated our proved property for possible impairment and concluded that no further impairments were necessary at that time. Impairment of Goodwill During 2017, we recorded goodwill impairment charges of $75.1 million resulting from the purchase price allocation of the assets acquired in the Delaware Basin. The impairment was primarily due to a combination of increases in per well development and operational costs and our drilling of two exploratory dry holes in the Delaware Basin subsequent to the acquisition. In conjunction with our then-current lower future commodity price outlook, we determined that a triggering event had occurred in the quarter ended September 30, 2017. General and Administrative Expense General and administrative expense increased 42 percent to $170.5 million in 2018 compared to 2017. The increase was primarily attributable to a $16.1 million increase in payroll and employee benefits, a $14.0 million increase in legal related costs, a $9.2 million increase in government relations expenses and a $6.3 million increase related to professional services. These increases were partially offset by a $0.9 million decrease related to environmental matters. General and administrative expense increased seven percent to $120.4 million in 2017 compared to 2016. The increase was primarily attributable to an $8.1 million increase in payroll and employee benefits, a $4.4 million increase related to professional services, a $4.2 million increase in legal related costs, a $1.4 million increase in software licenses and subscriptions and a $1.3 million increase for the rental of additional office space. The increases were partially offset by the $12.2 million of legal and professional fees related to the acquisition in the Delaware Basin that were incurred in 2016. Depreciation, Depletion and Amortization Crude oil and natural gas properties. During 2018, 2017 and 2016, we invested $982.7 million, $788.0 million and $396.4 million, net of changes in accounts payable related to capital expenditures, in the development of our crude oil and natural gas properties, respectively. DD&A expense related to crude oil and natural gas properties is directly related to proved reserves and production volumes. DD&A expense related to crude oil and natural gas properties was $551.3 million, $462.5 million and $413.1 million in 2018, 2017 and 2016, respectively. The year-over-year changes in DD&A expense related to crude oil and natural gas properties were primarily due to the following: The following table presents our DD&A expense rates for crude oil and natural gas properties: ____________ (1) The 2016 Delaware Basin rate represents one month of DD&A expense. Accordingly, the comparisons of the 2018 and 2017 rates to the 2016 rate are not meaningful. (2) The Utica Shale properties were classified as held-for-sale during the third quarter of 2017; therefore, we did not record DD&A expense on these properties in 2018. In March 2018, we completed the disposition of our Utica Shale properties. Provision for Uncollectible Notes Receivable In 2016, we recorded a provision for uncollectible notes receivable of $44.0 million to impair two third-party notes receivable whose collection was not reasonably assured. In April 2017, we signed a definitive agreement and simultaneously closed on the sale of one of the associated notes receivable to an unrelated third-party for $40.2 million. Accordingly, we reversed $40.2 million of the provision for uncollectible notes receivable during 2017. Accretion of Asset Retirement Obligations Accretion of asset retirement obligations for 2018 decreased 20 percent to $5.1 million compared to 2017, and decreased 11 percent in 2017 to $6.3 million compared to 2016. The decreases in 2018 and 2017 were due to the replacement of vertical wells that have been plugged and abandoned with horizontal wells, which have a longer expected life. Interest Expense Interest expense decreased by $8.0 million to $70.7 million in 2018 compared to $78.7 million in 2017. The decrease was primarily related to a $38.1 million decrease in interest expense relating to the net settlement of previously outstanding senior notes in December 2017 and a $4.2 million increase in capitalized interest. The decreases were partially offset by a $32.2 million increase in interest expense related to the issuance of our 2026 Senior Notes in November 2017 and a $1.7 million increase in interest related to our revolving credit facility. Interest expense increased by approximately $16.7 million to $78.7 million in 2017 compared to $62.0 million in 2016. The increase is primarily attributable to an $18.0 million increase in interest for the issuance of our 2024 Senior Notes, a $7.4 million increase in interest expense for the issuance of $200 million principal amount of our 1.125% convertible notes due 2021 (the "2021 Convertible Notes") in September 2016, a $3.1 million increase in interest expense for the issuance of our 2026 Notes in November 2017 and a $3.0 million increase in the utilization fee of our revolving credit facility. The increases were partially offset by a $9.3 million charge for a bridge loan commitment related to the 2016 acquisition of properties in the Delaware Basin, a $3.5 million decrease in interest expense resulting from the net settlement of our 2016 Convertible Notes in May 2016 and a $1.8 million decrease in interest expense resulting from the net settlement of our 2022 Notes in December 2017. Interest costs capitalized in 2018, 2017 and 2016 were $9.2 million, $5.0 million and $4.5 million, respectively. Loss on Extinguishment of Debt The $24.7 million loss on extinguishment of debt relates to the redemption of the 2022 Senior Notes during the fourth quarter of 2017. The loss consists of a $19.4 million make-whole premium and the write-off of unamortized debt issuance costs of $5.4 million. Provision for Income Taxes Current income tax (expense) benefit in 2018, 2017 and 2016 was $0.7 million, $8.2 million and $9.9 million, respectively. Current income taxes generally relate to the cash that is paid or recovered for income taxes associated with the applicable period. The remaining portion of the total income tax provision is comprised of deferred income taxes, which are a result of differences in the timing of deductions from our U.S. GAAP presentation of financial statements and the income tax regulations. Our effective income tax rates for 2018, 2017 and 2016 were 72.8 percent, 62.4 percent and 37.4 percent, respectively, on income (loss) from operations. The 2018 rate differs from the federal statutory tax rate primarily due to state taxes, federal tax credits, valuation allowance for state tax attributes and nondeductible expenses that consist primarily of officers' compensation cost and government lobbying expenses. The 2017 rate differs from the federal statutory rate primarily due to the reduction in the federal corporate income tax rate resulting from the 2017 Tax Cuts & Jobs Act ("The 2017 Act"), which increased the tax benefit rate by 33.7 percent. Additionally, the nondeductible goodwill impairment charge in 2017 reduced the 2017 tax rate by 7.7 percent. The 2017 tax rate was also impacted by state taxes. The 2016 rate differs from the federal statutory tax rate, primarily due to state taxes and excess tax benefit from stock compensation, offset by nondeductible expenses that consist primarily of officers' compensation and government lobbying expenses. As of the date of this report, we are current with our income tax filings in all applicable state jurisdictions. We continue to voluntarily participate in the Internal Revenue Service’s ("IRS") Compliance Assurance Program (the "CAP Program") for the 2018 and 2019 tax years. We have received a partial acceptance notice from the IRS for our filed 2017 federal tax return and the IRS's post filing review is currently ongoing. Net Income (Loss)/Adjusted Net Income (Loss) The factors resulting in changes in net income in 2018 and net loss in 2017 and 2016 are discussed above. These same reasons similarly impacted adjusted net income (loss), a non-U.S. GAAP financial measure, with the exception of the net change in fair value of unsettled derivatives, adjusted for taxes, of $198.3 million, $13.1 million and $208.9 million in 2018, 2017 and 2016, respectively. Adjusted net loss, a non-U.S. GAAP financial measure, was $196.3 million, $114.4 million and $37.0 million in 2018, 2017 and 2016 respectively. See Reconciliation of Non-U.S. GAAP Financial Measures, below, for a more detailed discussion of this non-U.S. GAAP financial measure. Financial Condition, Liquidity and Capital Resources Our primary sources of liquidity are cash flows from operating activities, our revolving credit facility, proceeds from debt and equity capital market transactions and asset sales. In 2018, our net cash flows from operating activities were $889.3 million. Our primary source of cash flows from operating activities is the sale of crude oil, natural gas and NGLs. Fluctuations in our operating cash flows are principally driven by commodity prices and changes in our production volumes. Commodity prices have historically been volatile and we manage a portion of this volatility through our use of derivative instruments. We enter into commodity derivative instruments with maturities of no greater than five years from the date of the instrument. Our revolving credit facility imposes limits on the amount of our production we can hedge, and we may choose not to hedge the maximum amounts permitted. Therefore, we may still have fluctuations in our cash flows from operating activities due to the remaining non-hedged portion of our future production. Due to a decreasing leverage ratio that we have recently experienced, the percentage of our expected future production that we currently have hedged is lower than we have historically maintained and we anticipate that this may remain the case in the near future. Our working capital fluctuates for various reasons, including, but not limited to, changes in the fair value of our commodity derivative instruments and changes in our cash and cash equivalents due to our practice of utilizing excess cash to reduce the outstanding borrowings under our revolving credit facility. At December 31, 2018, we had a working capital deficit of $166.6 million compared to a working capital deficit of $16.4 million at December 31, 2017. The decrease in working capital as of December 31, 2018 is primarily the result of a decrease in cash and cash equivalents of $179.3 million related to the Bayswater Asset Acquisition, partially offset by an increase in accounts payable of $31.8 million related to increased development and exploration activity. Our cash and cash equivalents were $1.4 million at December 31, 2018 and availability under our revolving credit facility was $1.3 billion, providing for total liquidity of $1.3 billion as of December 31, 2018. Assuming a NYMEX crude oil price of $50.00, we expect cash flows from operations to exceed our capital investments in crude oil and natural gas properties in 2019 by approximately $25.0 million. We anticipate that capital investments will exceed cash flows from operations during the first half of 2019 and expect cash flows from operations to exceed capital investment during the remainder of the year. Our leverage ratio, as defined in our revolving credit facility agreement, is currently expected to decrease to approximately 1.3 by the end of 2019 based on anticipated production and $50.00 to $55.00 NYMEX crude oil prices. We are in the process of actively marketing our Delaware Basin crude oil gathering, natural gas gathering and produced water gathering and disposal assets for sale and currently expect to execute agreements for the sales of these assets in the first half of 2019. We anticipate making capital investments for midstream assets during 2019, a portion of which would be made prior to such anticipated sales depending on the timing of the divestitures. We expect that we would recover a portion of these expenditures upon settlement of the final sale prices. Based on our expected cash flows from operations, our cash and cash equivalents and availability under our revolving credit facility, we believe that we will have sufficient capital available to fund our planned activities through the 12-month period following the filing of this report. Our revolving credit facility is available for working capital requirements, capital investments, acquisitions, to support letters of credit and for general corporate purposes. The borrowing base is based on, among other things, the loan value assigned to the proved reserves attributable to our crude oil and natural gas interests. The revolving credit facility contains covenants customary for agreements of this type, with the most restrictive being certain financial tests on a quarterly basis. The financial tests, as defined per the revolving credit facility, include requirements to: (a) maintain a minimum current ratio of 1.0:1.0 and (b) not exceed a maximum leverage ratio of 4.0:1.0. At December 31, 2018, we were in compliance with all covenants in the revolving credit facility with a current ratio of 3.3:1.0 and a leverage ratio of 1.4:1.0. We expect to remain in compliance throughout the 12-month period following the filing of this report. The indentures governing our 2024 Senior Notes and 2026 Senior Notes contain customary restrictive covenants that, among other things, limit our ability and the ability of our restricted subsidiaries to: (a) incur additional debt including under our revolving credit facility, (b) make certain investments or pay dividends or distributions on our capital stock or purchase, redeem or retire capital stock, (c) sell assets, including capital stock of our restricted subsidiaries, (d) restrict the payment of dividends or other payments by restricted subsidiaries to us, (e) create liens that secure debt, (f) enter into transactions with affiliates and (g) merge or consolidate with another company. See the footnote titled Long-Term Debt to the accompanying consolidated financial statements included elsewhere in this report for more information regarding our revolving credit facility. Cash Flows Operating Activities. Our net cash flows from operating activities are primarily impacted by commodity prices, production volumes, net settlements from our commodity derivative positions, operating costs and general and administrative expenses. Cash flows provided by operating activities increased by $291.5 million to $889.3 million in 2018 as compared to 2017, primarily due to the increase in crude oil, natural gas and NGLs sales of $476.9 million and an increase in changes in assets and liabilities of $65.1 million. The increases were partially offset by a decrease in derivative commodity settlements of $128.9 million and increases in general and administrative expense of $50.1 million, lease operating expenses of $41.3 million and production taxes of $29.6 million. Cash flows provided by operating activities increased by $111.6 million to $597.8 million in 2017 as compared to 2016, primarily due to the increase in crude oil, natural gas, and NGLs sales of $415.7 million. The increase was partially offset by a decrease in derivative commodity settlements of $194.8 million and increases in lease operating expenses of $29.7 million, production taxes of $29.3 million, interest expense of $16.7 million, transportation, gathering, and processing expenses of $14.8 million, and increases in general and administrative expense of $7.9 million as well as a decrease in changes in assets and liabilities of $13.0 million. Adjusted cash flows from operations, a non-U.S. GAAP financial measure, increased by $226.3 million in 2018 to $808.4 million, and increased by $115.3 million in 2017 to $582.1 million, when compared to the respective prior years. These changes were primarily due to the same factors mentioned above for changes in cash flows provided by operating activities, without regard to changes in assets and liabilities. Adjusted EBITDAX, a non-U.S. GAAP financial measure, increased by $186.2 million in 2018 to $868.3 million from $682.1 million in 2017, primarily as the result of the increase in crude oil, natural gas and NGLs sales of $476.9 million. This increase was partially offset by a decrease in derivative commodity settlements of $128.9 million, an increase in general and administrative expense of $50.1 million, an increase in lease operating expenses of $41.3 million, the sale of the note described below in 2017 to a third-party for $40.2 million, and an increase in production taxes of $29.6 million. Adjusted EBITDAX, a non-U.S. GAAP financial measure, increased by $222.3 million in 2017 to $682.1 million from $459.8 million in 2016, primarily as the result of the increase in crude oil, natural gas, and NGLs sales of $415.7 million, as well as the recording of a provision for a note receivable in 2016 of $44.0 million and the subsequent sale of the note in 2017 to a third-party for $40.2 million. The increase was partially offset by a decrease in derivative commodity settlements of $194.8 million, and increases in lease operating expenses of $29.7 million, production taxes of $29.3 million, interest expense of $16.7 million, transportation, gathering, and processing expenses of $14.8 million, and general and administrative expense of $7.9 million. See Item 7. Reconciliation of Non-U.S. GAAP Financial Measures for a reconciliation of our U.S. GAAP to non-U.S. GAAP financial measures. Investing Activities. Because crude oil and natural gas production from a well declines rapidly in the first few years of production, we continue to invest significant amounts of capital in order to maintain and grow our production and replace our reserves. If capital markets are not available in the future, we will be limited to our cash flows from operations and liquidity under our revolving credit facility as the sources for funding our capital investments. Cash flows from investing activities primarily consist of the acquisition, exploration and development of crude oil and natural gas properties, net of dispositions of crude oil and natural gas properties. Net cash used in investing activities of $1.1 billion during 2018 was primarily related to the purchase price of the Bayswater Asset Acquisition of $179.0 million and our drilling operations, including completion activities, of $946.4 million. Partially offsetting these investments was the receipt of approximately $39.0 million related to the divestiture of our Utica Shale properties. Net cash used in investing activities during 2017 of $717.0 million was primarily related to cash utilized for our drilling operations, including completion activities of $737.2 million, a $21.0 million deposit toward the Bayswater Asset Acquisition, purchases of short-term investments of $49.9 million and a $9.3 million deposit with a third-party transportation service provider for surety of an existing firm transportation obligation. Partially offsetting these investments was the receipt of approximately $49.9 million related to the sale of short-term investments, $40.2 million from the sale of a promissory note and $5.4 million related to post-closing settlements of properties acquired in 2016. Net cash used in investing activities during 2016 of $1.5 billion was primarily related to cash utilized for our acquisition in the Delaware Basin of $1.1 billion and $436.9 million for our drilling operations. Financing Activities. Net cash from financing activities in 2018 of $18.1 million was comprised of net borrowings from our credit facility of $32.5 million, partially offset by $7.7 million of debt issuance costs and $5.1 million related to purchases of our stock. Net cash from financing activities in 2017 of $65.0 million was primarily related to $592.4 million of net proceeds from issuance of the 2026 Senior Notes, partially offset by the $519.4 million used to redeem our 2022 Senior Notes. Net cash from financing activities in 2016 of $1.3 billion was primarily related to the $855.1 million of net proceeds received from the issuance of 9.4 million shares of our common stock, $392.2 million of net proceeds from issuance of the 2024 Senior Notes and $193.9 million of net proceeds from issuance of the 2021 Convertible Notes, partially offset by the $115.0 million payment upon the maturity of the 2016 Convertible Notes and net payments of approximately $37.0 million to pay down amounts borrowed under our revolving credit facility. Contractual Obligations and Contingent Commitments The following table presents our contractual obligations and contingent commitments as of December 31, 2018: __________ (1) Table does not include deferred income tax liability to taxing authorities of $198.1 million due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. (2) Amount presented does not agree with the consolidated balance sheets in that it excludes $22.8 million of unamortized debt discount and $14.9 million of unamortized debt issuance costs. (3) Represents our gross liability related to the fair value of derivative positions. (4) Includes deferred compensation to former executive officers, deferred payments related to firm transportation agreements and capital leases. (5) The table does not include termination benefits related to employment agreements with our executive officers, due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. (6) Amounts presented include $276.0 million to the holders of our 2026 Senior Notes, $147.0 million to the holders of our 2024 Senior Notes and $6.8 million payable to the holders of our 2021 Convertible Notes. Amounts also include interest of $21.0 million related to unutilized commitments at a rate of 0.375 percent per annum. (7) Represents our gross commitment which includes volumes produced by us, purchased from third parties and produced by our affiliated partnerships and other third-party working, royalty and overriding royalty interest owners whose volumes we market on their behalf. This includes anticipated and estimated commitments associated with two new gas processing facilities by our primary mid-stream provider. The timing of such payments has been estimated and is subject to change based on the completion of construction and the commencement of operations by the midstream provider. From time to time, we are a party to various legal proceedings in the ordinary course of business. We are not currently a party to any litigation that we believe would have a materially adverse effect on our business, financial condition, results of operations or liquidity. Information regarding our legal proceedings can be found in the footnote titled Commitments and Contingencies - Litigation and Legal Items to our consolidated financial statements included elsewhere in this report. Critical Accounting Policies and Estimates We have identified the following policies as critical to business operations and the understanding of our results of operations. This is not a comprehensive list of all of the accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP, with no need for our judgment in the application. There are also areas in which our judgment in selecting available alternatives would not produce a materially different result. However, certain of our accounting policies are particularly important to the presentation of our financial position and results of operations and we may use significant judgment in their application. As a result, they are subject to an inherent degree of uncertainty. In applying those policies, we use our judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on historical experience, observation of trends in the industry and information available from other outside sources, as appropriate. For a more detailed discussion on the application of these and other accounting policies, see the footnote titled Summary of Significant Accounting Policies to our consolidated financial statements included elsewhere in this report. Crude Oil and Natural Gas Properties. We account for our crude oil and natural gas properties under the successful efforts method of accounting. Costs of proved developed producing properties, successful exploratory wells and developmental dry hole costs are capitalized and depreciated or depleted by the unit-of-production method based on estimated proved developed producing reserves. Property acquisition costs are depreciated or depleted on the unit-of-production method based on estimated proved reserves. Annually, we engage independent petroleum engineers to prepare reserve and economic evaluations of all our properties on a well-by-well basis as of December 31. We adjust our crude oil and natural gas reserves for major acquisitions, new drilling and divestitures during the year as needed. The process of estimating and evaluating crude oil and natural gas reserves is complex, requiring significant decisions in the evaluation of available geological, geophysical, engineering and economic data. The data for a given property may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and a continual reassessment of the viability of production under changing economic conditions. As a result, revisions in existing reserve estimates occur. Although every reasonable effort is made to ensure that reserve estimates reported represent our most accurate assessments possible, the subjective decisions and variances in available data for various properties increase the likelihood of significant changes in these estimates over time. Because estimates of reserves significantly affect our DD&A expense, a change in our estimated reserves could have an effect on our net income (loss). Exploration costs, including geological and geophysical expenses, the acquisition of seismic data covering unproved acreage and delay rentals, are charged to expense as incurred. Exploratory well drilling costs, including the cost of stratigraphic test wells, are initially capitalized, but are charged to expense if the well is determined to be nonproductive. The status of each in-progress well is reviewed quarterly to determine the proper accounting treatment under the successful efforts method of accounting. Exploratory well costs continue to be capitalized as long as the well has found a sufficient quantity of reserves to justify completion as a producing well and we are making sufficient progress assessing our reserves and economic and operating viability. If an in-progress exploratory well is found to be unsuccessful prior to the issuance of the financial statements, the costs incurred prior to the end of the reporting period are charged to exploration expense. If we are unable to make a final determination about the productive status of a well prior to issuance of the financial statements, the well is classified as a "suspended well" until we have had sufficient time to conduct additional completion or testing operations to evaluate the pertinent geological and engineering data obtained. At the time when we are able to make a final determination of a well’s productive status, the well is removed from suspended well status and the proper accounting treatment is applied. Acquisition costs of unproved properties are capitalized when incurred until such properties are transferred to proved properties or charged to expense. Unproved crude oil and natural gas properties with individually significant acquisition costs are periodically assessed, and any impairment in value is charged to impairment of crude oil and natural gas properties. The amount of impairment recognized on unproved properties which are not individually significant is determined by amortizing the costs of such properties within appropriate fields based on our historical experience, acquisition dates and average lease terms, with the amortization recognized in impairment of properties and equipment. The valuation of unproved properties is subjective and requires us to make estimates and assumptions which, with the passage of time, may prove to be materially different from actual realizable values. We assess our crude oil and natural gas properties for possible impairment annually, or upon a triggering event, by comparing carrying value to estimated undiscounted future net cash flows on a field-by-field basis using estimated production and prices at which we reasonably estimate the commodities will be sold. Any impairment in value is charged to impairment of properties and equipment. The estimates of future prices may differ from current market prices of crude oil and natural gas. Any downward revisions in estimates to our reserve quantities, expectations of falling commodity prices or rising operating costs could result in a triggering event, and therefore, a reduction in undiscounted future net cash flows and an impairment of our crude oil and natural gas properties. Although our cash flow estimates are based on the relevant information available at the time the estimates are made, estimates of future cash flows are, by nature, highly uncertain and may vary significantly from actual results. Crude Oil, Natural Gas and NGLs Sales Revenue Recognition. Crude oil, natural gas and NGLs revenues are recognized when we have transferred control of crude oil, natural gas, or NGLs production to the purchaser. We consider the transfer of control to have occurred when the purchaser has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the crude oil, natural gas or NGLs production. We record sales revenue based on an estimate of the volumes delivered at estimated prices as determined by the applicable sales agreement. We estimate our sales volumes based on company-measured volume readings. We then adjust our crude oil, natural gas and NGLs sales in subsequent periods based on the data received from our purchasers that reflects actual volumes delivered and prices received. We receive payment for sales one to two months after actual delivery has occurred. The differences in sales estimates and actual sales are recorded one to two months later. Historically, these differences have not been material. If a sale is deemed uncollectible, an allowance for doubtful collection is recorded. Fair Value of Financial Instruments. Our fair value measurements are estimated pursuant to a fair value hierarchy that requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date, giving the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable data (Level 3). In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The lowest level input that is significant to a fair value measurement in its entirety determines the applicable level in the fair value hierarchy. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability and may affect the valuation of the assets and liabilities and their placement within the fair value hierarchy levels. The three levels of inputs that may be used to measure fair value are defined as: Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability and inputs that are derived from observable market data by correlation or other means. Level 3 - Unobservable inputs for the asset or liability, including situations where there is little, if any, market activity. Commodity Derivative Financial Instruments. We measure the fair value of our commodity derivative instruments based on a pricing model that utilizes market-based inputs, including but not limited to the contractual price of the underlying position, current market prices, crude oil and natural gas forward curves, discount rates such as the LIBOR curve for a similar duration of each outstanding position, volatility factors and nonperformance risk. Nonperformance risk considers the effect of our credit standing on the fair value of commodity derivative liabilities and the effect of our counterparties' credit standings on the fair value of commodity derivative assets. Both inputs to the model are based on published credit default swap rates and the duration of each outstanding commodity derivative position. We validate our fair value measurement through the review of counterparty statements and other supporting documentation, the determination that the source of the inputs is valid, the corroboration of the original source of inputs through access to multiple quotes, if available, or other information and monitoring changes in valuation methods and assumptions. Net settlements on our commodity derivative instruments are initially recorded to accounts receivable or payable, as applicable, and may not be received from or paid to counterparties to our commodity derivative contracts within the same accounting period. Such settlements typically occur the month following the maturity of the commodity derivative instrument. We have evaluated the credit risk of the counterparties holding our commodity derivative assets, which are primarily financial institutions who are also major lenders in our revolving credit facility, giving consideration to amounts outstanding for each counterparty and the duration of each outstanding commodity derivative position. Based on our evaluation, we have determined that the potential impact of nonperformance of our counterparties on the fair value of our commodity derivative instruments is not significant. Deferred Income Tax Asset Valuation Allowance. Deferred income tax assets are recognized for deductible temporary differences, net operating loss carry-forwards and credit carry-forwards if it is more likely than not that the tax benefits will be realized. To the extent a deferred tax asset is not expected to be realized under the preceding criteria, we establish a valuation allowance. The factors which we consider in assessing whether we will realize the value of deferred income tax assets involve judgments and estimates of both amount and timing. The judgments used in applying these policies are based on our evaluation of the relevant facts and circumstances as of the date of the financial statements. Actual results may differ from those estimates. Accounting for Business Combinations. We utilize the purchase method to account for acquisitions of businesses and assets. The value of the purchase consideration takes into account the degree to which the consideration is objective and measurable such as cash consideration paid to a seller. With the issuance of equity, restrictions upon the sale of the issued stock are taken into consideration. Pursuant to purchase method accounting, we allocate the cost of the acquisition to assets acquired and liabilities assumed based on fair values as of the acquisition date. The purchase price allocations are based on appraisals, discounted cash flows, quoted market prices and estimates by management. When appropriate, we review comparable purchases and sales of crude oil and natural gas properties within the same regions and use that data as a basis for fair market value as such sales represent the amount at which a willing buyer and seller would enter into an exchange for such properties. In estimating the fair values of assets acquired and liabilities assumed, we make various assumptions. The most significant assumptions relate to the estimated fair values assigned to proved developed producing, proved developed non-producing, proved undeveloped and unproved crude oil and natural gas properties and other non-crude oil and natural gas properties. To estimate the fair values of these properties, we prepare estimates of crude oil and natural gas reserves. We estimate future prices by using the applicable forward pricing strip to apply to our estimate of reserve quantities acquired, and estimates of future operating and development costs to arrive at an estimate of future net revenues. For estimated proved reserves, the future net revenues are discounted using a market-based weighted-average cost of capital rate determined appropriate at the time of the acquisition. The market-based weighted-average cost of capital rate is subject to additional project-specific risking factors. To compensate for the inherent risk of estimating and valuing unproved properties, we reduce the discounted future net revenues of probable and possible reserves by additional risk-weighting factors. Additionally, for acquisitions with significant unproved properties, we complete an analysis of comparable purchased properties to determine an estimation of fair value. If applicable, we record deferred taxes for any differences between the assigned values and tax basis of assets and liabilities. Estimated deferred taxes are based on available information concerning the tax basis of assets acquired and liabilities assumed and loss carryforwards at the acquisition date, although such estimates may change in the future as additional information becomes known. Acreage Exchanges. From time to time, we enter into acreage exchanges in order to consolidate our core acreage positions, enabling us to have more control over the timing of development activities, achieve higher working interests and providing us the ability to drill longer lateral length wells within those core areas. We account for our nonmonetary acreage exchanges of non-producing interests and unproved mineral leases in accordance with the guidance prescribed by Accounting Standards Codification 845, Nonmonetary Transactions. For those exchanges that lack commercial substance, we record the acreage received at the net carrying value of the acreage surrendered to obtain it. For those acreage exchanges that are deemed to have commercial substance, we record the acreage received at fair value, with a related gain or loss recognized in earnings, in accordance with Accounting Standards Codification 820, Fair Value Measurement. Recent Accounting Standards See the footnote titled Summary of Significant Accounting Policies - Recently Adopted Accounting Standards to our consolidated financial statements included elsewhere in this report. Reconciliation of Non-U.S. GAAP Financial Measures We use "adjusted cash flows from operations," "adjusted net income (loss)" and "adjusted EBITDAX," non-U.S. GAAP financial measures, for internal management reporting, when evaluating period-to-period changes and, in some cases, providing public guidance on possible future results. These measures are not measures of financial performance under U.S. GAAP and should be considered in addition to, not as a substitute for, net income (loss) or cash flows from operations, investing or financing activities and should not be viewed as liquidity measures or indicators of cash flows reported in accordance with U.S. GAAP. The non-U.S. GAAP financial measures that we use may not be comparable to similarly titled measures reported by other companies. Also, in the future, we may disclose different non-U.S. GAAP financial measures in order to help our investors more meaningfully evaluate and compare our future results of operations to our previously reported results of operations. We strongly encourage investors to review our financial statements and publicly filed reports in their entirety and not rely on any single financial measure. Adjusted cash flows from operations. We define adjusted cash flows from operations as the cash flows earned or incurred from operating activities, without regard to changes in operating assets and liabilities. We believe it is important to consider adjusted cash flows from operations, as well as cash flows from operations, as we believe it often provides more transparency into what drives the changes in our operating trends, such as production, prices, operating costs and related operational factors, without regard to whether the related asset or liability was received or paid during the same period. We also use this measure because the timing of cash received from our assets, cash paid to obtain an asset or payment of our obligations has generally been a timing issue from one period to the next as we have not had significant accounts receivable collection problems, nor been unable to purchase assets or pay our obligations. Adjusted net income (loss). We define adjusted net income (loss) as net income (loss), plus loss on commodity derivatives, less gain on commodity derivatives and net settlements on commodity derivatives, each adjusted for tax effect. We believe it is important to consider adjusted net income (loss), as well as net income (loss). We believe this measure often provides more transparency into our operating trends, such as production, prices, operating costs, net settlements from derivatives and related factors, without regard to changes in our net income (loss) from our mark-to-market adjustments resulting from net changes in the fair value of unsettled derivatives. Additionally, other items which are not indicative of future results may be excluded to clearly identify operating trends. Adjusted EBITDAX. We define adjusted EBITDAX as net income (loss), plus loss on commodity derivatives, interest expense, net of interest income, income taxes, impairment of properties and equipment, exploration, geologic and geophysical expense, depreciation, depletion and amortization expense, accretion of asset retirement obligations and non-cash stock-based compensation, less gain on commodity derivatives and net settlements on commodity derivatives. Adjusted EBITDAX is not a measure of financial performance or liquidity under U.S. GAAP and should be considered in addition to, not as a substitute for, net income (loss), and should not be considered an indicator of cash flows reported in accordance with U.S. GAAP. Adjusted EBITDAX includes certain non-cash costs incurred by us and does not take into account changes in operating assets and liabilities. Other companies in our industry may calculate adjusted EBITDAX differently than we do, limiting its usefulness as a comparative measure. We believe adjusted EBITDAX is relevant because it is a measure of our operational and financial performance, as well as a measure of our liquidity, and is used by our management, investors, commercial banks, research analysts, and others to analyze such things as: • operating performance and return on capital as compared to our peers; • financial performance of our assets and our valuation without regard to financing methods, capital structure or historical cost basis; • our ability to generate sufficient cash to service our debt obligations; and • the viability of acquisition opportunities and capital expenditure projects, including the related rate of return. PV-10. We define PV-10 as the estimated present value of the future net cash flows from our proved reserves before income taxes, discounted using a 10 percent discount rate. We believe that PV-10 provides useful information to investors as it is widely used by professional analysts and sophisticated investors when evaluating oil and gas companies. We believe that PV-10 is relevant and useful for evaluating the relative monetary significance of our reserves. Professional analysts, investors and other users of our financial statements may utilize the measure as a basis for comparison of the relative size and value of our reserves to other companies' reserves. Because there are many unique factors that can impact an individual company when estimating the amount of future income taxes to be paid, we believe the use of a pre-tax measure is valuable in evaluating us and our reserves. PV-10 is not intended to represent the current market value of our estimated reserves. The following table presents a reconciliation of our non-U.S. GAAP financial measures to its most comparable U.S. GAAP measure:

<s>[INST] SUMMARY 2018 Financial Overview of Operations and Liquidity Production volumes increased 26 percent to 40.2 MMBoe in 2018 compared to 2017. The increase in production volumes was primarily attributable to the continued success of our horizontal Niobrara and Codell drilling program in the Wattenberg Field and growing production from our horizontal Wolfcamp drilling program in our Delaware Basin properties. Crude oil production increased 32 percent in 2018 and comprised approximately 42 percent of our total production. Natural gas production increased 23 percent and NGLs production increased 22 percent in 2018 compared to 2017. On a combined basis, total liquids production of crude oil and NGLs comprised 63 percent of production in 2018. For the month ended December 31, 2018, we maintained an average production rate of approximately 129,000 Boe per day, up from approximately 97,000 Boe per day for the month ended December 31, 2017. Crude oil, natural gas and NGLs sales increased to $1.4 billion in 2018 compared to $913.1 million in 2017, due to a 26 percent increase in production, combined with a 21 percent increase in weighted average realized commodity prices. Crude oil, natural gas and NGLs sales increased 84 percent in 2017 as compared to 2016 due to a 44 percent increase in production, combined with a 28 percent increase in average realized commodity prices. We had negative net settlements from our commodity derivative contracts of $115.5 million for 2018 as compared to positive net settlements of $13.3 million and $208.1 million for 2017 and 2016, respectively. See Results of Operations Commodity Price Risk Management, Net for further details of our settlements of derivatives and changes in the fair value of unsettled derivatives. The combined revenue from crude oil, natural gas and NGLs sales and net settlements received on our commodity derivative instruments increased 38 percent to $1.3 billion in 2018 from $926.4 million in 2017. Such combined revenue of $926.4 million in 2017 represented an increase of 31 percent from $705.5 million in 2016. During 2018, we recorded unproved and proved property impairment charges of $458.4 million, primarily resulting from identified current and anticipated nearterm leasehold expirations within our nonfocus areas of the Delaware Basin and our determination that we would no longer pursue plans to develop these properties. For more information regarding these charges see Results of Operations Impairments of Properties. In 2018, we generated a net income of $2.0 million or $0.03 per diluted share. Our net income was most negatively impacted by the aforementioned impairment charges. During the same period, our adjusted EBITDAX, a nonU.S. GAAP financial measure, was $868.3 million, up 27 percent relative to 2017. See Reconciliation of NonU.S. GAAP Financial Measures, below, for a more detailed discussion of adjusted EBITDAX and a reconciliation of adjusted EBITDAX to net income and cash from operating activities. The increase in our 2018 adjusted EBITDAX as compared to 2017 was primarily the result of the increase in crude oil, natural gas and NGLs sales of $476.9 million. This increase was partially offset by a decrease in derivative commodity settlements of $128.9 million, an increase in operating costs of $125.3 million and the reversal of a provision for uncollectible notes receivable of $40.2 million in 2017. In 2017 and 2016, our net loss per diluted share was $1.94 and $5.01, respectively, and our adjusted EBITDAX was $682 [/INST] Positive. </s>

PDC ENERGY, INC.

2020-02-27

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with our consolidated financial statements and related notes thereto included elsewhere in this report. A discussion of changes in our results of operations from 2017 to 2018 has been omitted from this report, but may be found in Item 7, Management's Discussion and Analysis, of our Annual Report on Form 10-K for the year ended December 31, 2018, filed with the SEC on February 28, 2019. Further, we encourage you to revisit the Special Note Regarding Forward-Looking Statements in Part I of this report. EXECUTIVE SUMMARY 2019 Financial Overview of Operations and Liquidity Production volumes increased 23 percent to 49.4 MMBoe in 2019 compared to 2018. The increase in production volumes was primarily attributable to the continued success of our horizontal Niobrara and Codell drilling program in the Wattenberg Field and growing production from our horizontal Wolfcamp drilling program in our Delaware Basin properties. Total liquids production of crude oil and NGLs comprised 61 percent of production in 2019. For the month ended December 31, 2019, we maintained an average production rate of approximately 139,000 Boe per day, up from approximately 129,000 Boe per day for the month ended December 31, 2018. Crude oil, natural gas and NGLs sales decreased to $1.3 billion in 2019 compared to $1.4 billion in 2018, driven by a 24 percent decrease in weighted-average realized commodity prices, partially offset by the 23 percent increase in production. We had negative net settlements from commodity derivative contracts of $17.6 million for 2019 as compared to negative net settlements of $115.5 million for 2018. The combined revenue from crude oil, natural gas and NGLs sales and net settlements received on our commodity derivative instruments was $1.3 billion in both 2019 and 2018. In 2019, we generated a net loss of $56.7 million or, $0.89 per diluted share, compared to net income of $2.0 million, or $0.03 per diluted share, in 2018. Adjusted EBITDAX, a non-U.S. GAAP financial measure, was $882.7 million in 2019, up two percent from $868.7 million in 2018. Net cash flows from operating activities in 2019 and 2018 were $858.2 million and $889.3 million, respectively, and adjusted cash flows from operations, a non-U.S. GAAP financial measure, were $825.4 million and $808.4 million, respectively. Free cash flow, a non-U.S. GAAP financial measure, was $37.7 million for 2019 as compared to a deficit of $174.3 million for 2018. See Reconciliation of Non-U.S. GAAP Financial Measures below for a more detailed discussion of these non-U.S. GAAP financial measures and a reconciliation of these measures to the most comparable U.S. GAAP measures. Acquisition In January 2020, we merged with SRC in a transaction valued at $1.7 billion, inclusive of SRC's net debt. Upon closing, we issued approximately 39 million shares of our common stock to SRC shareholders, reflecting issuance of 0.158 of a share of our common stock in exchange for each share of SRC common stock held. Liquidity Available liquidity as of December 31, 2019 was $1.3 billion, primarily due to $1.3 billion available for borrowing under our revolving credit facility. In October 2019, as part of our semi-annual redetermination, the borrowing base on our revolving credit facility was reaffirmed at $1.6 billion and we elected to retain our commitment amount at $1.3 billion. Pursuant to closing the SRC Acquisition, the borrowing base on our revolving credit facility increased to $2.1 billion and we elected to increase the aggregate commitment amount under the facility to $1.7 billion. As part of the SRC Acquisition, we assumed $550 million in 6.25% Senior Notes due December 2025 and paid off and terminated SRC's revolving credit facility, which had an outstanding balance of $165 million at closing. The indenture governing the SRC Senior Notes has a change of control provision and on January 17, 2020, we commenced an offer to repurchase the SRC Senior Notes at 101 percent of the principal amount of the notes, together with any accrued and unpaid interest to the date of purchase. Upon expiration of the repurchase offer on February 18, 2020, holders of $447.7 million of the outstanding SRC Senior Notes accepted our redemption offer for a total redemption price of approximately $452.2 million, plus accrued and unpaid interest of $6.2 million. We funded the repurchase with proceeds from our revolving credit facility. Had we closed the SRC Acquisition in 2019 with our new commitment level, we estimate that our available liquidity as of December 31, 2019 would have been approximately $1.6 billion, comprised of approximately $66.6 million of cash and cash equivalents and approximately $1.5 billion available for borrowing under our revolving credit facility. Stock Repurchase Program In April 2019, the Board approved the acquisition of up to $200 million of our outstanding common stock, dependent on market conditions (the "Stock Repurchase Program"). Effective with the closing of the SRC Acquisition, the Board approved an increase and extension of the Stock Repurchase Program from $200 million to $525 million with a target completion date of December 31, 2021. Pursuant to the Stock Repurchase Program, we repurchased 4.7 million shares of outstanding common stock at a cost of $154.4 million during 2019. Subsequent to December 31, 2019, we repurchased approximately 0.6 million shares of our outstanding common stock at a cost of $12.5 million. As of February 24, 2020, $358.2 million of our outstanding common stock remained available for repurchase under the Stock Repurchase Program. Midstream Asset Divestitures In the second quarter of 2019, we completed the Midstream Asset Divestitures for an aggregate cash purchase price of $345.6 million ($263.6 million of which was paid upon closing with $82.0 million to be paid in June 2020), subject to certain customary post-closing adjustments, plus potential future long-term incentive payments. We do not currently expect to meet the conditions to receive these incentive payments. Proceeds were allocated first to the assets sold based upon the fair values of the tangible assets, with $179.6 million allocated to the acreage dedication agreements. 2019 Drilling Overview During 2019, we ran three drilling rigs in the Wattenberg Field through mid-September and then dropped to a two-rig pace through the remainder of the year. In the Delaware Basin, we ran three rigs through May 2019 and then dropped to a two-rig pace through the remainder of the year. The following tables summarizes our drilling and completion activity for the year ended December 31, 2019: Our in-process wells represent wells that are in the process of being drilled and/or have been drilled and are waiting to be fractured and/or for gas pipeline connection. Our drilled uncompleted wells are generally completed and turned-in-line within a year of drilling. 2020 Operational and Financial Outlook We anticipate that our total production for 2020 will range between 205,000 Boe to 215,000 Boe per day, approximately 78,000 Bbls to 82,000 Bbls of which are expected to be crude oil. Our planned 2020 capital investments in crude oil and natural gas properties, which we expect to be between $1.0 billion and $1.1 billion, are focused on continued execution of our development plans in the Wattenberg Field, including acreage received in the SRC Acquisition, and the Delaware Basin. We believe that we maintain a degree of operational flexibility to control the pace of our capital spending. As we execute our capital investment program, we continually monitor, among other things, expected rates of return, the political environment and our remaining inventory in order to best meet our short- and long-term corporate strategy. Should commodity pricing or the operating environment deteriorate, we may determine that an adjustment to our development plan is appropriate. Wattenberg Field. We are drilling in the horizontal Niobrara and Codell plays in the rural areas of the core Wattenberg Field, which is further delineated between the Kersey, Prairie and Plains development areas, as well as the mix of rural and municipal acreage received in the SRC Acquisition. Our 2020 capital investment program for the Wattenberg Field is approximately 75 percent of our expected total capital investments in crude oil and natural gas properties, of which approximately 95 percent is expected to be invested in operated drilling and completion activity. The majority of the wells we plan to drill in 2020 in the Wattenberg Field are standard-reach lateral (“SRL”), mid-reach lateral (“MRL”) and extended-reach lateral (“XRL”) wells. In 2020, we anticipate spudding approximately 150 to 175 operated wells and turning-in-line approximately 200 to 225 operated wells. We expect to drill at a three-rig pace in 2020 with an average development cost per well of between $2.7 million and $4.5 million, depending upon the lateral length of the well. The remainder of the Wattenberg Field capital investment program is expected to be used for non-operated drilling, land, capital workovers and facilities projects. Delaware Basin. Our 2020 capital investment program for the Delaware Basin contemplates operating a single rig into the third quarter, with a second rig planned for the remainder of the year. Total capital investments in crude oil and natural gas properties in the Delaware Basin for 2020 are expected to be approximately 25 percent of our total capital investments in crude oil and natural gas properties, of which approximately 90 percent is expected to be invested in operated drilling and completion activity. In 2020, we anticipate spudding approximately 15 to 20 operated wells and turn-in-line approximately 20 to 25 operated wells. The majority of the wells we plan to drill in 2020 in the Delaware Basin are MRL and XRL wells. We expect average development costs per well of between $9.5 million and $11.0 million, depending upon the lateral length of the well. We do not plan to drill any SRL wells in the Delaware Basin in 2020. Financial Guidance. We are committed to our disciplined approach to managing our development plans. Based on our current production forecast for 2020 and assumed average NYMEX prices of $52.50 per Bbl of crude oil and $2.00 per Mcf of natural gas and an assumed average composite price of $11.00 per Bbl for NGLs, we expect 2020 adjusted cash flows from operations, a non-U.S. GAAP financial measure, to exceed our capital investments in crude oil and natural gas properties by approximately $250 million. Assuming consistent realization percentages, we estimate that for every: • $2.50 change in the NYMEX crude oil price from $52.50, our adjusted cash flows from operations would increase or decrease by approximately $30 million; • $0.25 change in the NYMEX natural gas price from $2.00, our adjusted cash flows from operations would increase or decrease by approximately $20 million; and • $1.00 change in the composite price for NGLs from $11.00, our adjusted cash flows from operations would increase or decrease by approximately $20 million. We may revise our 2020 capital investment program during the year as a result of, among other things, changes in commodity prices or our internal long-term outlook for commodity prices, requirements to hold acreage, the cost of services for drilling and well completion activities, drilling results, changes in our borrowing capacity, a significant change in cash flows, regulatory issues, requirements to maintain continuous activity on leaseholds or acquisition and/or divestiture opportunities. The following table provides projected financial guidance for 2020: On a per unit basis and excluding transaction costs incurred related to the SRC Acquisition of approximately $30 million, we expect our general and administrative expense to be in the range of $1.90 to $2.10 per Boe for 2020. Ballot Initiative Update Certain interest groups in Colorado opposed to oil and natural gas development generally, and hydraulic fracturing in particular, have advanced various alternatives for ballot initiatives which would result in significantly limiting or preventing oil and natural gas development in the state. Proponents of such initiatives have begun the process of attempting to qualify six initiatives to appear on the ballot in November 2020. Five of the initiatives are focused on increased setbacks, with differing distances and criteria, and one is focused on bonding requirements. These initiatives will undergo a review by the Colorado Legislative Council, and will be the subject of other procedural requirements. If those requirements are satisfied, proponents of the initiatives can begin the process of collecting the signatures needed to qualify them for the November 2020 ballot. We do not know what the outcome of this process will be; however, a similar setback ballot initiative, Proposition 112, qualified for the ballot but failed to pass in 2018. Because approximately 81 percent of our proved reserves are located in Colorado, the risks we face with respect to these proposals, and possible similar future proposals, are greater than those of our competitors with more geographically diverse operations. We cannot predict the outcome of the potentially pending initiatives or possible future regulatory developments. See Part I, Item1A, Risk Factors, for additional information regarding the ballot initiatives. Results of Operations Summary Operating Results The following table presents selected information regarding our operating results: * Percentage change is not meaningful. Amounts may not recalculate due to rounding. (1) In March 2018, we completed the disposition of our Utica Shale properties. Crude Oil, Natural Gas and NGLs Sales The year-over-year change in crude oil, natural gas and NGLs sales revenue were primarily due to the following: Crude Oil, Natural Gas and NGLs Production The following table presents crude oil, natural gas and NGLs production. * Percentage change is not meaningful. Amounts may not recalculate due to rounding. (1) In March 2018, we completed the disposition of our Utica Shale properties. The following table presents our crude oil, natural gas and NGLs production ratio by operating region: (1) In March 2018, we completed the disposition of our Utica Shale properties. Midstream Capacity Our ability to market our production depends substantially on the availability, proximity and capacity of gathering systems, pipelines and processing facilities owned and operated by third parties. If adequate midstream facilities and services are not available to us on a timely basis and at acceptable costs, our production and results of operations could be adversely affected. In recent years, there has been substantial development drilling in our current areas of operation, and this has made it more challenging for providers of midstream infrastructure and services to keep pace with the corresponding increases in field-wide production. The ultimate timing and availability of adequate infrastructure is not within our control and we could experience capacity constraints for extended periods of time that could negatively impact our ability to meet our production targets. Weather, regulatory developments and other factors also affect the adequacy of midstream infrastructure. Like other producers, we from time to time enter into volume commitments with midstream providers in order to incentivize them to provide increased capacity to sufficiently meet our projected volume growth from our areas of operation. If our production falls below the level required under these agreements, we could be subject to transportation charges or aid in construction payments for commitment shortfalls. Wattenberg Field. Elevated line pressures on gas gathering facilities operated by DCP have adversely affected production from our Wattenberg Field operations from mid-2017 to the early fourth quarter of 2019. However, beginning in the mid-fourth quarter of 2019, through the combination of DCP’s continued system expansions and the availability of additional NGLs takeaway capacity out of the basin, DCP was able to more meaningfully reduce line pressures through most of our operated areas of the Wattenberg Field. As a result of the decreased line pressures, we experienced increased production volumes in the Wattenberg Field in the fourth quarter of 2019 from incremental NGL takeaway expansion projects and increased firm residue gas space obtained by DCP. As we exited 2019, DCP was able to utilize the full capacity of the O’Connor II plant. As midstream development continues in the field, we anticipate having the ability to move additional volumes on DCP’s system with the start-up of the Cheyenne Connector residue pipeline planned for mid-second quarter of 2020 and the completion of DCP in-basin infrastructure designed to deliver gas volumes to the Latham II plant, which is expected in mid-2020. Our production in the Wattenberg Field is significantly dependent on DCP's gathering system, and this reliance increased considerably when we closed the SRC Acquisition. We continue to work with our midstream service providers in an effort to ensure all of the existing in-basin infrastructure is fully utilized and that all options for system expansion are evaluated and implemented to the extent possible to accommodate projected future volume growth from the field. NGL fractionation on the Gulf Coast and Conway continues to operate at or near full capacity and this could potentially impact the operation of gas plants in the Wattenberg Field. Our Wattenberg Field operations are not currently being impacted by NGL fractionation capacity constraints; however, limitations on downstream fractionation capacity could limit the ability of our service providers to adjust ethane and propane recoveries to optimize the plant product mix to maximize revenue. Additional fractionation capacity came online during 2019 and additional capacity is expected to become available throughout 2020. Delaware Basin. Our production from the Delaware Basin was not materially affected by midstream or downstream capacity constraints during 2019. However, despite the completion and start-up of a new natural gas residue pipeline, natural gas takeaway capacity downstream of in-field gathering and processing facilities in the basin continues to operate close to capacity and near-term production constraints, and lower natural gas netback pricing, are likely until at least the first quarter of 2021, when the next natural gas residue pipeline out of the basin is scheduled to be commissioned. As discussed above, NGL fractionation on the Gulf Coast and at Conway is running at or near full capacity, and this could potentially impact the operation of gas plants in the Delaware Basin. Two new crude oil pipelines out of the Permian Basin were recently completed and are now operational. As a result, we believe the crude oil takeaway constraints that were experienced in 2018 and early 2019 have been somewhat alleviated for the near future. Crude Oil, Natural Gas and NGLs Pricing Our results of operations depend upon many factors. Key factors include market prices of crude oil, natural gas and NGLs and our ability to market our production effectively. Crude oil, natural gas and NGLs prices have a high degree of volatility and our realizations can change substantially. Our realized sales prices for crude oil, natural gas and NGLs decreased during 2019 as compared to 2018. NYMEX average daily crude oil and NYMEX first-of-the-month natural gas prices decreased 12 percent and 15 percent, respectively, as compared to 2018. The following tables present weighted-average sales prices of crude oil, natural gas and NGLs for the periods presented: * Percentage change is not meaningful. Amounts may not recalculate due to rounding. (1) In March 2018, we completed the disposition of our Utica Shale properties. Crude oil, natural gas and NGLs revenues are recognized when we transfer control of crude oil, natural gas or NGLs production to the purchaser. We consider the transfer of control to occur when the purchaser has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the crude oil, natural gas or NGLs production. We record sales revenue based on an estimate of the volumes delivered at estimated prices as determined by the applicable sales agreement. We estimate our sales volumes based on company-measured volume readings. We then adjust our crude oil, natural gas and NGLs sales in subsequent periods based on the data received from our purchasers that reflects actual volumes delivered and prices received. Our crude oil, natural gas and NGLs sales are recorded using either the “net-back” or "gross" method of accounting, depending upon the related purchase agreement. We use the net-back method when control of the crude oil, natural gas or NGLs has been transferred to the purchasers of these commodities that are providing transportation, gathering or processing services. In these situations, the purchaser pays us based on a percent of proceeds or a sales price fixed at index less specified deductions. The net-back method results in the recognition of a net sales price that is lower than the index on which the production is based because the operating costs and profit of the midstream facilities are embedded in the net price we are paid. We use the gross method of accounting when control of the crude oil, natural gas or NGLs is not transferred to the purchaser and the purchaser does not provide transportation, gathering or processing services as a function of the price we receive. Rather, we contract separately with midstream providers for the applicable transportation and processing on a per unit basis. Under this method, we recognize revenues based on the gross selling price and recognize transportation, gathering and processing expenses. As discussed above, we enter into agreements for the sale and transportation, gathering and processing of our production, the terms of which can result in variances in the per unit realized prices that we receive for our crude oil, natural gas and NGLs. Information related to the components and classifications in the consolidated statements of operations is shown below. For crude oil, the average NYMEX prices shown below are based on average daily prices throughout each month and, for natural gas, the average NYMEX pricing is based on first-of-the-month index prices, as in each case this is the method used to sell the majority of these commodities pursuant to terms of the relevant sales agreements. For NGLs, we use the NYMEX crude oil price as a reference for presentation purposes. The average realized price both before and after transportation, gathering and processing expenses shown in the table below represents our approximate composite per barrel price for NGLs. Our average realization percentages for crude oil in 2019 were consistent with those for 2018. The realization percentage for our natural gas sales decreased as compared to 2018, primarily due to widening of the basis between NYMEX and the indices upon which we sell our natural gas production. In the Delaware Basin, we experienced certain months during 2019 when the transportation, gathering and processing cost to deliver our natural gas to market exceeded the price we received. The realization percentages for our NGLs sales also decreased as compared to 2018, primarily due to reductions in prices for the individual NGLs components for 2019 as compared to the same periods in 2018. As noted above, average NYMEX prices for both crude oil and natural gas during 2019 decreased as compared to 2018, resulting in lower average realizations. Based on our current pricing projections, we expect realizations in 2020 to decrease relative to 2019. Commodity Price Risk Management We use commodity derivative instruments to manage fluctuations in crude oil and natural gas prices, including fixed-price swaps, collars and basis protection swaps on a portion of our estimated crude oil and natural gas production. For our commodity swaps, we ultimately realize the fixed price value related to the swaps. See the footnote titled Commodity Derivative Financial Instruments to our accompanying consolidated financial statements included elsewhere in this report for a summary of our derivative positions as of December 31, 2019. Commodity price risk management, net, includes cash settlements upon maturity of our derivative instruments, as well as the change in fair value of unsettled commodity derivatives related to our crude oil and natural gas production. Net settlements of commodity derivative instruments are based on the difference between the crude oil and natural gas index prices at the settlement date of our commodity derivative instruments compared to the respective strike prices contracted for the settlement months that were established at the time we entered into the commodity derivative transaction. The net change in fair value of unsettled commodity derivatives is comprised of the net increase or decrease in the beginning-of-period fair value of commodity derivative instruments that settled during the period and the net change in fair value of unsettled commodity derivatives during the period or from inception of any new contracts entered into during the applicable period. The net change in fair value of unsettled commodity derivatives during the period is primarily related to shifts in the crude oil and natural gas forward curves and changes in certain differentials. The following table presents net settlements and net change in fair value of unsettled derivatives included in commodity price risk management, net: Lease Operating Expenses Lease operating expenses increased nine percent to $142.2 million in 2019 compared to $131.0 million in 2018, primarily due to wells turned-in-line during 2019. Significant changes in lease operating expenses included increases of $10.5 million related to produced water disposal expense, $4.7 related to additional compressor and equipment rental, $2.4 million related to expense for non-operated wells, $2.1 million for payroll and employee benefits related to increases in headcount and $1.4 million related to chemical treatments. The increases were partially offset by decreases of $6.3 million related to workover projects and $4.7 million related to midstream expense resulting from the sale of Delaware Basin midstream assets during the second quarter of 2019. Lease operating expense per Boe decreased by 12 percent to $2.88 for 2019 from $3.26 for 2018. Production Taxes Production taxes, which are comprised mainly of severance tax and ad valorem tax, are directly related to crude oil, natural gas and NGLs sales and are generally assessed as a percentage of net revenues. From time to time, there are adjustments to the statutory rates for these taxes based upon certain credits that are determined by activity levels and relative commodity prices from year-to-year. Production taxes decreased 11 percent to $80.8 million in 2019 compared to $90.4 million in 2018, primarily due to the six percent decrease in crude oil, natural gas and NGLs sales for 2019 compared to 2018, refunds of ad valorem tax related to high-cost natural gas wells and a decrease in ad valorem tax rates in the Delaware Basin. Transportation, Gathering and Processing Expenses Transportation, gathering and processing expenses are primarily impacted by the volumes delivered through pipelines and for natural gas gathering and transportation operations. Transportation, gathering and processing expenses increased 24 percent to $46.4 million in 2019 compared to $37.4 million in 2018, primarily due to an increase in production. Transportation, gathering and processing expenses per Boe remained consistent at $0.94 for 2019 compared to $0.93 for 2018. Exploration, Geologic and Geophysical Expense Geological and geophysical costs. Geological and geophysical costs of $4.1 million in 2019 compared to $6.2 million in 2018 were primarily for the purchase of seismic data related to unproved acreage in the Delaware Basin. Impairment of Properties and Equipment The following table sets forth the major components of our impairment of properties and equipment: During 2019 and 2018, we recorded impairment charges totaling $10.6 million and $458.4 million, respectively, related to the divestiture of leaseholds and then-current and anticipated near-term leasehold expirations within our non-focus areas of the Delaware Basin that we determined not to develop. We determined the fair value of the properties based upon estimated future discounted cash flow, a Level 3 input, using estimated production and prices at which we reasonably expect the crude oil and natural gas will be sold. During 2019, we also recorded impairments of $27.9 million related to certain midstream facility infrastructure in the Delaware Basin. Upon closing of the Midstream Asset Divestitures, it was determined that the net book value of these assets was not recoverable. General and Administrative Expense General and administrative expense decreased five percent to $161.8 million in 2019 compared to $170.5 million in 2018. The decrease was primarily attributable to decreases of $17.9 million in legal-related fees and $8.2 million in government relations costs. The decreases were partially offset by increases of $7.8 million in costs related to the SRC Acquisition, $6.0 million related to shareholder activism, $3.4 million for the allowance adjustment for royalty owner payments and $1.0 million in payroll and related benefits. Depreciation, Depletion and Amortization Crude oil and natural gas properties. During 2019 and 2018, we invested $787.7 million and $982.7 million, exclusive of changes in accounts payable related to capital expenditures, in the development of our crude oil and natural gas properties, respectively. DD&A expense related to crude oil and natural gas properties is directly related to proved reserves and production volumes. DD&A expense related to crude oil and natural gas properties was $638.5 million, $551.3 million and $462.5 million in 2019, 2018 and 2017, respectively. The year-over-year change in DD&A expense for 2019 compared to 2018 related to crude oil and natural gas properties was primarily due to the following: The following table presents our per Boe DD&A expense rates for crude oil and natural gas properties: Loss on sale of properties and equipment In 2019, we exchanged acreage located in Reeves County, Texas with a third party. As additional consideration for the acreage acquired, we paid $2.7 million in cash and recognized a loss of $45.6 million based on the carrying value of the acreage sold. Interest Expense Interest expense increased by $0.4 million to $71.2 million in 2019 compared to $70.7 million in 2018. The increase was primarily related to a $4.2 million increase in interest related to our revolving credit facility, partially offset by a $4.1 million increase in capitalized interest. Interest costs capitalized in 2019 and 2018 were $13.4 million and $9.2 million, respectively. Provision for Income Taxes Current income tax benefit in 2019 and 2018 was $1.1 million and $0.7 million, respectively. Current income taxes generally relate to the cash that is paid or recovered for income taxes associated with the applicable period. The remaining portion of the total income tax provision is comprised of deferred income taxes, which are a result of differences in the timing of deductions from our U.S. GAAP presentation of financial statements and the income tax regulations. Our effective income tax rates for 2019 and 2018 were 5.5 percent and 72.8 percent, respectively, on income/(loss) from operations. The 2019 rate differs from the federal statutory tax rate primarily due to state taxes, valuation allowance for state tax attributes, stock compensation detriments and nondeductible expenses that consist primarily of officers' compensation, acquisition costs and government lobbying expenses. The 2018 rate differs from the federal statutory tax rate primarily due to state taxes, federal tax credits, valuation allowance for state tax attributes and nondeductible expenses that consist primarily of officers' compensation cost and government lobbying expenses. As of the date of this report, we are current with our income tax filings in all applicable state jurisdictions. The Internal Revenue Service ("IRS") partially accepted our 2018 tax return. The 2018 tax return is in the IRS Compliance Assurance Program (the "CAP Program") post-filing review process, with no significant tax adjustments currently proposed. We continue to voluntarily participate in the IRS CAP Program for the 2019 and 2020 tax years. Net Income (Loss)/Adjusted Net Income (Loss) The factors resulting in changes in net income (loss) in 2019 and 2018 are discussed above. These same reasons similarly impacted adjusted net income (loss), a non-U.S. GAAP financial measure, with the exception of the net change in fair value of unsettled derivatives, adjusted for taxes, of $110.0 million and $198.3 million in 2019 and 2018, respectively. Adjusted net income was $53.3 million in 2019 and adjusted net loss was $196.3 million in 2018. See Reconciliation of Non-U.S. GAAP Financial Measures below for a more detailed discussion of these non-U.S. GAAP financial measures and a reconciliation of these measures to the most comparable U.S. GAAP measures. Financial Condition, Liquidity and Capital Resources Our primary sources of liquidity are cash flows from operating activities, our revolving credit facility, proceeds raised in debt and equity capital market transactions and asset sales. In 2019, our net cash flows from operating activities were $858.2 million. Our primary source of cash flows from operating activities is the sale of crude oil, natural gas and NGLs. Fluctuations in our operating cash flows are principally driven by commodity prices and changes in our production volumes. Commodity prices have historically been volatile and we manage a portion of this volatility through our use of derivative instruments. We enter into commodity derivative instruments with maturities of no greater than five years from the date of the instrument. Our revolving credit facility imposes limits on the amount of our production we can hedge, and we may choose not to hedge the maximum amounts permitted. Therefore, we may still have fluctuations in our cash flows from operating activities due to the remaining non-hedged portion of our future production. We may use our available liquidity for operating activities, capital investments, working capital requirements, acquisitions and for general corporate purposes. We maintain a significant capital investment program to execute our development plans, which requires capital expenditures to be made in periods prior to initial production from newly developed wells. From time to time, these activities may result in a working capital deficit; however, we do not believe that our working capital deficit as of December 31, 2019 is an indication of a lack of liquidity. We had working capital deficits of $57.2 million and $166.6 million at December 31, 2019 and December 31, 2018, respectively. We intend to continue to manage our liquidity position by a variety of means, including through the generation of cash flows from operations, investment in projects with favorable rates of return, protection of cash flows on a portion of our anticipated sales through the use of an active commodity derivative hedging program, utilization of the borrowing capacity under our revolving credit facility and, if warranted, capital markets transactions from time to time. Our cash and cash equivalents were $1.0 million at December 31, 2019 and availability under our revolving credit facility was $1.3 billion, providing for total liquidity of $1.3 billion as of December 31, 2019. In October 2019, as part of our semi-annual redetermination, the borrowing base on our revolving credit facility was reaffirmed at $1.6 billion and we elected to retain our commitment amount at $1.3 billion. Based on our current production forecast for 2020 and assumed average NYMEX prices of $52.50 per Bbl of crude oil and $2.00 per Mcf of natural gas and an assumed average composite price of $11.00 per Bbl for NGLs, we expect 2020 adjusted cash flows from operations, a non-U.S. GAAP financial measure, to exceed our capital investments in crude oil and natural gas properties by approximately $250 million. Pursuant to closing the SRC Acquisition, the borrowing base on our revolving credit facility increased to $2.1 billion and we elected to increase the aggregate commitment amount under the facility to $1.7 billion. Had we closed the SRC Acquisition in 2019 with our new commitment level, we estimate that our available liquidity as of December 31, 2019 would have been approximately $1.6 billion, comprised of approximately $66.6 million of cash and cash equivalents and approximately $1.5 billion available for borrowing under our revolving credit facility. In the second quarter of 2019, we completed the Midstream Asset Divestitures for an aggregate cash purchase price of $345.6 million ($263.6 million of which was paid upon closing with the remaining $82.0 million to be paid in June 2020), subject to certain customary post-closing adjustments, plus potential future long-term incentive payments. We do not currently expect to meet the conditions to receive these incentive payments. Proceeds were allocated first to the assets sold based upon the fair values of the tangible assets, with $179.6 million allocated to the acreage dedication agreements. We used the proceeds from these divestitures for our capital investment program. As a result of merging with SRC, we assumed the SRC Senior Notes and paid off and terminated SRC's revolving credit facility. On January 17, 2020, we commenced an offer to repurchase the outstanding SRC Senior Notes at 101 percent of the principal amount. Upon expiration of the repurchase offer on February 18, 2020, holders of $447.7 million of the outstanding SRC Senior Notes accepted our redemption offer for a total redemption price of approximately $452.2 million, plus accrued and unpaid interest of $6.2 million. We funded the repurchase with proceeds from our revolving credit facility. In April 2019, the Board approved the acquisition of up to $200 million of our outstanding common stock, depending on market conditions. Pursuant to the Stock Repurchase Program, we repurchased 4.7 million shares of outstanding common stock at a cost of $154.4 million during 2019. Subsequent to December 31, 2019, we repurchased approximately 0.6 million shares of our outstanding common stock at a cost of $12.5 million. Additionally, in August 2019, contingent on the closing of the SRC Acquisition, our Board approved an increase and extension to the Stock Repurchase Program from $200 million to $525 million with a target completion date of December 31, 2021. As of February 24, 2020, $358.2 million of our outstanding common stock remained available for repurchase under the Stock Repurchase Program. We currently project that we will generate a sufficient level of cash flow through December 2021 to fund the Stock Repurchase Program, while maintaining the ability to pursue additional future return of capital programs, depending on market conditions. Repurchases under the Stock Repurchase Program can be made in open markets at our discretion and in compliance with safe harbor provisions, or in privately negotiated transactions. The Stock Repurchase Program does not require any specific number of shares to be acquired, and can be modified or discontinued by the Board at any time. Based on our expected cash flows from operations, our cash and cash equivalents and availability under our revolving credit facility, we believe that we will have sufficient capital available to fund our planned activities through the 12-month period following the filing of this report. Our revolving credit facility is available for working capital requirements, capital investments, acquisitions, to support letters of credit and for general corporate purposes. The borrowing base is primarily based on the loan value assigned to the proved reserves attributable to our crude oil and natural gas interests. In August 2019, we entered into a First Amendment to the Restated Credit Agreement. The First Amendment primarily modifies certain sections of the Restated Credit Agreement to permit the consummation of the SRC Acquisition and provides for certain borrowings in connection with the SRC Acquisition. The revolving credit facility contains covenants customary for agreements of this type, with the most restrictive being certain financial tests on a quarterly basis. The financial tests, as defined per the revolving credit facility, include requirements to: (i) maintain a minimum current ratio of 1.0:1.0 and (ii) not exceed a maximum leverage ratio of 4.0:1.0. At December 31, 2019, we were in compliance with all covenants in the revolving credit facility with a current ratio of 4.4:1.0 and a leverage ratio of 1.4:1.0. We expect to remain in compliance throughout the 12-month period following the filing of this report. The indentures governing our 2024 Senior Notes, our 2026 Senior Notes and the SRC Senior Notes contain customary restrictive covenants that, among other things, limit our ability and the ability of our restricted subsidiaries to: (i) incur additional debt including under our revolving credit facility, (ii) make certain investments or pay dividends or distributions on our capital stock or purchase, redeem or retire capital stock, (iii) sell assets, including capital stock of our restricted subsidiaries, (iv) restrict the payment of dividends or other payments by restricted subsidiaries to us, (v) create liens that secure debt, (vi) enter into transactions with affiliates and (vii) merge or consolidate with another company. Cash Flows Operating Activities. Our net cash flows from operating activities are primarily impacted by commodity prices, production volumes, net settlements from our commodity derivative positions, operating costs and general and administrative expenses. Cash flows from operating activities decreased by $31.1 million to $858.2 million in 2019 as compared to $889.3 million in 2018, primarily due to a decrease in crude oil, natural gas and NGLs sales of $82.7 million and a decrease in changes in assets and liabilities of $48.1 million, primarily attributable to $95.5 million in deferred midstream gathering credits related to our Midstream Asset Divestitures. These changes were partially offset by an increase in commodity derivative settlements of $97.9 million. Adjusted cash flows from operations, a non-U.S. GAAP financial measure, increased by $17.0 million in 2019 to $825.4 million from $808.4 million in 2018. The increase was primarily due to the factors mentioned above for changes in cash flows provided by operating activities, without regard to timing of cash payments and receipts of assets and liabilities. Free cash flow, a non-U.S GAAP financial measure, increased by $212.0 million in 2019 to $37.7 million from a free cash flow deficit of $174.3 million in 2018. The increase was due to the increase in adjusted cash flows from operations, combined with a decrease in capital investments in crude oil and natural gas properties. See Reconciliation of Non-U.S. GAAP Financial Measures, below, for a more detailed discussion of these non-U.S. GAAP financial measures and a reconciliation of these measures to the most comparable U.S. GAAP measures. Investing Activities. Because crude oil and natural gas production from a well declines rapidly in the first few years of production, we need to continue to commit significant amounts of capital in order to maintain and grow our production and replace our reserves. If capital is not available or is constrained in the future, we will be limited to our cash flows from operations and liquidity under our revolving credit facility as the sources for funding our capital investments. Cash flows from investing activities primarily consist of the acquisition, exploration and development of crude oil and natural gas properties, net of dispositions of crude oil and natural gas properties. Net cash used in investing activities of $677.8 million during 2019 was primarily related to our drilling and completion activities of $855.9 million. Partially offsetting these investing activities was net cash received from the Midstream Asset Divestitures and certain Delaware Basin crude oil and natural gas properties of $199.4 million. Net cash used in investing activities of $1.1 billion during 2018 was primarily related to cash utilized toward property acquisitions of $180.0 million and our drilling and completion activities of $946.4 million. Partially offsetting these investments was the receipt of approximately $43.5 million, primarily related to the sale of our Utica Shale assets in March 2018. Financing Activities. Net cash from financing activities in 2019 of $188.9 million was primarily due to the repurchase and retirement of shares of our common stock totaling $154.4 million pursuant to the Stock Repurchase Program, net borrowings from our credit facility of $28.5 million and $4.0 million related to purchases of our stock for employee stock-based compensation tax withholding obligations. Net cash from financing activities in 2018 of $18.1 million was comprised of net borrowings from our credit facility of $32.5 million, partially offset by $7.7 million of debt issuance costs and $5.1 million related to purchases of our stock. Contractual Obligations and Contingent Commitments The following table presents our contractual obligations and contingent commitments as of December 31, 2019: (1) Table does not include net deferred income tax liability to taxing authorities of $195.8 million due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. (2) Amount presented does not agree with the consolidated balance sheets in that it excludes $14.8 million of unamortized debt discounts and $12.0 million of unamortized debt issuance costs. (3) Represents our gross liability related to the fair value of derivative positions. (4) Includes deferred compensation to former executive officers and deferred payments related to firm transportation agreements. (5) The table does not include termination benefits related to employment agreements with our executive officers, due to the uncertainty surrounding the ultimate settlement of amounts and timing of these obligations. (6) Amounts presented include $241.5 million to the holders of our 2026 Senior Notes, $122.5 million to the holders of our 2024 Senior Notes and $4.5 million payable to the holders of our 2021 Convertible Notes. Amounts also include interest of $16.7 million related to unutilized commitments at a rate of 0.375 percent per annum. (7) Represents our gross commitment which includes volumes produced by us and purchased from third parties and produced by other third-party working, royalty and overriding royalty interest owners whose volumes we market on their behalf. From time to time, we are a party to various legal proceedings in the ordinary course of business. We are not currently a party to any litigation that we believe would have a materially adverse effect on our business, financial condition, results of operations or liquidity. Information regarding our legal proceedings can be found in the footnote titled Commitments and Contingencies - Litigation and Legal Items to our consolidated financial statements included elsewhere in this report. Off-Balance Sheet Arrangements At December 31, 2019, we had no off-balance sheet arrangements, as defined under SEC rules, which have or are reasonably likely to have a material current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital investments or capital resources. Critical Accounting Policies and Estimates We have identified the following policies as critical to business operations and the understanding of our results of operations. This is not a comprehensive list of all of the accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. GAAP, with no need for our judgment in the application. There are also areas in which our judgment in selecting available alternatives would not produce a materially different result. However, certain of our accounting policies are particularly important to the presentation of our financial position and results of operations and we may use significant judgment in their application. As a result, they are subject to an inherent degree of uncertainty. In applying those policies, we use our judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on historical experience, observation of trends in the industry and information available from other outside sources, as appropriate. For a more detailed discussion on the application of these and other accounting policies, see the footnote titled Summary of Significant Accounting Policies to our consolidated financial statements included elsewhere in this report. Crude Oil and Natural Gas Properties. We account for our crude oil and natural gas properties under the successful efforts method of accounting. Costs of proved developed producing properties, successful exploratory wells and developmental dry hole costs are capitalized and depleted by the unit-of-production method based on estimated proved developed producing reserves. Property acquisition costs are depleted on the unit-of-production method based on estimated proved reserves. Annually, we engage independent petroleum engineers to prepare reserve and economic evaluations of all our properties on a well-by-well basis as of December 31. We adjust our crude oil and natural gas reserves for major acquisitions, new drilling and divestitures during the year as needed. The process of estimating and evaluating crude oil and natural gas reserves is complex, requiring significant decisions in the evaluation of available geological, geophysical, engineering and economic data. The data for a given property may also change substantially over time as a result of numerous factors, including additional development activity, evolving production history and a continual reassessment of the viability of production under changing economic conditions. As a result, revisions in existing reserve estimates occur. Although every reasonable effort is made to ensure that reserve estimates reported represent our most accurate assessments possible, the subjective decisions and variances in available data for various properties increase the likelihood of significant changes in these estimates over time. Because estimates of reserves significantly affect our DD&A expense, a change in our estimated reserves could have an effect on our net earnings. Exploration costs, including geological and geophysical expenses, the acquisition of seismic data covering unproved acreage and delay rentals, are charged to expense as incurred. Exploratory well drilling costs, including the cost of stratigraphic test wells, are initially capitalized, but are charged to expense if the well is determined to be nonproductive. The status of each in-progress well is reviewed quarterly to determine the proper accounting treatment under the successful efforts method of accounting. Exploratory well costs continue to be capitalized as long as the well has found a sufficient quantity of reserves to justify completion as a producing well and we are making sufficient progress assessing our reserves and economic and operating viability. If an in-progress exploratory well is found to be unsuccessful prior to the issuance of the financial statements, the costs incurred prior to the end of the reporting period are charged to exploration expense. If we are unable to make a final determination about the productive status of a well prior to issuance of the financial statements, the well is classified as a "suspended well" until we have had sufficient time to conduct additional completion or testing operations to evaluate the pertinent geological and engineering data obtained. At the time when we are able to make a final determination of a well’s productive status, the well is removed from suspended well status and the proper accounting treatment is applied. Acquisition costs of unproved properties are capitalized when incurred until such properties are transferred to proved properties or charged to expense. Unproved crude oil and natural gas properties with individually significant acquisition costs are periodically assessed, and any impairment in value is charged to impairment of crude oil and natural gas properties. The amount of impairment recognized on unproved properties which are not individually significant is determined by amortizing the costs of such properties within appropriate fields based on our historical experience, acquisition dates and average lease terms, with the amortization recognized in impairment of properties and equipment. The valuation of unproved properties is subjective and requires us to make estimates and assumptions which, with the passage of time, may prove to be materially different from actual realizable values. We assess our crude oil and natural gas properties for possible impairment annually, or upon a triggering event, by comparing carrying value to estimated undiscounted future net cash flows on a field-by-field basis using estimated production and prices at which we reasonably estimate the commodities will be sold. Significant inputs and assumptions to the valuation of proved crude oil and natural gas properties include estimates of reserve volumes, future operating and development costs, future commodity prices and estimated future cash flows. Any impairment in value is charged to impairment of properties and equipment. The estimates of future prices may differ from current market prices of crude oil and natural gas. Any downward revisions in estimates to our reserve quantities, expectations of falling commodity prices or rising operating costs could result in a triggering event, and therefore, a reduction in undiscounted future net cash flows and an impairment of our crude oil and natural gas properties. Although our cash flow estimates are based on the relevant information available at the time the estimates are made, estimates of future cash flows are, by nature, highly uncertain and may vary significantly from actual results. Crude Oil, Natural Gas and NGLs Sales Revenue Recognition. Crude oil, natural gas and NGLs revenues are recognized when we have transferred control of crude oil, natural gas or NGLs production to the purchaser. We consider the transfer of control to have occurred when the purchaser has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the crude oil, natural gas or NGLs production. We record sales revenue based on an estimate of the volumes delivered at estimated prices as determined by the applicable sales agreement. We estimate our sales volumes based on company-measured volume readings. We then adjust our crude oil, natural gas and NGLs sales in subsequent periods based on the data received from our purchasers that reflects actual volumes delivered and prices received. We receive payment for sales one to two months after actual delivery has occurred. The differences in sales estimates and actual sales are recorded one to two months later. Historically, these differences have not been material. Fair Value of Financial Instruments. Our fair value measurements are estimated pursuant to a fair value hierarchy that requires us to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date, giving the highest priority to quoted prices in active markets (Level 1) and the lowest priority to unobservable data (Level 3). In some cases, the inputs used to measure fair value might fall in different levels of the fair value hierarchy. The lowest level input that is significant to a fair value measurement in its entirety determines the applicable level in the fair value hierarchy. Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability and may affect the valuation of the assets and liabilities and their placement within the fair value hierarchy levels. The three levels of inputs that may be used to measure fair value are defined as: Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable for the asset or liability, including quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in inactive markets, inputs other than quoted prices that are observable for the asset or liability and inputs that are derived from observable market data by correlation or other means. Level 3 - Unobservable inputs for the asset or liability, including situations where there is little, if any, market activity. Commodity Derivative Financial Instruments. We measure the fair value of our commodity derivative instruments based on a pricing model that utilizes market-based inputs, including but not limited to the contractual price of the underlying position, current market prices, crude oil and natural gas forward curves, discount rates such as the LIBOR curve for a similar duration of each outstanding position, volatility factors and nonperformance risk. Nonperformance risk considers the effect of our credit standing on the fair value of commodity derivative liabilities and the effect of our counterparties' credit standings on the fair value of commodity derivative assets. Both inputs to the model are based on published credit default swap rates and the duration of each outstanding commodity derivative position. We validate our fair value measurement by corroborating the original source of inputs, monitoring changes in valuation methods and assumptions and through the review of counterparty statements and other supporting documentation. Net settlements on our commodity derivative instruments are initially recorded to accounts receivable or payable, as applicable, and may not be received from or paid to counterparties to our commodity derivative contracts within the same accounting period. Such settlements typically occur the month following the maturity of the commodity derivative instrument. We have evaluated the credit risk of the counterparties holding our commodity derivative assets, which are primarily financial institutions who are also major lenders in our revolving credit facility, giving consideration to amounts outstanding for each counterparty and the duration of each outstanding commodity derivative position. Based on our evaluation, we have determined that the potential impact of nonperformance of our counterparties on the fair value of our commodity derivative instruments is not significant. Deferred Income Tax Asset Valuation Allowance. Deferred income tax assets are recognized for deductible temporary differences, net operating loss carry-forwards and credit carry-forwards if it is more likely than not that the tax benefits will be realized. To the extent a deferred tax asset is not expected to be realized under the preceding criteria, we establish a valuation allowance. The factors which we consider in assessing whether we will realize the value of deferred income tax assets involve judgments and estimates of both amount and timing. The judgments used in applying these policies are based on our evaluation of the relevant facts and circumstances as of the date of the financial statements. Actual results may differ from those estimates. Accounting for Business Combinations. We utilize the purchase method to account for acquisitions of businesses and assets. The value of the purchase consideration takes into account the degree to which the consideration is objective and measurable such as cash consideration paid to a seller. With the issuance of equity, restrictions upon the sale of the issued stock are taken into consideration. Pursuant to purchase method accounting, we allocate the cost of the acquisition to assets acquired and liabilities assumed based on fair values as of the acquisition date. The purchase price allocations are based on appraisals, discounted cash flows, quoted market prices and estimates by management. When appropriate, we review comparable purchases and sales of crude oil and natural gas properties within the same regions and use that data as a basis for fair market value as such sales represent the amount at which a willing buyer and seller would enter into an exchange for such properties. In estimating the fair values of assets acquired and liabilities assumed, we make various assumptions. The most significant assumptions relate to the estimated fair values assigned to proved developed producing, proved developed non-producing, proved undeveloped and unproved crude oil and natural gas properties. To estimate the fair values of these properties, we prepare estimates of crude oil and natural gas reserves. We estimate future prices by using the applicable forward pricing strip to apply to our estimate of reserve quantities acquired, and estimates of future operating and development costs to arrive at an estimate of future net revenues. For estimated proved reserves, the future net revenues are discounted using a market-based weighted-average cost of capital rate determined appropriate at the time of the acquisition. The market-based weighted-average cost of capital rate is subject to additional project-specific risking factors. To compensate for the inherent risk of estimating and valuing unproved properties, we reduce the discounted future net revenues of probable and possible reserves by additional risk-weighting factors. Additionally, for acquisitions with significant unproved properties, we complete an analysis of comparable purchased properties to determine an estimation of fair value. If applicable, we record deferred taxes for any differences between the assigned values and tax basis of assets and liabilities. Estimated deferred taxes are based on available information concerning the tax basis of assets acquired and liabilities assumed and loss carryforwards at the acquisition date, although such estimates may change in the future as additional information becomes known. Acreage Exchanges. From time to time, we enter into acreage exchanges in order to consolidate our core acreage positions, enabling us to have more control over the timing of development activities, achieve higher working interests and providing us the ability to drill longer lateral length wells within those core areas. We account for our nonmonetary acreage exchanges of non-producing interests and unproved mineral leases in accordance with the guidance prescribed by Accounting Standards Codification 845, Nonmonetary Transactions. For those exchanges that lack commercial substance, we record the acreage received at the net carrying value of the acreage surrendered to obtain it. For those acreage exchanges that are deemed to have commercial substance, we record the acreage received at fair value, with a related gain or loss recognized in earnings, in accordance with Accounting Standards Codification 820, Fair Value Measurement. Recent Accounting Standards See the footnote titled Summary of Significant Accounting Policies - Recently Adopted Accounting Standards to our consolidated financial statements included elsewhere in this report. Reconciliation of Non-U.S. GAAP Financial Measures We use "adjusted cash flows from operations," "free cash flow (deficit)," "adjusted net income (loss)" and "adjusted EBITDAX," non-U.S. GAAP financial measures, for internal management reporting, when evaluating period-to-period changes and, in some cases, in providing public guidance on possible future results. In addition, we believe these are measures of our fundamental business and can be useful to us, investors, lenders and other parties in the evaluation of our performance relative to our peers and in assessing acquisition opportunities and capital expenditure projects. These supplemental measures are not measures of financial performance under U.S. GAAP and should be considered in addition to, not as a substitute for, net income (loss) or cash flows from operations, investing or financing activities and should not be viewed as liquidity measures or indicators of cash flows reported in accordance with U.S. GAAP. The non-U.S. GAAP financial measures that we use may not be comparable to similarly titled measures reported by other companies. In the future, we may disclose different non-U.S. GAAP financial measures in order to help us and our investors more meaningfully evaluate and compare our future results of operations to our previously reported results of operations. We strongly encourage investors to review our financial statements and publicly filed reports in their entirety and to not rely on any single financial measure. Adjusted cash flows from operations and free cash flow (deficit). We believe adjusted cash flows from operations can provide additional transparency into the drivers of trends in our operating cash flows, such as production, realized sales prices and operating costs, as it disregards the timing of settlement of operating assets and liabilities. We believe free cash flow (deficit) provides additional information that may be useful in an analysis of our ability to generate cash to fund exploration and development activities and to return capital to stockholders. We are unable to present a reconciliation of forward-looking free cash flow because components of the calculation, including fluctuations in working capital accounts, are inherently unpredictable. Moreover, estimating the most directly comparable GAAP measure with the required precision necessary to provide a meaningful reconciliation is extremely difficult and could not be accomplished without unreasonable effort. We believe that forward-looking estimates of free cash flow are important to investors because they assist in the analysis of our ability to generate cash from our operations in excess of capital investments in crude oil and natural gas properties. Adjusted net income (loss). We believe that adjusted net income (loss) provides additional transparency into operating trends, such as production, realized sales prices, operating costs and net settlements on commodity derivative contracts, because it disregards changes in our net income (loss) from mark-to-market adjustments resulting from net changes in the fair value of our unsettled commodity derivative contracts, and these changes are not directly reflective of our operating performance. Adjusted EBITDAX. We believe that adjusted EBITDAX provides additional transparency into operating trends because it reflects the financial performance of our assets without regard to financing methods, capital structure, accounting methods or historical cost basis. In addition, because adjusted EBITDAX excludes certain non-cash expenses, we believe it is not a measure of income, but rather a measure of our liquidity and ability to generate sufficient cash for exploration, development, acquisitions and to service our debt obligations. Beginning in the third quarter of 2019, we included a reconciling item for gains or losses on the sale of properties and equipment when calculating adjusted EBITDAX, thereby no longer including such gains or losses in our reported adjusted EBITDAX. We believe this methodology for calculating adjusted EBITDAX will enable greater comparability to our peers, as well as consistent treatment of adjustments for impairment and gains or losses on the sale of properties and equipment. For comparability, all prior periods presented have been conformed to the aforementioned methodology. PV-10. We define PV-10 as the estimated present value of the future net cash flows from our proved reserves before income taxes, discounted using a 10 percent discount rate. We believe that PV-10 provides useful information to investors as it is widely used by professional analysts and sophisticated investors when evaluating oil and gas companies. We believe that PV-10 is relevant and useful for evaluating the relative monetary significance of our reserves. Professional analysts, investors and other users of our financial statements may utilize the measure as a basis for comparison of the relative size and value of our reserves to other companies' reserves. Because there are many unique factors that can impact an individual company when estimating the amount of future income taxes to be paid, we believe the use of a pre-tax measure is valuable in evaluating us and our reserves. PV-10 is not intended to represent the current market value of our estimated reserves. The following table presents a reconciliation of each of our non-U.S. GAAP financial measures to its most comparable U.S. GAAP measure:

<s>[INST] EXECUTIVE SUMMARY 2019 Financial Overview of Operations and Liquidity Production volumes increased 23 percent to 49.4 MMBoe in 2019 compared to 2018. The increase in production volumes was primarily attributable to the continued success of our horizontal Niobrara and Codell drilling program in the Wattenberg Field and growing production from our horizontal Wolfcamp drilling program in our Delaware Basin properties. Total liquids production of crude oil and NGLs comprised 61 percent of production in 2019. For the month ended December 31, 2019, we maintained an average production rate of approximately 139,000 Boe per day, up from approximately 129,000 Boe per day for the month ended December 31, 2018. Crude oil, natural gas and NGLs sales decreased to $1.3 billion in 2019 compared to $1.4 billion in 2018, driven by a 24 percent decrease in weightedaverage realized commodity prices, partially offset by the 23 percent increase in production. We had negative net settlements from commodity derivative contracts of $17.6 million for 2019 as compared to negative net settlements of $115.5 million for 2018. The combined revenue from crude oil, natural gas and NGLs sales and net settlements received on our commodity derivative instruments was $1.3 billion in both 2019 and 2018. In 2019, we generated a net loss of $56.7 million or, $0.89 per diluted share, compared to net income of $2.0 million, or $0.03 per diluted share, in 2018. Adjusted EBITDAX, a nonU.S. GAAP financial measure, was $882.7 million in 2019, up two percent from $868.7 million in 2018. Net cash flows from operating activities in 2019 and 2018 were $858.2 million and $889.3 million, respectively, and adjusted cash flows from operations, a nonU.S. GAAP financial measure, were $825.4 million and $808.4 million, respectively. Free cash flow, a nonU.S. GAAP financial measure, was $37.7 million for 2019 as compared to a deficit of $174.3 million for 2018. See Reconciliation of NonU.S. GAAP Financial Measures below for a more detailed discussion of these nonU.S. GAAP financial measures and a reconciliation of these measures to the most comparable U.S. GAAP measures. Acquisition In January 2020, we merged with SRC in a transaction valued at $1.7 billion, inclusive of SRC's net debt. Upon closing, we issued approximately 39 million shares of our common stock to SRC shareholders, reflecting issuance of 0.158 of a share of our common stock in exchange for each share of SRC common stock held. Liquidity Available liquidity as of December 31, 2019 was $1.3 billion, primarily due to $1.3 billion available for borrowing under our revolving credit facility. In October 2019, as part of our semiannual redetermination, the borrowing base on our revolving credit facility was reaffirmed at $1.6 billion and we elected to retain our commitment amount at $1.3 billion. Pursuant to closing the SRC Acquisition, the borrowing base on our revolving credit facility increased to $2.1 billion and we elected to increase the aggregate commitment amount under the facility to $1.7 billion. As part of the SRC Acquisition, we assumed $550 million in 6.25% Senior Notes due December 2025 and paid off and terminated SRC's revolving credit facility, which had an outstanding balance of $165 million at closing. The indenture governing the SRC Senior Notes has a change of control provision and on January 17, [/INST] Positive. </s>

APPLIED MATERIALS INC /DE

2015-12-09

2015-10-25

Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations Introduction Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to facilitate an understanding of Applied’s business and results of operations. This MD&A should be read in conjunction with Applied’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10-K. The following discussion contains forward-looking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10-K. MD&A consists of the following sections: • Overview: a summary of Applied’s business and measurements • Results of Operations: a discussion of operating results • Segment Information: a discussion of segment operating results • Business Combinations: a summary of announced or completed business combinations and acquisitions • Recent Accounting Pronouncements: a discussion of new accounting pronouncements and its impact to Applied's consolidated financial statements • Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash • Off-Balance Sheet Arrangements and Contractual Obligations • Critical Accounting Policies and Estimates: a discussion of critical accounting policies that require the exercise of judgments and estimates • Non-GAAP Adjusted Results: a presentation of results reconciling GAAP to non-GAAP adjusted measures Overview Applied provides manufacturing equipment, services and software to the global semiconductor, display, solar photovoltaic (PV) and related industries. Applied’s customers include manufacturers of semiconductor wafers and chips, liquid crystal and other displays, solar PV cells and modules, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Applied operates in four reportable segments: Silicon Systems, Applied Global Services, Display, and Energy and Environmental Solutions. A summary of financial information for each reportable segment is found in Note 16 of Notes to Consolidated Financial Statements. A discussion of factors that could affect Applied’s operations is set forth under “Risk Factors” in Part I, Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in the United States, Europe, Israel, and Asia. Applied’s broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied’s results are driven primarily by worldwide demand for semiconductors, which in turn depends on end-user demand for electronic products. Each of Applied’s businesses is subject to cyclical industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, display technologies, solar PVs and other electronic devices, as well as other factors, such as global economic and market conditions, and the nature and timing of technological advances in fabrication processes. In addition, a significant driver in the semiconductor and display industries is end-demand for mobile consumer products, which is characterized by seasonality that impacts the timing of customer investments in manufacturing equipment and, in turn, Applied's business. In light of these conditions, Applied's results can vary significantly year-over-year, as well as quarter-over-quarter. Applied's strategic priorities for fiscal 2016 include developing products that help solve customers’ challenges at technology inflections; expanding its served market opportunities in the semiconductor and display industries; and growing its services business. On April 26, 2015, Applied and Tokyo Electron Limited (TEL) announced that they had mutually agreed to terminate their previously announced Business Combination Agreement, which was entered into on September 24, 2013 and intended to effect a strategic combination of their respective business into a new combined company. No termination fee was payable by either Applied or TEL. Results of Operations The following table presents certain significant measurements for the past three fiscal years: Reconciliations of non-GAAP adjusted measures are presented under "Non-GAAP Adjusted Results" below. Fiscal 2015, 2014 and 2013 each contained 52 weeks. Mobility, and the increasing technological functionality of mobile devices, continues to be the largest drivers of semiconductor industry spending. Fiscal 2015 was characterized by steady demand for semiconductor equipment, with increased investment in technology upgrades and additional capacity by memory customers. Demand from foundry customers reflected investments in new technology at advanced nodes, driven by demand for advanced mobile chips. Mobility represented a significant driver of display industry spending during fiscal 2015, which resulted in continued manufacturing capacity expansion for mobile applications. Demand for larger TVs was also a factor for display industry investments, although demand for TV manufacturing equipment remains susceptible to highly cyclical conditions. Investment in solar equipment remained low during fiscal 2015 due to ongoing excess manufacturing capacity in the industry. Gross margin challenges are expected in the first half of fiscal 2016 primarily due to higher demand for semiconductor equipment from memory customers and mobility display equipment. Applied expects the mobility trend to remain the main growth driver for the semiconductor industry, and in turn for Silicon Systems, in fiscal 2016. Demand in the semiconductor manufacturing equipment industry is expected to be driven by foundry and memory spending. Applied also expects semiconductor spares and services, and display equipment investment to remain healthy in fiscal 2016. During fiscal 2014, demand for advanced mobile chips drove demand for semiconductor equipment by foundry customers. In addition, demand for semiconductor equipment from memory customers improved as manufacturers invested in technology upgrades. Mobility and demand for larger TVs drove investment in display equipment during fiscal 2014. Investment in solar equipment remained low during fiscal 2014, despite continued end-market growth, due to excess manufacturing capacity in the industry. Fiscal 2013 was characterized by strong demand for semiconductor equipment from foundry customers driven by demand for advanced mobile chips. In the second half of fiscal 2013, demand from foundry customers softened, while demand from memory and logic customers improved. Display industry spending during fiscal 2013 reflected strong demand for mobile display equipment, as well as a recovery in demand for TV manufacturing equipment compared to weak industry levels in fiscal 2012. Investment in solar equipment remained low during fiscal 2013 due to continued excess manufacturing capacity in the industry. New Orders New orders by reportable segment for each fiscal year were as follows: New orders for fiscal 2015 slightly increased from fiscal 2014 due to higher demand for semiconductor equipment, and semiconductor spares and services, partially offset by lower demand for display and solar equipment. New orders for Silicon Systems and Applied Global Services continued to comprise the majority of Applied's consolidated total new orders. New orders increased in fiscal 2014 from fiscal 2013 across all segments, primarily due to higher demand for semiconductor equipment, semiconductor spares and services, and display equipment. New orders by geographic region for each fiscal year, determined by the product shipment destination specified by the customer, were as follows: The changes in new orders from customers in Korea, Japan, the United States and Europe in fiscal 2015 compared to fiscal 2014, and changes in new orders from customers in the United States, Japan, Taiwan and Korea for fiscal 2014 compared to fiscal 2013, primarily reflected changes in customer mix for the Silicon Systems segment. The increase in new orders in fiscal 2014 compared to fiscal 2013 from China resulted from increased demand from display manufacturing equipment. Changes in backlog during each fiscal year were as follows: Backlog consists of: (1) orders for which written authorizations have been accepted and assigned shipment dates are within the next 12 months, or shipment has occurred but revenue has not been recognized; and (2) contractual service revenue and maintenance fees to be earned within the next 12 months. Applied’s backlog at any particular time is not necessarily indicative of actual sales for any future periods, due to the potential for customer changes in delivery schedules or cancellation of orders. Approximately 70 percent of the backlog as of the end of fiscal 2015 is anticipated to be shipped within the first two quarters of fiscal 2016. Applied’s backlog was $3.1 billion at October 25, 2015 compared to $2.9 billion at October 26, 2014. Backlog adjustments were negative for fiscal 2015 and totaled $220 million, primarily consisting of order cancellations, unfavorable foreign currency impacts and other adjustments. Backlog by reportable segment as of the end of each fiscal year was as follows: Total backlog increased in fiscal 2015 from fiscal 2014 primarily due to increases in demand from memory customers and for semiconductor spares and services, which was partially offset by lower demand for display and solar manufacturing equipment. In the fourth quarter of fiscal 2015 approximately 55 percent of net sales in Silicon Systems, Applied’s largest business segment, were for orders received and shipped within the quarter, up from 44 percent in the fourth quarter of fiscal 2014. Net Sales Net sales by reportable segment for each fiscal year were as follows: Net sales increased in fiscal 2015 compared to fiscal 2014 primarily due to greater customer investments in semiconductor equipment, semiconductor spares and services, 200mm equipment systems and display equipment. The Silicon Systems segment remains the largest contributor of net sales. Net sales for all segments increased in fiscal 2014 compared to fiscal 2013. The increase primarily reflected increased customer investments in semiconductor and display equipment, as well as semiconductor spares and services. Net sales by geographic region for each fiscal year, determined by the location of customers' facilities to which products were shipped, were as follows: (1) Amount of net sales attributed to each geographic region differ from those included in Applied’s press release issued on November 12, 2015. These reclassifications did not affect Applied’s previously announced financial results as total net sales remain unchanged. The changes in net sales from customers in Korea, Japan and Taiwan in fiscal 2015 compared to fiscal 2014 primarily reflected changes in customer mix for semiconductor equipment. The decrease in net sales from customers in the United States was due to lower customer spending on semiconductor equipment, partially offset by increased spending on semiconductor spares and services, and 200mm equipment. Net sales from customers in China increased for fiscal 2014 compared to fiscal 2013 primarily due to greater investments in semiconductor, display and solar manufacturing equipment, while net sales from customers in the United States increased due to higher investments in semiconductor equipment. Gross Margin Gross profit and gross margin for each fiscal year were as follows: Reconciliations of non-GAAP adjusted measures are presented under "Non-GAAP Adjusted Results" below. Gross profit and non-GAAP adjusted gross profit in fiscal 2015 increased compared to fiscal 2014, primarily due to higher net sales, while gross margin and non-GAAP adjusted gross margin decreased primarily due to unfavorable changes in product mix and the absence of a recovery of a regional customs duty assessment charge recorded in fiscal 2014. Gross profit and gross margin and non-GAAP adjusted gross profit and non-GAAP adjusted gross margin increased in fiscal 2014 compared to fiscal 2013 primarily reflecting higher net sales, the recovery of a regional customs duty assessment charge recorded in fiscal 2013, sales of display and solar tools that had been previously written down, lower manufacturing costs and change in product mix. Gross profit and non-GAAP adjusted gross profit during fiscal 2015, 2014 and 2013 included $57 million, $53 million and $50 million, respectively, of share-based compensation expense. Research, Development and Engineering Research, development and engineering (RD&E) expenses for each fiscal year were as follows: Applied’s future operating results depend to a considerable extent on its ability to maintain a competitive advantage in the equipment and service products it provides. Development cycles range from 12 to 36 months depending on whether the product is an enhancement of an existing product, which typically has a shorter development cycle, or a new product, which typically has a longer development cycle. Most of Applied’s existing products resulted from internal development activities and innovations involving new technologies, materials and processes. In certain instances, Applied acquires technologies, either in existing or new product areas, to complement its existing technology capabilities and to reduce time to market. Management believes that it is critical to continue to make substantial investments in RD&E to assure the availability of innovative technology that meets the current and projected requirements of its customers’ most advanced designs. Applied has maintained and intends to continue its commitment to investing in RD&E in order to continue to offer new products and technologies. In fiscal 2015, Applied increased its investments in new product growth in etch, chemical vapor deposition, high throughput atomic layer deposition, and next generation inspection technology. Applied’s investments in etch and chemical vapor deposition were focused on supporting the adoption of the etch Centris Sym 3 product and customer ramps of 3D NAND technology. Applied's investment in atomic layer deposition is yielding products to address customer needs for future nodes, and investments in inspection include a new e-beam inspection platform and improved brightfield capabilities. RD&E expenses increased in fiscal 2015 compared to the prior year and also in fiscal 2014 compared to fiscal 2013, reflecting the impact of ongoing product development initiatives. As part of its growth strategy, Applied continued to reprioritize existing spend, to enable increased funding for investments in technical capabilities and critical RD&E programs in current and new markets, with a focus on semiconductor technologies. RD&E expense during fiscal 2015, 2014 and 2013 included $69 million, $66 million and $53 million, respectively, of share-based compensation expense. Marketing and Selling Marketing and selling expenses for each fiscal year were as follows: Marketing and selling expenses remained relatively flat in fiscal 2015 compared to fiscal 2014 due to continued cost management efforts. The decrease in marketing and selling expenses for fiscal 2014 compared to fiscal 2013 was mainly due to headcount reductions. Marketing and selling expenses during fiscal 2015, 2014 and 2013 included $26 million, $23 million and $20 million, respectively, of share-based compensation expense. General and Administrative General and administrative expenses for each fiscal year were as follows: General and administrative (G&A) expenses for fiscal 2015 decreased compared to fiscal 2014 primarily due to lower acquisition-related and integration costs related to the terminated business combination with TEL, which was terminated in April 2015, and continued cost management efforts. G&A expenses for fiscal 2014 increased compared to fiscal 2013 primarily due to integration planning costs associated with the terminated business combination with TEL, partially offset by proceeds from a favorable litigation outcome. G&A expenses during fiscal 2015, 2014 and 2013 included $35 million, $35 million and $34 million, respectively, of share-based compensation expense. Loss (Gain) on Derivatives Associated with Terminated Business Combination Changes in gain or loss on derivatives associated with the terminated business combination with TEL resulted from the sale of derivative contracts and exchange rate fluctuations. Due to the termination of the proposed business combination, the derivatives were sold during the third quarter of fiscal 2015. For further details, see Note 5 of Notes to Consolidated Financial Statements. Impairment of Goodwill and Intangible Assets In the fourth quarter of fiscal 2015 and 2014, Applied performed a qualitative assessment to test goodwill for all of its reporting units for impairment. Applied determined that it was more likely than not that each of its reporting units' fair values exceeded its respective carrying values and that it was not necessary to perform the two-step goodwill impairment test for any of its reporting units. During fiscal 2013, the solar industry faced continued deterioration in market conditions associated with manufacturing overcapacity and weak operating performance and outlook, resulting in uncertainties regarding the timing and nature of a recovery in solar capital equipment expenditures. Applied performed a two-step goodwill impairment test and, as a result, recorded $224 million of goodwill impairment charges in its Energy and Environmental Solutions segment in fiscal 2013. Applied also recorded a $54 million impairment charge related to intangible assets in the Energy and Environmental Solutions segment in fiscal 2013. The evaluation of goodwill and intangible assets for impairment requires the exercise of significant judgment. In the event of future changes in business conditions, Applied will reassess and update its forecasts and estimates used in future impairment analyses. If the results of these analyses are lower than current estimates, a material impairment charge may result at that time. For further details, see Note 9 of Notes to Consolidated Financial Statements. Restructuring and Asset Impairments Restructuring and asset impairment expenses for each fiscal year were as follows: The increase in restructuring and asset impairments, net for fiscal 2015 compared to fiscal 2014 was primarily due to the cost reduction measures in the solar business taken during fiscal 2015 to achieve a lower break-even level and improve business performance. The decrease in restructuring and asset impairments, net for fiscal 2014 compared to fiscal 2013 was due to completion of the principal activities for the previously announced restructuring plans. Also in fiscal 2013, Applied incurred $2 million of severance and other employee-related costs in connection with the integration of Varian Semiconductor Equipment Associates, Inc. On October 3, 2012, Applied announced a restructuring plan (the 2012 Global Restructuring Plan) to realign its global workforce and enhance its ability to invest for growth. Under this plan, Applied implemented a voluntary retirement program and other workforce reduction actions that affected approximately 1,300 positions. As of January 26, 2014, principal activities related to this plan were complete. During fiscal 2014 and 2013, Applied recognized $5 million and $39 million, respectively, of employee-related costs in connection with the 2012 Global Restructuring Plan. Total costs incurred in implementing this plan were $150 million, none of which were allocated to the operating segments. On May 10, 2012, Applied announced a plan (the 2012 EES Restructuring Plan) to restructure its Energy and Environmental Solutions segment in light of challenging industry conditions affecting the solar photovoltaic and light-emitting diode (LED) equipment markets. Total costs incurred in implementing this plan were $87 million, of which $13 million were inventory-related charges. During fiscal 2015, Applied recorded a favorable adjustment of $2 million associated with restructuring reserves under this program. During fiscal 2013, Applied recognized $26 million, of restructuring and asset impairment charges in connection with the 2012 EES Restructuring Plan. These costs were reported in the Energy and Environmental Solutions and Applied Global Services segments. For further details, see Note 11 of Notes to Consolidated Financial Statements. Interest Expense and Interest and Other Income, net Interest expense and interest and other income, net for each fiscal year were as follows: Interest expenses incurred during the past three fiscal years were primarily associated with senior unsecured notes that were issued in June 2011 to fund a portion of the consideration and certain costs associated with the acquisition of Varian. Interest expense for fiscal 2015 increased compared to fiscal 2014 due to the issuance of senior unsecured notes in the aggregate principal amount of $1.8 billion in September 2015. Interest expense remained flat during fiscal 2014 compared to fiscal 2013. Interest income primarily includes interest earned on cash and investments and realized gains on sale of securities. Interest and other income, net, decreased in fiscal 2015 compared to fiscal 2014 primarily due to lower realized gains on sales of strategic investments in fiscal 2015. Interest and other income, net, increased in fiscal 2014 compared to fiscal 2013 primarily due to an increase in realized gains on sales of securities recorded during fiscal 2014, partially offset by increased impairments of strategic investments. Income Taxes The provision for income taxes and effective tax rates for each fiscal year were as follows: Applied’s effective tax rate is affected by the geographical composition of income, which includes jurisdictions with income tax incentives and differing tax rates. It is also affected by events that are not consistent from period to period, such as changes in income tax laws and regulations and the resolution of income tax filings. The effective tax rate for fiscal 2015 was lower than the rate for fiscal 2014 primarily due to acquisition costs that became deductible in the second quarter of fiscal 2015 as a result of the termination of the proposed business combination with TEL, an adjustment in the second quarter of fiscal 2015 to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales, reinstatement of the U.S. federal research and development tax credit during the first quarter of fiscal 2015 which was retroactive to its expiration in December 2013, resolutions and changes related to income tax liabilities for prior years, and changes in the geographical composition of income. The effective tax rate for fiscal 2014 was lower than the rate for fiscal 2013 due primarily to nondeductible goodwill impairment charges in fiscal 2013, offset by resolutions and changes related to prior years and expiration of the U.S. federal research and development tax credit. Segment Information Applied reports financial results in four segments: Silicon Systems, Applied Global Services, Display, and Energy and Environmental Solutions. A description of the products and services, as well as financial data, for each reportable segment can be found in Note 16 of Notes to Consolidated Financial Statements. Applied does not allocate to its reportable segments certain operating expenses that it manages separately at the corporate level. These unallocated costs include costs for share-based compensation; certain management, finance, legal, human resource, and RD&E functions provided at the corporate level; and unabsorbed information technology and occupancy. In addition, Applied does not allocate to its reportable segments restructuring and asset impairment charges and any associated adjustments related to restructuring actions, unless these actions pertain to a specific reportable segment. The results for each reportable segment are discussed below. Silicon Systems Segment The Silicon Systems segment includes semiconductor capital equipment for deposition, etch, ion implantation, rapid thermal processing, chemical mechanical planarization, metrology and inspection, and wafer packaging. Development efforts are focused on solving customers' key technical challenges in transistor, patterning, interconnect and packaging performance as devices scale to advanced technology nodes. The mobility trend remains the largest influence on industry spending, as it drives device manufacturers to continually improve their ability to deliver high-performance, low-power processors and affordable solid-state storage in a small form factor. The competitive environment for Silicon Systems in fiscal 2015 reflected continued investment by semiconductor manufacturers. Memory manufacturers increased investments in technology upgrades and additional capacity. Foundry investments reflected demand for new technology as customers ramp wafer starts at advanced nodes to meet demand for advanced mobile chips, but decreased primarily due to customers managing excess inventory, improving yields and re-using equipment. Certain significant measures for each fiscal year were as follows: Reconciliations of non-GAAP adjusted measures are presented under "Non-GAAP Adjusted Results" below. The composition of new orders for Silicon Systems by end use application for the past three fiscal years was as follows: One region accounted for at least 30 percent of total net sales for the Silicon Systems segment for one or more of the past three fiscal years: Customers in Taiwan accounted for 32 percent, 37 percent and 45 percent of total net sales for Silicon Systems in fiscal 2015, 2014 and 2013, respectively. Customers in the United States, China and Korea together contributed 47 percent, 47 percent and 37 percent of the total net sales for this segment in fiscal 2015, 2014 and 2013, respectively. Financial results in the Silicon Systems segment for fiscal 2015 reflected continued wafer fabrication equipment spending in the semiconductor industry. The increase in new orders and net sales in fiscal 2015 compared to fiscal 2014 primarily reflected increased demand and spending from memory customers, partially offset by lower demand and spending from foundry customers. Two customers accounted for approximately 41 percent of net sales and three customers accounted for 53 percent of new orders in this segment in fiscal 2015. Operating income and non-GAAP adjusted operating income for fiscal 2015 increased compared to fiscal 2014, reflecting the increase in net sales, partially offset by changes in product mix and higher research and development expenses. The increase in new orders and net sales in fiscal 2014 compared to fiscal 2013 primarily reflected increased demand and spending from memory customers, as well as continued demand from foundry customers. Three customers accounted for approximately 54 percent of net sales and three customers accounted for 75 percent of new orders in this segment in fiscal 2014. Operating income and non-GAAP adjusted operating income for fiscal 2014 increased compared to fiscal 2013, reflecting the increase in net sales, partially offset by changes in product mix and higher research and development expenses. Applied Global Services Segment The Applied Global Services segment encompasses integrated solutions to optimize equipment and fab performance and productivity, including spares, upgrades, services, remanufactured earlier generation equipment and factory automation software for semiconductor, display and solar products. Customer demand for products and services is fulfilled through a global distribution system with trained service engineers located in close proximity to customer sites. Industry conditions that affected Applied Global Services' sales of spares and services during fiscal 2015 were principally semiconductor manufacturers' wafer starts, as well as utilization rates. Certain significant measures for each fiscal year were as follows: Reconciliations of non-GAAP adjusted measures are presented under "Non-GAAP Adjusted Results" below. There were no individual regions that accounted for at least 30 percent of total net sales for the Applied Global Services segment for any of the past three fiscal years. New orders and net sales for fiscal 2015 increased compared to fiscal 2014 mainly due to higher demand for semiconductor spares and services, and 200mm equipment systems. Operating income, operating margin, non-GAAP adjusted operating income, and non-GAAP adjusted operating margin increased in fiscal 2015 compared fiscal 2014, reflecting the increase in net sales, which was partially offset by unfavorable product mix and the absence of a recovery of a regional customs duty assessment charge recorded in fiscal 2014. New orders and net sales for fiscal 2014 increased compared to fiscal 2013 mainly due to increased demand for semiconductor spares and services, as well as 200mm equipment systems and equipment upgrades. Operating income and non-GAAP adjusted operating income increased in fiscal 2014 compared to the prior year, reflecting the increase in net sales as well as the recovery of a regional customs duty assessment charge recorded in fiscal 2013. Display Segment The Display segment encompasses products for manufacturing liquid crystal displays (LCDs), organic light-emitting diodes (OLEDs), and other display technologies for TVs, personal computers (PCs), tablets, smart phones, and other consumer-oriented devices. The segment is focused on expanding its presence through technologically-differentiated equipment for manufacturing large-scale TVs; new markets such as low temperature polysilicon (LTPS), metal oxide, and touch panel sectors; and development of products that enable cost reductions through productivity and uniformity. Display industry growth depends primarily on consumer demand for increasingly larger and more advanced LCD TVs and high resolution displays for next generation mobile devices. The market environment for Applied's Display segment in fiscal 2015 has been characterized by continued demand for manufacturing equipment for TV and high-end mobile devices, although this sector remains susceptible to highly cyclical conditions. Uneven order and revenue patterns in the Display segment can cause significant fluctuations quarter-over-quarter, as well as year-over year. Certain significant measures for each fiscal year were as follows: Reconciliations of non-GAAP adjusted measures are presented under "Non-GAAP Adjusted Results" below. The following regions accounted for at least 30 percent of total net sales for the Display segment for one or more of the past three fiscal years: In fiscal 2015, 2014 and 2013, customers in China accounted for 75 percent, 80 percent and 48 percent, respectively, of the Display segment's total net sales. Customers in Korea accounted for 18 percent, 16 percent and 32 percent of total net sales for the Display segment in fiscal 2015, 2014 and 2013, respectively. The increase in net sales from customers in China reflected TV manufacturing capacity expansion, while the increase in net sales from customers in Korea increasingly related to sales of mobile display manufacturing equipment. New orders for fiscal 2015 decreased compared to fiscal 2014 primarily due to lower TV manufacturing equipment orders, while net sales for fiscal 2015 were higher due to the timing of shipments. Operating income and non-GAAP adjusted operating income increased for fiscal 2015 from fiscal 2014, reflecting higher net sales. Operating margin and non-GAAP adjusted operating margin decreased, despite the increase in net sales, primarily due to unfavorable product mix, increased research and development expenses and the sale of tools in fiscal 2014 for which inventory had been previously fully reserved. Four customers accounted for approximately 65 percent of new orders for the Display segment in fiscal 2015, with two customers accounting for approximately 37 percent of new orders. Four customers accounted for approximately 79 percent of net sales for this segment in fiscal 2015, with two customers accounting for approximately 46 percent of net sales. New orders and net sales for fiscal 2014 increased compared to fiscal 2013, reflecting strong TV manufacturing capacity expansions. Operating income and non-GAAP adjusted operating income increased over the prior year, due primarily to higher net sales, sales of tools for which inventory had been written down previously, better installation and warranty performance, and material and manufacturing cost reductions, partially offset by increased research and development expenses. Four customers accounted for approximately 87 percent of new orders for the Display segment in fiscal 2014, with two customers accounting for approximately 50 percent of new orders. Four customers accounted for approximately 77 percent of net sales for this segment in fiscal 2014, with one customer accounting for approximately 40 percent of net sales. Energy and Environmental Solutions Segment The Energy and Environmental Solutions segment includes products for fabricating crystalline-silicon (c-Si) solar PV wafers and cells, as well as high throughput roll-to-roll deposition equipment for flexible electronics, packaging and other applications. While end-demand for solar PVs has been robust over the last several years, investment in capital equipment has remained low as global PV production capacity exceeds anticipated demand. Certain significant measures for each fiscal year were as follows: Reconciliations of non-GAAP adjusted measures are presented under "Non-GAAP Adjusted Results" below. The following regions accounted for at least 30 percent of total net sales for the Energy and Environmental Solutions segment for one or more of these recent fiscal periods: In fiscal 2015, 2014 and 2013, customers in China accounted for 33 percent, 62 percent and 58 percent, respectively, of total net sales for the Energy and Environmental Solutions segment. Financial results during fiscal 2015 remained at low levels due to continued excess manufacturing capacity in the solar industry, which resulted in low levels of new orders and net sales, and consequently an operating loss for the segment. Two customers accounted for approximately 20 percent of net sales for this segment during fiscal 2015. Operating loss for fiscal 2015 included $17 million in restructuring charges and asset impairments and $32 million of inventory charges recorded in cost of products sold, related to cost reduction measures taken in the third quarter of fiscal 2015. Details on restructuring charges and asset impairments are included in Note 11 of the Notes to the Consolidated Financial Statements. New orders and net sales for fiscal 2014 increased compared to fiscal 2013 but remained at low levels, reflecting excess manufacturing capacity in the solar industry. One customer accounted for approximately 23 percent of net sales for this segment during fiscal 2014. Operating margin and non-GAAP adjusted operating margin increased for fiscal 2014 compared to prior year, reflecting increased net sales, lower inventory charges, sales of solar tools that were written down previously and continued cost reduction measures, proceeds from a favorable litigation outcome, and spending controls. Business Combinations Tokyo Electron Limited On September 24, 2013, Applied and TEL entered into a Business Combination Agreement, which was intended to effect a strategic combination of their respective businesses into a new combined company, and was subject to regulatory approvals. On April 26, 2015, Applied and TEL announced that they had mutually agreed to terminate the Business Combination Agreement. No termination fee was payable by either Applied or TEL. Recent Accounting Pronouncements For a description of recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on Applied's consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements. Financial Condition, Liquidity and Capital Resources Applied’s cash, cash equivalents and investments increased to $5.9 billion at October 25, 2015 from $4.1 billion at October 26, 2014. Cash, cash equivalents and investments consisted of the following: Sources and Uses of Cash A summary of cash provided by (used in) operating, investing, and financing activities was as follows: Operating Activities Cash from operating activities for fiscal 2015 was $1.2 billion, which reflects net income adjusted for the effect of non-cash charges and changes in working capital components. Non-cash charges included depreciation, amortization, share-based compensation, restructuring and asset impairments and deferred income taxes. The primary drivers of the decrease in cash from operating activities from fiscal 2014 to fiscal 2015 were the increases in inventories and deferred income taxes and decreases in accounts payable, accrued expenses, customer deposits, deferred revenue and income taxes payable, partially offset by higher net income. The increase in cash from operating activities from fiscal 2013 to fiscal 2014 was primarily due to higher business volume and improved working capital performance. Applied did not utilize programs to discount letters of credit issued by customers in fiscal 2015 and 2013. Applied discounted $29 million of letters of credit issued by customers in fiscal 2014. Discounting of letters of credit depends on many factors, including the willingness of financial institutions to discount the letters of credit and the cost of such arrangements. Applied did not factor accounts receivable nor discounted promissory notes in fiscal 2015 and 2013. Applied factored accounts receivable and discounted promissory notes of $45 million in fiscal 2014. Applied’s working capital was $5.5 billion at October 25, 2015 and $4.1 billion at October 26, 2014. Days sales, inventory and payable outstanding at the end of each of the periods indicated were: Days sales outstanding varies due to the timing of shipments and the payment terms. Days sales outstanding remained flat at the end of fiscal 2015 compared to fiscal 2014. The decrease for fiscal 2014 compared to fiscal 2013 was primarily due to an increase in revenue and better linearity. Days inventory outstanding increased at the end of fiscal 2015 reflecting higher inventory near the end of the period due to increase in deferred inventory and more builds as compared to revenue turns. Days inventory outstanding remained flat in fiscal 2014 and 2013. Days payable outstanding remained relatively flat in fiscal 2015, 2014 and 2013. Investing Activities Applied used $281 million of cash in investing activities in fiscal 2015 and $161 million in fiscal 2014. Applied generated $215 million in cash from investing activities in fiscal 2013. Capital expenditures in fiscal 2015, 2014 and 2013 were $215 million, $241 million and $197 million, respectively. Capital expenditures in fiscal 2015 were primarily for demonstration and test equipment and laboratory tools in North America. Capital expenditures in fiscal 2014 were primarily for demonstration and test equipment and infrastructure improvements in North America, including creation of a new pilot operation facility and distribution center. Capital expenditures in fiscal 2013 were primarily for demonstration and test equipment as well as laboratory tools and equipment upgrades in North America. Purchases of investments, net of proceeds from sales and maturities of investments was $62 million for fiscal 2015 and proceeds from sales and maturities of investments, net of purchases of investments totaled $67 million and $406 million in fiscal 2014 and 2013, respectively. Investing activities also included investments in technology to allow Applied to access new market opportunities or emerging technologies. Applied’s investment portfolio consists principally of investment grade money market mutual funds, U.S. Treasury and agency securities, municipal bonds, corporate bonds and mortgage-backed and asset-backed securities, as well as equity securities. Applied regularly monitors the credit risk in its investment portfolio and takes appropriate measures, which may include the sale of certain securities, to manage such risks prudently in accordance with its investment policies. Financing Activities Applied generated $913 million of cash from financing activities in fiscal 2015, consisting primarily of net proceeds received from the issuance of senior unsecured notes of $1.8 billion and short-term borrowings by a wholly-owned foreign subsidiary of $800 million, offset by cash used for repurchases of its common stock of $1.3 billion and payment of cash dividends of $487 million. Applied used cash in financing activities in fiscal 2014 and 2013 of $348 million and $519 million, respectively, which included payment of cash dividends to stockholders and issuances of common stock. Applied made no repurchases of its common stock in fiscal 2014 and used cash to repurchase shares of its common stock in fiscal 2013 of $245 million. On April 26, 2015, Applied's Board of Directors approved a common stock repurchase program authorizing up to $3.0 billion in repurchases over the three years ending April 2018. At October 25, 2015, $1.7 billion remained available for future stock repurchases under this repurchase program. Applied's prior stock repurchase program ended in March 2015. Proceeds from stock issuances under equity compensation awards and related excess tax benefits in fiscal 2015, 2014 and 2013 were $144 million, $137 million and $182 million, respectively. During each of fiscal 2015 and 2014, Applied’s Board of Directors declared four quarterly cash dividends of $0.10 per share. During fiscal 2013, Applied’s Board of Directors declared three quarterly cash dividends of $0.10 per share and one quarterly cash dividend of $0.09 per share. Cash paid in dividends during fiscal 2015, 2014 and fiscal 2013 amounted to $487 million, $485 million and $456 million, respectively. Applied currently anticipates that cash dividends will continue to be paid on a quarterly basis, although the declaration of any future cash dividend is at the discretion of the Board of Directors and will depend on Applied’s financial condition, results of operations, capital requirements, business conditions and other factors, as well as a determination by the Board of Directors that cash dividends are in the best interests of Applied’s stockholders. Applied has credit facilities for unsecured borrowings in various currencies of up to $1.6 billion. In September 2015, Applied entered into a $1.5 billion committed revolving credit agreement with a group of banks that is scheduled to expire in September 2020. This credit agreement provides for borrowings in United States dollars at interest rates keyed to one of various benchmark rates selected by Applied for each advance, plus a margin based on Applied's public debt rating, and includes financial and other covenants with which Applied was in compliance at October 25, 2015. Remaining credit facilities in the amount of approximately $67 million are with Japanese banks. Applied’s ability to borrow under these facilities is subject to bank approval at the time of the borrowing request, and any advances will be at rates indexed to the banks’ prime reference rate denominated in Japanese yen. No amounts were outstanding under any of these facilities at both October 25, 2015 and October 26, 2014, and Applied has not utilized these credit facilities. In fiscal 2011, Applied established a short-term commercial paper program of up to $1.5 billion. At October 25, 2015 and October 26, 2014, Applied did not have any commercial paper outstanding, but may issue commercial paper notes under this program from time to time in the future. In September 2015, Applied issued senior unsecured notes in the aggregate principal amount of $1.8 billion. The indenture governing the notes includes certain covenants with which Applied was in compliance at October 25, 2015. In November 2015, Applied completed the redemption of the entire outstanding $400 million in principal amount of senior notes due in 2016. The redemption price was $405 million, and after adjusting for the carrying value of the debt issuance costs and discounts, Applied recorded a $5 million loss on the prepayment of the $400 million debt, which will be included in non-operating loss in the Consolidated Statement of Operations for the first quarter of fiscal 2016. See Note 10 of Notes to Consolidated Financial Statements for additional discussion of long-term debt. In October 2015, a wholly-owned foreign subsidiary of Applied entered into a short-term loan agreement, guaranteed by Applied, under which it borrowed $800 million to facilitate the return of capital to Applied. Others During fiscal 2015, 2014 and 2013, Applied did not record any additional bad debt provision but released $9 million, $16 million and $13 million, respectively, of its allowance for doubtful accounts as a result of an overall lower risk profile of Applied's customers. While Applied believes that its allowance for doubtful accounts at October 25, 2015 is adequate, it will continue to closely monitor customer liquidity and economic conditions. As of October 25, 2015, approximately $2.7 billion of cash, cash equivalents, and marketable securities held by foreign subsidiaries may be subject to U.S. taxes if repatriated for U.S. operations. Of this amount, Applied intends to indefinitely reinvest approximately $2.3 billion of these funds outside of the U.S. and does not plan to repatriate these funds. For the remaining cash, cash equivalents and marketable securities held by foreign subsidiaries, U.S. taxes have been provided for in the financial statements. Although cash requirements will fluctuate based on the timing and extent of factors such as those discussed above, Applied’s management believes that cash generated from operations, together with the liquidity provided by existing cash balances and borrowing capability, will be sufficient to satisfy Applied’s liquidity requirements for the next 12 months. For further details regarding Applied’s operating, investing and financing activities, see the Consolidated Statements of Cash Flows in this report. For details on standby letters of credit and other agreements with banks, see Off-Balance Sheet Arrangements below. Off-Balance Sheet Arrangements In the ordinary course of business, Applied provides standby letters of credit or other guarantee instruments to third parties as required for certain transactions initiated by either Applied or its subsidiaries. As of October 25, 2015, the maximum potential amount of future payments that Applied could be required to make under these guarantee agreements was approximately $58 million. Applied has not recorded any liability in connection with these guarantee agreements beyond that required to appropriately account for the underlying transaction being guaranteed. Applied does not believe, based on historical experience and information currently available, that it is probable that any amounts will be required to be paid under these guarantee agreements. Applied also has agreements with various banks to facilitate subsidiary banking operations worldwide, including overdraft arrangements, issuance of bank guarantees, and letters of credit. As of October 25, 2015, Applied Materials Inc. has provided parent guarantees to banks for approximately $100 million to cover these arrangements. Applied also has operating leases for various facilities. Total rent expense for fiscal 2015, 2014 and 2013 was $32 million, $37 million and $36 million, respectively. Contractual Obligations The following table summarizes Applied’s contractual obligations as of October 25, 2015: ______________________ Represents Applied’s agreements to purchase goods and services consisting of Applied’s outstanding purchase orders for goods and services. Other long-term liabilities in the table do not include pension, post-retirement and deferred compensation plans due to the uncertainty in the timing of future payments. Applied evaluates the need to make contributions to its pension and post-retirement benefit plans after considering the funded status of the plans, movements in the discount rate, performance of the plan assets and related tax consequences. Payments to the plans would be dependent on these factors and could vary across a wide range of amounts and time periods. Payments for deferred compensation plans are dependent on activity by participants, making the timing of payments uncertain. Information on Applied’s pension, post-retirement benefit and deferred compensation plans is presented in Note 13, Employee Benefit Plans, of the consolidated financial statements. Other long-term liabilities in the table do not include noncurrent income taxes payable, noncurrent deferred income taxes payable and certain tax-related liabilities classified as other noncurrent liabilities on the balance sheet, due to the uncertainty in the timing and amount of future payments. As of October 25, 2015, the gross liability for unrecognized tax benefits that was not expected to result in payment of cash within one year was $177 million. Interest and penalties related to uncertain tax positions that were not expected to result in payment of cash within one year of October 25, 2015 and October 26, 2014 were $14 million and $25 million, respectively. Critical Accounting Policies and Estimates The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported. Note 1 of Notes to Consolidated Financial Statements describes the significant accounting policies used in the preparation of the consolidated financial statements. Certain of these significant accounting policies are considered to be critical accounting policies. A critical accounting policy is defined as one that is both material to the presentation of Applied’s consolidated financial statements and that requires management to make difficult, subjective or complex judgments that could have a material effect on Applied’s financial condition or results of operations. Specifically, these policies have the following attributes: (1) Applied is required to make assumptions about matters that are highly uncertain at the time of the estimate; and (2) different estimates Applied could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on Applied’s financial condition or results of operations. Estimates and assumptions about future events and their effects cannot be determined with certainty. Applied bases its estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as Applied’s operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they became known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties include those discussed in Part I, Item 1A, “Risk Factors.” Based on a critical assessment of its accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that Applied’s consolidated financial statements are fairly stated in accordance with accounting principles generally accepted in the United States of America, and provide a meaningful presentation of Applied’s financial condition and results of operations. Management believes that the following are critical accounting policies and estimates: Revenue Recognition Applied recognizes revenue when all four revenue recognition criteria have been met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; sales price is fixed or determinable; and collectability is probable. Each sale arrangement may contain commercial terms that differ from other arrangements. In addition, Applied frequently enters into contracts that contain multiple deliverables. Judgment is required to properly identify the accounting units of the multiple deliverable transactions and to determine the manner in which revenue should be allocated among the accounting units. Moreover, judgment is used in interpreting the commercial terms and determining when all criteria of revenue recognition have been met in order for revenue recognition to occur in the appropriate accounting period. While changes in the allocation of the estimated sales price between the units of accounting will not affect the amount of total revenue recognized for a particular sales arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could have a material effect on Applied’s financial condition and results of operations. Warranty Costs Applied provides for the estimated cost of warranty when revenue is recognized. Estimated warranty costs are determined by analyzing specific product, current and historical configuration statistics and regional warranty support costs. Applied’s warranty obligation is affected by product and component failure rates, material usage and labor costs incurred in correcting product failures during the warranty period. As Applied’s customer engineers and process support engineers are highly trained and deployed globally, labor availability is a significant factor in determining labor costs. The quantity and availability of critical replacement parts is another significant factor in estimating warranty costs. Unforeseen component failures or exceptional component performance can also result in changes to warranty costs. If actual warranty costs differ substantially from Applied’s estimates, revisions to the estimated warranty liability would be required, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Allowance for Doubtful Accounts Applied maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. This allowance is based on historical experience, credit evaluations, specific customer collection history and any customer-specific issues Applied has identified. Changes in circumstances, such as an unexpected material adverse change in a major customer’s ability to meet its financial obligation to Applied or its payment trends, may require Applied to further adjust its estimates of the recoverability of amounts due to Applied, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Inventory Valuation Inventories are generally stated at the lower of cost or market, with cost determined on a first-in, first-out basis. The carrying value of inventory is reduced for estimated obsolescence by the difference between its cost and the estimated market value based upon assumptions about future demand. Applied evaluates the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional adjustments for excess or obsolete inventory may be required, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Goodwill and Intangible Assets Applied reviews goodwill and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, and also annually reviews goodwill and intangibles with indefinite lives for impairment. Intangible assets, such as purchased technology, are generally recorded in connection with a business acquisition. The value assigned to intangible assets is usually based on estimates and judgments regarding expectations for the success and life cycle of products and technology acquired. If actual product acceptance differs significantly from the estimates, Applied may be required to record an impairment charge to reduce the carrying value of the reporting unit to its estimated fair value. To test goodwill for impairment, Applied first performs a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If it is concluded that this is the case, Applied then performs the two-step goodwill impairment test. Otherwise, the two-step goodwill impairment test is not required. Under the two-step goodwill impairment test, Applied would in the first step compare the estimated fair value of each reporting unit to its carrying value. If the carrying value of a reporting unit exceeds its estimated fair value, Applied would then perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If Applied determines that the carrying value of a reporting unit’s goodwill exceeds its implied fair value, Applied would record an impairment charge equal to the difference. Applied determines the fair value of each reporting unit based on a weighting of an income and a market approach. Applied bases the fair value estimates on assumptions that it believes to be reasonable but that are unpredictable and inherently uncertain. Under the income approach, Applied estimates the fair value based on discounted cash flow method. The estimates used in the impairment testing are consistent with the discrete forecasts that Applied uses to manage its business, and considers any significant developments during the period. Under the discounted cash flow method, cash flows beyond the discrete forecasts are estimated using a terminal growth rate, which considers the long-term earnings growth rate specific to the reporting units. The estimated future cash flows are discounted to present value using each reporting unit's weighted average cost of capital. The weighted average cost of capital measures a reporting unit's cost of debt and equity financing weighted by the percentage of debt and equity in a reporting unit's target capital structure. In addition, the weighted average cost of capital is derived using both known and estimated market metrics, and is adjusted to reflect both the timing and risks associated with the estimated cash flows. The tax rate used in the discounted cash flow method is the median tax rate of comparable companies and reflects Applied's current international structure, which is consistent with the market participant perspective. Under the market approach, Applied uses the guideline company method which applies market multiples to forecasted revenues and earnings before interest, taxes, depreciation and amortization. Applied uses market multiples that are consistent with comparable publicly-traded companies and considers each reporting unit's size, growth and profitability relative to its comparable companies. Management uses significant judgment when assessing goodwill for potential impairment, especially in emerging markets. Indicators of potential impairment include, but are not limited to, challenging economic conditions, an unfavorable industry or economic environment or other severe decline in market conditions. Such conditions could have the effect of changing one of the critical assumptions or estimates used for the fair value calculation, resulting in an unexpected goodwill impairment charge, which could have a material adverse effect on Applied’s business, financial condition and results of operations. See Note 9 of Notes to Consolidated Financial Statements for additional discussion of goodwill impairment. Income Taxes Applied’s effective tax rate is affected by the geographical composition of income and income tax laws and regulations in multiple jurisdictions. Applied accounts for income taxes by recognizing deferred tax assets and liabilities using statutory tax rates for the effect of temporary differences between the book and tax bases of recorded assets and liabilities, net operating losses and tax credit carryovers. Deferred tax assets are also reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. Management has determined that it is more likely than not that Applied’s future taxable income will be sufficient to realize its deferred tax assets, net of existing valuation allowance. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with Applied’s expectations could have a material impact on Applied’s results of operations and financial condition. Non-GAAP Adjusted Results Management uses non-GAAP adjusted results to evaluate operating and financial performance in light of business objectives and for planning purposes. Applied believes these measures enhance investors’ ability to review the Company’s business from the same perspective as management and facilitate comparisons of this period’s results with prior periods. The non-GAAP adjusted results presented below exclude the impact of the following, where applicable: certain items related to acquisitions; restructuring charges and any associated adjustments; impairments of assets, goodwill, or investments; gain or loss on sale of strategic investments or facilities; and certain discrete adjustments and tax items. These non-GAAP adjusted measures are not in accordance with GAAP and may differ from non-GAAP methods of accounting and reporting used by other companies. The presentation of this additional information should not be considered a substitute for results prepared in accordance with GAAP. The following tables present a reconciliation of the GAAP and non-GAAP adjusted consolidated results for the past three fiscal years: APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS These items are incremental charges attributable to completed acquisitions, consisting of amortization of purchased intangible assets. These items are incremental charges related to the terminated business combination agreement with Tokyo Electron Limited, consisting of acquisition-related and integration planning costs. Results for fiscal 2015 primarily included $35 million of inventory charges, $17 million of restructuring charges and asset impairments related to cost reductions in the solar business, and a $2 million favorable adjustment of restructuring reserves related to prior restructuring plans. Results for fiscal 2013 included $39 million of employee-related costs, net, related to the restructuring program announced on October 3, 2012, and restructuring and asset impairment charges of $26 million related to the restructuring program announced on May 10, 2012, partially offset by a favorable adjustment of $2 million related to other restructuring plans. Amounts for fiscal 2015 included an adjustment to decrease the provision for income taxes by $28 million with a corresponding increase in net income, resulting in an increase in diluted earnings per share of $0.02. The adjustment was excluded in Applied's non-GAAP adjusted results and was made primarily to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales, which resulted in overstating profitability in the U.S. and the provision for income taxes in immaterial amounts in each year since fiscal 2010. Results for fiscal 2015 included a $19 million foreign exchange loss due to an immaterial correction of an error related to functional currency change. These items are significant gains, losses, or charges during a period that are the result of isolated events or transactions which have not occurred frequently in the past and are not expected to occur regularly or be repeated in the future. APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS Amounts for fiscal 2015 included an adjustment to decrease the provision for income taxes by $28 million with a corresponding increase in net income, resulting in an increase in diluted earnings per share of $0.02. The adjustment was excluded in Applied's non-GAAP adjusted results and was made primarily to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales, which resulted in overstating profitability in the U.S. and the provision for income taxes in immaterial amounts in each year since fiscal 2010. The following table presents a reconciliation of the GAAP and non-GAAP adjusted segment results for the past three fiscal years: APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS These items are incremental charges attributable to completed acquisitions, consisting of amortization of purchased intangible assets. Results for fiscal 2015 primarily included $35 million of inventory charges, $17 million of restructuring charges and asset impairments related to cost reductions in the solar business, and a $2 million favorable adjustment of restructuring reserves related to prior restructuring plans. Results for fiscal 2013 included restructuring and asset impairment charges of $26 million related to the restructuring program announced announced on May 10, 2012 and severance charges of $2 million related to the integration of Varian. These items are significant gains, losses, or charges during a period that are the result of isolated events or transactions which have not occurred frequently in the past and are not expected to occur regularly or be repeated in the future. Note: The reconciliation of GAAP and non-GAAP adjusted segment results above does not include certain operating expenses that are managed separately at the corporate level and certain expenses that are not absorbed by the segments, which are reported within corporate and unallocated costs and included in consolidated operating income.

<s>[INST] Introduction Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to facilitate an understanding of Applied’s business and results of operations. This MD&A should be read in conjunction with Applied’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10K. The following discussion contains forwardlooking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10K. MD&A consists of the following sections: Overview: a summary of Applied’s business and measurements Results of Operations: a discussion of operating results Segment Information: a discussion of segment operating results Business Combinations: a summary of announced or completed business combinations and acquisitions Recent Accounting Pronouncements: a discussion of new accounting pronouncements and its impact to Applied's consolidated financial statements Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash OffBalance Sheet Arrangements and Contractual Obligations Critical Accounting Policies and Estimates: a discussion of critical accounting policies that require the exercise of judgments and estimates NonGAAP Adjusted Results: a presentation of results reconciling GAAP to nonGAAP adjusted measures Overview Applied provides manufacturing equipment, services and software to the global semiconductor, display, solar photovoltaic (PV) and related industries. Applied’s customers include manufacturers of semiconductor wafers and chips, liquid crystal and other displays, solar PV cells and modules, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Applied operates in four reportable segments: Silicon Systems, Applied Global Services, Display, and Energy and Environmental Solutions. A summary of financial information for each reportable segment is found in Note 16 of Notes to Consolidated Financial Statements. A discussion of factors that could affect Applied’s operations is set forth under “Risk Factors” in Part I, Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in the United States, Europe, Israel, and Asia. Applied’s broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied’s results are driven primarily by worldwide demand for semiconductors, which in turn depends on enduser demand for electronic products. Each of Applied’s businesses is subject to cyclical industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, display technologies, solar PVs and other electronic devices, as well as other factors, such as global economic and market conditions, and the nature and timing of technological advances in fabrication processes. In addition, a significant driver in the semiconductor and display industries is enddemand for mobile consumer products, which is characterized by seasonality that impacts the timing of customer investments in manufacturing equipment and, in turn, Applied's business. In light of these conditions, Applied's results can vary significantly yearoveryear, as well as quarteroverquarter. Applied's strategic priorities for fiscal 2016 include developing products that help solve customers’ challenges at technology inflections; expanding its served market opportunities in the semiconductor and display industries; and growing its services business. On April 26, 2015, Applied and Tokyo Electron Limited (TEL) announced that they had mutually agreed to terminate their previously announced Business Combination Agreement, which was entered into on September 24, 2013 and intended to effect a strategic combination of their respective business into a new combined company. No termination fee was payable by either Applied or TEL. Results of Operations The following table presents certain significant measurements for the past three fiscal years: Reconciliations of nonGAAP adjusted measures are presented under "NonGAAP Adjusted Results" below. Fiscal 2015, 2014 and 2013 each contained 52 weeks. Mobility, and the increasing technological functionality of mobile devices, continues to be the largest drivers of sem [/INST] Negative. </s>

APPLIED MATERIALS INC /DE

2016-12-15

2016-10-30

Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations Introduction Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to facilitate an understanding of Applied’s business and results of operations. This MD&A should be read in conjunction with Applied’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10-K. The following discussion contains forward-looking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10-K. MD&A consists of the following sections: • Overview: a summary of Applied’s business and measurements • Results of Operations: a discussion of operating results • Segment Information: a discussion of segment operating results • Recent Accounting Pronouncements: a discussion of new accounting pronouncements and its impact to Applied’s consolidated financial statements • Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash • Off-Balance Sheet Arrangements and Contractual Obligations • Critical Accounting Policies and Estimates: a discussion of critical accounting policies that require the exercise of judgments and estimates • Non-GAAP Adjusted Results: a presentation of results reconciling GAAP to non-GAAP adjusted measures Overview Applied provides manufacturing equipment, services and software to the global semiconductor, display, and related industries. Applied’s customers include manufacturers of semiconductor wafers and chips, liquid crystal and other displays, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Applied operates in three reportable segments: Semiconductor Systems (previously Silicon Systems), Applied Global Services, and Display and Adjacent Markets (previously Display). A summary of financial information for each reportable segment is found in Note 14 of Notes to Consolidated Financial Statements. A discussion of factors that could affect Applied’s operations is set forth under “Risk Factors” in Part I, Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in the United States, Europe, Israel, and Asia. Applied’s broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied’s results are driven primarily by worldwide demand for semiconductors and displays, which in turn depends on end-user demand for electronic products. Each of Applied’s businesses is subject to variable industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, display technologies, and other electronic devices, as well as other factors, such as global economic and market conditions, and the nature and timing of technological advances in fabrication processes. In addition, a significant driver in the semiconductor and display industries is end-demand for mobile consumer products, which is characterized by seasonality that impacts the timing of customer investments in manufacturing equipment and, in turn, Applied’s business. In light of these conditions, Applied’s results can vary significantly year-over-year, as well as quarter-over-quarter. The following table presents certain significant measurements for the past three fiscal years: Reconciliations of non-GAAP adjusted measures are presented below under “Non-GAAP Adjusted Results.” Fiscal 2016 contained 53 weeks and fiscal 2015 and 2014 each contained 52 weeks. Applied’s strategic priorities include developing products that help solve customers’ challenges at technology inflections; expanding its served market opportunities in the semiconductor and display industries; and growing its services business. Mobility, and the increasing technological functionality of mobile devices, continues to be a strong driver of semiconductor industry spending. During fiscal 2016, memory manufacturers invested in technology upgrades and additional capacity, both of which were driven primarily by the transition from planar NAND to 3D NAND. Foundry customers also invested in technology upgrades and new capacity to meet demand for advanced mobile chips. Mobility investments, including increasing investments in new technology such as OLED for mobile devices, represents a significant driver of display industry spending, which has resulted in higher manufacturing capacity expansion for mobile applications. As a result, new orders for display equipment increased in fiscal 2016 compared to the prior year. Demand for larger LCD TVs is also a factor for display industry investments, although demand for TV manufacturing equipment remains susceptible to cyclical conditions. In fiscal 2017, Applied expects these trends to continue to drive demand for the semiconductor industry, and in turn for the Semiconductor Systems segment. Applied also expects healthy spending in semiconductor spares and services, and increased spending for display manufacturing equipment in fiscal 2017. Effective in the third quarter of fiscal 2016, Applied began to account for its flexible coating systems (previously in Energy and Environmental Solutions) and display upgrade equipment (previously in Applied Global Services) under the Display and Adjacent Markets segment. As a result of the change, Applied’s solar business (previously in Energy and Environmental Solutions) is included in Corporate and Other as it did not meet the threshold for a separate reportable segment. Results for prior periods have been recast to conform to the current presentation. Results of Operations New Orders New orders for the periods indicated were as follows: New orders for fiscal 2016 increased across all segments compared to the prior year, primarily due to higher demand for display and semiconductor equipment. New orders for the Semiconductor Systems segment continued to comprise the majority of Applied’s consolidated total new orders. New orders for fiscal 2015 slightly increased from fiscal 2014 due to higher demand for semiconductor equipment, and semiconductor spares and services, partially offset by lower demand for display equipment. New orders by geographic region for each fiscal year, determined by the product shipment destination specified by the customer, were as follows: The increase in new orders from customers in Taiwan, Europe and Southeast Asia in fiscal 2016 compared to fiscal 2015 was primarily due to higher demand for semiconductor equipment, and the increase in new orders in China in fiscal 2016 reflected increased demand for semiconductor and display equipment. The increase in new orders from customers in Korea in fiscal 2016 was primarily due to higher demand for display equipment. The decrease in new orders from customers in Japan in fiscal 2016 compared to the prior year was primarily attributed to lower orders from memory customers, partially offset by higher demand for display equipment. The changes in new orders from customers in Korea, Japan, the United States and Europe in fiscal 2015 compared with fiscal 2014 primarily reflected changes in customer mix for semiconductor equipment. Changes in backlog during each fiscal year were as follows: Backlog consists of: (1) orders for which written authorizations have been accepted and assigned shipment dates are within the next 12 months, or shipment has occurred but revenue has not been recognized; and (2) contractual service revenue and maintenance fees to be earned within the next 12 months. Applied’s backlog at any particular time is not necessarily indicative of actual sales for any future periods due to the potential for customer changes in delivery schedules or cancellation of orders. Approximately 64 percent of backlog as of the end of fiscal 2016 is anticipated to be shipped within the next two quarters. Applied’s backlog was $4.6 billion at October 30, 2016 compared to $3.1 billion at October 25, 2015. Backlog adjustments were negative for fiscal 2016 and totaled $155 million, primarily due to change in expected timing of shipments, order cancellations and other adjustments, partially offset by favorable foreign currency impact. Backlog adjustments were also negative for fiscal 2015 and totaled $220 million, primarily consisting of order cancellations, unfavorable foreign currency impacts and other adjustments. Backlog as of the end of the most recent two fiscal years was as follows: Total backlog in fiscal 2016 compared to fiscal 2015 increased primarily due to higher demand for display and semiconductor equipment. In the fourth quarter of fiscal 2016 approximately 37 percent of net sales in the Semiconductor Systems segment, Applied’s largest business segment, were for orders received and shipped within the quarter, down from 55 percent in the fourth quarter of fiscal 2015. Net Sales Net sales for the periods indicated were as follows: Net sales in fiscal 2016 compared to fiscal 2015 increased primarily due to increased customer investments in semiconductor and display equipment. The Semiconductor Systems segment’s relative share of total net sales remained flat compared to the prior year and remains the largest contributor of net sales. Net sales increased in fiscal 2015 compared to fiscal 2014 primarily due to greater customer investments in semiconductor spares and services, 200mm equipment systems and display and semiconductor equipment. Net sales by geographic region, determined by the location of customers’ facilities to which products were shipped, were as follows: The changes in net sales in all regions for fiscal 2016 compared to fiscal 2015 reflected increased spending on semiconductor equipment and changes in customer mix for semiconductor equipment. The changes in net sales in Korea, Japan and China also reflected changes in customer mix for display equipment. The changes in net sales in Korea, Japan and Taiwan in fiscal 2015 compared to fiscal 2014 primarily reflected changes in customer mix for semiconductor equipment. The decrease in net sales in the United States was due to lower customer spending on semiconductor equipment, partially offset by increased spending on semiconductor spares and services, and 200mm equipment. Gross Margin Gross margins for the periods indicated were as follows: Reconciliations of non-GAAP adjusted measures are presented below under “Non-GAAP Adjusted Results” below. Gross profit, non-GAAP adjusted gross profit, gross margin and non-GAAP adjusted gross margin in fiscal 2016 increased compared to fiscal 2015 primarily due to higher net sales, partially offset by unfavorable changes in product mix. Gross profit and non-GAAP adjusted gross profit in fiscal 2015 increased compared to fiscal 2014, primarily due to higher net sales, while gross margin and non-GAAP adjusted gross margin decreased primarily due to unfavorable changes in product mix and the absence of a recovery of a regional customs duty assessment charge recorded in fiscal 2014. Gross profit and non-GAAP adjusted gross profit during fiscal 2016, 2015 and 2014 included $62 million, $57 million and $53 million, respectively, of share-based compensation expense. Research, Development and Engineering Research, Development and Engineering (RD&E) expenses for the periods indicated were as follows: Applied’s future operating results depend to a considerable extent on its ability to maintain a competitive advantage in the equipment and service products it provides. Development cycles range from 12 to 36 months depending on whether the product is an enhancement of an existing product, which typically has a shorter development cycle, or a new product, which typically has a longer development cycle. Most of Applied’s existing products resulted from internal development activities and innovations involving new technologies, materials and processes. In certain instances, Applied acquires technologies, either in existing or new product areas, to complement its existing technology capabilities and to reduce time to market. Management believes that it is critical to continue to make substantial investments in RD&E to assure the availability of innovative technology that meets the current and projected requirements of its customers’ most advanced designs. Applied has maintained and intends to continue its commitment to investing in RD&E in order to continue to offer new products and technologies. In fiscal 2016, Applied increased its RD&E investments in new product growth across Semiconductor Systems and Display and Adjacent Markets, including etch, e-beam inspection, new materials engineering solutions to improve transistor performance and OLED displays. Applied’s investments in etch were focused on supporting the adoption of the Producer® Selectra™ Etch system, an extreme selectivity etch tool for enabling continued scaling of 3D logic and memory chips. The investment in e-beam inspection was in support of the PROVision™ system, which helps achieve higher yields at advanced nodes by detecting the most challenging defects and monitoring process marginality. Applied also invested in materials engineering solutions to improve transistor performance by lowering the contact resistance between the transistor and interconnect wiring. In Display and Adjacent Markets, RD&E investments were focused on expanding the company’s market opportunity with a new high-resolution inline e-beam review system and forthcoming solutions to improve OLED and flexible display manufacturing. RD&E expenses increased in fiscal 2016 compared to the prior year and also in fiscal 2015 compared to fiscal 2014, reflecting the impact of ongoing investments in product development initiatives. As part of its growth strategy, Applied continued to reprioritize existing spend, to enable increased funding for investments in technical capabilities and critical RD&E programs in current and new markets, with a focus on semiconductor technologies. RD&E expense during fiscal 2016, 2015 and 2014 included $76 million, $69 million and $66 million, respectively, of share-based compensation expense. Marketing and Selling Marketing and selling expenses for the periods indicated were as follows: Marketing and selling expenses remained relatively flat in fiscal 2016 compared to fiscal 2015 and fiscal 2014 due to continued cost management efforts. Marketing and selling expenses for fiscal years 2016, 2015, and 2014 included $26 million, $26 million and $23 million, respectively, of share-based compensation expense. General and Administrative General and administrative expenses for the periods indicated were as follows: General and administrative (G&A) expenses for fiscal 2016 decreased compared to the prior year. G&A expenses were higher in fiscal 2015 primarily due to acquisition-related and integration costs related to the terminated business combination with Tokyo Electron Limited (TEL), impact of foreign currency exchange loss as a result of functional currency correction, and restructuring charges, all recorded during fiscal 2015. G&A expenses for fiscal 2015 decreased compared to fiscal 2014 primarily due to lower acquisition-related and integration costs related to the terminated business combination with TEL, which was terminated in April 2015, and continued cost management efforts. G&A expenses during fiscal 2016, 2015 and 2014 included $37 million, $35 million and $35 million, respectively, of share-based compensation expense. Loss (Gain) on Derivatives Associated with Terminated Business Combination Changes in gain or loss on derivatives associated with the terminated business combination with TEL resulted from exchange rate fluctuations and the sale of derivative contracts in fiscal 2015. For further details, see Note 5 of Notes to Consolidated Financial Statements. Interest Expense and Interest and Other Income (loss), net Interest expense and interest and other income (loss), net for the periods indicated were as follows: Interest expenses incurred were primarily associated with the senior unsecured notes issued in June 2011 and September 2015. Interest expense for fiscal 2016 increased compared to fiscal 2015 due to the issuance of senior unsecured notes in September 2015. Interest and other income, net primarily includes interest earned on cash and investments, realized gains or losses on sales of securities and impairment of strategic investments. Interest and other income, net in fiscal 2016 increased compared to fiscal 2015 primarily due to higher interest income from investments, partially offset by a $5 million loss from prepayment of $400 million debt. Interest and other income, net in fiscal 2015 decreased compared to fiscal 2014 primarily due to lower realized gains on sales of strategic investments in fiscal 2015. Income Taxes Provision for income taxes and effective tax rates for the periods indicated were as follows: Applied’s provision for income taxes and effective tax rate are affected by the geographical composition of pre-tax income which includes jurisdictions with differing tax rates, conditional reduced tax rates and other income tax incentives. It is also affected by events that are not consistent from period to period, such as changes in income tax laws and the resolution of prior years’ income tax filings. Applied’s effective tax rates for fiscal 2016, 2015 and 2014 were 14.5%, 13.8% and 26.0%, respectively. The effective tax rate for fiscal 2016 was higher than fiscal 2015 primarily due to resolutions and changes related to income tax liabilities for uncertain tax positions, partially offset by changes in the geographical composition of income. The effective tax rate for fiscal 2015 was lower than the rate for fiscal 2014 primarily due to acquisition costs that became deductible in the second quarter of fiscal 2015 as a result of the termination of the proposed business combination with TEL, an adjustment in the second quarter of fiscal 2015 to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales as discussed below, reinstatement of the U.S. federal research and development tax credit during the first quarter of fiscal 2015 which was retroactive to its expiration in December 2013, resolutions and changes related to income tax liabilities for prior years, and changes in the geographical composition of income. The effective tax rate for fiscal 2015 included the effect of an adjustment primarily to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales. While this error had no impact on Applied’s consolidated cost of sales, it resulted in overstating profitability in the U.S. and the provision for income taxes, income taxes payable and other tax balance sheet accounts in each year since fiscal 2010. The impact of the adjustment to fiscal 2015 was a decrease in provision for income taxes of $28 million which was determined to be immaterial on the originating periods and fiscal 2015. Accordingly, a restatement was not considered necessary. Segment Information Applied reports financial results in three segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets. A description of the products and services, as well as financial data, for each reportable segment can be found in Note 14 of Notes to Consolidated Financial Statements. The Corporate and Other category includes revenues from products, as well as costs of products sold, for fabricating solar photovoltaic cells and modules and certain operating expenses that are not allocated to its reportable segments and are managed separately at the corporate level. These operating expenses include costs for share-based compensation; certain management, finance, legal, human resource, and RD&E functions provided at the corporate level; and unabsorbed information technology and occupancy. In addition, Applied does not allocate to its reportable segments restructuring and asset impairment charges and any associated adjustments related to restructuring actions, unless these actions pertain to a specific reportable segment. The results for each reportable segment are discussed below. Semiconductor Systems Segment The Semiconductor Systems segment includes semiconductor capital equipment for deposition, etch, ion implantation, rapid thermal processing, chemical mechanical planarization, metrology and inspection, and wafer level packaging. Development efforts are focused on solving customers’ key technical challenges in transistor, interconnect, patterning and packaging performance as devices scale to advanced technology nodes. The mobility trend remains the largest influence on industry spending, as it drives semiconductor device manufacturers to continually improve their ability to deliver high-performance, low-power processors and affordable memories. Certain significant measures for the periods indicated were as follows: Reconciliations of non-GAAP adjusted measures are presented below under “Non-GAAP Adjusted Results.” New orders for Semiconductor Systems by end use application for the periods indicated were as follows: The following region accounted for at least 30 percent of total net sales for the Semiconductor Systems segment for one or more of past three fiscal years: Customers in Taiwan accounted for 32 percent, 32 percent and 37 percent of total net sales for Semiconductor Systems in fiscal 2016, 2015 and 2014, respectively. The increase in net sales from customers in Taiwan primarily reflected increased investments from foundry customers. Financial results in the Semiconductor Systems segment for fiscal 2016 reflected steady overall demand for semiconductor equipment, with continued investments by memory customers in technology upgrades and additional capacity, reflecting primarily the transition from planar technology to 3D architectures. Foundry customers also invested in technology upgrades and new capacity to meet demand for advanced mobile chips. New orders for fiscal 2016 increased compared to the prior year primarily due to higher demand from foundry customers, partially offset by lower demand from memory customers. Net sales for fiscal 2016 increased compared to fiscal 2015 primarily due to higher spending from foundry and memory customers. The increase in the operating income, non-GAAP adjusted operating income, operating margin and non-GAAP adjusted operating margin for fiscal 2016 compared to fiscal 2015 primarily reflected higher net sales. Three customers accounted for approximately 54 percent of this segment’s new orders for fiscal 2016, each of whom represented at least 10 percent of this segment’s new orders. Four customers accounted for approximately 60 percent of this segment’s net sales for fiscal 2016, each of whom represented at least 10 percent of this segment’s net sales. The increase in new orders and net sales in fiscal 2015 compared to fiscal 2014 primarily reflected increased demand and spending from memory customers, partially offset by lower demand and spending from foundry customers. Two customers accounted for approximately 41 percent of net sales and three customers accounted for 53 percent of new orders in this segment in fiscal 2015. Operating income and non-GAAP adjusted operating income for fiscal 2015 increased compared to fiscal 2014, reflecting the increase in net sales, partially offset by changes in product mix and higher research and development expenses. Applied Global Services Segment The Applied Global Services segment provides integrated solutions to optimize equipment and fab performance and productivity, including spares, upgrades, services, certain remanufactured earlier generation equipment and factory automation software for semiconductor, display and other products. Customer demand for products and services is fulfilled through a global distribution system with trained service engineers located in close proximity to customer sites. Certain significant measures for the periods indicated were as follows: Reconciliations of non-GAAP adjusted measures are presented below under “Non-GAAP Adjusted Results.” There was no single region that accounted for at least 30 percent of total net sales for the Applied Global Services segment for any of the past three fiscal years. New orders and net sales for fiscal 2016 slightly increased compared to fiscal 2015 primarily due to higher demand and spending on spares and services, partially offset by lower investments in 200mm equipment systems. Operating income, non-GAAP adjusted operating income, operating margin and non-GAAP adjusted operating margin for fiscal 2016 increased compared to fiscal 2015, reflecting higher net sales partially offset by increased headcount to support business growth. One customer accounted for approximately 15 percent of this segment’s new orders for fiscal 2016. Two customers accounted for approximately 23 percent of this segment’s net sales for fiscal 2016, each of whom represented at least 10 percent of this segment’s net sales. New orders and net sales for fiscal 2015 increased compared to fiscal 2014 mainly due to higher demand for semiconductor spares and services, and 200mm equipment systems. Operating income, operating margin, non-GAAP adjusted operating income, and non-GAAP adjusted operating margin increased in fiscal 2015 compared fiscal 2014, reflecting the increase in net sales, which was partially offset by unfavorable product mix and the absence of a recovery of a regional customs duty assessment charge recorded in fiscal 2014. Display and Adjacent Markets Segment The Display and Adjacent Markets segment encompasses products for manufacturing liquid crystal displays (LCDs), organic light-emitting diodes (OLEDs), upgrades and flexible coating systems and other display technologies for TVs, personal computers (PCs), tablets, smart phones and other consumer-oriented devices. The segment is focused on expanding its presence through technologically-differentiated equipment for manufacturing large-scale TVs; emerging markets such as OLED, low temperature polysilicon (LTPS), metal oxide, and touch panel sectors; and development of products that provide customers with improved performance and yields. Display and Adjacent Markets industry growth depends primarily on consumer demand for increasingly larger and more advanced TVs as well as larger and higher resolution displays for next generation mobile devices, including OLED. Certain significant measures for the periods presented were as follows: Reconciliations of non-GAAP adjusted measures are presented below under “Non-GAAP Adjusted Results.” The following regions accounted for at least 30 percent of total net sales for the Display and Adjacent Markets segment for one or more of the periods presented: In fiscal 2016, 2015 and 2014, customers in China accounted for 37 percent, 66 percent and 69 percent, respectively, of the Display and Adjacent Markets segment’s total net sales. Customers in Korea accounted for 41 percent, 17 percent and 17 percent of total net sales for the Display and Adjacent Markets segment in fiscal 2016, 2015 and 2014, respectively. The decrease in net sales from customers in China reflected lower customer investments in TV manufacturing equipment, while the increase in net sales from customers in Korea related to investments in mobile display manufacturing equipment. New orders for fiscal 2016 increased compared to fiscal 2015 primarily due to increased orders for mobile display manufacturing equipment, reflecting increased demand for new technology, and TV manufacturing equipment. Net sales for fiscal 2016 increased compared to fiscal 2015 primarily due to higher customer investments in mobile display manufacturing equipment, partially offset by lower customer spending in TV manufacturing equipment. Operating income and non-GAAP adjusted operating income increased while operating margin and non-GAAP adjusted operating margin remained essentially flat or decreased slightly for fiscal 2016 compared to fiscal 2015, reflecting unfavorable product mix and higher research and new product development costs. Two customers accounted for approximately 63 percent of new orders for the Display and Adjacent Markets segment in fiscal 2016, with one customer accounting for approximately 36 percent of new orders. Two customers accounted for approximately 55 percent of net sales for this segment in fiscal 2016, with one customer accounting for approximately 44 percent of net sales. New orders for fiscal 2015 decreased compared to fiscal 2014 primarily due to lower TV manufacturing equipment orders, while net sales for fiscal 2015 were higher due to the timing of shipments. Operating income and non-GAAP adjusted operating income increased for fiscal 2015 from fiscal 2014, reflecting higher net sales. Operating margin and non-GAAP adjusted operating margin decreased, despite the increase in net sales, primarily due to unfavorable product mix, increased research and development expenses and the sale of tools in fiscal 2014 for which inventory had been previously fully reserved. Four customers accounted for approximately 65 percent of new orders for the Display and Adjacent Markets segment in fiscal 2015, with two customers accounting for approximately 37 percent of new orders. Four customers accounted for approximately 79 percent of net sales for this segment in fiscal 2015, with two customers accounting for approximately 46 percent of net sales. Recent Accounting Pronouncements For a description of recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on Applied’s consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements. Financial Condition, Liquidity and Capital Resources Applied’s cash, cash equivalents and investments consist of the following: Sources and Uses of Cash A summary of cash provided by (used in) operating, investing, and financing activities is as follows: Operating Activities Cash from operating activities for fiscal 2016 was $2.5 billion, which reflects net income adjusted for the effect of non-cash charges and changes in working capital components. Non-cash charges included depreciation, amortization, share-based compensation and deferred income taxes. The primary drivers of the increase in cash from operating activities from fiscal 2015 to fiscal 2016 included higher net income and increases in customer deposits, deferred revenue, accounts payable and accrued expenses, partially offset by higher increases in accounts receivable. The primary drivers of the decrease in cash from operating activities from fiscal 2014 to fiscal 2015 were the increases in inventories and deferred income taxes and decreases in accounts payable, accrued expenses, customer deposits, deferred revenue and income taxes payable, partially offset by higher net income. Applied has agreements with various financial institutions to sell accounts receivable and discount promissory notes from selected customers. Applied sells its accounts receivable without recourse. Applied, from time to time, also discounts letters of credit issued by customers through various financial institutions. The discounting of letters of credit depends on many factors, including the willingness of financial institutions to discount the letters of credit and the cost of such arrangements. Applied sold $75 million and $45 million of accounts receivable during fiscal 2016 and 2014, respectively. Applied did not sell accounts receivable during fiscal 2015. Applied did not discount promissory notes or utilize programs to discount letters of credit issued by customers during fiscal 2016 or 2015. Applied discounted $29 million letters of credit issued by customers during fiscal 2014. Applied’s working capital was $4.7 billion at October 30, 2016 and $5.5 billion at October 25, 2015. Applied’s working capital at October 30, 2016 includes the effects of the adoption of the authoritative guidance requiring all deferred tax assets and liabilities, and any related valuation allowance, to be classified as noncurrent on the balance sheet. Prior periods were not retrospectively adjusted. Days sales, inventory and payable outstanding at the end of each of the periods indicated were: Days sales outstanding varies due to the timing of shipments and payment terms. Days sales outstanding decreased at the end of fiscal 2016 compared to fiscal 2015 primarily due to higher revenue and sale of accounts receivable, and remained flat at the end of fiscal 2015 compared to fiscal 2014. The decrease in days inventory outstanding during the current year compared to prior year reflected increased business volume, offset by higher inventory balances at the end of fiscal 2016. Days inventory outstanding increased at the end of fiscal 2015 compared to fiscal 2014 reflecting higher inventory near the end of the period due to increase in deferred inventory and more builds as compared to revenue turns. Days payable outstanding decreased slightly during fiscal 2016 compared to fiscal 2015 reflecting higher total cost of products sold due to higher business volume, and remained relatively flat in fiscal 2015 compared to fiscal 2014. Investing Activities Applied used $425 million, $281 million, and $161 million of cash in investing activities in fiscal 2016, 2015 and 2014, respectively. Capital expenditures in fiscal 2016, 2015 and 2014 were $253 million, $215 million and $241 million, respectively. Capital expenditures in fiscal 2016 and 2015 were primarily for demonstration and test equipment and laboratory tools in North America. Capital expenditures in fiscal 2014 were primarily for demonstration and test equipment and infrastructure improvements in North America, including creation of a new pilot operation facility and distribution center. Purchases of investments, net of proceeds from sales and maturities of investments was $156 million and $62 million for fiscal 2016 and 2015, respectively. Proceeds from sales and maturities of investments, net of purchases of investments totaled $67 million in fiscal 2014. Investing activities also included investments in technology to allow Applied to access new market opportunities or emerging technologies. Applied’s investment portfolio consists principally of investment grade money market mutual funds, U.S. Treasury and agency securities, municipal bonds, corporate bonds and mortgage-backed and asset-backed securities, as well as equity securities. Applied regularly monitors the credit risk in its investment portfolio and takes appropriate measures, which may include the sale of certain securities, to manage such risks prudently in accordance with its investment policies. Financing Activities Applied used $3.4 billion of cash in financing activities in fiscal 2016, consisting primarily of $1.2 billion in debt repayments, $1.9 billion in repurchases of its common stock, and $444 million in cash dividends to stockholders, offset by excess tax benefits from share-based compensation of $23 million and proceeds from common stock issuances of $88 million. Applied generated $913 million of cash from financing activities in fiscal 2015, consisting primarily of net proceeds received from the issuance of senior unsecured notes of $1.8 billion and short-term borrowings of $800 million, offset by cash used for repurchases of its common stock of $1.3 billion and payment of cash dividends of $487 million. Applied used $348 million of cash in financing activities in fiscal 2014, which included payment of cash dividends to stockholders and issuances of common stock. Applied made no repurchases of its common stock in fiscal 2014. On June 9, 2016, Applied’s Board of Directors approved a new common stock repurchase program authorizing up to $2.0 billion in repurchases which followed the completion of a $3.0 billion common stock repurchase program approved on April 26, 2015. At October 30, 2016, $1.8 billion remained available for future stock repurchases under this repurchase program. Proceeds from stock issuances under equity compensation awards and related excess tax benefits in fiscal 2016, 2015 and 2014 were $111 million, $144 million and $137 million, respectively. During each of fiscal 2016, 2015 and 2014, Applied’s Board of Directors declared quarterly cash dividends in the amount of $0.10 per share. Applied currently anticipates that cash dividends will continue to be paid on a quarterly basis, although the declaration of any future cash dividend is at the discretion of the Board of Directors and will depend on Applied’s financial condition, results of operations, capital requirements, business conditions and other factors, as well as a determination by the Board of Directors that cash dividends are in the best interests of Applied’s stockholders. Applied has credit facilities for unsecured borrowings in various currencies of up to $1.6 billion, of which $1.5 billion is comprised of a committed revolving credit agreement with a group of banks that is scheduled to expire in September 2020. This agreement provides for borrowings in United States dollars at interest rates keyed to one of two rates selected by Applied for each advance and includes financial and other covenants with which Applied was in compliance at October 30, 2016. Remaining credit facilities in the amount of approximately $77 million are with Japanese banks. Applied’s ability to borrow under these facilities is subject to bank approval at the time of the borrowing request, and any advances will be at rates indexed to the banks’ prime reference rate denominated in Japanese yen. No amounts were outstanding under any of these facilities at both October 30, 2016 and October 25, 2015, and Applied has not utilized these credit facilities. In fiscal 2011, Applied established a short-term commercial paper program of up to $1.5 billion. At October 30, 2016 and October 25, 2015, Applied did not have any commercial paper outstanding, but may issue commercial paper notes under this program from time to time in the future. Applied had senior unsecured notes in the aggregate principal amount of $3.4 billion outstanding as of October 30, 2016. The indentures governing these notes include covenants with which Applied was in compliance at October 30, 2016. In November 2015, Applied completed the redemption of the entire outstanding $400 million in principal amount of senior notes due in 2016. The redemption price was $405 million, and after adjusting for the carrying value of the debt issuance costs and discounts, Applied recorded a $5 million loss on the prepayment of the $400 million debt, which is included in non-operating loss in the Consolidated Statement of Operations for the first quarter of fiscal 2016. See Note 9 of Notes to Consolidated Financial Statements for additional discussion of existing debt. Applied may seek to refinance its existing debt and may incur additional indebtedness depending on Applied’s capital requirements and the availability of financing. Others During fiscal 2016, Applied recorded a bad debt provision of $3 million, and released $9 million and $16 million in fiscal 2015 and 2014, respectively, of its allowance for doubtful accounts as a result of an overall lower risk profile of Applied’s customers. While Applied believes that its allowance for doubtful accounts at October 30, 2016 is adequate, it will continue to closely monitor customer liquidity and economic conditions. As of October 30, 2016, approximately $4.0 billion of cash, cash equivalents and marketable securities held by foreign subsidiaries may be subject to U.S. income taxes if repatriated for U.S. operations. Applied intends to indefinitely reinvest approximately $3.3 billion of these funds outside of the U.S. and does not plan to repatriate these funds. Applied would need to accrue and pay U.S. taxes if these funds were repatriated. For the remaining cash, cash equivalents and marketable securities held by foreign subsidiaries, U.S. income taxes have been provided for in the financial statements. Subsequent to October 30, 2016, a foreign subsidiary of Applied made an advance payment of $1.8 billion to Applied. Applied’s provision for income taxes and effective tax rate will not be materially affected by this transaction. Although cash requirements will fluctuate based on the timing and extent of factors such as those discussed above, Applied’s management believes that cash generated from operations, together with the liquidity provided by existing cash balances and borrowing capability, will be sufficient to satisfy Applied’s liquidity requirements for the next 12 months. For further details regarding Applied’s operating, investing and financing activities, see the Consolidated Statements of Cash Flows in this report. For details on standby letters of credit and other agreements with banks, see Off-Balance Sheet Arrangements below. Off-Balance Sheet Arrangements In the ordinary course of business, Applied provides standby letters of credit or other guarantee instruments to third parties as required for certain transactions initiated by either Applied or its subsidiaries. As of October 30, 2016, the maximum potential amount of future payments that Applied could be required to make under these guarantee agreements was approximately $52 million. Applied has not recorded any liability in connection with these guarantee agreements beyond that required to appropriately account for the underlying transaction being guaranteed. Applied does not believe, based on historical experience and information currently available, that it is probable that any amounts will be required to be paid under these guarantee agreements. Applied also has agreements with various banks to facilitate subsidiary banking operations worldwide, including overdraft arrangements, issuance of bank guarantees, and letters of credit. As of October 30, 2016, Applied Materials Inc. has provided parent guarantees to banks for approximately $100 million to cover these arrangements. Applied also has operating leases for various facilities. Total rent expense for fiscal 2016, 2015 and 2014 was $38 million, $32 million and $37 million, respectively. Contractual Obligations The following table summarizes Applied’s contractual obligations as of October 30, 2016: ______________________ Represents Applied’s agreements to purchase goods and services consisting of Applied’s outstanding purchase orders for goods and services. Other long-term liabilities in the table do not include pension, post-retirement and deferred compensation plans due to the uncertainty in the timing of future payments. Applied evaluates the need to make contributions to its pension and post-retirement benefit plans after considering the funded status of the plans, movements in the discount rate, performance of the plan assets and related tax consequences. Payments to the plans would be dependent on these factors and could vary across a wide range of amounts and time periods. Payments for deferred compensation plans are dependent on activity by participants, making the timing of payments uncertain. Information on Applied’s pension, post-retirement benefit and deferred compensation plans is presented in Note 11, Employee Benefit Plans, of the consolidated financial statements. Applied’s other long-term liabilities in the Consolidated Balance Sheets include deferred tax liabilities, gross unrecognized tax benefits and related gross interest and penalties. As of October 30, 2016, the gross liability for unrecognized tax benefits that was not expected to result in payment of cash within one year was $320 million. Interest and penalties related to uncertain tax positions that were not expected to result in payment of cash within one year of October 30, 2016 and October 25, 2015 were $33 million and $14 million, respectively. At this time, Applied is unable to make a reasonably reliable estimate of the timing of payments due to uncertainties in the timing of tax audit outcomes; therefore, such amounts are not included in the above contractual obligation table. Critical Accounting Policies and Estimates The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported. Note 1 of Notes to Consolidated Financial Statements describes the significant accounting policies used in the preparation of the consolidated financial statements. Certain of these significant accounting policies are considered to be critical accounting policies. A critical accounting policy is defined as one that is both material to the presentation of Applied’s consolidated financial statements and that requires management to make difficult, subjective or complex judgments that could have a material effect on Applied’s financial condition or results of operations. Specifically, these policies have the following attributes: (1) Applied is required to make assumptions about matters that are highly uncertain at the time of the estimate; and (2) different estimates Applied could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on Applied’s financial condition or results of operations. Estimates and assumptions about future events and their effects cannot be determined with certainty. Applied bases its estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as Applied’s operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they became known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties include those discussed in Part I, Item 1A, “Risk Factors.” Based on a critical assessment of its accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that Applied’s consolidated financial statements are fairly stated in accordance with accounting principles generally accepted in the United States of America, and provide a meaningful presentation of Applied’s financial condition and results of operations. Management believes that the following are critical accounting policies and estimates: Revenue Recognition Applied recognizes revenue when all four revenue recognition criteria have been met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; sales price is fixed or determinable; and collectability is probable. Each sale arrangement may contain commercial terms that differ from other arrangements. In addition, Applied frequently enters into contracts that contain multiple deliverables. Judgment is required to properly identify the accounting units of the multiple deliverable transactions and to determine the manner in which revenue should be allocated among the accounting units. Moreover, judgment is used in interpreting the commercial terms and determining when all criteria of revenue recognition have been met in order for revenue recognition to occur in the appropriate accounting period. While changes in the allocation of the estimated sales price between the units of accounting will not affect the amount of total revenue recognized for a particular sales arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could have a material effect on Applied’s financial condition and results of operations. Warranty Costs Applied provides for the estimated cost of warranty when revenue is recognized. Estimated warranty costs are determined by analyzing specific product, current and historical configuration statistics and regional warranty support costs. Applied’s warranty obligation is affected by product and component failure rates, material usage and labor costs incurred in correcting product failures during the warranty period. As Applied’s customer engineers and process support engineers are highly trained and deployed globally, labor availability is a significant factor in determining labor costs. The quantity and availability of critical replacement parts is another significant factor in estimating warranty costs. Unforeseen component failures or exceptional component performance can also result in changes to warranty costs. If actual warranty costs differ substantially from Applied’s estimates, revisions to the estimated warranty liability would be required, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Allowance for Doubtful Accounts Applied maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. This allowance is based on historical experience, credit evaluations, specific customer collection history and any customer-specific issues Applied has identified. Changes in circumstances, such as an unexpected material adverse change in a major customer’s ability to meet its financial obligation to Applied or its payment trends, may require Applied to further adjust its estimates of the recoverability of amounts due to Applied, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Inventory Valuation Inventories are generally stated at the lower of cost or market, with cost determined on a first-in, first-out basis. The carrying value of inventory is reduced for estimated obsolescence by the difference between its cost and the estimated market value based upon assumptions about future demand. Applied evaluates the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional adjustments for excess or obsolete inventory may be required, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Goodwill and Intangible Assets Applied reviews goodwill and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, and also annually reviews goodwill and intangibles with indefinite lives for impairment. Intangible assets, such as purchased technology, are generally recorded in connection with a business acquisition. The value assigned to intangible assets is usually based on estimates and judgments regarding expectations for the success and life cycle of products and technology acquired. If actual product acceptance differs significantly from the estimates, Applied may be required to record an impairment charge to reduce the carrying value of the reporting unit to its estimated fair value. To test goodwill for impairment, Applied first performs a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If it is concluded that this is the case, Applied then performs the two-step goodwill impairment test. Otherwise, the two-step goodwill impairment test is not required. Under the two-step goodwill impairment test, Applied would in the first step compare the estimated fair value of each reporting unit to its carrying value. If the carrying value of a reporting unit exceeds its estimated fair value, Applied would then perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If Applied determines that the carrying value of a reporting unit’s goodwill exceeds its implied fair value, Applied would record an impairment charge equal to the difference. Applied determines the fair value of each reporting unit based on a weighting of an income and a market approach. Applied bases the fair value estimates on assumptions that it believes to be reasonable but that are unpredictable and inherently uncertain. Under the income approach, Applied estimates the fair value based on discounted cash flow method. The estimates used in the impairment testing are consistent with the discrete forecasts that Applied uses to manage its business, and considers any significant developments during the period. Under the discounted cash flow method, cash flows beyond the discrete forecasts are estimated using a terminal growth rate, which considers the long-term earnings growth rate specific to the reporting units. The estimated future cash flows are discounted to present value using each reporting unit’s weighted average cost of capital. The weighted average cost of capital measures a reporting unit’s cost of debt and equity financing weighted by the percentage of debt and equity in a reporting unit’s target capital structure. In addition, the weighted average cost of capital is derived using both known and estimated market metrics, and is adjusted to reflect both the timing and risks associated with the estimated cash flows. The tax rate used in the discounted cash flow method is the median tax rate of comparable companies and reflects Applied’s current international structure, which is consistent with the market participant perspective. Under the market approach, Applied uses the guideline company method which applies market multiples to forecasted revenues and earnings before interest, taxes, depreciation and amortization. Applied uses market multiples that are consistent with comparable publicly-traded companies and considers each reporting unit’s size, growth and profitability relative to its comparable companies. Management uses significant judgment when assessing goodwill for potential impairment, especially in emerging markets. Indicators of potential impairment include, but are not limited to, challenging economic conditions, an unfavorable industry or economic environment or other severe decline in market conditions. Such conditions could have the effect of changing one of the critical assumptions or estimates used for the fair value calculation, resulting in an unexpected goodwill impairment charge, which could have a material adverse effect on Applied’s business, financial condition and results of operations. See Note 8 of Notes to Consolidated Financial Statements for additional discussion of goodwill impairment. Income Taxes Applied’s provision for income taxes and effective tax rate are affected by the geographical composition of pre-tax income which includes jurisdictions with differing tax rates, conditional reduced tax rates and other income tax incentives. It is also affected by events that are not consistent from period to period, such as changes to income tax laws and the resolution of prior years’ income tax filings. Applied recognizes a current tax liability for the estimated amount of income tax payable on tax returns for the current fiscal year. Deferred tax assets and liabilities are recognized for the estimated future tax effects of temporary differences between the book and tax bases of assets and liabilities. Deferred tax assets are also recognized for net operating loss and tax credit carryforwards. Deferred tax assets are offset by a valuation allowance to the extent it is more likely than not that they are not expected to be realized. Applied recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities based on the technical merits of the position. The tax benefits recognized from such positions are estimated based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Any changes in judgment related to uncertain tax positions are recognized in the Consolidated Statements of Operations in the quarter in which such change occurs. Interest and penalties related to uncertain tax positions are recognized in Applied’s provision for income taxes. The calculation of Applied’s provision for income taxes and effective tax rate involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with Applied’s expectations could have an adverse material impact on Applied’s results of operations and financial condition. Non-GAAP Adjusted Financial Results Applied provides investors with certain non-GAAP adjusted financial measures, which are adjusted to exclude the impact of certain costs, expenses, gains and losses, including certain items related to mergers and acquisitions; restructuring charges and any associated adjustments; impairments of assets, or investments; gain or loss on sale of strategic investments; certain other discrete adjustments and income tax items. Reconciliations of these non-GAAP measures to the most directly comparable financial measures calculated and presented in accordance with GAAP are provided in the financial tables presented below. Management uses these non-GAAP adjusted financial measures to evaluate the Company’s operating and financial performance and for planning purposes, and as performance measures in its executive compensation program. Applied believes these measures enhance an overall understanding of our performance and investors’ ability to review the Company’s business from the same perspective as the Company’s management and facilitate comparisons of this period’s results with prior periods on a consistent basis by excluding items that we do not believe are indicative of our ongoing operating performance. There are limitations in using non-GAAP financial measures because the non-GAAP financial measures are not prepared in accordance with generally accepted accounting principles, may be different from non-GAAP financial measures used by other companies, and may exclude certain items that may have a material impact upon our reported financial results. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the directly comparable financial measures prepared in accordance with GAAP. The following tables present a reconciliation of the GAAP and non-GAAP adjusted consolidated results for the past three fiscal years: APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS These items are incremental charges attributable to completed acquisitions, consisting of amortization of purchased intangible assets. These items are incremental charges related to the terminated business combination agreement with Tokyo Electron Limited, consisting of acquisition-related and integration planning costs. Results for fiscal 2016 primarily included benefit from sales of solar equipment tools for which inventory had been previously reserved related to the cost reductions in the solar business. Results for fiscal 2015 primarily included $35 million of inventory charges, $17 million of restructuring charges and asset impairments related to cost reductions in the solar business, and a $2 million favorable adjustment of restructuring reserves related to prior restructuring plans. Results for fiscal 2014 included $5 million of employee-related costs related to the restructuring program announced on October 3, 2012. Results for fiscal 2016 included a loss of $8 million due to discontinuance of cash flow hedges that were probable not to occur by the end of the originally specified time period. Results for fiscal 2015 included immaterial correction of errors related to prior periods, partially offset by costs related to executive termination. Amounts for fiscal 2016 and 2015 included resolution of prior years' income tax filings and other tax items. Amounts for fiscal 2015 included an adjustment to decrease the provision for income taxes by $28 million with a corresponding increase in net income, resulting in an increase in diluted earnings per share of $0.02. The adjustment was excluded in Applied's non-GAAP adjusted results and was made primarily to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales, which resulted in overstating profitability in the U.S. and the provision for income taxes in immaterial amounts in each year since fiscal 2010. These amounts represent non-GAAP adjustments above multiplied by the effective tax rate within the jurisdictions the adjustments affect. APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS Amounts for fiscal 2016 and 2015 included resolution of prior years' income tax filings and other tax items. Amounts for fiscal 2015 included an adjustment to decrease the provision for income taxes by $28 million with a corresponding increase in net income, resulting in an increase in diluted earnings per share of $0.02. The adjustment was excluded in Applied's non-GAAP adjusted results and was made primarily to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales, which resulted in overstating profitability in the U.S. and the provision for income taxes in immaterial amounts in each year since fiscal 2010. The following table presents a reconciliation of the GAAP and non-GAAP adjusted segment results for the past three fiscal years: APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS These items are incremental charges attributable to completed acquisitions, consisting of amortization of purchased intangible assets. Results for fiscal 2015 included $3 million of inventory charges related to cost reduction in the solar business. Results for fiscal 2015 included immaterial correction of errors related to prior periods, partially offset by costs related to executive termination. Note: The reconciliation of GAAP and non-GAAP adjusted segment results above does not include certain revenues, costs of products sold and operating expenses that are reported within corporate and other and included in consolidated operating income.

<s>[INST] Introduction Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to facilitate an understanding of Applied’s business and results of operations. This MD&A should be read in conjunction with Applied’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10K. The following discussion contains forwardlooking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10K. MD&A consists of the following sections: Overview: a summary of Applied’s business and measurements Results of Operations: a discussion of operating results Segment Information: a discussion of segment operating results Recent Accounting Pronouncements: a discussion of new accounting pronouncements and its impact to Applied’s consolidated financial statements Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash OffBalance Sheet Arrangements and Contractual Obligations Critical Accounting Policies and Estimates: a discussion of critical accounting policies that require the exercise of judgments and estimates NonGAAP Adjusted Results: a presentation of results reconciling GAAP to nonGAAP adjusted measures Overview Applied provides manufacturing equipment, services and software to the global semiconductor, display, and related industries. Applied’s customers include manufacturers of semiconductor wafers and chips, liquid crystal and other displays, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Applied operates in three reportable segments: Semiconductor Systems (previously Silicon Systems), Applied Global Services, and Display and Adjacent Markets (previously Display). A summary of financial information for each reportable segment is found in Note 14 of Notes to Consolidated Financial Statements. A discussion of factors that could affect Applied’s operations is set forth under “Risk Factors” in Part I, Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in the United States, Europe, Israel, and Asia. Applied’s broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied’s results are driven primarily by worldwide demand for semiconductors and displays, which in turn depends on enduser demand for electronic products. Each of Applied’s businesses is subject to variable industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, display technologies, and other electronic devices, as well as other factors, such as global economic and market conditions, and the nature and timing of technological advances in fabrication processes. In addition, a significant driver in the semiconductor and display industries is enddemand for mobile consumer products, which is characterized by seasonality that impacts the timing of customer investments in manufacturing equipment and, in turn, Applied’s business. In light of these conditions, Applied’s results can vary significantly yearoveryear, as well as quarteroverquarter. The following table presents certain significant measurements for the past three fiscal years: Reconciliations of nonGAAP adjusted measures are presented below under “NonGAAP Adjusted Results.” Fiscal 2016 contained 53 weeks and fiscal 2015 and 2014 each contained 52 weeks. Applied’s strategic priorities include developing products that help solve customers’ challenges at technology inflections; expanding its served market opportunities in the semiconductor and display industries; and growing its services business. Mobility, and the increasing technological functionality of mobile devices, continues to be a strong driver of semiconductor industry spending. During fiscal 2016, memory manufacturers invested in technology upgrades and additional capacity, both of which were driven primarily by the transition from planar NAND to 3D NAND. Foundry customers also invested in technology upgrades and new capacity to meet demand for advanced mobile chips. Mobility investments, including increasing investments in new technology such as OLED for mobile devices, represents a significant driver of display industry spending, which has resulted in higher manufacturing capacity expansion for mobile applications. As a result, new orders for [/INST] Positive. </s>

APPLIED MATERIALS INC /DE

2017-12-15

2017-10-29

Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations Introduction Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to facilitate an understanding of Applied’s business and results of operations. This MD&A should be read in conjunction with Applied’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10-K. The following discussion contains forward-looking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10-K. MD&A consists of the following sections: • Overview: a summary of Applied’s business and measurements • Results of Operations: a discussion of operating results • Segment Information: a discussion of segment operating results • Recent Accounting Pronouncements: a discussion of new accounting pronouncements and its impact to Applied’s consolidated financial statements • Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash • Off-Balance Sheet Arrangements and Contractual Obligations • Critical Accounting Policies and Estimates: a discussion of critical accounting policies that require the exercise of judgments and estimates • Non-GAAP Adjusted Results: a presentation of results reconciling GAAP to non-GAAP adjusted measures Overview Applied provides manufacturing equipment, services and software to the semiconductor, display, and related industries. Applied’s customers include manufacturers of semiconductor wafers and chips, liquid crystal and organic light-emitting diode (OLED) displays, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Each of Applied’s businesses is subject to variable industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, display technologies, and other electronic devices, as well as other factors, such as global economic and market conditions, and the nature and timing of technological advances in fabrication processes. Applied operates in three reportable segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets. A summary of financial information for each reportable segment is found in Note 15 of Notes to Consolidated Financial Statements. A discussion of factors that could affect Applied’s operations is set forth under “Risk Factors” in Part I, Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in the United States, Europe, Israel, and Asia. Applied’s broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied’s results are driven primarily by customer spending on capital equipment and services to support key technology transitions or to increase production volume in response to worldwide demand for semiconductors and displays. Spending by semiconductor customers, which include companies that operate in the foundry, memory and logic markets, is driven by demand for advanced electronic products, including smartphones and other mobile devices, servers, personal computers, automotive devices, storage, and other products. The growth of data and new end-market drivers such as artificial intelligence, augmented and virtual reality and smart vehicles are also creating new opportunities for the industry. As a result, products within the Semiconductor Systems segment are subject to significant changes in customer requirements, including transitions to smaller dimensions, increasingly complex chip architectures, new materials and an increasing number of applications. Demand for display manufacturing equipment spending depends primarily on consumer demand for increasingly larger and more advanced TVs as well as larger and higher resolution displays for next generation mobile devices, and investments in new types of display technologies. While certain existing technologies may be adapted to new requirements, some applications create the need for an entirely different technological approach. The timing of customer investment in manufacturing equipment is also affected by the timing of next generation production schedules, and the timing of capacity expansion to meet end market demand. In light of these conditions, Applied’s results can vary significantly year-over-year, as well as quarter-over-quarter. Applied’s strategic priorities include developing products that help solve customers’ challenges at technology inflections; expanding its served market opportunities in the semiconductor and display industries; and growing its services business. Applied’s long-term growth strategy requires continued development of new materials engineering capabilities, including products and platforms that enable expansion into new and adjacent markets. Applied’s significant investments in research, development and engineering must generally enable it to deliver new products and technologies before the emergence of strong demand, thus allowing customers to incorporate these products into their manufacturing plans during early-stage technology selection. Applied works closely with its global customers to design systems and processes that meet their planned technical and production requirements. The following table presents certain significant measurements for the past three fiscal years: Fiscal 2017 and 2015 contained 52 weeks, and fiscal 2016 contained 53 weeks. Fiscal 2017 reflected healthy investment in semiconductor manufacturing equipment and services, as memory manufacturers invested in technology upgrades and new capacity, driven by the transition from planar NAND to 3D NAND, and an overall increase in demand for memory for high performance storage in data centers and increasing smartphone content. Foundry customers also invested in technology upgrades and new capacity to meet demand for advanced mobile chips and high performance computing. Display equipment spending reflected continued investment in new technology and manufacturing equipment as customers prepare for broad adoption of OLED for mobile applications, as well as investments in new equipment to manufacture larger TVs. In fiscal 2018, Applied expects these trends to continue to drive demand for the semiconductor industry, and in turn for the Semiconductor Systems segment. Applied also expects healthy spending in semiconductor spares and services, and increased spending for display manufacturing equipment in fiscal 2018. Results of Operations Net Sales Net sales for the periods indicated were as follows: Net sales in fiscal 2017 compared to fiscal 2016 increased primarily due to increased customer investments in all segments, with majority of the increases resulting from investments in semiconductor equipment. The Semiconductor Systems segment increased slightly in relative share of total net sales in fiscal 2017 compared to fiscal 2016, and continued to represent the largest contributor of net sales. Net sales in fiscal 2016 compared to fiscal 2015 increased primarily due to increased customer investments in semiconductor and display equipment. Net sales by geographic region, determined by the location of customers’ facilities to which products were shipped, were as follows: The changes in net sales from customers in all regions for fiscal 2017 compared to fiscal 2016 primarily reflected increased investments in semiconductor equipment and changes in semiconductor equipment customer mix. In addition, the increase in net sales from customers in China also reflected increased investments from display manufacturing equipment customers. The changes in net sales in all regions for fiscal 2016 compared to fiscal 2015 reflected increased spending on semiconductor equipment and changes in customer mix for semiconductor equipment. The changes in net sales in Korea, Japan and China also reflected changes in customer mix for display equipment. Gross Margin Gross margins for the periods indicated were as follows: Gross margin in fiscal 2017 increased compared to fiscal 2016, primarily due to higher net sales, favorable product mix and materials cost savings. Gross margin in fiscal 2016 increased compared to fiscal 2015 primarily due to higher net sales, partially offset by unfavorable changes in product mix. Gross margin during fiscal 2017, 2016 and 2015 included $69 million, $62 million and $57 million, respectively, of share-based compensation expense. Research, Development and Engineering Research, Development and Engineering (RD&E) expenses for the periods indicated were as follows: Applied’s future operating results depend to a considerable extent on its ability to maintain a competitive advantage in the equipment and service products it provides. Development cycles range from 12 to 36 months depending on whether the product is an enhancement of an existing product, which typically has a shorter development cycle, or a new product, which typically has a longer development cycle. Most of Applied’s existing products resulted from internal development activities and innovations involving new technologies, materials and processes. In certain instances, Applied acquires technologies, either in existing or new product areas, to complement its existing technology capabilities and to reduce time to market. Management believes that it is critical to continue to make substantial investments in RD&E to assure the availability of innovative technology that meets the current and projected requirements of its customers’ most advanced designs. Applied has maintained and intends to continue its commitment to investing in RD&E in order to continue to offer new products and technologies. In fiscal 2017, Applied increased its RD&E investments across Semiconductor Systems and Display and Adjacent Markets, including etch, e-beam inspection and other materials engineering solutions to improve chip performance and enable advanced displays. Applied’s investments in etch were focused on supporting the adoption of extreme selectivity and precision etch technology for enabling continued scaling of 3D logic and memory chips. The investment in e-beam inspection was in support of strengthening our e-beam portfolio, which helps achieve higher yields at advanced nodes by detecting the most challenging defects and monitoring and controlling process marginality. Applied also invested in materials engineering solutions to support patterning applications as well as to improve transistor performance and device power efficiency. In Display and Adjacent Markets, RD&E investments were focused on expanding the company’s market opportunity with new display technologies. RD&E expenses increased in fiscal 2017 compared to the prior year and also in fiscal 2016 compared to fiscal 2015, primarily due to additional headcount and increased research and development spending in Semiconductor Systems and Display and Adjacent Market segments. These increases reflect Applied’s ongoing investments in product development initiatives, consistent with the Company’s growth strategy. Applied continued to prioritize existing RD&E investments in technical capabilities and critical research and development programs in current and new markets, with a focus on semiconductor technologies. RD&E expense during fiscal 2017, 2016 and 2015 included $83 million, $76 million and $69 million, respectively, of share-based compensation expense. Marketing and Selling Marketing and selling expenses for the periods indicated were as follows: Marketing and selling expenses increased in fiscal 2017 compared to fiscal 2016, primarily due to additional headcount, partially offset by the reduction in bad debt provision recorded during fiscal 2017. Marketing and selling expenses remained relatively flat in fiscal 2016 compared to fiscal 2015. Marketing and selling expenses for fiscal years 2017, 2016 and 2015 included $28 million, $26 million and $26 million, respectively, of share-based compensation expense. General and Administrative General and administrative expenses for the periods indicated were as follows: General and administrative (G&A) expenses in fiscal 2017 increased compared to fiscal 2016, primarily due to higher variable compensation and additional headcount. G&A expenses for fiscal 2016 decreased compared to fiscal 2015. G&A expenses were higher in fiscal 2015 primarily due to acquisition-related and integration costs related to the terminated business combination with Tokyo Electron Limited (TEL), impact of foreign currency exchange loss as a result of functional currency correction, and restructuring charges, all recorded during fiscal 2015. G&A expenses during fiscal 2017, 2016 and 2015 included $40 million, $37 million and $35 million, respectively, of share-based compensation expense. Loss (Gain) on Derivatives Associated with Terminated Business Combination During fiscal 2015, Applied recorded a gain on derivatives associated with the terminated business combination with TEL which resulted from exchange rate fluctuations and the sale of derivative contracts in fiscal 2015. For further details, see Note 5 of Notes to Consolidated Financial Statements. Interest Expense and Interest and Other Income (loss), net Interest expense and interest and other income (loss), net for the periods indicated were as follows: Interest expenses incurred were primarily associated with the senior unsecured notes issued in June 2011, September 2015, and March 2017. Interest expense in fiscal 2017 increased compared to fiscal 2016, primarily due to the issuance of senior unsecured notes in March 2017. Interest expense for fiscal 2016 increased compared to fiscal 2015 due to the issuance of senior unsecured notes in September 2015. Interest and other income, net primarily includes interest earned on cash and investments, realized gains or losses on sales of securities and impairment of strategic investments. Interest and other income, net in fiscal 2017 increased compared to the prior year primarily due to higher interest income from investments, partially offset by higher impairment of strategic investments in fiscal 2017. Interest and other income, net in fiscal 2016 increased compared to fiscal 2015 primarily due to higher interest income from investments, partially offset by a $5 million loss from prepayment of $400 million debt. Income Taxes Provision for income taxes and effective tax rates for the periods indicated were as follows: Applied’s provision for income taxes and effective tax rate are affected by the geographical composition of pre-tax income which includes jurisdictions with differing tax rates, conditional reduced tax rates and other income tax incentives. It is also affected by events that are not consistent from period to period, such as changes in income tax laws and the resolution of prior years’ income tax filings. Applied’s effective tax rates for fiscal 2017, 2016 and 2015 were 8.0%, 14.5% and 13.8%, respectively. The effective tax rate for fiscal 2017 was lower than the prior year primarily due to the recognition of previously unrecognized foreign tax credits and changes in the geographical composition of income. In addition, the effective tax rate in fiscal 2016 included unfavorable resolutions and changes related to income tax liabilities for uncertain tax positions as well as the reinstatement of the U.S. federal R&D tax credit retroactive to its expiration in December of 2015, neither of which reoccurred in fiscal 2017. The effective tax rate for fiscal 2016 was higher than fiscal 2015 primarily due to resolutions and changes related to income tax liabilities for uncertain tax positions, partially offset by changes in the geographical composition of income. The effective tax rate for fiscal 2015 included an adjustment to decrease provision for income taxes of $28 million primarily to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales. The impact of the adjustment to fiscal 2015 was determined to be immaterial on the originating periods and fiscal 2015. Segment Information Applied reports financial results in three segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets. A description of the products and services, as well as financial data, for each reportable segment can be found in Note 15 of Notes to Consolidated Financial Statements. The Corporate and Other category includes revenues from products, as well as costs of products sold, for fabricating solar photovoltaic cells and modules and certain operating expenses that are not allocated to its reportable segments and are managed separately at the corporate level. These operating expenses include costs for share-based compensation; certain management, finance, legal, human resource, and RD&E functions provided at the corporate level; and unabsorbed information technology and occupancy. In addition, Applied does not allocate to its reportable segments restructuring and asset impairment charges and any associated adjustments related to restructuring actions, unless these actions pertain to a specific reportable segment. The results for each reportable segment are discussed below. Semiconductor Systems Segment The Semiconductor Systems segment is comprised primarily of capital equipment used to fabricate semiconductor chips. Semiconductor industry spending on capital equipment is driven by demand for advanced electronic products, including smartphones and other mobile devices, servers, personal computers, automotive devices, storage, and other products, and the nature and timing of technological advances in fabrication processes, and as a result is subject to variable industry conditions. Development efforts are focused on solving customers’ key technical challenges in transistor, interconnect, patterning and packaging performance as devices scale to advanced technology nodes. During fiscal 2017, the market for Semiconductor Systems products and technologies was characterized by continued healthy investment by semiconductor manufacturers. Memory manufacturers invested in technology upgrades and new capacity, driven by the transition from planar NAND to 3D NAND, and an overall increase in demand for memory for high performance storage in data centers and increasing smartphone content. Foundry customers also invested in technology upgrades and new capacity to meet demand for advanced mobile chips. Certain significant measures for the periods indicated were as follows: Net sales for Semiconductor Systems by end use application for the periods indicated were as follows: Net sales for fiscal 2017 increased compared to fiscal 2016 primarily due to higher spending from foundry and memory customers. Operating income and operating margin for fiscal 2017 increased compared to prior year primarily due to favorable changes in product mix and higher net sales, partially offset by higher RD&E expenses. Two customers represented at least 10 percent of this segment’s net sales, and together they accounted for approximately 47 percent of this segment’s net sales for fiscal 2017. Net sales for fiscal 2016 increased compared to fiscal 2015 also primarily due to higher spending from foundry and memory customers. The increase in the operating income and operating margin for fiscal 2016 compared to fiscal 2015 primarily reflected higher net sales. The following regions accounted for at least 30 percent of total net sales for the Semiconductor Systems segment for one or more of past three fiscal years: In fiscal 2017, 2016 and 2015, customers in Korea accounted for 31 percent, 17 percent, and 21 percent, of the Semiconductor Systems segment’s net sales. Customers in Taiwan accounted for 28 percent, 32 percent and 32 percent of total net sales for Semiconductor Systems in fiscal 2017, 2016 and 2015, respectively. The increase in net sales in fiscal 2017 compared to fiscal 2016 from customers in Korea and Taiwan primarily reflected increased investments from memory and foundry customers. The increase in net sales in fiscal 2016 compared to fiscal 2015 from customers in Taiwan primarily reflected increased investments from foundry customers, while the decrease in net sales from customers in Korea reflected decreased investments from memory customers. Applied Global Services Segment The Applied Global Services segment provides integrated solutions to optimize equipment and fab performance and productivity, including spares, upgrades, services, certain remanufactured earlier generation equipment and factory automation software for semiconductor, display and solar products. Customer demand for products and services is fulfilled through a global distribution system with trained service engineers located in close proximity to customer sites. Demand for Applied Global Services’ service solutions are driven by Applied’s large and growing installed base of manufacturing systems, and customers’ needs to shorten ramp times, improve device performance and yield, and optimize factory output and operating costs. Industry conditions that affected Applied Global Services’ sales of spares and services during fiscal 2017 were characterized by increases in semiconductor manufacturers’ wafer starts and continued strong utilization rates, growth of the installed base of equipment, growing service intensity of newer tools, and the company’s ability to sell more comprehensive service agreements. Certain significant measures for the periods indicated were as follows: There was no single region that accounted for at least 30 percent of total net sales for the Applied Global Services segment for any of the past three fiscal years. Net sales for fiscal 2017 increased compared fiscal 2016 primarily due to higher customer spending for spares and services. One customer accounted for more than 10 percent of this segment’s net sales for fiscal 2017. Net sales for fiscal 2016 slightly increased compared to fiscal 2015 primarily due to higher demand and spending on spares and services, partially offset by lower investments in 200mm equipment systems. Operating income and operating margin for fiscal 2017 and 2016 increased compared to the prior year, reflecting higher net sales partially offset by increased headcount to support business growth. Display and Adjacent Markets Segment The Display and Adjacent Markets segment encompasses products for manufacturing liquid crystal and OLED displays, and other display technologies for TVs, personal computers, electronic tablets, smart phones, and other consumer-oriented devices, equipment upgrades and flexible coating systems. The segment is focused on expanding its presence through technologically-differentiated equipment for manufacturing large-scale TVs; emerging technologies such as OLED, low temperature polysilicon (LTPS), metal oxide, and touch panel sectors; and development of products that provide customers with improved performance and yields. Display industry growth depends primarily on consumer demand for increasingly larger and more advanced TVs as well as larger and higher resolution displays for next generation mobile devices. During fiscal 2017, display equipment spending reflected continued investment in new technology and manufacturing equipment for OLED in mobile applications, as well as investments in new equipment to manufacture larger TVs. The market environment for Applied’s Display and Adjacent Markets segment is expected to continue to be characterized by healthy demand for manufacturing equipment for high-end mobile devices and TV manufacturing equipment, although these markets remain susceptible to cyclical conditions. Uneven demand patterns in the Display and Adjacent Markets segment can cause significant fluctuations quarter-over-quarter, as well as year-over-year. Certain significant measures for the periods presented were as follows: Net sales for fiscal 2017 increased compared to prior year primarily due to higher customer investments in mobile and TV display manufacturing equipment. Operating income and operating margin for fiscal 2017 increased compared to the prior year, reflecting higher net sales and favorable product mix, partially offset by increased RD&E spending. Two customers, that represented at least 10 percent of this segment’s net sales, accounted for approximately 56 percent of net sales for this segment in fiscal 2017, with one customer accounting for approximately 32 percent of net sales. Net sales for fiscal 2016 increased compared to fiscal 2015 primarily due to higher customer investments in mobile display manufacturing equipment, partially offset by lower customer spending in TV manufacturing equipment. Operating income increased while operating margin remained essentially flat for fiscal 2016 compared to fiscal 2015, reflecting unfavorable product mix and higher research and new product development costs. The following regions accounted for at least 30 percent of total net sales for the Display and Adjacent Markets segment for one or more of the periods presented: In fiscal 2017, 2016 and 2015, customers in China accounted for 51 percent, 37 percent and 66 percent, respectively, of the Display and Adjacent Markets segment’s total net sales. Customers in Korea accounted for 39 percent, 41 percent and 17 percent of total net sales for the Display and Adjacent Markets segment in fiscal 2017, 2016 and 2015, respectively. The increase in net sales from customers in China in fiscal 2017 compared to fiscal 2016, reflected higher customer investments in TV and mobile display manufacturing equipment, while the decrease in fiscal 2016 compared to fiscal 2015, reflected lower customer investments in TV manufacturing equipment. The increases in net sales from customers in Korea in fiscal 2017 and 2016 compared to the prior year were primarily related to higher investments in mobile display manufacturing equipment. Recent Accounting Pronouncements For a description of recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on Applied’s consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements. Financial Condition, Liquidity and Capital Resources Applied’s cash, cash equivalents and investments consist of the following: Sources and Uses of Cash A summary of cash provided by (used in) operating, investing, and financing activities is as follows: Operating Activities Cash from operating activities for fiscal 2017 was $3.6 billion, which reflects net income adjusted for the effect of non-cash charges and changes in working capital components. Non-cash charges included depreciation, amortization, share-based compensation and deferred income taxes. Cash provided by operating activities increased from fiscal 2016 to fiscal 2017 primarily due to higher net income, offset by a smaller increase in customer deposits and a greater increase in inventory in fiscal 2017. The primary drivers of the increase in cash from operating activities from fiscal 2015 to fiscal 2016 included higher net income and increases in customer deposits, deferred revenue, accounts payable and accrued expenses, partially offset by higher increases in accounts receivable. Applied has agreements with various financial institutions to sell accounts receivable and discount promissory notes from selected customers. Applied sells its accounts receivable without recourse. Applied, from time to time, also discounts letters of credit issued by customers through various financial institutions. The discounting of letters of credit depends on many factors, including the willingness of financial institutions to discount the letters of credit and the cost of such arrangements. Applied sold $746 million and $75 million of accounts receivable during fiscal 2017 and 2016, respectively. Applied did not sell accounts receivable during fiscal 2015. Applied did not discount promissory notes or utilize programs to discount letters of credit issued by customers during any of the past three fiscal years. Applied’s working capital was $8.8 billion at October 29, 2017 and $4.7 billion at October 30, 2016. Days sales outstanding at the end of fiscal 2017, 2016 and 2015 was 54 days, 63 days, and 67 days, respectively. Days sales outstanding varies due to the timing of shipments and payment terms, and the decrease from fiscal 2016 to fiscal 2017 was primarily due to better collections performance and increase in factoring of accounts receivable. Days sales outstanding decreased at the end of fiscal 2016 compared to fiscal 2015 primarily due to higher revenue and sales of accounts receivable. Investing Activities Applied used $2.5 billion, $425 million, and $281 million of cash in investing activities in fiscal 2017, 2016 and 2015, respectively. Capital expenditures in fiscal 2017, 2016 and 2015 were $345 million, $253 million and $215 million, respectively. Capital expenditures in all three fiscal years were primarily for demonstration and test equipment and laboratory tools in North America. Purchases of investments, net of proceeds from sales and maturities of investments were $2.1 billion, $156 million, and $62 million for fiscal 2017, 2016 and 2015, respectively. In November 2017, Applied acquired additional property for $100 million in cash to support the Company’s growth. Investing activities also included investments in technology to allow Applied to access new market opportunities or emerging technologies. Applied’s investment portfolio consists principally of investment grade money market mutual funds, U.S. Treasury and agency securities, municipal bonds, corporate bonds and mortgage-backed and asset-backed securities, as well as equity securities. Applied regularly monitors the credit risk in its investment portfolio and takes appropriate measures, which may include the sale of certain securities, to manage such risks prudently in accordance with its investment policies. Financing Activities Applied generated $521 million of cash from financing activities in fiscal 2017, consisting primarily of net proceeds received from the issuance of senior unsecured notes of $2.2 billion, proceeds from common stock issuances of $97 million and excess tax benefits from share-based compensation of $55 million, partially offset by cash used for repurchases of common stock of $1.2 billion, cash dividends to stockholders of $430 million and debt repayments of $205 million. Applied used $3.4 billion of cash in financing activities in fiscal 2016, consisting primarily $1.2 billion in debt repayments, $1.9 billion in repurchases of its common stock, and $444 million in cash dividends to stockholders, offset by excess tax benefits from share-based compensation of $23 million and proceeds from common stock issuances of $88 million. Applied generated $913 million of cash from financing activities in fiscal 2015, consisting primarily of net proceeds received from the issuance of senior unsecured notes of $1.8 billion and short-term borrowings of $800 million, offset by cash used for repurchases of its common stock of $1.3 billion and payments of cash dividends of $487 million. In June 2016, Applied’s Board of Directors approved a common stock repurchase program authorizing up to $2.0 billion in repurchases, which followed the completion of a $3.0 billion common stock repurchase program approved in April 2015. In September 2017, Applied’s Board of Directors approved an additional common stock repurchase program authorizing up to an additional $3.0 billion in repurchases. At October 29, 2017, $3.6 billion remained available for future stock repurchases under these repurchase programs. Proceeds from stock issuances under equity compensation awards and related excess tax benefits in fiscal 2017, 2016 and 2015 were $152 million, $111 million and $144 million, respectively. During each of fiscal 2017, 2016 and 2015, Applied’s Board of Directors declared quarterly cash dividends in the amount of $0.10 per share. Applied currently anticipates that cash dividends will continue to be paid on a quarterly basis, although the declaration of any future cash dividend is at the discretion of the Board of Directors and will depend on Applied’s financial condition, results of operations, capital requirements, business conditions and other factors, as well as a determination by the Board of Directors that cash dividends are in the best interests of Applied’s stockholders. Applied has credit facilities for unsecured borrowings in various currencies of up to $1.6 billion, of which $1.5 billion is comprised of a committed revolving credit agreement with a group of banks that is scheduled to expire in September 2021. This agreement provides for borrowings in United States dollars at interest rates keyed to one of two rates selected by Applied for each advance and includes financial and other covenants with which Applied was in compliance at October 29, 2017. Remaining credit facilities in the amount of approximately $70 million are with Japanese banks. Applied’s ability to borrow under these facilities is subject to bank approval at the time of the borrowing request, and any advances will be at rates indexed to the banks’ prime reference rate denominated in Japanese yen. No amounts were outstanding under any of these facilities at both October 29, 2017 and October 30, 2016, and Applied has not utilized these credit facilities. In fiscal 2011, Applied established a short-term commercial paper program of up to $1.5 billion. At October 29, 2017 and October 30, 2016, Applied did not have any commercial paper outstanding, but may issue commercial paper notes under this program from time to time in the future. In March 2017, Applied issued senior unsecured notes in the aggregate principal amount of $2.2 billion. Applied had senior unsecured notes in the aggregate principal amount of $5.4 billion outstanding as of October 29, 2017. The indentures governing these notes include covenants with which Applied was in compliance at October 29, 2017. In May 2017, Applied completed the redemption of the entire outstanding $200 million in principal amount of senior notes due in October 2017. In November 2015, Applied completed the redemption of the entire outstanding $400 million in principal amount of senior notes due in 2016. See Note 10 of Notes to Consolidated Financial Statements for additional discussion of existing debt. Applied may seek to refinance its existing debt and may incur additional indebtedness depending on Applied’s capital requirements and the availability of financing. Others During 2017 and 2015, Applied reduced $17 million and $9 million, respectively, of its allowance for doubtful accounts as a result of an overall lower risk profile of Applied’s customers. Applied recorded a bad debt provision of $3 million in fiscal 2016. While Applied believes that its allowance for doubtful accounts at October 29, 2017 is adequate, it will continue to closely monitor customer liquidity and economic conditions. As of October 29, 2017, approximately $5.5 billion of cash, cash equivalents and marketable securities held by foreign subsidiaries may be subject to U.S. income taxes if repatriated for U.S. operations. Applied intends to indefinitely reinvest approximately $4.5 billion of these funds outside of the U.S. and does not plan to repatriate these funds. Applied would need to accrue and pay U.S. taxes if these funds were repatriated. For the remaining cash, cash equivalents and marketable securities held by foreign subsidiaries, U.S. income taxes have been provided for in the financial statements. Although cash requirements will fluctuate based on the timing and extent of factors such as those discussed above, Applied’s management believes that cash generated from operations, together with the liquidity provided by existing cash balances and borrowing capability, will be sufficient to satisfy Applied’s liquidity requirements for the next 12 months. For further details regarding Applied’s operating, investing and financing activities, see the Consolidated Statements of Cash Flows in this report. For details on standby letters of credit and other agreements with banks, see Off-Balance Sheet Arrangements below. Off-Balance Sheet Arrangements In the ordinary course of business, Applied provides standby letters of credit or other guarantee instruments to third parties as required for certain transactions initiated by either Applied or its subsidiaries. As of October 29, 2017, the maximum potential amount of future payments that Applied could be required to make under these guarantee agreements was approximately $57 million. Applied has not recorded any liability in connection with these guarantee agreements beyond that required to appropriately account for the underlying transaction being guaranteed. Applied does not believe, based on historical experience and information currently available, that it is probable that any amounts will be required to be paid under these guarantee agreements. Applied also has agreements with various banks to facilitate subsidiary banking operations worldwide, including overdraft arrangements, issuance of bank guarantees, and letters of credit. As of October 29, 2017, Applied Materials Inc. has provided parent guarantees to banks for approximately $140 million to cover these arrangements. Applied also has operating leases for various facilities. Total rent expense for fiscal 2017, 2016 and 2015 was $34 million, $38 million and $32 million, respectively. Contractual Obligations The following table summarizes Applied’s contractual obligations as of October 29, 2017: ______________________ Represents Applied’s agreements to purchase goods and services consisting of Applied’s outstanding purchase orders for goods and services. Other long-term liabilities in the table do not include pension, post-retirement and deferred compensation plans due to the uncertainty in the timing of future payments. Applied evaluates the need to make contributions to its pension and post-retirement benefit plans after considering the funded status of the plans, movements in the discount rate, performance of the plan assets and related tax consequences. Payments to the plans would be dependent on these factors and could vary across a wide range of amounts and time periods. Payments for deferred compensation plans are dependent on activity by participants, making the timing of payments uncertain. Information on Applied’s pension, post-retirement benefit and deferred compensation plans is presented in Note 12, Employee Benefit Plans, of the consolidated financial statements. Applied’s other long-term liabilities in the Consolidated Balance Sheets include deferred tax liabilities, gross unrecognized tax benefits and related gross interest and penalties. As of October 29, 2017, the gross liability for unrecognized tax benefits that was not expected to result in payment of cash within one year was $391 million. Interest and penalties related to uncertain tax positions that were not expected to result in payment of cash within one year of October 29, 2017 was $46 million. At this time, Applied is unable to make a reasonably reliable estimate of the timing of payments due to uncertainties in the timing of tax audit outcomes; therefore, such amounts are not included in the above contractual obligation table. Critical Accounting Policies and Estimates The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported. Note 1 of Notes to Consolidated Financial Statements describes the significant accounting policies used in the preparation of the consolidated financial statements. Certain of these significant accounting policies are considered to be critical accounting policies. A critical accounting policy is defined as one that is both material to the presentation of Applied’s consolidated financial statements and that requires management to make difficult, subjective or complex judgments that could have a material effect on Applied’s financial condition or results of operations. Specifically, these policies have the following attributes: (1) Applied is required to make assumptions about matters that are highly uncertain at the time of the estimate; and (2) different estimates Applied could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on Applied’s financial condition or results of operations. Estimates and assumptions about future events and their effects cannot be determined with certainty. Applied bases its estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as Applied’s operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they became known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties include those discussed in Part I, Item 1A, “Risk Factors.” Based on a critical assessment of its accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that Applied’s consolidated financial statements are fairly stated in accordance with accounting principles generally accepted in the United States of America, and provide a meaningful presentation of Applied’s financial condition and results of operations. Management believes that the following are critical accounting policies and estimates: Revenue Recognition Applied recognizes revenue when all four revenue recognition criteria have been met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; sales price is fixed or determinable; and collectability is probable. Each sale arrangement may contain commercial terms that differ from other arrangements. In addition, Applied frequently enters into contracts that contain multiple deliverables. Judgment is required to properly identify the accounting units of the multiple deliverable transactions and to determine the manner in which revenue should be allocated among the accounting units. Moreover, judgment is used in interpreting the commercial terms and determining when all criteria of revenue recognition have been met in order for revenue recognition to occur in the appropriate accounting period. While changes in the allocation of the estimated sales price between the units of accounting will not affect the amount of total revenue recognized for a particular sales arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could have a material effect on Applied’s financial condition and results of operations. Warranty Costs Applied provides for the estimated cost of warranty when revenue is recognized. Estimated warranty costs are determined by analyzing specific product, current and historical configuration statistics and regional warranty support costs. Applied’s warranty obligation is affected by product and component failure rates, material usage and labor costs incurred in correcting product failures during the warranty period. As Applied’s customer engineers and process support engineers are highly trained and deployed globally, labor availability is a significant factor in determining labor costs. The quantity and availability of critical replacement parts is another significant factor in estimating warranty costs. Unforeseen component failures or exceptional component performance can also result in changes to warranty costs. If actual warranty costs differ substantially from Applied’s estimates, revisions to the estimated warranty liability would be required, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Allowance for Doubtful Accounts Applied maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. This allowance is based on historical experience, credit evaluations, specific customer collection history and any customer-specific issues Applied has identified. Changes in circumstances, such as an unexpected material adverse change in a major customer’s ability to meet its financial obligation to Applied or its payment trends, may require Applied to further adjust its estimates of the recoverability of amounts due to Applied, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Inventory Valuation Inventories are generally stated at the lower of cost or market, with cost determined on a first-in, first-out basis. The carrying value of inventory is reduced for estimated obsolescence by the difference between its cost and the estimated market value based upon assumptions about future demand. Applied evaluates the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional adjustments for excess or obsolete inventory may be required, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Goodwill and Intangible Assets Applied reviews goodwill and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, and also annually reviews goodwill and intangibles with indefinite lives for impairment. Intangible assets, such as purchased technology, are generally recorded in connection with a business acquisition. The value assigned to intangible assets is usually based on estimates and judgments regarding expectations for the success and life cycle of products and technology acquired. If actual product acceptance differs significantly from the estimates, Applied may be required to record an impairment charge to reduce the carrying value of the reporting unit to its estimated fair value. To test goodwill for impairment, Applied first performs a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If it is concluded that this is the case, Applied then performs the two-step goodwill impairment test. Otherwise, the two-step goodwill impairment test is not required. Under the two-step goodwill impairment test, Applied would in the first step compare the estimated fair value of each reporting unit to its carrying value. If the carrying value of a reporting unit exceeds its estimated fair value, Applied would then perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If Applied determines that the carrying value of a reporting unit’s goodwill exceeds its implied fair value, Applied would record an impairment charge equal to the difference. Applied determines the fair value of each reporting unit based on a weighting of an income and a market approach. Applied bases the fair value estimates on assumptions that it believes to be reasonable but that are unpredictable and inherently uncertain. Under the income approach, Applied estimates the fair value based on discounted cash flow method. The estimates used in the impairment testing are consistent with the discrete forecasts that Applied uses to manage its business, and considers any significant developments during the period. Under the discounted cash flow method, cash flows beyond the discrete forecasts are estimated using a terminal growth rate, which considers the long-term earnings growth rate specific to the reporting units. The estimated future cash flows are discounted to present value using each reporting unit’s weighted average cost of capital. The weighted average cost of capital measures a reporting unit’s cost of debt and equity financing weighted by the percentage of debt and equity in a reporting unit’s target capital structure. In addition, the weighted average cost of capital is derived using both known and estimated market metrics, and is adjusted to reflect both the timing and risks associated with the estimated cash flows. The tax rate used in the discounted cash flow method is the median tax rate of comparable companies and reflects Applied’s current international structure, which is consistent with the market participant perspective. Under the market approach, Applied uses the guideline company method which applies market multiples to forecasted revenues and earnings before interest, taxes, depreciation and amortization. Applied uses market multiples that are consistent with comparable publicly-traded companies and considers each reporting unit’s size, growth and profitability relative to its comparable companies. Management uses significant judgment when assessing goodwill for potential impairment, especially in emerging markets. Indicators of potential impairment include, but are not limited to, challenging economic conditions, an unfavorable industry or economic environment or other severe decline in market conditions. Such conditions could have the effect of changing one of the critical assumptions or estimates used for the fair value calculation, resulting in an unexpected goodwill impairment charge, which could have a material adverse effect on Applied’s business, financial condition and results of operations. See Note 9 of Notes to Consolidated Financial Statements for additional discussion of goodwill impairment. Income Taxes Applied’s provision for income taxes and effective tax rate are affected by the geographical composition of pre-tax income which includes jurisdictions with differing tax rates, conditional reduced tax rates and other income tax incentives. It is also affected by events that are not consistent from period to period, such as changes to income tax laws and the resolution of prior years’ income tax filings. Applied recognizes a current tax liability for the estimated amount of income tax payable on tax returns for the current fiscal year. Deferred tax assets and liabilities are recognized for the estimated future tax effects of temporary differences between the book and tax bases of assets and liabilities. Deferred tax assets are also recognized for net operating loss and tax credit carryforwards. Deferred tax assets are offset by a valuation allowance to the extent it is more likely than not that they are not expected to be realized. Applied recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities based on the technical merits of the position. The tax benefits recognized from such positions are estimated based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Any changes in judgment related to uncertain tax positions are recognized in Applied’s provision for income taxes in the quarter in which such change occurs. Interest and penalties related to uncertain tax positions are recognized in Applied’s provision for income taxes. The calculation of Applied’s provision for income taxes and effective tax rate involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with Applied’s expectations could have an adverse material impact on Applied’s results of operations and financial condition. Non-GAAP Adjusted Financial Results Management uses non-GAAP adjusted financial measures to evaluate the Company’s operating and financial performance and for planning purposes, and as performance measures in its executive compensation program. Applied believes these measures enhance an overall understanding of our performance and investors’ ability to review the Company’s business from the same perspective as the Company’s management and facilitate comparisons of this period’s results with prior periods on a consistent basis by excluding items that we do not believe are indicative of our ongoing operating performance. The non-GAAP adjusted financial measures presented below are adjusted to exclude the impact of certain costs, expenses, gains and losses, including certain items related to mergers and acquisitions; restructuring charges and any associated adjustments; impairments of assets, or investments; gain or loss on sale of strategic investments; certain other discrete adjustments and income tax items. Reconciliations of these non-GAAP measures to the most directly comparable financial measures calculated and presented in accordance with GAAP are provided in the financial tables presented below. There are limitations in using non-GAAP financial measures because the non-GAAP financial measures are not prepared in accordance with generally accepted accounting principles, may be different from non-GAAP financial measures used by other companies, and may exclude certain items that may have a material impact upon our reported financial results. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the directly comparable financial measures prepared in accordance with GAAP. The following tables present a reconciliation of the GAAP and non-GAAP adjusted consolidated results for the past three fiscal years: APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS These items are incremental charges attributable to completed acquisitions, consisting of amortization of purchased intangible assets. Results for fiscal 2016 included adjustments associated with the cost reductions in the solar business. Results for fiscal 2015 primarily included $35 million of inventory charges, $17 million of restructuring charges and asset impairments related to cost reductions in the solar business, and a $2 million favorable adjustment of restructuring reserves related to prior restructuring plans. These items are incremental charges related to the terminated business combination agreement with Tokyo Electron Limited, consisting of acquisition-related and integration planning costs. Amounts for fiscal 2017 included the recognition of the previously unrecognized foreign tax credits. Amounts for fiscal 2015 included an adjustment to decrease the provision for income taxes by $28 million with a corresponding increase in net income, resulting in an increase in diluted earnings per share of $0.02. The adjustment was excluded in Applied’s non-GAAP adjusted results and was made primarily to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales, which resulted in overstating profitability in the U.S. and the provision for income taxes in immaterial amounts in each year since fiscal 2010. These amounts represent non-GAAP adjustments above multiplied by the effective tax rate within the jurisdictions that the adjustments affect. APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS Amounts for fiscal 2017 included the recognition of the previously unrecognized foreign tax credits. Amounts for fiscal 2015 included an adjustment to decrease the provision for income taxes by $28 million with a corresponding increase in net income, resulting in an increase in diluted earnings per share of $0.02. The adjustment was excluded in Applied’s non-GAAP adjusted results and was made primarily to correct an error in the recognition of cost of sales in the U.S. related to intercompany sales, which resulted in overstating profitability in the U.S. and the provision for income taxes in immaterial amounts in each year since fiscal 2010. The following table presents a reconciliation of the GAAP and non-GAAP adjusted segment results for the past three fiscal years: APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS These items are incremental charges attributable to completed acquisitions, consisting of amortization of purchased intangible assets. Results for fiscal 2015 included $3 million of inventory charges related to cost reduction in the solar business. Note: The reconciliation of GAAP and non-GAAP adjusted segment results above does not include certain revenues, costs of products sold and operating expenses that are reported within corporate and other and included in consolidated operating income.

<s>[INST] Introduction Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to facilitate an understanding of Applied’s business and results of operations. This MD&A should be read in conjunction with Applied’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10K. The following discussion contains forwardlooking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10K. MD&A consists of the following sections: Overview: a summary of Applied’s business and measurements Results of Operations: a discussion of operating results Segment Information: a discussion of segment operating results Recent Accounting Pronouncements: a discussion of new accounting pronouncements and its impact to Applied’s consolidated financial statements Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash OffBalance Sheet Arrangements and Contractual Obligations Critical Accounting Policies and Estimates: a discussion of critical accounting policies that require the exercise of judgments and estimates NonGAAP Adjusted Results: a presentation of results reconciling GAAP to nonGAAP adjusted measures Overview Applied provides manufacturing equipment, services and software to the semiconductor, display, and related industries. Applied’s customers include manufacturers of semiconductor wafers and chips, liquid crystal and organic lightemitting diode (OLED) displays, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Each of Applied’s businesses is subject to variable industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, display technologies, and other electronic devices, as well as other factors, such as global economic and market conditions, and the nature and timing of technological advances in fabrication processes. Applied operates in three reportable segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets. A summary of financial information for each reportable segment is found in Note 15 of Notes to Consolidated Financial Statements. A discussion of factors that could affect Applied’s operations is set forth under “Risk Factors” in Part I, Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in the United States, Europe, Israel, and Asia. Applied’s broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied’s results are driven primarily by customer spending on capital equipment and services to support key technology transitions or to increase production volume in response to worldwide demand for semiconductors and displays. Spending by semiconductor customers, which include companies that operate in the foundry, memory and logic markets, is driven by demand for advanced electronic products, including smartphones and other mobile devices, servers, personal computers, automotive devices, storage, and other products. The growth of data and new endmarket drivers such as artificial intelligence, augmented and virtual reality and smart vehicles are also creating new opportunities for the industry. As a result, products within the Semiconductor Systems segment are subject to significant changes in customer requirements, including transitions to smaller dimensions, increasingly complex chip architectures, new materials and an increasing number of applications. Demand for display manufacturing equipment spending depends primarily on consumer demand for increasingly larger and more advanced TVs as well as larger and higher resolution displays for next generation mobile devices, and investments in new types of display technologies. While certain existing technologies may be adapted to new requirements, some applications create the need for an entirely different technological approach. The timing of customer investment in manufacturing equipment is also affected by the timing of next generation production schedules, and the timing of capacity expansion to meet end market demand. In light of these conditions, Applied’s results can vary significantly yearoveryear, as well as quarteroverquarter. Applied’s strategic priorities include developing products that help solve customers’ challenges at technology inflections; expanding its served market opportunities in the semiconductor and display industries; and growing its services business. Applied’s longterm growth strategy requires continued development of new materials engineering capabilities, including products and platforms that enable expansion into new and [/INST] Positive. </s>

APPLIED MATERIALS INC /DE

2018-12-13

2018-10-28

Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations Introduction Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to facilitate an understanding of Applied’s business and results of operations. This MD&A should be read in conjunction with Applied’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10-K. The following discussion contains forward-looking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10-K. MD&A consists of the following sections: • Overview: a summary of Applied’s business and measurements • Results of Operations: a discussion of operating results • Segment Information: a discussion of segment operating results • Recent Accounting Pronouncements: a discussion of new accounting pronouncements and its impact to Applied’s consolidated financial statements • Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash • Off-Balance Sheet Arrangements and Contractual Obligations • Critical Accounting Policies and Estimates: a discussion of critical accounting policies that require the exercise of judgments and estimates • Non-GAAP Adjusted Results: a presentation of results reconciling GAAP to non-GAAP adjusted measures Overview Applied provides manufacturing equipment, services and software to the semiconductor, display, and related industries. Applied’s customers include manufacturers of semiconductor wafers and chips, liquid crystal and organic light-emitting diode (OLED) displays, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Each of Applied’s businesses is subject to variable industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, display technologies, and other electronic devices, as well as other factors, such as global economic and market conditions, and the nature and timing of technological advances in fabrication processes. Applied operates in three reportable segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets. A summary of financial information for each reportable segment is found in Note 15 of Notes to Consolidated Financial Statements. A discussion of factors that could affect Applied’s operations is set forth under “Risk Factors” in Part I, Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in the United States, Europe, Israel, and Asia. Applied’s broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied’s results are driven primarily by customer spending on capital equipment and services to support key technology transitions or to increase production volume in response to worldwide demand for semiconductors and displays. Spending by semiconductor customers, which include companies that operate in the foundry, memory and logic markets, is driven by demand for advanced electronic products, including smartphones and other mobile devices, servers, personal computers, automotive devices, storage, and other products. The growth of data and emerging end-market drivers such as artificial intelligence, augmented and virtual reality, the Internet of Things and smart vehicles are also creating new opportunities for the industry. As a result, products within the Semiconductor Systems segment are subject to significant changes in customer requirements, including transitions to smaller dimensions, increasingly complex chip architectures, new materials and an increasing number of applications. Demand for display manufacturing equipment spending depends primarily on consumer demand for increasingly larger and more advanced TVs as well as larger and higher resolution displays for next-generation mobile devices, and investments in new types of display technologies. While certain existing technologies may be adapted to new requirements, some applications create the need for an entirely different technological approach. The timing of customer investment in manufacturing equipment is also affected by the timing of next-generation process development and the timing of capacity expansion to meet end-market demand. In light of these conditions, Applied’s results can vary significantly year-over-year, as well as quarter-over-quarter. Applied’s strategic priorities include developing products that help solve customers’ challenges at technology inflections; expanding its served market opportunities in the semiconductor and display industries; and growing its services business. Applied’s long-term growth strategy requires continued development of new materials engineering capabilities, including products and platforms that enable expansion into new and adjacent markets. Applied’s significant investments in research, development and engineering must generally enable it to deliver new products and technologies before the emergence of strong demand, thus allowing customers to incorporate these products into their manufacturing plans during early-stage technology selection. Applied works closely with its global customers to design systems and processes that meet their planned technical and production requirements. The following table presents certain significant measurements for the past three fiscal years: Fiscal 2018 and 2017 contained 52 weeks, and fiscal 2016 contained 53 weeks. Fiscal 2018 included a one-time expense related to the enactment of recent U.S. tax legislation that reduced diluted earnings per share by $1.08. Investment in semiconductor and display manufacturing equipment and services continued to be a strong driver of revenue during fiscal 2018. Semiconductor equipment customers made investments in new capacity and technology transitions, and Applied’s overall semiconductor systems revenue increased as compared to the prior year. Demand for dynamic random-access memory (DRAM) and NAND increased in fiscal 2018 although overall spending by memory customers was lower towards the second half of the year. Logic customers’ spending remained strong while foundry customers’ spending decreased compared to the prior year and Applied continues to see these customers optimize existing capacity and re-prioritize their capital spending plans on longer lead-time equipment not in Applied’s product portfolio. Display equipment spending during fiscal 2018 reflected continued investment in new technology and manufacturing equipment for producing larger LCD TVs and in new equipment for mobile devices. Applied also continued to see strong growth in demand for spares and services from customers as compared to the prior year. While Applied anticipates major technology trends to continue driving long-term growth in the semiconductor industry, the trends characterizing the second half of 2018 are likely to continue into early fiscal 2019, with lower spending by memory customers, and foundry customers prioritizing spending on longer lead-time equipment not in Applied’s product portfolio. Applied also expects lower spending for display manufacturing equipment in fiscal 2019, although long-term demand drivers remain in place. Applied anticipates continued growth in semiconductor spares and services spending in fiscal 2019. Results of Operations Net Sales Net sales for the periods indicated were as follows: Net sales in fiscal 2018 compared to fiscal 2017 increased due to increased customer investments across all segments. The Semiconductor Systems segment continued to represent the largest contributor of net sales and to the increase in net sales. Net sales in fiscal 2017 compared to fiscal 2016 increased due to increased customer investments in all segments, with the majority of the increases resulting from investments in semiconductor equipment. Net sales by geographic region, determined by the location of customers’ facilities to which products were shipped, were as follows: The changes in net sales in all regions other than Korea for fiscal 2018 compared to fiscal 2017 primarily reflected changes in semiconductor equipment spending, including product and customer mix, and increased spending in semiconductor spares and services. The increase in net sales to customers in China also reflected increased investments in display manufacturing equipment. The decrease in net sales to customers in Korea primarily reflected decreased investments in display manufacturing equipment. The changes in net sales from customers in all regions for fiscal 2017 compared to fiscal 2016 primarily reflected increased investments in semiconductor equipment and changes in semiconductor equipment customer mix. In addition, the increase in net sales from customers in China also reflected increased investments from display manufacturing equipment customers. Gross Margin Gross margins for the periods indicated were as follows: Gross margin in fiscal 2018 increased slightly compared to fiscal 2017, primarily due to higher net sales and materials cost savings. Gross margin in fiscal 2017 increased compared to fiscal 2016, primarily due to higher net sales, favorable product mix and materials cost savings. Gross margin during fiscal 2018, 2017 and 2016 included $87 million, $69 million and $62 million, respectively, of share-based compensation expense. Research, Development and Engineering Research, Development and Engineering (RD&E) expenses for the periods indicated were as follows: Applied’s future operating results depend to a considerable extent on its ability to maintain a competitive advantage in the equipment and service products it provides. Development cycles range from 12 to 36 months depending on whether the product is an enhancement of an existing product, which typically has a shorter development cycle, or a new product, which typically has a longer development cycle. Most of Applied’s existing products resulted from internal development activities and innovations involving new technologies, materials and processes. In certain instances, Applied acquires technologies, either in existing or new product areas, to complement its existing technology capabilities and to reduce time to market. Management believes that it is critical to continue to make substantial investments in RD&E to assure the availability of innovative technology that meets the current and projected requirements of its customers’ most advanced designs. Applied has maintained and intends to continue its commitment to investing in RD&E in order to continue to offer new products and technologies. In fiscal 2018, Applied increased its RD&E investments across Semiconductor Systems and Display and Adjacent Markets, including etch, e-beam inspection and other materials engineering solutions to improve chip performance and enable advanced displays. Applied’s investments in etch were focused on supporting the adoption of precision etch technology for enabling continued scaling of 3D logic and memory chips. The investment in e-beam inspection was in support of strengthening our e-beam portfolio, which helps achieve higher yields at advanced nodes by detecting the most challenging defects and monitoring and controlling process marginality. Applied also invested in materials engineering solutions to support patterning applications as well as to improve transistor performance and device power efficiency. In Display and Adjacent Markets, RD&E investments were focused on expanding the company’s market opportunity with new display technologies. RD&E expenses increased in fiscal 2018 compared to the prior year and also in fiscal 2017 compared to fiscal 2016, primarily due to additional headcount and increased research and development spending in Semiconductor Systems and Display and Adjacent Market segments. These increases reflect Applied’s ongoing investments in product development initiatives, consistent with the Company’s growth strategy. Applied continued to prioritize existing RD&E investments in technical capabilities and critical research and development programs in current and new markets, with a focus on semiconductor technologies. RD&E expense during fiscal 2018, 2017 and 2016 included $96 million, $83 million and $76 million, respectively, of share-based compensation expense. Marketing and Selling Marketing and selling expenses for the periods indicated were as follows: Marketing and selling expenses increased in fiscal 2018 compared to fiscal 2017 primarily due to additional headcount. Marketing and selling expenses increased in fiscal 2017 compared to fiscal 2016, primarily due to additional headcount, partially offset by the reduction in bad debt provision recorded during fiscal 2017. Marketing and selling expenses for fiscal years 2018, 2017 and 2016 included $31 million, $28 million and $26 million, respectively, of share-based compensation expense. General and Administrative General and administrative (G&A) expenses for the periods indicated were as follows: General and administrative expenses in fiscal 2018 increased compared to fiscal 2017 primarily due to additional headcount and unfavorable impact from foreign exchange fluctuation, partially offset by lower variable compensation expense. General and administrative expenses in fiscal 2017 increased compared to fiscal 2016, primarily due to higher variable compensation and additional headcount. G&A expenses during fiscal 2018, 2017 and 2016 included $44 million, $40 million and $37 million, respectively, of share-based compensation expense. Interest Expense and Interest and Other Income (loss), net Interest expense and interest and other income (loss), net for the periods indicated were as follows: Interest expenses incurred were primarily associated with the senior unsecured notes issued in June 2011, September 2015, and March 2017. Interest expense increased in fiscal 2018 compared to the prior year and also in fiscal 2017 compared to fiscal 2016 due to the issuance of senior unsecured notes in March 2017. Interest and other income, net primarily includes interest earned on cash and investments, realized gains or losses on sales of securities and impairment of strategic investments. Interest and other income, net in fiscal 2018 increased compared to fiscal 2017 primarily driven by realized gains on sales of securities and higher interest income from investments. Interest and other income, net in fiscal 2017 increased compared to the prior year primarily due to higher interest income from investments, partially offset by higher impairment of strategic investments in fiscal 2017. Income Taxes Provision for income taxes and effective tax rates for the periods indicated were as follows: Applied’s provision for income taxes and effective tax rate are affected by the geographical composition of pre-tax income which includes jurisdictions with differing tax rates, conditional reduced tax rates and other income tax incentives. It is also affected by events that are not consistent from period to period, such as changes in income tax laws and the resolution of prior years’ income tax filings. On December 22, 2017, the U.S. government enacted the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act includes a reduction to the U.S. federal corporate tax rate from 35.0 percent to 21.0 percent and requires a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries payable over eight years. U.S. deferred tax assets and liabilities were subject to remeasurement due to the reduction of the U.S. federal corporate tax rate. Applied has a blended U.S. federal corporate tax rate of 23.4 percent for fiscal 2018 based on the number of days before and after the effective date of the Tax Act. The U.S. Securities and Exchange Commission issued Staff Accounting Bulletin No. 118 (SAB 118), which provides guidance on accounting for the income tax effects of the Tax Act. SAB 118 provides a measurement period for companies to complete this accounting. Pursuant to SAB 118, provisional adjustments were recorded when reasonable estimates could be determined. These provisional estimates will be revised as information becomes available and as guidance is issued by the Internal Revenue Service. The accounting for the income tax effects of the Tax Act will be completed during the measurement period, which will not extend beyond one year from the Tax Act enactment date. Applied continues to evaluate certain unrepatriated earnings of foreign subsidiaries used to calculate the transition tax. The remeasurement of U.S. deferred tax assets and liabilities is complete. The effective tax rate for fiscal 2018 was higher than fiscal 2017 primarily due to tax expense of $1.1 billion for the transition tax and remeasurement of deferred tax assets as a result of the Tax Act, partially offset by changes in the geographical composition of income, tax benefits from the lower U.S. federal corporate tax rate, adoption of authoritative guidance for share-based compensation, and the resolution of tax liabilities for uncertain tax positions. In addition, fiscal 2017 included tax benefits from the recognition of previously unrecognized foreign tax credits. The effective tax rate for fiscal 2017 was lower than fiscal 2016 primarily due to the recognition of previously unrecognized foreign tax credits and changes in the geographical composition of income. In addition, fiscal 2016 included unfavorable resolutions and changes related to income tax liabilities for uncertain tax positions as well as the reinstatement of the U.S. federal R&D tax credit retroactive to its expiration in December of 2015 which did not reoccur in fiscal 2017. Segment Information Applied reports financial results in three segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets. A description of the products and services, as well as financial data, for each reportable segment can be found in Note 15 of Notes to Consolidated Financial Statements. The Corporate and Other category includes revenues from products, as well as costs of products sold, for fabricating solar photovoltaic cells and modules and certain operating expenses that are not allocated to its reportable segments and are managed separately at the corporate level. These operating expenses include costs for share-based compensation; certain management, finance, legal, human resource, and RD&E functions provided at the corporate level; and unabsorbed information technology and occupancy. In addition, Applied does not allocate to its reportable segments restructuring and asset impairment charges and any associated adjustments related to restructuring actions, unless these actions pertain to a specific reportable segment. The results for each reportable segment are discussed below. Semiconductor Systems Segment The Semiconductor Systems segment is comprised primarily of capital equipment used to fabricate semiconductor chips. Semiconductor industry spending on capital equipment is driven by demand for advanced electronic products, including smartphones and other mobile devices, servers, personal computers, automotive devices, storage, and other products, and the nature and timing of technological advances in fabrication processes, and as a result is subject to variable industry conditions. Development efforts are focused on solving customers’ key technical challenges in transistor, interconnect, patterning and packaging performance as devices scale to advanced technology nodes. Investment in semiconductor manufacturing equipment continued to be a strong driver of revenue during fiscal 2018. Semiconductor equipment customers made investments in new capacity and technology transitions, and overall semiconductor systems revenue increased. Demand for logic, DRAM, and NAND increased during fiscal 2018. Foundry customers’ spending decreased compared to the prior year and Applied continues to see these customers optimize existing capacity and re-prioritize their capital spending plans on longer lead-time equipment not in Applied’s product portfolio. Certain significant measures for the periods indicated were as follows: Net sales for Semiconductor Systems by end use application for the periods indicated were as follows: Net sales for fiscal 2018 increased compared to fiscal 2017 primarily due to higher spending from memory and logic customers, offset by lower spending from foundry customers. Although operating margin remained flat, operating income for fiscal 2018 increased compared to fiscal 2017 primarily due to favorable changes in product mix and higher net sales, partially offset by higher RD&E expenses. Six customers represented at least 10 percent of this segment’s net sales, and together they accounted for approximately 76 percent of this segment’s net sales for fiscal 2018. Net sales for fiscal 2017 increased compared to fiscal 2016 primarily due to higher spending from foundry and memory customers. Operating income and operating margin for fiscal 2017 increased compared to prior year primarily due to favorable changes in product mix and higher net sales, partially offset by higher RD&E expenses. The following regions accounted for at least 30 percent of total net sales for the Semiconductor Systems segment for one or more of past three fiscal years: Applied Global Services Segment The Applied Global Services segment provides integrated solutions to optimize equipment and fab performance and productivity, including spares, upgrades, services, certain remanufactured earlier generation equipment and factory automation software for semiconductor, display and solar products. Customer demand for products and services is fulfilled through a global distribution system with trained service engineers located in close proximity to customer sites. Demand for Applied Global Services’ service solutions are driven by Applied’s large and growing installed base of manufacturing systems, and customers’ needs to shorten ramp times, improve device performance and yield, and optimize factory output and operating costs. Industry conditions that affect Applied Global Services’ sales of spares and services are primarily characterized by increases in semiconductor manufacturers’ wafer starts and continued strong utilization rates, growth of the installed base of equipment, growing service intensity of newer tools, and the company’s ability to sell more comprehensive service agreements. Certain significant measures for the periods indicated were as follows: There was no single region that accounted for at least 30 percent of total net sales for the Applied Global Services segment for any of the past three fiscal years. Net sales increased in fiscal 2018 compared to the prior year and also in fiscal 2017 compared to fiscal 2016 primarily due to higher customer spending for spares and services. Two customers represented at least 10 percent of this segment’s net sales, and together they accounted for approximately 23 percent of this segment’s net sales for fiscal 2018. Operating income and operating margin for fiscal 2018 increased compared to the prior year and also in fiscal 2017 compared to fiscal 2016, reflecting higher net sales partially offset by increased headcount to support business growth. Display and Adjacent Markets Segment The Display and Adjacent Markets segment encompasses products for manufacturing liquid crystal and OLED displays, and other display technologies for TVs, monitors, laptops, personal computers, electronic tablets, smart phones, and other consumer-oriented devices, equipment upgrades and flexible coating systems. The segment is focused on expanding its presence through technologically-differentiated equipment for manufacturing large-scale LCD TVs, OLEDs, low temperature polysilicon (LTPS), metal oxide, and touch panel sectors; and development of products that provide customers with improved performance and yields. Display industry growth depends primarily on consumer demand for increasingly larger and more advanced TVs as well as larger and higher resolution displays for next-generation mobile devices. The market environment for Applied's Display and Adjacent Markets segment in fiscal 2018 was characterized by increased demand for manufacturing equipment for TV and mobile devices. Uneven demand patterns in the Display and Adjacent Markets segment can cause significant fluctuations quarter-over-quarter, as well as year-over-year. Certain significant measures for the periods presented were as follows: Net sales for fiscal 2018 increased compared to fiscal 2017 primarily due to higher customer investments in TV display manufacturing equipment. Operating income and operating margin for fiscal 2018 increased compared fiscal 2017, reflecting higher net sales and favorable product mix, partially offset by higher RD&E spending. Three customers, that represented at least 10 percent of this segment’s net sales, accounted for approximately 58 percent of net sales for this segment in fiscal 2018, with one customer accounting for approximately 33 percent of net sales. Net sales for fiscal 2017 increased compared to prior year primarily due to higher customer investments in mobile and TV display manufacturing equipment. Operating income and operating margin for fiscal 2017 increased compared to the prior year, reflecting higher net sales and favorable product mix, partially offset by increased RD&E spending. The following regions accounted for at least 30 percent of total net sales for the Display and Adjacent Markets segment for one or more of the periods presented: Recent Accounting Pronouncements For a description of recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on Applied’s consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements. Financial Condition, Liquidity and Capital Resources Applied’s cash, cash equivalents and investments consist of the following: Sources and Uses of Cash A summary of cash provided by (used in) operating, investing, and financing activities is as follows: In March 2016, the Financial Accounting Standards Board issued authoritative guidance that simplifies several aspects of the accounting for share-based payment transactions, including forfeitures, income tax, and classification on the statement of cash flows. Applied adopted this guidance in the first quarter of fiscal 2018. Upon adoption, Applied elected to apply the presentation requirements for cash flows related to excess tax benefits and employee taxes paid for withheld shares retrospectively. Adopting this guidance increased cash provided by operating activities by $180 million and $100 million with corresponding net decreases in cash provided by financing activities for fiscal 2017 and 2016, respectively. See Note 1 of Notes to Consolidated Financial Statements for additional discussion of this adoption. Operating Activities Cash from operating activities for fiscal 2018 was $3.8 billion, which reflects net income adjusted for the effect of non-cash charges and changes in working capital components. Non-cash charges included depreciation, amortization, share-based compensation and deferred income taxes. Cash provided from operating activities remained flat from fiscal 2017 to fiscal 2018 due to the increase in income taxes payable, offset by lower deferred revenue and higher increase in accounts receivable. Cash provided by operating activities increased from fiscal 2016 to fiscal 2017 primarily due to higher net income, offset by a smaller increase in customer deposits and a greater increase in inventory in fiscal 2017. Applied has agreements with various financial institutions to sell accounts receivable and discount promissory notes from selected customers. Applied sells its accounts receivable without recourse. Applied, from time to time, also discounts letters of credit issued by customers through various financial institutions. The discounting of letters of credit depends on many factors, including the willingness of financial institutions to discount the letters of credit and the cost of such arrangements. Applied sold $1.6 billion, $746 million and $75 million of accounts receivable during fiscal 2018, 2017 and 2016, respectively. Applied discounted letters of credit issued by customers of $37 million in fiscal 2018. There was no discounting of promissory notes in fiscal 2018. Applied did not discount letters of credit issued by customers or discount promissory notes during fiscal 2017 or 2016. Applied’s working capital was $6.7 billion at October 28, 2018 and $8.8 billion at October 29, 2017. Days sales outstanding at the end of fiscal 2018, 2017 and 2016 was 58 days, 54 days, and 63 days, respectively. Days sales outstanding varies due to the timing of shipments and payment terms, and the increase from fiscal 2017 to fiscal 2018 was primarily due to better revenue linearity in fiscal 2017. Days sales outstanding decreased from fiscal 2016 to fiscal 2017 primarily due to better collections performance and increase in factoring of accounts receivable. Investing Activities Applied generated $571 million in cash from investing activities in fiscal 2018. Applied used $2.5 billion of cash in investing activities in fiscal 2017 and $425 million in fiscal 2016. Capital expenditures in fiscal 2018, 2017 and 2016 were $622 million, $345 million and $253 million, respectively. Capital expenditures in fiscal 2018 were primarily for real property acquisitions and improvements in North America and Taiwan, as well as investments in demonstration, testing and laboratory tools. Capital expenditures in fiscal 2017 and fiscal 2016 were primarily for demonstration and test equipment and laboratory tools in North America. Proceeds from sales and maturities of investments, net of purchase of investments was $1.2 billion for fiscal 2018. Purchases of investments, net of proceeds from sales and maturities of investments were $2.1 billion and $156 million for fiscal 2017 and 2016, respectively. Investing activities also included investments in technology to allow Applied to access new market opportunities or emerging technologies. Applied’s investment portfolio consists principally of investment grade money market mutual funds, U.S. Treasury and agency securities, municipal bonds, corporate bonds and mortgage-backed and asset-backed securities, as well as equity securities. Applied regularly monitors the credit risk in its investment portfolio and takes appropriate measures, which may include the sale of certain securities, to manage such risks prudently in accordance with its investment policies. Financing Activities Applied used $5.9 billion of cash in financing activities in fiscal 2018, consisting primarily of repurchases of common stock of $5.3 billion, cash dividends to stockholders of $605 million and tax withholding payments for vested equity awards of $164 million, offset by proceeds from common stock issuances of $124 million. Applied generated $341 million of cash from financing activities in fiscal 2017, consisting primarily of net proceeds received from the issuance of senior unsecured notes of $2.2 billion, proceeds from common stock issuances of $97 million, partially offset by cash used for repurchases of common stock of $1.2 billion, cash dividends to stockholders of $430 million and debt repayments of $205 million. Applied used $3.5 billion of cash in financing activities in fiscal 2016, consisting primarily $1.2 billion in debt repayments, $1.9 billion in repurchases of its common stock, and $444 million in cash dividends to stockholders, offset by proceeds from common stock issuances of $88 million. In September 2017, Applied’s Board of Directors approved a common stock repurchase program authorizing up to $3.0 billion in repurchases. In February 2018, the Board of Directors approved a new common stock repurchase program authorizing up to an additional $6.0 billion in repurchases. At October 28, 2018, $4.3 billion remained available for future stock repurchases under this repurchase program. During fiscal 2018, Applied's Board of Directors declared three quarterly cash dividends of $0.20 per share and one quarterly cash dividend of $0.10 per share. During each of fiscal 2017 and 2016, Applied’s Board of Directors declared four quarterly cash dividends in the amount of $0.10 per share. Applied currently anticipates that cash dividends will continue to be paid on a quarterly basis, although the declaration of any future cash dividend is at the discretion of the Board of Directors and will depend on Applied’s financial condition, results of operations, capital requirements, business conditions and other factors, as well as a determination by the Board of Directors that cash dividends are in the best interests of Applied’s stockholders. Applied has credit facilities for unsecured borrowings in various currencies of up to $1.6 billion, of which $1.5 billion is comprised of a committed revolving credit agreement with a group of banks that is scheduled to expire in September 2021. This agreement provides for borrowings in United States dollars at interest rates keyed to one of two rates selected by Applied for each advance and includes financial and other covenants with which Applied was in compliance at October 28, 2018. Remaining credit facilities in the amount of approximately $71 million are with Japanese banks. Applied’s ability to borrow under these facilities is subject to bank approval at the time of the borrowing request, and any advances will be at rates indexed to the banks’ prime reference rate denominated in Japanese yen. No amounts were outstanding under any of these facilities at both October 28, 2018 and October 29, 2017, and Applied has not utilized these credit facilities. In fiscal 2011, Applied established a short-term commercial paper program of up to $1.5 billion. At October 28, 2018 and October 29, 2017, Applied did not have any commercial paper outstanding, but may issue commercial paper notes under this program from time to time in the future. In March 2017, Applied issued senior unsecured notes in the aggregate principal amount of $2.2 billion. Applied had senior unsecured notes in the aggregate principal amount of $5.4 billion outstanding as of October 28, 2018. The indentures governing these notes include covenants with which Applied was in compliance at October 28, 2018. In May 2017, Applied completed the redemption of the entire outstanding $200 million in principal amount of senior notes due in October 2017. See Note 10 of Notes to Consolidated Financial Statements for additional discussion of existing debt. Applied may seek to refinance its existing debt and may incur additional indebtedness depending on Applied’s capital requirements and the availability of financing. Others During 2018 and 2017, Applied reduced $1 million and $17 million, respectively, of its allowance for doubtful accounts as a result of an overall lower risk profile of Applied’s customers. Applied recorded a bad debt provision of $3 million in fiscal 2016. While Applied believes that its allowance for doubtful accounts at October 28, 2018 is adequate, it will continue to closely monitor customer liquidity and economic conditions. On December 22, 2017, the U.S. government enacted the Tax Cuts and Jobs Act. The Tax Act requires a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries payable over eight years, with eight percent due in each of the first five years starting with fiscal 2018. For fiscal 2018, Applied realized tax expense of $1.1 billion associated with the Tax Act, primarily due to the transition tax. The transition tax eliminated the requirement that cash, cash equivalents and marketable securities held by certain foreign subsidiaries be subject to U.S income taxes if repatriated for U.S. operations. Accordingly, cash, cash equivalents and marketable securities held by all foreign subsidiaries may be repatriated for U.S. operation without being subject to further U.S. income taxes. Although cash requirements will fluctuate based on the timing and extent of factors such as those discussed above, Applied’s management believes that cash generated from operations, together with the liquidity provided by existing cash balances and borrowing capability, will be sufficient to satisfy Applied’s liquidity requirements for the next 12 months. For further details regarding Applied’s operating, investing and financing activities, see the Consolidated Statements of Cash Flows in this report. For details on standby letters of credit and other agreements with banks, see Off-Balance Sheet Arrangements below. Off-Balance Sheet Arrangements In the ordinary course of business, Applied provides standby letters of credit or other guarantee instruments to third parties as required for certain transactions initiated by either Applied or its subsidiaries. As of October 28, 2018, the maximum potential amount of future payments that Applied could be required to make under these guarantee agreements was approximately $58 million. Applied has not recorded any liability in connection with these guarantee agreements beyond that required to appropriately account for the underlying transaction being guaranteed. Applied does not believe, based on historical experience and information currently available, that it is probable that any amounts will be required to be paid under these guarantee agreements. Applied also has agreements with various banks to facilitate subsidiary banking operations worldwide, including overdraft arrangements, issuance of bank guarantees, and letters of credit. As of October 28, 2018, Applied has provided parent guarantees to banks for approximately $149 million to cover these arrangements. Applied also has operating leases for various facilities. Total rent expense for fiscal 2018, 2017 and 2016 was $50 million, $34 million and $38 million, respectively. Contractual Obligations The following table summarizes Applied’s contractual obligations as of October 28, 2018: ______________________ Represents an estimate of a provisional tax amount for the transition tax liability associated with the deemed repatriation of accumulated foreign earnings as a result from the enactment of the Tax Cuts and Jobs Act into law on December 22, 2017. Represents Applied’s agreements to purchase goods and services consisting of Applied’s outstanding purchase orders for goods and services. Other long-term liabilities in the table do not include pension, post-retirement and deferred compensation plans due to the uncertainty in the timing of future payments. Applied evaluates the need to make contributions to its pension and post-retirement benefit plans after considering the funded status of the plans, movements in the discount rate, performance of the plan assets and related tax consequences. Payments to the plans would be dependent on these factors and could vary across a wide range of amounts and time periods. Payments for deferred compensation plans are dependent on activity by participants, making the timing of payments uncertain. Information on Applied’s pension, post-retirement benefit and deferred compensation plans is presented in Note 12, Employee Benefit Plans, of the consolidated financial statements. Applied’s other long-term liabilities in the Consolidated Balance Sheets include deferred tax liabilities, gross unrecognized tax benefits and related gross interest and penalties. As of October 28, 2018, the gross liability for unrecognized tax benefits that was not expected to result in payment of cash within one year was $374 million. Interest and penalties related to uncertain tax positions that were not expected to result in payment of cash within one year of October 28, 2018 was $26 million. At this time, Applied is unable to make a reasonably reliable estimate of the timing of payments due to uncertainties in the timing of tax audit outcomes; therefore, such amounts are not included in the above contractual obligation table. Critical Accounting Policies and Estimates The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported. Note 1 of Notes to Consolidated Financial Statements describes the significant accounting policies used in the preparation of the consolidated financial statements. Certain of these significant accounting policies are considered to be critical accounting policies. A critical accounting policy is defined as one that is both material to the presentation of Applied’s consolidated financial statements and that requires management to make difficult, subjective or complex judgments that could have a material effect on Applied’s financial condition or results of operations. Specifically, these policies have the following attributes: (1) Applied is required to make assumptions about matters that are highly uncertain at the time of the estimate; and (2) different estimates Applied could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on Applied’s financial condition or results of operations. Estimates and assumptions about future events and their effects cannot be determined with certainty. Applied bases its estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as Applied’s operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they became known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties include those discussed in Part I, Item 1A, “Risk Factors.” Based on a critical assessment of its accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that Applied’s consolidated financial statements are fairly stated in accordance with accounting principles generally accepted in the United States of America, and provide a meaningful presentation of Applied’s financial condition and results of operations. Management believes that the following are critical accounting policies and estimates: Revenue Recognition Applied recognizes revenue when all four revenue recognition criteria have been met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; sales price is fixed or determinable; and collectability is probable. Each sale arrangement may contain commercial terms that differ from other arrangements. In addition, Applied frequently enters into contracts that contain multiple deliverables. Judgment is required to properly identify the accounting units of the multiple deliverable transactions and to determine the manner in which revenue should be allocated among the accounting units. Moreover, judgment is used in interpreting the commercial terms and determining when all criteria of revenue recognition have been met in order for revenue recognition to occur in the appropriate accounting period. While changes in the allocation of the estimated sales price between the units of accounting will not affect the amount of total revenue recognized for a particular sales arrangement, any material changes in these allocations could impact the timing of revenue recognition, which could have a material effect on Applied’s financial condition and results of operations. Warranty Costs Applied provides for the estimated cost of warranty when revenue is recognized. Estimated warranty costs are determined by analyzing specific product, current and historical configuration statistics and regional warranty support costs. Applied’s warranty obligation is affected by product and component failure rates, material usage and labor costs incurred in correcting product failures during the warranty period. As Applied’s customer engineers and process support engineers are highly trained and deployed globally, labor availability is a significant factor in determining labor costs. The quantity and availability of critical replacement parts is another significant factor in estimating warranty costs. Unforeseen component failures or exceptional component performance can also result in changes to warranty costs. If actual warranty costs differ substantially from Applied’s estimates, revisions to the estimated warranty liability would be required, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Allowance for Doubtful Accounts Applied maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. This allowance is based on historical experience, credit evaluations, specific customer collection history and any customer-specific issues Applied has identified. Changes in circumstances, such as an unexpected material adverse change in a major customer’s ability to meet its financial obligation to Applied or its payment trends, may require Applied to further adjust its estimates of the recoverability of amounts due to Applied, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Inventory Valuation Inventories are generally stated at the lower of cost or net realizable value, with cost determined on a first-in, first-out basis. The carrying value of inventory is reduced for estimated obsolescence by the difference between its cost and the estimated net realizable value based upon assumptions about future demand. Applied evaluates the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional adjustments for excess or obsolete inventory may be required, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Goodwill and Intangible Assets Applied reviews goodwill and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, and also annually reviews goodwill and intangibles with indefinite lives for impairment. Intangible assets, such as purchased technology, are generally recorded in connection with a business acquisition. The value assigned to intangible assets is usually based on estimates and judgments regarding expectations for the success and life cycle of products and technology acquired. If actual product acceptance differs significantly from the estimates, Applied may be required to record an impairment charge to reduce the carrying value of the reporting unit to its estimated fair value. To test goodwill for impairment, Applied first performs a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If it is concluded that this is the case, Applied then performs the two-step goodwill impairment test. Otherwise, the two-step goodwill impairment test is not required. Under the two-step goodwill impairment test, Applied would in the first step compare the estimated fair value of each reporting unit to its carrying value. If the carrying value of a reporting unit exceeds its estimated fair value, Applied would then perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If Applied determines that the carrying value of a reporting unit’s goodwill exceeds its implied fair value, Applied would record an impairment charge equal to the difference. Applied determines the fair value of each reporting unit based on a weighting of an income and a market approach. Applied bases the fair value estimates on assumptions that it believes to be reasonable but that are unpredictable and inherently uncertain. Under the income approach, Applied estimates the fair value based on discounted cash flow method. The estimates used in the impairment testing are consistent with the discrete forecasts that Applied uses to manage its business, and considers any significant developments during the period. Under the discounted cash flow method, cash flows beyond the discrete forecasts are estimated using a terminal growth rate, which considers the long-term earnings growth rate specific to the reporting units. The estimated future cash flows are discounted to present value using each reporting unit’s weighted average cost of capital. The weighted average cost of capital measures a reporting unit’s cost of debt and equity financing weighted by the percentage of debt and equity in a reporting unit’s target capital structure. In addition, the weighted average cost of capital is derived using both known and estimated market metrics, and is adjusted to reflect both the timing and risks associated with the estimated cash flows. The tax rate used in the discounted cash flow method is the median tax rate of comparable companies and reflects Applied’s current international structure, which is consistent with the market participant perspective. Under the market approach, Applied uses the guideline company method which applies market multiples to forecasted revenues and earnings before interest, taxes, depreciation and amortization. Applied uses market multiples that are consistent with comparable publicly-traded companies and considers each reporting unit’s size, growth and profitability relative to its comparable companies. Management uses significant judgment when assessing goodwill for potential impairment, especially in emerging markets. Indicators of potential impairment include, but are not limited to, challenging economic conditions, an unfavorable industry or economic environment or other severe decline in market conditions. Such conditions could have the effect of changing one of the critical assumptions or estimates used for the fair value calculation, resulting in an unexpected goodwill impairment charge, which could have a material adverse effect on Applied’s business, financial condition and results of operations. See Note 9 of Notes to Consolidated Financial Statements for additional discussion of goodwill impairment. Income Taxes Applied’s provision for income taxes and effective tax rate are affected by the geographical composition of pre-tax income which includes jurisdictions with differing tax rates, conditional reduced tax rates and other income tax incentives. It is also affected by events that are not consistent from period to period, such as changes to income tax laws and the resolution of prior years’ income tax filings. Applied recognizes a current tax liability for the estimated amount of income tax payable on tax returns for the current fiscal year. Deferred tax assets and liabilities are recognized for the estimated future tax effects of temporary differences between the book and tax bases of assets and liabilities. Deferred tax assets are also recognized for net operating loss and tax credit carryforwards. Deferred tax assets are offset by a valuation allowance to the extent it is more likely than not that they are not expected to be realized. Applied recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities based on the technical merits of the position. The tax benefits recognized from such positions are estimated based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Any changes in judgment related to uncertain tax positions are recognized in Applied’s provision for income taxes in the quarter in which such change occurs. Interest and penalties related to uncertain tax positions are recognized in Applied’s provision for income taxes. The calculation of Applied’s provision for income taxes and effective tax rate involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with Applied’s expectations could have an adverse material impact on Applied’s results of operations and financial condition. Non-GAAP Adjusted Financial Results Management uses non-GAAP adjusted financial measures to evaluate the Company’s operating and financial performance and for planning purposes, and as performance measures in its executive compensation program. Applied believes these measures enhance an overall understanding of its performance and investors’ ability to review the Company’s business from the same perspective as the Company’s management and facilitate comparisons of this period’s results with prior periods on a consistent basis by excluding items that management does not believe are indicative of Applied's ongoing operating performance. The non-GAAP adjusted financial measures presented below are adjusted to exclude the impact of certain costs, expenses, gains and losses, including certain items related to mergers and acquisitions; restructuring charges and any associated adjustments; impairments of assets, or investments; gain or loss on sale of strategic investments; certain income tax items and other discrete adjustments. Additionally, fiscal 2018 non-GAAP results exclude estimated discrete income tax expense items associated with recent U.S. tax legislation. Reconciliations of these non-GAAP measures to the most directly comparable financial measures calculated and presented in accordance with GAAP are provided in the financial tables presented below. There are limitations in using non-GAAP financial measures because the non-GAAP financial measures are not prepared in accordance with generally accepted accounting principles, may be different from non-GAAP financial measures used by other companies, and may exclude certain items that may have a material impact upon our reported financial results. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the directly comparable financial measures prepared in accordance with GAAP. The following tables present a reconciliation of the GAAP and non-GAAP adjusted consolidated results for the past three fiscal years: APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS These items are incremental charges attributable to completed acquisitions, consisting of amortization of purchased intangible assets. Results for fiscal 2016 included adjustments associated with the cost reductions in the solar business. Charges to income tax provision related to a one-time transition tax and a decrease in U.S. deferred tax assets as a result of the recent U.S. tax legislation. Amounts for fiscal 2017 included the recognition of the previously unrecognized foreign tax credits. Adjustment to provision for income taxes related to non-GAAP adjustments reflected in income before income taxes. APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS The following table presents a reconciliation of the GAAP and non-GAAP adjusted segment results for the past three fiscal years: APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS These items are incremental charges attributable to completed acquisitions, consisting of amortization of purchased intangible assets. Note: The reconciliation of GAAP and non-GAAP adjusted segment results above does not include certain revenues, costs of products sold and operating expenses that are reported within corporate and other and included in consolidated operating income.

<s>[INST] Introduction Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to facilitate an understanding of Applied’s business and results of operations. This MD&A should be read in conjunction with Applied’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10K. The following discussion contains forwardlooking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10K. MD&A consists of the following sections: Overview: a summary of Applied’s business and measurements Results of Operations: a discussion of operating results Segment Information: a discussion of segment operating results Recent Accounting Pronouncements: a discussion of new accounting pronouncements and its impact to Applied’s consolidated financial statements Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash OffBalance Sheet Arrangements and Contractual Obligations Critical Accounting Policies and Estimates: a discussion of critical accounting policies that require the exercise of judgments and estimates NonGAAP Adjusted Results: a presentation of results reconciling GAAP to nonGAAP adjusted measures Overview Applied provides manufacturing equipment, services and software to the semiconductor, display, and related industries. Applied’s customers include manufacturers of semiconductor wafers and chips, liquid crystal and organic lightemitting diode (OLED) displays, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Each of Applied’s businesses is subject to variable industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, display technologies, and other electronic devices, as well as other factors, such as global economic and market conditions, and the nature and timing of technological advances in fabrication processes. Applied operates in three reportable segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets. A summary of financial information for each reportable segment is found in Note 15 of Notes to Consolidated Financial Statements. A discussion of factors that could affect Applied’s operations is set forth under “Risk Factors” in Part I, Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in the United States, Europe, Israel, and Asia. Applied’s broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied’s results are driven primarily by customer spending on capital equipment and services to support key technology transitions or to increase production volume in response to worldwide demand for semiconductors and displays. Spending by semiconductor customers, which include companies that operate in the foundry, memory and logic markets, is driven by demand for advanced electronic products, including smartphones and other mobile devices, servers, personal computers, automotive devices, storage, and other products. The growth of data and emerging endmarket drivers such as artificial intelligence, augmented and virtual reality, the Internet of Things and smart vehicles are also creating new opportunities for the industry. As a result, products within the Semiconductor Systems segment are subject to significant changes in customer requirements, including transitions to smaller dimensions, increasingly complex chip architectures, new materials and an increasing number of applications. Demand for display manufacturing equipment spending depends primarily on consumer demand for increasingly larger and more advanced TVs as well as larger and higher resolution displays for nextgeneration mobile devices, and investments in new types of display technologies. While certain existing technologies may be adapted to new requirements, some applications create the need for an entirely different technological approach. The timing of customer investment in manufacturing equipment is also affected by the timing of nextgeneration process development and the timing of capacity expansion to meet endmarket demand. In light of these conditions, Applied’s results can vary significantly yearoveryear, as well as quarteroverquarter. Applied’s strategic priorities include developing products that help solve customers’ challenges at technology inflections; expanding its served market opportunities in the semiconductor and display industries; and growing its services business. Applied’s longterm growth strategy requires continued development of new materials engineering capabilities, including products and platforms [/INST] Negative. </s>

APPLIED MATERIALS INC /DE

2019-12-13

2019-10-27

Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations Introduction Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to facilitate an understanding of Applied’s business and results of operations. This MD&A should be read in conjunction with Applied’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10-K. The following discussion contains forward-looking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10-K. MD&A consists of the following sections: •Overview: a summary of Applied’s business and measurements •Results of Operations: a discussion of operating results •Segment Information: a discussion of segment operating results •Recent Accounting Pronouncements: a discussion of new accounting pronouncements and its impact to Applied’s consolidated financial statements •Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash •Off-Balance Sheet Arrangements and Contractual Obligations •Critical Accounting Policies and Estimates: a discussion of critical accounting policies that require the exercise of judgments and estimates •Non-GAAP Adjusted Results: a presentation of results reconciling GAAP to non-GAAP adjusted measures Overview Applied provides manufacturing equipment, services and software to the semiconductor, display, and related industries. Applied’s customers include manufacturers of semiconductor wafers and chips, liquid crystal and organic light-emitting diode (OLED) displays, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Each of Applied’s businesses is subject to variable industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, display technologies, and other electronic devices, as well as other factors, such as global economic and market conditions, and the nature and timing of technological advances in fabrication processes. Applied operates in three reportable segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets. A summary of financial information for each reportable segment is found in Note 16 of Notes to Consolidated Financial Statements. A discussion of factors that could affect Applied’s operations is set forth under “Risk Factors” in Part I, Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in the United States, Europe, Israel, and Asia. Applied’s broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied’s results are driven primarily by customer spending on capital equipment and services to support key technology transitions or to increase production volume in response to worldwide demand for semiconductors and displays. Spending by semiconductor customers, which include companies that operate in the foundry, logic and memory markets, is driven by demand for advanced electronic products, including smartphones and other mobile devices, servers, personal computers, automotive devices, storage, and other products. The growth of data and emerging end-market drivers such as artificial intelligence, augmented and virtual reality, the Internet of Things and smart vehicles are also creating new opportunities for the industry. As a result, products within the Semiconductor Systems segment are subject to significant changes in customer requirements, including transitions to smaller dimensions, increasingly complex chip architectures, new materials and an increasing number of applications. Demand for display manufacturing equipment spending depends primarily on consumer demand for increasingly larger and more advanced TVs as well as larger and higher resolution displays for next-generation mobile devices, and investments in new types of display technologies. While certain existing technologies may be adapted to new requirements, some applications create the need for an entirely different technological approach. The timing of customer investment in manufacturing equipment is also affected by the timing of next-generation process development and the timing of capacity expansion to meet end-market demand. In light of these conditions, Applied’s results can vary significantly year-over-year, as well as quarter-over-quarter. Applied’s strategic priorities include developing products that help solve customers’ challenges at technology inflections; expanding its served market opportunities in the semiconductor and display industries; and growing its services business. Applied’s long-term growth strategy requires continued development of new materials engineering capabilities, including products and platforms that enable expansion into new and adjacent markets. Applied’s significant investments in research, development and engineering must generally enable it to deliver new products and technologies before the emergence of strong demand, thus allowing customers to incorporate these products into their manufacturing plans during early-stage technology selection. Applied works closely with its global customers to design systems and processes that meet their planned technical and production requirements. The following table presents certain significant measurements for the past three fiscal years: Fiscal 2019, 2018 and 2017 each contained 52 weeks. Fiscal 2018 included a one-time expense related to the enactment of U.S. income tax law that reduced diluted earnings per share by $1.08. Customer investments in semiconductor and display manufacturing equipment and services continued to be the primary contributor of revenue during fiscal 2019. Semiconductor equipment customers continued to make strategic investments in new technology transitions. Spending by memory customers, compared to fiscal 2018, was lower as they delayed new capacity additions and lowered their fab utilization rates in response to excess industry supply and inventory levels. Foundry and logic spending increased year-over-year led by customer investments in both advanced and mature foundry-logic nodes. Overall semiconductor systems revenue for fiscal 2019 decreased as compared to the prior year. Despite the overall wafer fab equipment market being down in 2019, Applied saw modest growth in its services business as compared to the prior year. This was driven by an increase in the installed base of equipment and continued growth in revenues from long-term service agreements, offset by a weaker demand for transactional spares due to lower memory fab utilization. Applied’s display and adjacent markets revenue declined during fiscal 2019 due to weak demand for display manufacturing equipment for mobile products and TVs. Results of Operations Net Sales Net sales for the periods indicated were as follows: Net sales in fiscal 2019 compared to fiscal 2018 decreased primarily due to decreased customer investments in semiconductor and display manufacturing equipment. Net sales in fiscal 2018 compared to fiscal 2017 increased due to increased customer investments across all segments. The Semiconductor Systems segment continued to represent the largest contributor of net sales. Net sales by geographic region, determined by the location of customers’ facilities to which products were shipped, were as follows: The changes in net sales in all regions in fiscal 2019 compared to fiscal 2018 primarily reflected changes in semiconductor and display manufacturing equipment spending and customer and product mix. The increase in net sales to customers in Taiwan and United States for fiscal 2019 compared the prior year was primarily due to increased investments in semiconductor manufacturing equipment. The decrease in net sales to customers in all other regions for fiscal 2019 compared to fiscal 2018 primarily reflected a decrease in investments in semiconductor and display manufacturing equipment. The changes in net sales in all regions other than Korea for fiscal 2018 compared to fiscal 2017 primarily reflected changes in semiconductor equipment spending, including product and customer mix, and increased spending in semiconductor spares and services. The increase in net sales to customers in China also reflected increased investments in display manufacturing equipment. The decrease in net sales to customers in Korea primarily reflected decreased investments in display manufacturing equipment. Gross Margin Gross margins for the periods indicated were as follows: Gross margin in fiscal 2019 decreased compared to fiscal 2018, primarily due to the decrease in net sales and unfavorable changes in customer and product mix. Gross margin in fiscal 2018 remained flat compared to fiscal 2017. Gross margin during fiscal 2019, 2018 and 2017 included $89 million, $87 million and $69 million, respectively, of share-based compensation expense. Research, Development and Engineering Research, Development and Engineering (RD&E) expenses for the periods indicated were as follows: Applied’s future operating results depend to a considerable extent on its ability to maintain a competitive advantage in the equipment and service products it provides. Development cycles range from 12 to 36 months depending on whether the product is an enhancement of an existing product, which typically has a shorter development cycle, or a new product, which typically has a longer development cycle. Most of Applied’s existing products resulted from internal development activities and innovations involving new technologies, materials and processes. In certain instances, Applied acquires technologies, either in existing or new product areas, to complement its existing technology capabilities and to reduce time to market. Management believes that it is critical to continue to make substantial investments in RD&E to assure the availability of innovative technology that meets the current and projected requirements of its customers’ most advanced designs. Applied has maintained and intends to continue its commitment to investing in RD&E in order to continue to offer new products and technologies. Applied continued its RD&E investments across Semiconductor Systems and Display and Adjacent Markets on the development of new unit process systems and integrated materials solutions. Areas of investment include etch, inspection, patterning and other technologies to improve chip performance, power, area and cost. In Display and Adjacent Markets, RD&E investments were focused on expanding the company’s market opportunity with new display technologies. RD&E expenses increased slightly in fiscal 2019 compared to the prior year and increased in fiscal 2018 compared to fiscal 2017, primarily due to additional headcount and increased research and development spending in Semiconductor Systems and Display and Adjacent Market segments. These increases reflect Applied’s ongoing investments in product development initiatives, consistent with the Company’s growth strategy. Applied continued to prioritize existing RD&E investments in technical capabilities and critical research and development programs in current and new markets, with a focus on semiconductor technologies. RD&E expense during fiscal 2019, 2018 and 2017 included $99 million, $96 million and $83 million, respectively, of share-based compensation expense. Marketing and Selling Marketing and selling expenses for the periods indicated were as follows: Marketing and selling expenses remained flat in fiscal 2019 compared to fiscal 2018. Marketing and selling expenses increased in fiscal 2018 compared to fiscal 2017 primarily due to additional headcount. Marketing and selling expenses for fiscal years 2019, 2018 and 2017 included $31 million, $31 million and $28 million, respectively, of share-based compensation expense. General and Administrative General and administrative (G&A) expenses for the periods indicated were as follows: General and administrative expenses in fiscal 2019 decreased slightly compared to fiscal 2018 primarily due to lower variable compensation expenses. General and administrative expenses in fiscal 2018 increased compared to fiscal 2017 primarily due to additional headcount and unfavorable impact from foreign exchange fluctuation, partially offset by lower variable compensation expense. G&A expenses during fiscal 2019, 2018 and 2017 included $44 million, $44 million and $40 million, respectively, of share-based compensation expense. Interest Expense and Interest and Other Income (loss), net Interest expense and interest and other income (loss), net for the periods indicated were as follows: Interest expenses incurred were primarily associated with the senior unsecured notes. Interest expense in fiscal 2019 remained relatively flat compared to the prior year. Interest expense increased slightly in fiscal 2018 compared to fiscal 2017 due to the issuance of senior unsecured notes in March 2017. Interest and other income, net primarily includes interest earned on cash and investments, realized gains or losses on sales of securities and impairment of strategic investments. Effective the first quarter of fiscal 2019, unrealized gains and losses on investments classified as equity investments are recognized in other income (expense), net in the Consolidated Statement of Operations. Prior to the adoption of Accounting Standards Update (ASU) 2016-01 Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities in the first quarter of fiscal 2019, these unrealized gains and temporary losses were included within accumulated other comprehensive income (loss), net of any related tax effect. Interest and other income, net in fiscal 2019 increased compared to fiscal 2018 primarily driven by unrealized gains on equity investment securities. Interest and other income, net in fiscal 2018 increased compared to fiscal 2017 primarily driven by realized gains on sales of securities and higher interest income from investments. Income Taxes Provision for income taxes and effective tax rates for the periods indicated were as follows: Applied’s provision for income taxes and effective tax rate are affected by the geographical composition of pre-tax income which includes jurisdictions with differing tax rates, conditional reduced tax rates and other income tax incentives. It is also affected by events that are not consistent from period to period, such as changes in income tax laws and the resolution of prior years’ income tax filings. On December 22, 2017, the U.S. government enacted the Tax Cuts and Jobs Act (Tax Act). The Tax Act requires a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries payable over eight years. U.S. deferred tax assets and liabilities were subject to remeasurement due to the reduction of the U.S. federal corporate tax rate. The U.S. Securities and Exchange Commission issued Staff Accounting Bulletin No. 118, which provided guidance on accounting for the income tax effects of the Tax Act and a measurement period for companies to complete this accounting. Applied completed the accounting for the Tax Act during the measurement period, which ended one year after the enactment date of the Tax Act. Accounting for the remeasurement of deferred tax assets was completed in the fourth quarter of fiscal 2018, and the accounting for the transition tax was completed in the first quarter of fiscal 2019. The Tax Act also includes provisions that impact Applied starting in fiscal 2019, including a provision designed to tax global intangible low-taxed income (GILTI). On June 14, 2019, the U.S. government released regulations that significantly affect how the GILTI provision of the Tax Act is interpreted. As a result, Applied reversed a tax benefit of $96 million in the third quarter of fiscal 2019 that had been realized in the first half of fiscal 2019. An accounting policy may be selected to treat GILTI temporary differences in taxable income either as a current-period expense when incurred (period cost method) or factor such amounts into the measurement of deferred taxes (deferred method). Applied has chosen the period cost method. Applied’s effective tax rate for fiscal 2019 was lower than fiscal 2018 primarily due to tax expense of $1.1 billion in fiscal 2018 for the transition tax and remeasurement of deferred tax assets as a result of the Tax Act. Excluding the tax expense of $1.1 billion, the effective tax rate for fiscal 2019 was higher than fiscal 2018 primarily due to certain provisions in the Tax Act becoming effective in fiscal 2019, tax expense of $87 million in fiscal 2019 related to changes in uncertain tax positions and the excess tax benefit from share-based compensation in fiscal 2019 being $42 million less than the prior fiscal year. The effective tax rate for fiscal 2018 was higher than fiscal 2017 primarily due to tax expense of $1.1 billion for the transition tax and remeasurement of deferred tax assets as a result of the Tax Act, partially offset by changes in the geographical composition of income, tax benefits from the lower U.S. federal corporate tax rate, adoption of authoritative guidance for share-based compensation, and the resolution of tax liabilities for uncertain tax positions. In addition, fiscal 2017 included tax benefits from the recognition of previously unrecognized foreign tax credits. Segment Information Applied reports financial results in three segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets. A description of the products and services, as well as financial data, for each reportable segment can be found in Note 16 of Notes to Consolidated Financial Statements. The Corporate and Other category includes revenues from products, as well as costs of products sold, for fabricating solar photovoltaic cells and modules and certain operating expenses that are not allocated to its reportable segments and are managed separately at the corporate level. These operating expenses include costs for share-based compensation; certain management, finance, legal, human resource, and RD&E functions provided at the corporate level; and unabsorbed information technology and occupancy. In addition, Applied does not allocate to its reportable segments restructuring and asset impairment charges and any associated adjustments related to restructuring actions, unless these actions pertain to a specific reportable segment. The results for each reportable segment are discussed below. Semiconductor Systems Segment The Semiconductor Systems segment is comprised primarily of capital equipment used to fabricate semiconductor chips. Semiconductor industry spending on capital equipment is driven by demand for advanced electronic products, including smartphones and other mobile devices, servers, personal computers, automotive devices, storage, and other products, and the nature and timing of technological advances in fabrication processes, and as a result is subject to variable industry conditions. Development efforts are focused on solving customers’ key technical challenges in transistor, interconnect, patterning and packaging performance as devices scale to advanced technology nodes. Customer investments in semiconductor manufacturing equipment continued to be the primary contributor of Applied’s revenue during fiscal 2019. Semiconductor equipment customers continued to make strategic investments in new technology transitions. Spending by memory customers, compared to fiscal 2018, was lower as they delayed new capacity additions and lowered their fab utilization rates in response to excess industry supply and inventory levels. Foundry and logic spending increased year-over-year led by customer investments in both advanced and mature foundry-logic nodes. Overall semiconductor systems revenue for fiscal 2019 decreased as compared to the prior year. Certain significant measures for the periods indicated were as follows: Net sales for Semiconductor Systems by end use application for the periods indicated were as follows: Net sales for fiscal 2019 decreased compared to fiscal 2018 primarily due to lower spending from memory customers, partially offset by increased spending from foundry, logic and other customers. Operating margin for fiscal 2019 decreased compared to the prior year, primarily reflecting lower net sales, unfavorable changes in customer and product mix. Five customers each accounted for at least 10 percent of this segment’s net sales, and together they accounted for approximately 65 percent of this segment’s net sales for fiscal 2019. Net sales for fiscal 2018 increased compared to fiscal 2017 primarily due to higher spending from memory customers, partially offset by lower spending from foundry, logic and other customers. Although operating margin remained flat, operating income for fiscal 2018 increased compared to fiscal 2017 primarily due to favorable changes in product mix and higher net sales, partially offset by higher RD&E expenses. The following region accounted for at least 30 percent of total net sales for the Semiconductor Systems segment for one or more of past three fiscal years: Applied Global Services Segment The Applied Global Services segment provides integrated solutions to optimize equipment and fab performance and productivity, including spares, upgrades, services, certain remanufactured earlier generation equipment and factory automation software for semiconductor, display and solar products. Demand for Applied Global Services’ service solutions are driven by Applied’s large and growing installed base of manufacturing systems, and customers’ needs to shorten ramp times, improve device performance and yield, and optimize factory output and operating costs. Industry conditions that affect Applied Global Services’ sales of spares and services are primarily characterized by increases in semiconductor manufacturers’ wafer starts and continued strong utilization rates, growth of the installed base of equipment, growing service intensity of newer tools, and the company’s ability to sell more comprehensive service agreements. Certain significant measures for the periods indicated were as follows: Net sales increased slightly in fiscal 2019 compared to the prior year primarily due to higher customer spending for comprehensive service agreements and legacy systems, partially offset by lower customer spending on semiconductor spares. Net sales increased in fiscal 2018 compared to fiscal 2017 primarily due to higher customer spending for spares and services. In fiscal 2019, two customers each accounted for at least 10 percent of this segment’s net sales. Operating income for fiscal 2019 remained flat compared to the prior year primarily due to higher net sales, partially offset by higher expenses related to an increase in headcount. Operating margin for fiscal 2019 decreased slightly compared to fiscal 2018 primarily due to an increase in headcount to support revenue growth. Operating income and operating margin for fiscal 2018 increased compared to the fiscal 2017, reflecting higher net sales partially offset by increased headcount to support business growth. There was no single region that accounted for at least 30 percent of total net sales for the Applied Global Services segment for any of the past three fiscal years. Display and Adjacent Markets Segment The Display and Adjacent Markets segment encompasses products for manufacturing liquid crystal and OLED displays, and other display technologies for TVs, monitors, laptops, personal computers, electronic tablets, smart phones, and other consumer-oriented devices, equipment upgrades and flexible coating systems. The segment is focused on expanding its presence through technologically-differentiated equipment for manufacturing large-scale LCD TVs, OLEDs, low temperature polysilicon (LTPS), metal oxide, and touch panel sectors; and development of products that provide customers with improved performance and yields. Display industry growth depends primarily on consumer demand for increasingly larger and more advanced TVs as well as larger and higher resolution displays for next-generation mobile devices. The market environment for Applied's Display and Adjacent Markets segment in fiscal 2019 was characterized by weak demand for display manufacturing equipment for mobile products and TVs, compared to fiscal 2018. In addition, uneven demand patterns in the Display and Adjacent Markets segment can cause significant fluctuations quarter-over-quarter, as well as year-over-year. Certain significant measures for the periods presented were as follows: Net sales for fiscal 2019 decreased compared to fiscal 2018 primarily due to lower customer investments in mobile and TV display manufacturing equipment. Operating income and operating margin for fiscal 2019 decreased compared to fiscal 2018, reflecting lower net sales and unfavorable changes in customer and product mix. Four customers each accounted for at least 10 percent of this segment’s net sales, and together they accounted for approximately 68 percent of net sales for this segment in fiscal 2019. Net sales for fiscal 2018 increased compared to fiscal 2017 primarily due to higher customer investments in TV display manufacturing equipment. Operating income and operating margin for fiscal 2018 decreased slightly compared fiscal 2017, primarily due to higher RD&E spending and unfavorable product mix, offset by higher net sales. The following regions accounted for at least 30 percent of total net sales for the Display and Adjacent Markets segment for one or more of the periods presented: Recent Accounting Pronouncements For a description of recent accounting pronouncements, including the expected dates of adoption and estimated effects, if any, on Applied’s consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements. Financial Condition, Liquidity and Capital Resources Applied’s cash, cash equivalents and investments consist of the following: Sources and Uses of Cash A summary of cash provided by (used in) operating, investing, and financing activities is as follows: In March 2016, the Financial Accounting Standards Board issued authoritative guidance that simplifies several aspects of the accounting for share-based payment transactions, including forfeitures, income tax, and classification on the statement of cash flows. Applied adopted this guidance in the first quarter of fiscal 2018. Upon adoption, Applied elected to apply the presentation requirements for cash flows related to excess tax benefits and employee taxes paid for withheld shares retrospectively. Adopting this guidance increased cash provided by operating activities by $180 million with corresponding net decreases in cash provided by financing activities for fiscal 2017. Operating Activities Cash from operating activities for fiscal 2019 was $3.2 billion, which reflects net income adjusted for the effect of non-cash charges and changes in working capital components. Non-cash charges included depreciation, amortization, share-based compensation and deferred income taxes. Cash provided from operating activities in fiscal 2019 decreased compared to fiscal 2018 due to lower net income, cash collections, change in income taxes payable and higher payments to suppliers, offset by a decrease in inventories. Cash provided from operating activities remained flat from fiscal 2017 to fiscal 2018 due to the increase in income taxes payable, offset by lower deferred revenue and higher increase in accounts receivable. Applied has agreements with various financial institutions to sell accounts receivable and discount promissory notes from selected customers. Applied sells its accounts receivable without recourse. Applied, from time to time, also discounts letters of credit issued by customers through various financial institutions. The discounting of letters of credit depends on many factors, including the willingness of financial institutions to discount the letters of credit and the cost of such arrangements. Applied sold $1.5 billion, $1.6 billion and $746 million of accounts receivable during fiscal 2019, 2018 and 2017, respectively. Applied discounted letters of credit issued by customers of $48 million and $37 million in fiscal 2019 and 2018, respectively. There was no discounting of promissory notes in each of fiscal 2019 and 2018. Applied did not discount letters of credit issued by customers or discount promissory notes during fiscal 2017. Applied’s working capital was $5.8 billion at October 27, 2019 and $6.7 billion at October 28, 2018. Days sales outstanding at the end of fiscal 2019, 2018 and 2017 was 61 days, 58 days, and 54 days, respectively. Days sales outstanding varies due to the timing of shipments and payment terms. The increase in days sales outstanding at the end of fiscal 2019 compared to the end of fiscal 2018 was primarily due to lower factoring of accounts receivable. The increase in days sales outstanding at the end of fiscal 2018 compared to the end of fiscal 2017 was primarily due to less favorable revenue linearity in fiscal 2018. Investing Activities Applied used $443 million and $2.5 billion of cash in investing activities in fiscal 2019 and 2017, respectively. Applied generated $571 million in cash from investing activities in fiscal 2018. Capital expenditures in fiscal 2019, 2018 and 2017 were $441 million, $622 million and $345 million, respectively. Capital expenditures in fiscal 2019 and 2018 were primarily for real property acquisitions and improvements in North America and Taiwan, as well as investments in demonstration, testing and laboratory tools. Capital expenditures in fiscal 2017 were primarily for demonstration and test equipment and laboratory tools in North America. Proceeds from sales and maturities of investments, net of purchase of investments were $26 million and $1.2 billion for fiscal 2019 and 2018, respectively. Purchases of investments, net of proceeds from sales and maturities of investments was $2.1 billion for fiscal 2017. Investing activities also included investments in technology to allow Applied to access new market opportunities or emerging technologies. Applied’s investment portfolio consists principally of investment grade money market mutual funds, U.S. Treasury and agency securities, municipal bonds, corporate bonds and mortgage-backed and asset-backed securities, as well as equity securities. Applied regularly monitors the credit risk in its investment portfolio and takes appropriate measures, which may include the sale of certain securities, to manage such risks prudently in accordance with its investment policies. Financing Activities Applied used $3.1 billion of cash in financing activities in fiscal 2019, consisting primarily of repurchases of common stock of $2.4 billion, cash dividends to stockholders of $771 million and tax withholding payments for vested equity awards of $86 million, offset by proceeds from common stock issuances of $145 million. Applied used $5.9 billion of cash in financing activities in fiscal 2018, consisting primarily of repurchases of common stock of $5.3 billion, cash dividends to stockholders of $605 million and tax withholding payments for vested equity awards of $164 million, offset by proceeds from common stock issuances of $124 million. Applied generated $341 million of cash from financing activities in fiscal 2017, consisting primarily of net proceeds received from the issuance of senior unsecured notes of $2.2 billion, proceeds from common stock issuance of $97 million, partially offset by cash used for repurchases of common stock of $1.2 billion, cash dividends to stockholders of $430 million and debt repayments of $205 million. In September 2017, Applied’s Board of Directors approved a common stock repurchase program authorizing up to $3.0 billion in repurchases. In February 2018, the Board of Directors approved a new common stock repurchase program authorizing up to an additional $6.0 billion in repurchases. At October 27, 2019, $1.9 billion remained available for future stock repurchases under this repurchase program. During fiscal 2019, Applied's Board of Directors declared one quarterly cash dividend of $0.20 per share and three quarterly cash dividends of $0.21 per share. During fiscal 2018, Applied's Board of Directors declared one quarterly cash dividend of $0.10 per share and three quarterly cash dividends of $0.20 per share. During fiscal 2017, Applied’s Board of Directors declared four quarterly cash dividends in the amount of $0.10 per share. Applied currently anticipates that cash dividends will continue to be paid on a quarterly basis, although the declaration of any future cash dividend is at the discretion of the Board of Directors and will depend on Applied’s financial condition, results of operations, capital requirements, business conditions and other factors, as well as a determination by the Board of Directors that cash dividends are in the best interests of Applied’s stockholders. Applied has credit facilities for unsecured borrowings in various currencies of up to $1.6 billion, of which $1.5 billion is comprised of a committed revolving credit agreement with a group of banks that is scheduled to expire in September 2021. This agreement provides for borrowings in United States dollars at interest rates keyed to one of two rates selected by Applied for each advance and includes financial and other covenants with which Applied was in compliance at October 27, 2019. Remaining credit facilities in the amount of approximately $74 million are with Japanese banks. Applied’s ability to borrow under these facilities is subject to bank approval at the time of the borrowing request, and any advances will be at rates indexed to the banks’ prime reference rate denominated in Japanese yen. In August 2019, Applied entered into a term loan credit agreement with a group of lenders. Under the agreement, the lenders have committed to make an unsecured term loan to Applied of up to $2.0 billion to finance in part Applied’s planned acquisition of all outstanding shares of Kokusai Electric, to pay related transaction fees and expenses and for general corporate purposes. The commitments of the lenders to make the term loan will terminate if the transactions contemplated by the Share Purchase Agreement (SPA) are not consummated on or before June 30, 2020, which date may be extended by three months on two separate occasions if, on the applicable date, the only remaining conditions to closing relate to required regulatory approvals. The term loan, if advanced, will bear interest at one of two rates selected by Applied, plus an applicable margin, which varies according to Applied’s public debt credit ratings, and must be repaid in full on the third anniversary of the funding date of the term loan. No amounts were outstanding under any of these facilities at both October 27, 2019 and October 28, 2018, and Applied has not utilized these credit facilities. In fiscal 2011, Applied established a short-term commercial paper program of up to $1.5 billion. At October 27, 2019 and October 28, 2018, Applied did not have any commercial paper outstanding, but may issue commercial paper notes under this program from time to time in the future. In March 2017, Applied issued senior unsecured notes in the aggregate principal amount of $2.2 billion. Applied had senior unsecured notes in the aggregate principal amount of $5.4 billion outstanding as of October 27, 2019. The indentures governing these notes include covenants with which Applied was in compliance at October 27, 2019. In May 2017, Applied completed the redemption of the entire outstanding $200 million in principal amount of senior notes due in October 2017. See Note 11 of Notes to Consolidated Financial Statements for additional discussion of existing debt. Applied may seek to refinance its existing debt and may incur additional indebtedness depending on Applied’s capital requirements and the availability of financing. Others On December 22, 2017, the U.S. government enacted the Tax Cuts and Jobs Act. The Tax Act requires a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries. For fiscal 2018, Applied realized tax expense of $1.1 billion associated with the Tax Act, primarily due to the transition tax. The transition tax expense is payable in installments over eight years, with eight percent due in each of the first five years starting with fiscal 2018. As of October 27, 2019, Applied has $938 million of total payments remaining, payable in installments in the next seven years. Before the Tax Act, U.S. income tax had not been provided for certain unrepatriated earnings that were considered indefinitely reinvested. Income tax is now provided for all unrepatriated earnings. Although cash requirements will fluctuate based on the timing and extent of factors such as those discussed above, Applied’s management believes that cash generated from operations, together with the liquidity provided by existing cash balances and borrowing capability, will be sufficient to satisfy Applied’s liquidity requirements for the next 12 months. For further details regarding Applied’s operating, investing and financing activities, see the Consolidated Statements of Cash Flows in this report. For details on standby letters of credit and other agreements with banks, see Off-Balance Sheet Arrangements below. Off-Balance Sheet Arrangements In the ordinary course of business, Applied provides standby letters of credit or other guarantee instruments to third parties as required for certain transactions initiated by either Applied or its subsidiaries. As of October 27, 2019, the maximum potential amount of future payments that Applied could be required to make under these guarantee agreements was approximately $76 million. Applied has not recorded any liability in connection with these guarantee agreements beyond that required to appropriately account for the underlying transaction being guaranteed. Applied does not believe, based on historical experience and information currently available, that it is probable that any amounts will be required to be paid under these guarantee agreements. Applied also has agreements with various banks to facilitate subsidiary banking operations worldwide, including overdraft arrangements, issuance of bank guarantees, and letters of credit. As of October 27, 2019, Applied has provided parent guarantees to banks for approximately $151 million to cover these arrangements. Applied also has operating leases for various facilities. Total rent expense for fiscal 2019, 2018 and 2017 was $51 million, $50 million and $34 million, respectively. Contractual Obligations The following table summarizes Applied’s contractual obligations as of October 27, 2019: ______________________ 1Represents the transition tax liability associated with the deemed repatriation of accumulated foreign earnings as a result of the enactment of the Tax Cuts and Jobs Act into law on December 22, 2017. 2Represents Applied’s agreements to purchase goods and services consisting of Applied’s outstanding purchase orders for goods and services. 3Other long-term liabilities in the table do not include pension, post-retirement and deferred compensation plans due to the uncertainty in the timing of future payments. Applied evaluates the need to make contributions to its pension and post-retirement benefit plans after considering the funded status of the plans, movements in the discount rate, performance of the plan assets and related tax consequences. Payments to the plans would be dependent on these factors and could vary across a wide range of amounts and time periods. Payments for deferred compensation plans are dependent on activity by participants, making the timing of payments uncertain. Information on Applied’s pension, post-retirement benefit and deferred compensation plans is presented in Note 13, Employee Benefit Plans, of the consolidated financial statements. 4Applied’s other long-term liabilities in the Consolidated Balance Sheets include deferred income tax liabilities, gross unrecognized tax benefits and related gross interest and penalties. As of October 27, 2019, the gross liability for unrecognized tax benefits that was not expected to result in payment of cash within one year was $489 million. Interest and penalties related to uncertain tax positions that were not expected to result in payment of cash within one year of October 27, 2019 was $50 million. At this time, Applied is unable to make a reasonably reliable estimate of the timing of payments due to uncertainties in the timing of tax audit outcomes; therefore, such amounts are not included in the above contractual obligation table. Critical Accounting Policies and Estimates The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires management to make judgments, assumptions and estimates that affect the amounts reported. Note 1 of Notes to Consolidated Financial Statements describes the significant accounting policies used in the preparation of the consolidated financial statements. Certain of these significant accounting policies are considered to be critical accounting policies. A critical accounting policy is defined as one that is both material to the presentation of Applied’s consolidated financial statements and that requires management to make difficult, subjective or complex judgments that could have a material effect on Applied’s financial condition or results of operations. Specifically, these policies have the following attributes: (1) Applied is required to make assumptions about matters that are highly uncertain at the time of the estimate; and (2) different estimates Applied could reasonably have used, or changes in the estimate that are reasonably likely to occur, would have a material effect on Applied’s financial condition or results of operations. Estimates and assumptions about future events and their effects cannot be determined with certainty. Applied bases its estimates on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as Applied’s operating environment changes. These changes have historically been minor and have been included in the consolidated financial statements as soon as they became known. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties include those discussed in Part I, Item 1A, “Risk Factors.” Based on a critical assessment of its accounting policies and the underlying judgments and uncertainties affecting the application of those policies, management believes that Applied’s consolidated financial statements are fairly stated in accordance with accounting principles generally accepted in the United States of America, and provide a meaningful presentation of Applied’s financial condition and results of operations. Management believes that the following are critical accounting policies and estimates: Revenue Recognition Applied recognizes revenue when promised goods or services (performance obligations) are transferred to a customer in an amount that reflects the consideration to which Applied expects to be entitled in exchange for those goods or services. Applied performs the following five steps to determine when to recognize revenue: (1) identification of the contract(s) with customers, (2) identification of the performance obligations in the contract, (3) determination of the transaction price, (4) allocation of the transaction price to the performance obligations in the contract, and (5) recognition of revenue when, or as, a performance obligation is satisfied. Management uses judgment to identify performance obligations within a contract and to determine whether multiple promised goods or services in a contract should be accounted for separately or as a group. Judgment is also used in interpreting commercial terms and determining when transfer of control occurs. Moreover, judgment is used to estimate the contract’s transaction price and allocate it to each performance obligation. Any material changes in the identification of performance obligations, determination and allocation of the transaction price to performance obligations, and determination of when transfer of control occurs to the customer, could impact the timing and amount of revenue recognition, which could have a material effect on Applied’s financial condition and results of operations. Warranty Costs Applied provides for the estimated cost of warranty when revenue is recognized. Estimated warranty costs are determined by analyzing specific product, current and historical configuration statistics and regional warranty support costs. Applied’s warranty obligation is affected by product and component failure rates, material usage and labor costs incurred in correcting product failures during the warranty period. As Applied’s customer engineers and process support engineers are highly trained and deployed globally, labor availability is a significant factor in determining labor costs. The quantity and availability of critical replacement parts is another significant factor in estimating warranty costs. Unforeseen component failures or exceptional component performance can also result in changes to warranty costs. If actual warranty costs differ substantially from Applied’s estimates, revisions to the estimated warranty liability would be required, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Allowance for Doubtful Accounts Applied maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. This allowance is based on historical experience, credit evaluations, specific customer collection history and any customer-specific issues Applied has identified. Changes in circumstances, such as an unexpected material adverse change in a major customer’s ability to meet its financial obligation to Applied or its payment trends, may require Applied to further adjust its estimates of the recoverability of amounts due to Applied, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Inventory Valuation Inventories are generally stated at the lower of cost or net realizable value, with cost determined on a first-in, first-out basis. The carrying value of inventory is reduced for estimated obsolescence by the difference between its cost and the estimated net realizable value based upon assumptions about future demand. Applied evaluates the inventory carrying value for potential excess and obsolete inventory exposures by analyzing historical and anticipated demand. In addition, inventories are evaluated for potential obsolescence due to the effect of known and anticipated engineering change orders and new products. If actual demand were to be substantially lower than estimated, additional adjustments for excess or obsolete inventory may be required, which could have a material adverse effect on Applied’s business, financial condition and results of operations. Goodwill and Intangible Assets Applied reviews goodwill and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of these assets may not be recoverable, and also annually reviews goodwill and intangibles with indefinite lives for impairment. Intangible assets, such as purchased technology, are generally recorded in connection with a business acquisition. The value assigned to intangible assets is usually based on estimates and judgments regarding expectations for the success and life cycle of products and technology acquired. If actual product acceptance differs significantly from the estimates, Applied may be required to record an impairment charge to reduce the carrying value of the reporting unit to its estimated fair value. To test goodwill for impairment, Applied first performs a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying value. If it is concluded that this is the case, Applied then performs the two-step goodwill impairment test. Otherwise, the two-step goodwill impairment test is not required. Under the two-step goodwill impairment test, Applied would in the first step compare the estimated fair value of each reporting unit to its carrying value. If the carrying value of a reporting unit exceeds its estimated fair value, Applied would then perform the second step of the impairment test in order to determine the implied fair value of the reporting unit’s goodwill. If Applied determines that the carrying value of a reporting unit’s goodwill exceeds its implied fair value, Applied would record an impairment charge equal to the difference. Applied determines the fair value of each reporting unit based on a weighting of an income and a market approach. Applied bases the fair value estimates on assumptions that it believes to be reasonable but that are unpredictable and inherently uncertain. Under the income approach, Applied estimates the fair value based on discounted cash flow method. The estimates used in the impairment testing are consistent with the discrete forecasts that Applied uses to manage its business, and considers any significant developments during the period. Under the discounted cash flow method, cash flows beyond the discrete forecasts are estimated using a terminal growth rate, which considers the long-term earnings growth rate specific to the reporting units. The estimated future cash flows are discounted to present value using each reporting unit’s weighted average cost of capital. The weighted average cost of capital measures a reporting unit’s cost of debt and equity financing weighted by the percentage of debt and equity in a reporting unit’s target capital structure. In addition, the weighted average cost of capital is derived using both known and estimated market metrics, and is adjusted to reflect both the timing and risks associated with the estimated cash flows. The tax rate used in the discounted cash flow method is the median tax rate of comparable companies and reflects Applied’s current international structure, which is consistent with the market participant perspective. Under the market approach, Applied uses the guideline company method which applies market multiples to forecasted revenues and earnings before interest, taxes, depreciation and amortization. Applied uses market multiples that are consistent with comparable publicly-traded companies and considers each reporting unit’s size, growth and profitability relative to its comparable companies. Management uses significant judgment when assessing goodwill for potential impairment, especially in emerging markets. Indicators of potential impairment include, but are not limited to, challenging economic conditions, an unfavorable industry or economic environment or other severe decline in market conditions. Such conditions could have the effect of changing one of the critical assumptions or estimates used for the fair value calculation, resulting in an unexpected goodwill impairment charge, which could have a material adverse effect on Applied’s business, financial condition and results of operations. See Note 10 of Notes to Consolidated Financial Statements for additional discussion of goodwill impairment. Income Taxes Applied’s provision for income taxes and effective tax rate are affected by the geographical composition of pre-tax income which includes jurisdictions with differing tax rates, conditional reduced tax rates and other income tax incentives. It is also affected by events that are not consistent from period to period, such as changes to income tax laws and the resolution of prior years’ income tax filings. Applied recognizes a current tax liability for the estimated amount of income tax payable on tax returns for the current fiscal year. Deferred tax assets and liabilities are recognized for the estimated future tax effects of temporary differences between the book and tax bases of assets and liabilities. Deferred tax assets are also recognized for net operating loss and tax credit carryforwards. Deferred tax assets are offset by a valuation allowance to the extent it is more likely than not that they are not expected to be realized. Applied recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained upon examination by the taxing authorities based on the technical merits of the position. The tax benefits recognized from such positions are estimated based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Any changes in judgment related to uncertain tax positions are recognized in Applied’s provision for income taxes in the quarter in which such change occurs. Interest and penalties related to uncertain tax positions are recognized in Applied’s provision for income taxes. The calculation of Applied’s provision for income taxes and effective tax rate involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with Applied’s expectations could have an adverse material impact on Applied’s results of operations and financial condition. Non-GAAP Adjusted Financial Results Management uses non-GAAP adjusted financial measures to evaluate the Company’s operating and financial performance and for planning purposes, and as performance measures in its executive compensation program. Applied believes these measures enhance an overall understanding of its performance and investors’ ability to review the Company’s business from the same perspective as the Company’s management and facilitate comparisons of this period’s results with prior periods on a consistent basis by excluding items that management does not believe are indicative of Applied's ongoing operating performance. The non-GAAP adjusted financial measures presented below are adjusted to exclude the impact of certain costs, expenses, gains and losses, including certain items related to mergers and acquisitions; restructuring charges and any associated adjustments; impairments of assets, or investments; gain or loss on sale of strategic investments; certain income tax items and other discrete adjustments. Additionally, fiscal 2019 and 2018 non-GAAP results exclude estimated discrete income tax expense items associated with recent U.S. tax legislation. Reconciliations of these non-GAAP measures to the most directly comparable financial measures calculated and presented in accordance with GAAP are provided in the financial tables presented below. There are limitations in using non-GAAP financial measures because the non-GAAP financial measures are not prepared in accordance with generally accepted accounting principles, may be different from non-GAAP financial measures used by other companies, and may exclude certain items that may have a material impact upon our reported financial results. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the directly comparable financial measures prepared in accordance with GAAP. The following tables present a reconciliation of the GAAP and non-GAAP adjusted consolidated results for the past three fiscal years: APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS 1 These items are incremental charges attributable to completed acquisitions, consisting of amortization of purchased intangible assets. 2 Amounts for fiscal 2017 included the recognition of the previously unrecognized foreign tax credits. 3 Charges to income tax provision related to a one-time transition tax and a decrease in U.S. deferred tax assets as a result of the recent U.S. tax legislation. 4 Adjustment to provision for income taxes related to non-GAAP adjustments reflected in income before income taxes. APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS The following table presents a reconciliation of the GAAP and non-GAAP adjusted segment results for the past three fiscal years: APPLIED MATERIALS, INC. UNAUDITED RECONCILIATION OF GAAP TO NON-GAAP ADJUSTED RESULTS 1 These items are incremental charges attributable to completed acquisitions, consisting of amortization of purchased intangible assets. Note: The reconciliation of GAAP and non-GAAP adjusted segment results above does not include certain revenues, costs of products sold and operating expenses that are reported within corporate and other and included in consolidated operating income.

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to facilitate an understanding of Applied’s business and results of operations. This MD&A should be read in conjunction with Applied’s Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this Form 10K. The following discussion contains forwardlooking statements and should also be read in conjunction with the cautionary statement set forth at the beginning of this Form 10K. MD&A consists of the following sections: Overview: a summary of Applied’s business and measurements Results of Operations: a discussion of operating results Segment Information: a discussion of segment operating results Recent Accounting Pronouncements: a discussion of new accounting pronouncements and its impact to Applied’s consolidated financial statements Financial Condition, Liquidity and Capital Resources: an analysis of cash flows, sources and uses of cash OffBalance Sheet Arrangements and Contractual Obligations Critical Accounting Policies and Estimates: a discussion of critical accounting policies that require the exercise of judgments and estimates NonGAAP Adjusted Results: a presentation of results reconciling GAAP to nonGAAP adjusted measures Overview Applied provides manufacturing equipment, services and software to the semiconductor, display, and related industries. Applied’s customers include manufacturers of semiconductor wafers and chips, liquid crystal and organic lightemitting diode (OLED) displays, and other electronic devices. These customers may use what they manufacture in their own end products or sell the items to other companies for use in advanced electronic components. Each of Applied’s businesses is subject to variable industry conditions, as demand for manufacturing equipment and services can change depending on supply and demand for chips, display technologies, and other electronic devices, as well as other factors, such as global economic and market conditions, and the nature and timing of technological advances in fabrication processes. Applied operates in three reportable segments: Semiconductor Systems, Applied Global Services, and Display and Adjacent Markets. A summary of financial information for each reportable segment is found in Note 16 of Notes to Consolidated Financial Statements. A discussion of factors that could affect Applied’s operations is set forth under “Risk Factors” in Part I, Item 1A, which is incorporated herein by reference. Product development and manufacturing activities occur primarily in the United States, Europe, Israel, and Asia. Applied’s broad range of equipment and service products are highly technical and are sold primarily through a direct sales force. Applied’s results are driven primarily by customer spending on capital equipment and services to support key technology transitions or to increase production volume in response to worldwide demand for semiconductors and displays. Spending by semiconductor customers, which include companies that operate in the foundry, logic and memory markets, is driven by demand for advanced electronic products, including smartphones and other mobile devices, servers, personal computers, automotive devices, storage, and other products. The growth of data and emerging endmarket drivers such as artificial intelligence, augmented and virtual reality, the Internet of Things and smart vehicles are also creating new opportunities for the industry. As a result, products within the Semiconductor Systems segment are subject to significant changes in customer requirements, including transitions to smaller dimensions, increasingly complex chip architectures, new materials and an increasing number of applications. Demand for display manufacturing equipment spending depends primarily on consumer demand for increasingly larger and more advanced TVs as well as larger and higher resolution displays for nextgeneration mobile devices, and investments in new types of display technologies. While certain existing technologies may be adapted to new requirements, some applications create the need for an entirely different technological approach. The timing of customer investment in manufacturing equipment is also affected by the timing of nextgeneration process development and the timing of capacity expansion to meet endmarket demand. In light of these conditions, Applied’s results can vary significantly yearoveryear, as well as quarteroverquarter. Applied’s strategic priorities include developing products that help solve customers’ challenges at technology inflections; expanding its served market opportunities in the semiconductor and display industries; and growing its services business. Applied’s longterm growth strategy requires continued development of new materials engineering capabilities, including products and platforms that enable [/INST] Negative. </s>

MTS SYSTEMS CORP

2015-12-02

2015-10-03

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in nine sections: · Overview · Financial Results · Cash Flow Comparison · Liquidity and Capital Resources · Off-Balance Sheet Arrangements · Critical Accounting Policies · Recently Issued Accounting Pronouncements · Quarterly Financial Information · Forward Looking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8 of this Annual Report on Form 10-K. All dollar amounts are in thousands (unless otherwise noted). Overview MTS Systems Corporation is a leading global supplier of high-performance test systems and position sensors. Our testing hardware and software solutions help customers accelerate and improve design, development and manufacturing processes and are used for determining the mechanical behavior of materials, products and structures. Our high-performance position sensors provide controls for a variety of industrial and vehicular applications. Our goal is to grow profitably, generate strong cash flow and deliver a strong return on invested capital to our shareholders by leveraging our leadership position in the research and development and industrial and mobile equipment global end markets. Our desire is to be the innovation leader in creating test and measurement solutions to support our customers. Through innovation, we believe we can create value for our customers that will drive our growth. There are four global macro-trends that will help enable this growth: energy scarcity; environmental concerns; globalization, including development of the emerging markets; and global demographics. These macro-trends have significant implications for our customers, such as increasing the demand for new and more innovative products and increasing our customers’ organizational complexity. We believe we have an excellent geographic footprint and are well positioned in both Test and Sensors markets to take advantage of these macro-trends and deliver profitable growth in the years ahead. We are working toward our goals of sustained double digit growth in annual revenue, margin expansion and mid-to-upper teens for Return on Invested Capital (ROIC). Our plan is to grow at twice the market rate with merger and acquisitions filling the gap to sustain our double-digit growth goals. Economic conditions and the competitive environment may impact the timing of when the goals are achieved. There are four primary opportunities we are pursuing which will support these goals: · Expanding service offerings in our Test business; · Growth in composite materials which drives new testing requirements and technologies in the Test materials market; · Development of intelligent machines which provides opportunity in the Sensors mobile hydraulics market; and · Opportunistic mergers and acquisitions. We believe that our business model supports achieving our double digit growth milestone assuming we continue to move aggressively to build our infrastructure, expand our offerings and execute on opportunities with our key customers around the world. In order to accelerate our revenue growth over the next few years, investments in infrastructure, sales support and field service capacity and capability are essential. We invested significantly in fiscal years 2014 and 2013, moderately in fiscal year 2015 and will continue to moderately invest in future years. Fiscal Year We have a 5-4-4 week accounting cycle with the fiscal year ending on the Saturday closest to September 30. Fiscal years 2015, 2014 and 2013 ended October 3, 2015, September 27, 2014 and September 28, 2013, respectively. Fiscal year 2015 included 53 weeks, while fiscal years 2014 and 2013 both included 52 weeks. Foreign Currency Approximately 75% of our revenue has historically been derived from customers outside of the United States. Our financial results are principally exposed to changes in exchange rates between the U.S. dollar and the Euro, the Japanese Yen and the Chinese Yuan. A change in foreign exchange rates could positively or negatively affect our reported financial results. The discussion below quantifies the impact of foreign currency translation on our financial results for the periods discussed. Financial Results Fiscal Year 2015 Compared to Fiscal Year 2014 Total Company Results of Operations The following table compares results of operations in fiscal years 2015 and 2014, separately identifying the estimated impact of currency translation and the acquisition of Roehrig Engineering, Inc. (REI) in fiscal year 2014. Severance and Related Costs We initiated workforce reductions and other cost reduction actions during fiscal year 2014. As a result of these actions, we incurred severance and related costs of $6,336 in fiscal year 2014, of which $3,507, $1,805, and $1,024 were reported in cost of sales, selling and marketing, and general and administrative expense, respectively. No severance and related costs were recognized in fiscal year 2015. Revenue Revenue was essentially flat. Increases in revenue from higher sales volumes, the impact of the 53rd week in fiscal year 2015 and $5,432 from the acquisition of REI which was completed in fiscal year 2014 were more than offset by the negative impact of currency translation. Excluding the impact of currency translation, revenue increased 5.8%. Test revenue increased $4,727 due to higher sales volumes, the impact of the 53rd week in fiscal year 2015 and the acquisition of REI which was completed in fiscal year 2014, partially offset by a 4.6% unfavorable currency translation. Sensors revenue declined $5,121 driven by an 11.3% unfavorable impact of currency translation. The following table compares revenue in fiscal years 2015 and 2014 by geography. Although selective product price changes were implemented during each of these fiscal years, the overall impact of pricing changes did not have a material effect on revenue. Gross Profit Gross profit declined due to the negative impact of currency translation, unfavorable product mix and an investment in labor and systems to improve utilization in the upcoming fiscal year. Due to a higher concentration of manufacturing performed in the U.S., currency had a 0.3 percentage point positive impact on the gross margin rate. Excluding the impact of currency translation, the gross margin rate decreased by 1.0 percentage point primarily driven by unfavorable product mix resulting from a higher number of custom projects which generally have lower margins and an investment in labor and systems to improve utilization in the upcoming fiscal year. The decrease was partially offset by severance and related costs of $3,507 recognized in fiscal year 2014 and nine months of profit totaling $1,692 from the acquisition of REI in fiscal year 2014. Selling and Marketing Expense Selling and marketing expenses decreased due to a favorable impact of currency translation, severance and related costs of $1,805 during fiscal year 2014 and lower external commissions as a result of revenue timing, partially offset by merit increases and the timing of selling activities to drive future revenue growth. General and Administrative Expense The general and administrative expense increase was driven by an estimated favorable impact of currency translation and $1,024 of severance and related costs incurred in fiscal year 2014 that did not recur in fiscal year 2015, offset by increased professional fees and nine months of expenses totaling $921 related to the acquisition of REI completed in fiscal year 2014. Research and Development Expense Research and development expense declined primarily due to an increase in the capitalization of internally developed software labor of $1,472 as headcount was reallocated to internally developed software activities and a favorable impact of currency translation, partially offset by higher compensation and benefits related to increased headcount. Income from Operations Income from operations increased primarily due to lower operating expenses. Interest Expense, net Interest expense, net was higher due to higher average borrowings on our credit facility. Other (Expense) Income, net The increase in other expense, net was primarily driven by increased net losses on foreign currency transactions. Provision for Income Taxes The decreased provision for income taxes during fiscal year 2015 was primarily due to a decrease in the effective tax rate. The decrease in the effective tax rate was primarily driven by the enactment of tax legislation during the three months ended December 27, 2014 that retroactively extended the United States research and development tax credit and resulted in a tax benefit of $2,098 in the first quarter of fiscal year 2015. In addition, we recognized a tax benefit of $1,836 associated with the favorable resolution in 2015 of audit matters in connection with the Internal Revenue Service examination of tax years ending October 1, 2011 and September 29, 2012. The 2015 rate was also favorably impacted by our geographic mix of earnings, with foreign income generally taxed at lower rates than domestic income. The 2014 effective tax rate includes a one-time benefit due to the recognition of additional federal and state research and development credit benefits of $2,563 which related to prior years. Net Income A $6,336 charge for severance and related costs negatively impacted fiscal year 2014 earnings per diluted share by $0.28. Excluding the severance and related costs, diluted earnings per share in fiscal year 2014 would have been essentially flat year-over-year. Orders and Backlog The following table compares orders in fiscal years 2015 and 2014, separately identifying the estimated impact of currency translation and the acquisition of REI in fiscal year 2014. Orders were up 0.4% driven by strong orders in Asia, partially offset by the unfavorable impact of currency translations. Excluding the impact of currency translation, orders increased 6.7%. Orders for fiscal year 2015 included six large orders in Asia totaling $67,696 and one large order in the Americas totaling $5,150. Orders for fiscal year 2014 included six large orders in Asia totaling $42,249 and two large Americas orders totaling $19,028. The following table compares orders in fiscal years 2015 and 2014 by geography. Backlog of undelivered orders at October 3, 2015 was $353,013, an increase of $26,540 or 8.1%, compared to backlog of $326,473 at September 27, 2014. The majority of this backlog is related to Test. Based on anticipated manufacturing schedules, we estimate that approximately $267,000 of the backlog at October 3, 2015 will be converted into revenue during fiscal year 2016 (76% conversion). The conversion rate is slightly down from the prior year rate of 77% due to a shift from short cycle, quicker turning orders to larger custom orders in fiscal year 2015. We believe backlog is not an absolute indicator of future revenue because a portion of the orders in backlog could be cancelled at the customer’s discretion. While the backlog is subject to order cancellations, we have not historically experienced a significant number of order cancellations. During fiscal year 2015, two custom orders in Test totaling approximately $8,484 were cancelled. During fiscal year 2014, one custom order in Test totaling approximately $11,109 was cancelled. These cancelled orders were booked in a fiscal year prior to the year in which they were cancelled. Test Segment Results of Operations The following table compares results of operations in fiscal years 2015 and 2014 for Test, separately identifying the estimated impact of currency translation and the acquisition of REI in fiscal year 2014. Revenue The increase in revenue was primarily a result of strong engineer-to-order revenue converted from a higher beginning of the year backlog, productivity improvements and the favorable impact of a 53rd week in fiscal year 2015, partially offset by the unfavorable impact of currency translation. Excluding the impact of currency translation, revenue increased 5.6%. The following table compares revenue in fiscal years 2015 and 2014 for Test by geography. Gross Profit Gross profit declined primarily due to the negative impact of currency translation, partially offset by $3,507 of severance and related costs recognized in fiscal year 2014 and nine months of profit related to the fiscal year 2014 acquisition of REI in the amount of $1,692. Excluding the aforementioned, the gross margin rate decreased 1.8 percentage points driven by unfavorable product mix as fiscal year 2015 gross profit included a higher number of large custom projects which generally have lower margins. Selling and Marketing Expense Selling and marketing expense declined primarily due to the favorable impact of currency translation, lower external commissions due to timing of revenue and severance and related costs of $1,799 recognized in fiscal year 2014, partially offset by merit increases and timing of selling activities to drive future revenue growth. General and Administrative Expense The general and administrative expense increase was driven by increased spending related to professional fees and nine months of expenses totaling $921 related to the acquisition of REI completed in fiscal year 2014, partially offset by the favorable impact of currency translation. Research and Development Expense Research and development expense increased primarily due to an increase in headcount resulting in higher compensation expense. Income from Operations Income from operations increased due to lower operating expenses. Orders and Backlog The following table compares orders in fiscal years 2015 and 2014 for Test, separately identifying the estimated impact of currency translation and the acquisition of REI in fiscal year 2014. Orders increased 2.3% driven by strong orders in Asia and Europe fueled by the ground vehicle market, partially offset by the unfavorable impact of currency translation. Excluding the impact of currency translation, orders increased 7.7%. Orders for fiscal year 2015 included six large orders in Asia totaling $67,696 and one large order in the Americas totaling $5,150. Orders for fiscal year 2014 included six large orders in Asia totaling $42,249 and two large Americas orders totaling $19,028. In fiscal year 2015, Test accounted for 83.9% of total Company orders, compared to 82.4% in fiscal year 2014. The following table compares orders in fiscal years 2015 and 2014 for Test by geography. Backlog of undelivered orders at October 3, 2015 was $339,967, an increase of 9.7% from backlog of $309,994 at September 27, 2014. As previously mentioned, backlog at the end of fiscal years 2015 and 2014 was negatively impacted by two custom orders in Test totaling approximately $8,484 and one custom order totaling approximately $11,109, respectively. Sensors Segment Results of Operations The following table compares results of operations in fiscal years 2015 and 2014 for Sensors, separately identifying the estimated impact of currency translation. Revenue The decrease in revenue was primarily driven by the negative impact of currency translation. Excluding the impact of currency translation, Sensors revenue was up 6.5% driven by a higher beginning of the period backlog for fiscal year 2015 and additional sales in machine markets due to the favorable Euro exchange rates prompting customers to buy. The following table compares revenue in fiscal years 2015 and 2014 for Sensors by geography. Gross Profit Gross profit declined primarily due to the unfavorable impact of currency translation. Excluding the impact of currency translation, the gross margin rate declined 0.8 percentage points due to an unfavorable product mix resulting from sales increases in certain lower margin industrial markets. Selling and Marketing Expense The decrease in selling and marketing expense was primarily driven by the favorable impact of currency translation, partially offset by higher compensation and benefits resulting from increased headcount to support future revenue growth. General and Administrative Expense The decrease in general and administrative expense was primarily driven by the favorable impact of currency translation and cost containment measures, partially offset by increased compensation. Research and Development Expense The decrease in research and development expense was primarily driven by the favorable impact of currency translation and cost containment measures, partially offset by increased compensation and benefits expense resulting from increased headcount. Income from Operations Income from operations decreased primarily as a result of decreased gross profit, partially offset by lower operating expenses. Orders and Backlog The following table compares orders in fiscal years 2015 and 2014 for Sensors, separately identifying the estimated impact of currency translation. The decline in orders was primarily driven by the unfavorable impact of currency translations. Excluding the impact of currency translation, Sensors orders were up 2.3% from increases in all geographies. Sensors accounted for 16.1% of total Company orders, compared to 17.6% for fiscal year 2014. The following table compares orders in fiscal years 2015 and 2014 for Sensors by geography. Backlog of undelivered orders at October 3, 2015 was $13,046, a decrease of 20.8% compared to backlog of $16,479 at September 27, 2014. Fiscal Year 2014 Compared to Fiscal Year 2013 Total Company Results of Operations The following table compares results of operations in fiscal years 2014 and 2013, separately identifying the estimated impact of currency translation and the acquisition of REI in fiscal year 2014. Revenue The decrease was driven by lower backlog at the end of fiscal year 2013 and a higher content of slower turning backlog in Test, partially offset by increased order volumes in Sensors and increased service revenue in Test. Test revenue decreased 3.4% to $458,153, while Sensors revenue increased 11.4% to $106,175. The following table compares revenue in fiscal years 2014 and 2013 by geography. Although selective product price changes were implemented during each of these fiscal years, the overall impact of pricing changes did not have a material effect on revenue. Gross profit The previously mentioned severance and related costs of $3,507 unfavorably impacted gross profit as a percentage of revenue by 0.7 percentage points. In addition, unfavorable product mix from a higher proportion of revenue from lower margin products decreased our gross margin percent by 1.2 percentage points. These unfavorable factors were partially offset by a 0.5 percentage point increase in gross margin primarily driven by the favorable impact of an increase in Sensors revenue, which is higher margin, compared to total Company revenue and a reduction in various miscellaneous manufacturing expenses. Selling and Marketing Expense The increase was driven by higher compensation and benefits resulting from increased headcount, higher sales commissions based on the increase in orders, as well as the previously mentioned severance and related costs of $1,805 during fiscal year 2014. General and Administrative Expense The increases were primarily driven by higher compensation and benefits driven by increased headcount of approximately $2,600, higher legal expenses of approximately $1,800, as well the previously mentioned severance and related costs of $1,024 which was partially offset by lower consulting fees of approximately $1,700 and other miscellaneous expenses of approximately $500 in fiscal year 2014. Research and Development Expense The increase was driven by higher compensation and benefits resulting from increased headcount in both Test and Sensors. Income from Operations Excluding the previously mentioned severance and related costs of $6,336, income from operations decreased 16.7% for fiscal year 2014, driven by a $4,789 decrease in gross profit and an $8,574 increase in operating expenses resulting from ongoing investments for growth in sales and research and development. Historically, our operating costs have been impacted by a level of inflation ranging from -1% to 4%. We use a number of strategies to mitigate the effects of cost inflation including cost productivity initiatives such as global procurement strategies, as well as price increases. However, if our operating costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs. Interest Expense, net The increase was driven by a relatively higher level of outstanding borrowings under the Company’s credit facility during fiscal year 2014 compared to fiscal year 2013. Other Expense, net The increase in net expense was primarily driven by $600 of royalty income in fiscal year 2013 that we did not receive in fiscal year 2014. Provision for Income Taxes The decrease in the provision for income taxes was primarily due to decreased income before income taxes. The tax rate was unfavorably impacted by lower R&D tax credits in the current year due to the expiration of the R&D tax credit. Both fiscal years 2014 and 2013 had one-time tax benefits associated with R&D tax credits that caused our effective tax rate to be lower than it has been historically. Net Income The decrease was primarily driven by lower income from operations. The previously mentioned $6,336 charge for severance and related costs in fiscal year 2014 negatively impacted earnings per diluted share by $0.28. Orders and Backlog The following table compares orders in fiscal years 2014 and 2013, separately identifying the estimated impact of currency translation and the acquisition of REI in fiscal year 2014. Orders totaled $615,586, an increase of $48,168 or 8.5%, compared to orders of $567,418 for fiscal year 2013. Fiscal year 2014 orders included eight large orders (equal to or in excess of $5,000) totaling $61,277. The large orders were comprised of six large Asian and two large Americas’ Test orders totaling $42,249 and $19,028, respectively. Fiscal year 2013 orders included five large orders totaling $37,397, and included three large European and two large Americas’ Test orders totaling $22,238 and $15,156, respectively. Excluding the large orders, base orders increased 4.6%, reflecting 3.1% growth in Test, primarily in the Americas and Asia, as well as 11.3% growth in Sensor which experienced growth across all geographies. The following table compares orders in fiscal years 2014 and 2013 by geography. Backlog of undelivered orders at September 27, 2014 was $326,473, an increase of $36,322, or 12.5%, compared to backlog of $290,151 at September 28, 2013. We believe backlog is not an absolute indicator of future revenue because a portion of the orders in backlog could be cancelled at the customer’s discretion. While the backlog is subject to order cancellations, we have not historically experienced a significant number of order cancellations. During fiscal year 2014, one custom order in Test totaling approximately $11,109 was cancelled. During fiscal year 2013, one custom order in Test totaling approximately $2,110 was cancelled. These cancelled orders were booked in a fiscal year prior to the year in which they were cancelled. Test Segment Results of Operations The following table compares results of operations in fiscal years 2014 and 2013 for Test, separately identifying the estimated impact of currency translation and the acquisition of REI in fiscal year 2014. Revenue Revenue was $458,153, a decrease of $15,966 or 3.4%, compared to revenue of $474,119 for fiscal year 2013, including an estimated $177 favorable impact of currency translation. This decrease was primarily driven by lower backlog at the end of fiscal year 2013 as well as the timing of conversion of custom order backlog, partially offset by growth in service and standard products. The following table compares revenue in fiscal years 2014 and 2013 for Test by geography. Gross Profit The previously mentioned severance and related costs of $3,507 unfavorably impacted gross profit as a percentage of revenue by 0.8 percentage points. Excluding these costs, the gross margin rate decreased by 0.6 percentage points. The decreased gross profit rate was driven by decreased Test volume, unfavorable product mix from a higher content of custom projects partially offset by reductions in compensation and benefits from lower than expected variable rate compensation and discretionary contributions related to an employee retirement plan. Selling and Marketing Expense The increase was driven by continued investment in sales expansion to drive future revenue growth, higher sales commissions due to the increase in orders, as well as the previously mentioned severance and related costs of $1,799 in fiscal year 2014. The continued investment in sales expansion primarily consists of higher compensation and benefits resulting from increased headcount. General and Administrative Expense The increase was primarily driven by higher legal expenses, higher compensation and benefits driven by increased headcount, as well as the previously mentioned severance and related costs of $1,024 in fiscal year 2014. These increases were partially offset by a lower level of investment in productivity and infrastructure initiatives. Research and Development Expense The decrease was primarily driven by the re-allocation of certain engineering resources to work on backlog conversion. Income from Operations Excluding the previously mentioned severance and related costs of $6,330, income from operations decreased 24.3%, driven by decreased gross profit as well as a $5,785 increase in operating expenses. Orders and Backlog The following table compares orders in fiscal years 2014 and 2013 for Test, separately identifying the estimated impact of currency translation and the acquisition of REI in fiscal year 2014. Orders totaled $507,223, an increase of $37,199 or 7.9% compared to orders of $470,024 for fiscal year 2013, primarily driven by 3.1% growth in base orders as well as variability in large orders. Large orders for fiscal year 2014 were $61,277. There were six large orders in Asia and two large orders in the Americas totaling $42,249 and $19,028, respectively. Orders in Asia consisted of two orders totaling $17,159 in the structures market and four orders totaling $25,090 in the ground vehicles market. Orders in Americas consisted of two orders totaling $19,028, one of which was a $12,199 order in the ground vehicles market and the other was a $6,829 order in the structures market. Large orders in fiscal year 2013 totaled $37,394 and included three large European orders in the ground vehicles market totaling approximately $22,238. In addition, fiscal year 2013 orders included two large Americas’ orders in the ground vehicles market totaling approximately $15,156. Currency translation unfavorably impacted orders by approximately $1,774. Test accounted for 82.4% of total Company orders, compared to 82.8% for fiscal year 2013. The following table compares orders in fiscal years 2014 and 2013 for Test by geography. Backlog of undelivered orders at September 27, 2014 was $309,994, an increase of 12.7% from backlog of $275,020 at September 28, 2013. As previously mentioned, backlog at the end of fiscal year 2014 was negatively impacted by a custom order in Test totaling approximately $11,109 that was cancelled during the second quarter of fiscal year 2014. Also, as previously mentioned, backlog at the end of fiscal year 2013 was negatively impacted by the cancellation of one custom order totaling approximately $2,110. Sensors Segment Results of Operations The following table compares results of operations in fiscal years 2014 and 2013 for Sensors, separately identifying the estimated impact of currency translation. Revenue The increase was primarily driven by higher beginning of period backlog and increased order volume. The following table compares revenue in fiscal years 2014 and 2013 for Sensors by geography. Gross Profit Gross profit was $58,188, an increase of $4,232 or 7.8%, compared to gross profit of $53,956 for fiscal year 2013. Gross profit as a percentage of revenue was 54.8%, down compared to fiscal year 2013. Selling and Marketing Expense The increase was primarily due to higher compensation and benefits driven by increased headcount to support future sales growth. General and Administrative Expense The decrease was primarily driven by expenses recognized in fiscal year 2013 related to senior management transition. Research and Development Expense The increase was primarily driven by higher compensation and benefits resulting from increased headcount. Income from Operations The increase was driven by higher gross profit, partially offset by increased operating expenses. Orders and Backlog The following table compares orders in fiscal years 2014 and 2013 for Sensors, separately identifying the estimated impact of currency translation. Orders totaled $108,363, an increase of $10,969 or 11.3% compared to orders of $97,394 for fiscal year 2013. The industrial and mobile hydraulic markets were up 9.0% and 26.0%, respectively, driven by strong demand in all geographic regions. Sensors accounted for 17.6% of total Company orders, compared to 17.2% for fiscal year 2013. The following table compares orders in fiscal years 2014 and 2013 for Sensors by geography. Backlog of undelivered orders at September 27, 2014 was $16,479, an increase of 8.9% from backlog of $15,131 at September 28, 2013. Cash Flow Comparison - Fiscal Years 2015, 2014 and 2013 Total cash and cash equivalents decreased $8,629 for fiscal year 2015. The decrease was primarily due to $50,026 in repayments of short-term borrowings, purchases of our common stock of $29,115, dividend payments of $22,445 and investment in property and equipment of $18,445. The decrease was partially offset by net income of $45,462, $21,106 in depreciation and amortization, $19,040 for decreased working capital requirements, $11,183 received through short-term borrowings, $7,351 in stock-based compensation and $4,847 of proceeds received from the exercise of stock options and share purchases under our employee stock purchase plan. Total cash and cash equivalents increased $12,064 during fiscal year 2014. This increase was driven by net income of $42,009, $24,102 in net proceeds received from borrowings on the credit facility, $19,279 in depreciation and amortization and $7,590 of proceeds from the exercise of stock options and stock purchases under our employee stock purchase plan. These increases were partially offset by purchases of our common stock of $31,013, investment in property and equipment of $20,038, dividend payments of $18,330 and $14,192 in cash payments associated with the acquisition of REI. Total cash and cash equivalents decreased $31,519 during fiscal year 2013. This decrease was driven by $77,850 for increased working capital requirements, investment in property and equipment of $29,690, purchases of our common stock of $24,767 and dividend payments of $19,113. These decreases were partially offset by net income of $57,806, $35,000 in proceeds received from borrowings on the credit facility, $16,589 in depreciation and amortization and $8,645 of proceeds from the exercise of stock options. Cash flow from operating activities provided cash totaling $100,436 during fiscal year 2015 compared to cash provided of $64,669 in fiscal year 2014 and cash used of $2,059 in fiscal year 2013. Fiscal year 2015 cash flow from operating activities was primarily driven by $45,462 in net income, $21,106 in depreciation and amortization, $13,065 in increased advance payments received from customers driven by the mix of orders, $6,772 in increased accounts payable resulting from general timing of purchases and payments, $3,308 in decreased accounts and unbilled receivables resulting from general timing of billing and collections, partially offset by $4,105 in increased inventories to support future revenue. Fiscal year 2014 cash flow from operating activities was primarily driven by net income of $42,009 and $19,279 in depreciation and amortization. Fiscal year 2013 cash flow from operating activities was primarily driven by $43,179 increased accounts and unbilled receivables resulting from higher volume as well as the general timing of billing and collections, $21,082 decreased advance payments received from customers driven by timing of customer orders and relatively unfavorable customer payment terms, $9,616 increased inventories to support future revenue and $3,973 decreased accounts payable resulting from general timing of purchases and payments. The decrease was partially offset by net income of $57,806 and $16,589 in depreciation and amortization. Cash flow from investing activities required $19,112, $34,230 and $29,690 use of cash during fiscal years 2015, 2014 and 2013, respectively. Fiscal year 2015 cash usage was due to $18,445 in investments in property and equipment and payment of $667 associated with the acquisition of Instrument and Calibration Sweden AB (ICS). The cash usage for fiscal year 2014 was due to $20,038 in investments in property and equipment and $14,192 in payments associated with the acquisition of REI. The cash usage for fiscal year 2013 represents investment in property and equipment. See Note 11 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information regarding the acquisition of ICS. Cash flow from financing activities used cash of $84,785 and $15,928 during fiscal years 2015 and 2014, respectively, compared to $1,280 of cash provided in fiscal year 2013. Cash was used in fiscal year 2015 to repay $50,026 of short-term borrowings, purchase 400,000 shares under our share purchase program and 12,918 shares related to stock-based compensation arrangements in an amount of $29,115 and to pay dividends of $22,445. The usage of cash was partially offset by $11,183 received through short-term borrowings and $4,847 of proceeds received in connection with stock option exercises and share purchases under our employee stock purchase plan. Cash used in fiscal year 2014 was primarily due to the purchase of approximately 457,000 shares of our common stock in an amount of $31,013, which includes purchases of approximately 7,000 shares related to stock-based compensation arrangements in the amount of $374, and to pay $18,330 in cash dividends. The usage of cash was partially offset by $24,102 in net proceeds from short-term borrowings and $7,590 received from stock option exercises and stock purchases under our employee stock purchase plan. Cash provided by financing activities in fiscal year 2013 was primarily due to $35,000 of borrowings on our credit facility and $8,645 received from stock option exercises and stock purchases under our employee stock purchase plan. The cash received was partially offset by purchases of our common stock in an amount of $24,767, including purchases of stock related to stock-based compensation arrangements of $454 and payment of cash dividends of $19,113. Liquidity and Capital Resources We had cash and cash equivalents of $51,768 as of October 3, 2015. Of this amount, approximately $4,618 was located in North America, $23,765 in Europe and $23,385 in Asia. Of the $47,150 of cash located outside of the U.S., approximately $24,772 is not available for use in the U.S. without the incurrence of U.S. federal and state income tax consequences. The North American balance was primarily invested in bank deposits. In Europe and Asia, the balances were primarily invested in money market funds and bank deposits. In accordance with our investment policy, we place cash equivalent investments with issuers who have high-quality investment credit ratings. In addition, we limit the amount of investment exposure we have with any particular issuer. Our investment objectives are to preserve principal, maintain liquidity and achieve the best available return consistent with our primary objectives of safety and liquidity. At October 3, 2015, we held no short-term investments. At October 3, 2015, our capital structure was comprised of $21,183 in short-term debt and $258,276 in shareholders’ equity. Total interest-bearing debt at October 3, 2015 was $21,183. The borrowings on the credit facility include, at our discretion, optional month-to-month term renewals and loan repricing until September 2019. Under the terms of the credit facility, we have agreed to certain financial covenants, including, among other covenants, the ratio of consolidated total indebtedness to consolidated earnings before interest, taxes, depreciation and amortization (EBITDA) and the ratio of consolidated EBITDA to consolidated interest expense. These covenants may restrict our ability to pay dividends and purchase outstanding shares of our common stock. At October 3, 2015, we were in compliance with these financial covenants. Shareholders’ equity increased by $15 during fiscal year 2015, primarily due to higher net income of $45,462, partially offset by $29,115 in purchases of our common stock and $17,969 in dividends declared. We believe that our liquidity, represented by funds available from cash, cash equivalents, credit facility and anticipated cash from operations are adequate to fund ongoing operations for the short-term and long-term internal growth opportunities, capital expenditures, dividends and share purchases, as well as to fund strategic acquisitions. Contractual Obligations As of October 3, 2015, our contractual obligations were as follows: 1 Operating leases are primarily for office space and automobiles. Refer to Note 13 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional lease information. 2 Other long-term obligations include liabilities under pension and other retirement plans and warehouse fee obligations. 3 Long-term income tax liabilities for uncertain tax positions have been excluded from the contractual obligations table as we are not able to make a reasonably reliable estimate of the amount and period of related future payments. At October 3, 2015, our long-term liability for uncertain tax positions was $5,649. Refer to Note 8 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional income tax information. At October 3, 2015, we had letters of credit and guarantees outstanding totaling $25,671 and $30,995, respectively, primarily to bond advance payments and performance guarantees related to customer contracts in Test. Off-Balance Sheet Arrangements As of the end of fiscal year 2015, we did not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Critical Accounting Policies The Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP), which require us to make estimates and assumptions in certain circumstances that affect amounts reported. The preparation of these financial statements requires us to make estimates and assumptions, giving due consideration to materiality, that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of any contingent assets and liabilities at the date of the financial statements. We regularly review our estimates and assumptions, which are based on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that of our significant accounting policies, the following are particularly important to the portrayal of our results of operations and financial position and are subject to an inherent degree of uncertainty as they may require the application of a higher level of judgment by us. For further information see “Summary of Significant Accounting Policies” under Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Revenue Recognition We are required to comply with a variety of technical accounting requirements in order to achieve consistent and accurate revenue recognition. The most significant area of judgment and estimation is percentage-of-completion contract accounting. We develop cost estimates that include materials, component parts, labor and overhead costs. Detailed costs plans are developed for all aspects of the contracts during the bidding phase. Cost estimates are largely based on actual historical performance of similar projects combined with current knowledge of the projects in progress. Significant factors that impact the cost estimates include technical risk, inflationary cost of materials and labor, changes in scope and schedule and internal and subcontractor performance. Actual costs incurred during the project phase are monitored and compared to the estimates on a monthly basis. Cost estimates are revised based on changes in circumstances. Anticipated losses on long-term contracts are recognized when such losses become evident. Inventories We maintain a material amount of inventory to support our engineering and manufacturing operations. This inventory is stated at the lower of cost or market. On a regular basis, we review our inventory and identify which is excess, slow moving or obsolete by considering factors such as inventory levels, expected product life and forecasted sales demand. Any identified excess, slow moving or obsolete inventory is written down to its market value through a charge to income from operations. It is possible that additional inventory write-down charges may be required in the future if there is a significant decline in demand for our products and we do not adjust our manufacturing production accordingly. Impairment of Long-Lived Assets We review the carrying value of long-lived assets or asset groups, such as property and equipment and intangibles subject to amortization, when events or changes in circumstances such as asset utilization, physical change, legal factors or other matters indicate that the carrying value may not be recoverable. When this review indicates the carrying value of an asset or asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group, we recognize an asset impairment charge against income from operations. The amount of the impairment loss recorded is the amount by which the carrying value of the impaired asset or asset group exceeds its fair value. Goodwill Goodwill represents the excess of cost over the fair value of the identifiable net assets of businesses acquired and allocated to our reporting units at the time of acquisition. Goodwill is tested for impairment annually and when an event occurs or circumstances change that indicate the carrying value of the reporting unit may not be recoverable. Evaluating goodwill for impairment involves the determination of the fair value of each reporting unit in which goodwill is recorded using a two-step process. A reporting unit is an operating segment or a component of an operating segment for which discrete financial information is available and reviewed by management on a regular basis. Prior to completing the two-step process described below, we have the option to perform a qualitative assessment of goodwill for impairment to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, including goodwill and other intangible assets. If we conclude the fair value is more likely than not less than the carrying value, we would perform the two-step process. Otherwise, no further testing would be needed. If the two-step process is required, the first step of the impairment test is to compare the calculated fair value of each reporting unit to its carrying value, including goodwill. We estimate the fair value of a reporting unit using a discounted cash flow model that requires input of certain estimates and assumptions requiring judgment, including projections of economic conditions and customer demand, revenue and margins, changes in competition, operating costs and new product introductions. If the fair value exceeds the carrying value, no further work is required and no impairment loss is recognized. If the carrying value exceeds the fair value, the goodwill of the reporting unit is potentially impaired and step 2 would need to be performed to measure the impairment loss. In step 2, we would calculate the implied fair value of goodwill by deducting the fair value of all tangible and intangible net assets, including unrecognized intangible assets, of the reporting unit from the fair value of the reporting unit. If the implied fair value of goodwill is less than the carrying value of goodwill, an impairment loss equal to the difference would be recognized in the period identified. The loss recognized cannot exceed the carrying amount of goodwill. While we believe the estimates and assumptions used in determining the fair value of our reporting units are reasonable, significant changes in estimates of future cash flows, such as those caused by unforeseen events or changes in market conditions, could materially impact the fair value of a reporting unit which could result in the recognition of a goodwill impairment charge. Software Development Costs We incur costs associated with the development of software to be sold, leased or otherwise marketed. Software development costs are expensed as incurred until technological feasibility has been established, at which time future costs incurred are capitalized until the product is available for general release to the public. A certain amount of judgment and estimation is required to assess when technological feasibility is established, as well as the ongoing assessment of the recoverability of capitalized costs. In evaluating the recoverability of capitalized software costs, we compare expected product performance, utilizing forecasted revenue amounts, to the total costs incurred to date and estimates of additional costs to be incurred. If revised forecasted product revenue is less than, and/or revised forecasted costs are greater than, the previously forecasted amounts, the net realizable value may be lower than previously estimated, which could result in the recognition of an impairment charge in the period in which such a determination is made. Warranty Obligations We are subject to warranty obligations on sales of our products. We record general warranty provisions based on an estimated warranty expense percentage applied to current period revenue. The percentage applied reflects our historical warranty claims experience over the preceding twelve-month period. Both the experience percentage and the warranty liability are evaluated on an ongoing basis for adequacy. In addition, warranty provisions are also recognized for certain nonrecurring product claims that are individually significant. A certain amount of judgment is required in determining appropriate reserve levels for anticipated warranty claims. While these reserve levels are based on our historical warranty claims experience, they may not reflect the actual claims that will occur over the upcoming warranty period and additional warranty reserves may be required. Income Taxes We record a tax provision for the anticipated tax consequences of the reported results of operations. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those deferred tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. We believe it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining net realizable value of its deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our financial condition and operating results. See Note 8 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information on income taxes. Recently Issued Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606). This update clarifies the principles for revenue recognition in transactions involving contracts with customers. The new revenue recognition guidance provides a five-step analysis to determine when and how revenue is recognized. The new guidance will require revenue recognition to depict the transfer of promised goods or services to a customer in an amount that reflects the consideration a company expects to receive in exchange for those goods or services. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606): Deferral of Effective Date. This update defers the mandatory effective date of its revenue recognition standard by one year. The standard is required to be adopted for annual periods beginning after December 15, 2017, including interim periods within that annual period, which is our fiscal year 2019. Early application is permitted for annual reporting periods beginning after December 15, 2016, and interim periods within that annual period, which is our fiscal year 2018. We have not yet evaluated what impact, if any, the adoption of this guidance may have on our financial condition, results of operations or disclosures. In July 2015, the FASB issued ASU No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory. This update modifies existing requirements regarding measuring inventory at the lower of cost or market. Under current inventory standards, the market value requires consideration of replacement cost, net realizable value and net realizable value less an approximately normal profit margin. The new guidance replaces market with net realizable value defined as estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal and transportation. This eliminates the need to determine and consider replacement cost or net realizable value less an approximately normal profit margin when measuring inventory. The standard is required to be adopted for annual periods beginning after December 15, 2016, including interim periods within that annual period, which is our fiscal year 2018. The amendment is to be applied prospectively with early permitted. We have not yet evaluated what impact, if any, the adoption of this guidance may have on our financial condition, results of operations or disclosures. In July 2015, the FASB issued ASU No. 2015-12, Plan Accounting: Defined Benefit Pension Plans (Topic 960), Defined Contribution Pension Plans (Topic 962), Health and Welfare Benefit Plans (Topic 965): (Part I) Fully Benefit-Responsive Investment Contracts, (Part II) Plan Investment Disclosures, (Part III) Measurement Date Practical Expedient (consensuses of the FASB Emerging Issues Task Force). The update allows for a plan with a fiscal year end that does not coincide with the end of the calendar month to measure its investments and investment-related accounts using the month end closest to its fiscal year end. In previous guidance, the measurement date was required to coincide with the fiscal year end. The standard is required to be adopted for periods beginning after December 15, 2015, which is our fiscal year 2017. The measurement date practical expedient is to be applied prospectively. We have not yet evaluated what impact, if any, the adoption of this guidance may have on our financial condition, results of operations or disclosures. In September 2015, the FASB issued ASU No. 2015-16, Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments. This update eliminates the requirement for an acquirer in a business combination to account for measurement-period adjustments retrospectively. Under the existing business combination standard, an acquirer reports provisional amounts with respect to acquired assets and liabilities when their measurements are incomplete as of the end of the reporting period. Prior to this update, an acquirer is required to adjust provisional amounts and the related impact on earnings by restating prior period financial statements during the measurement period which cannot exceed one year from the date of acquisition. The new guidance requires that the cumulative impact of a measurement-period adjustment, including the impact on prior periods, be recognized in the reporting period in which the adjustment is identified eliminating the requirement to restate prior period financial statements. The new standard requires disclosure of the nature and amount of measurement-period adjustments as well as information with respect to the portion of the adjustments recorded in current-period earnings that would have been recorded in previous reporting periods if the adjustments to provisional amounts had been recognized as of the acquisition date. The standard is required to be adopted for annual periods beginning after December 15, 2015, including interim periods within that annual period, which is our fiscal year 2017. The amendment is to be applied prospectively to measurement-period adjustments that occur after the effective date with earlier adoption permitted. We have not yet evaluated what impact, if any, the adoption of this guidance may have on our financial condition, results of operations or disclosures. In November 2015, the FASB issued ASU No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. This update requires deferred tax liabilities and assets to be classified as noncurrent in the Consolidated Balance Sheet. The standard is required to be adopted for annual periods beginning after December 15, 2016, including interim periods within that annual period, which is our fiscal year 2018. The amendment may be applied either prospectively to all deferred tax liabilities and assets or retrospectively to all periods presented. We have not yet evaluated what impact, if any, the adoption of this guidance may have on our financial condition, results of operations or disclosures. Quarterly Financial Information Revenue and operating results reported on a quarterly basis do not necessarily reflect trends in demand for our products or our operating efficiency. Revenue and operating results in any quarter may be significantly affected by customer shipments, installation timing or the timing of the completion of one or more contracts where revenue is recognized upon shipment or customer acceptance rather than on the percentage-of-completion method of revenue recognition. Our use of the percentage-of-completion revenue recognition method for large, long-term projects generally has the effect of minimizing significant fluctuations quarter-over-quarter. See Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information on our revenue recognition policy. Quarterly earnings also vary as a result of the use of estimates including, but not limited to, the rates used in recording federal, state and foreign income tax expense. See Notes 1 and 8 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information on our use of estimates and income tax related matters, respectively. Selected quarterly financial information for the fiscal years ended October 3, 2015 and September 27, 2014 was as follows: 1 The quarters will not sum to the fiscal year amount due to rounding and the effect of weighting. Forward-Looking Statements Statements contained in this Annual Report on Form 10-K including, but not limited to, the discussion under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, that are not statements of historical fact are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the Act). In addition, certain statements in our future filings with the SEC, in press releases, and in oral and written statements made by us or with our approval that are not statements of historical fact constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenue, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure, the adequacy of our liquidity and reserves, the anticipated level of expenditures required and other statements concerning future financial performance; (ii) statements of our plans and objectives by our management or Board of Directors, including those relating to products or services or planned merger or acquisition activity; (iii) statements of assumptions underlying such statements; (iv) statements regarding business relationships with vendors, customers or collaborators or statements relating to our order cancellation history; and (v) statements regarding products, their characteristics, our geographic footprint, performance, sales potential or effect in the hands of customers. Words such as “believes,” “anticipates,” “expects,” “intends,” “targeted,” “should,” “potential,” “goals,” “strategy,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, those described in Item 1A, Risk Factors. The performance of our business and our securities may be adversely affected by these factors and by other factors common to other businesses and investments, or to the general economy. Forward-looking statements are qualified by some or all of these risk factors. Therefore, you should consider these forward looking statements with caution and form your own critical and independent conclusions about the likely effect of these risk factors on our future performance. Forward-looking statements speak only as of the date on which statements are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made to reflect the occurrence of unanticipated events or circumstances. Readers should carefully review the disclosures and the risk factors described in this and other documents we file from time to time with the SEC, including our reports on Forms 10-Q and 8-K.

<s>[INST] · Overview · Financial Results · Cash Flow Comparison · Liquidity and Capital Resources · OffBalance Sheet Arrangements · Critical Accounting Policies · Recently Issued Accounting Pronouncements · Quarterly Financial Information · Forward Looking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8 of this Annual Report on Form 10K. All dollar amounts are in thousands (unless otherwise noted). Overview MTS Systems Corporation is a leading global supplier of highperformance test systems and position sensors. Our testing hardware and software solutions help customers accelerate and improve design, development and manufacturing processes and are used for determining the mechanical behavior of materials, products and structures. Our highperformance position sensors provide controls for a variety of industrial and vehicular applications. Our goal is to grow profitably, generate strong cash flow and deliver a strong return on invested capital to our shareholders by leveraging our leadership position in the research and development and industrial and mobile equipment global end markets. Our desire is to be the innovation leader in creating test and measurement solutions to support our customers. Through innovation, we believe we can create value for our customers that will drive our growth. There are four global macrotrends that will help enable this growth: energy scarcity; environmental concerns; globalization, including development of the emerging markets; and global demographics. These macrotrends have significant implications for our customers, such as increasing the demand for new and more innovative products and increasing our customers’ organizational complexity. We believe we have an excellent geographic footprint and are well positioned in both Test and Sensors markets to take advantage of these macrotrends and deliver profitable growth in the years ahead. We are working toward our goals of sustained double digit growth in annual revenue, margin expansion and midtoupper teens for Return on Invested Capital (ROIC). Our plan is to grow at twice the market rate with merger and acquisitions filling the gap to sustain our doubledigit growth goals. Economic conditions and the competitive environment may impact the timing of when the goals are achieved. There are four primary opportunities we are pursuing which will support these goals: · Expanding service offerings in our Test business; · Growth in composite materials which drives new testing requirements and technologies in the Test materials market; · Development of intelligent machines which provides opportunity in the Sensors mobile hydraulics market; and · Opportunistic mergers and acquisitions. We believe that our business model supports achieving our double digit growth milestone assuming we continue to move aggressively to build our infrastructure, expand our offerings and execute on opportunities with our key customers around the world. In order to accelerate our revenue growth over the next few years, investments in infrastructure, sales support and field service capacity and capability are essential. We invested significantly in fiscal years 2014 and 2013, moderately in fiscal year 2015 and will continue to moderately invest in future years. Fiscal Year We have a 544 week accounting cycle with the fiscal year ending on the Saturday closest to September 30. Fiscal years 2015, 2014 and 2013 ended October 3, 2015, September 27, 2014 and September 28, 2013, respectively. Fiscal year 2015 included 53 weeks, while fiscal years 2014 and 2013 both included 52 weeks. Foreign Currency Approximately 75% of our revenue has historically been derived from customers outside of the United States. Our financial results are principally exposed to changes in exchange rates between the U.S. dollar and the Euro, the Japanese Yen and the Chinese Yuan. A change in foreign exchange rates could positively or negatively affect our reported financial results. The discussion below quantifies the impact of foreign currency translation on our financial results for the periods discussed. Financial Results Fiscal Year 2015 Compared to Fiscal Year 2014 Total Company Results of Operations The following table compares results of operations in fiscal years 2015 and 2014, separately identifying the estimated impact of currency translation and the acquisition of Roehrig [/INST] Negative. </s>

MTS SYSTEMS CORP

2017-04-10

2016-10-01

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in nine sections: • Overview • Financial Results • Cash Flow Comparison • Liquidity and Capital Resources • Off-Balance Sheet Arrangements • Critical Accounting Policies • Recently Issued Accounting Pronouncements • Quarterly Financial Information • Forward Looking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8 of Part II of this Annual Report on Form 10-K. All dollar amounts are in thousands (unless otherwise noted). Overview MTS Systems Corporation is a leading global supplier of high-performance test systems and sensors. Our testing hardware and software solutions help customers accelerate and improve design, development and manufacturing processes and are used for determining the mechanical behavior of materials, products and structures. Our high-performance sensors provide controls for a variety of applications measuring acceleration, position, vibration, motion, pressure, force and sound. Our goal is to grow profitably, generate strong cash flow and deliver a strong return on invested capital to our shareholders by leveraging our leadership position in the research and development and industrial global end markets for high performance test systems and sensors. Our desire is to be the innovation leader in creating test and measurement solutions and provide total customer satisfaction. We believe we can create value for our customers by helping to enhance the precision, improve the reliability and create superior safety for their products, while reducing the delivery time to market for their products. Our competitive advantages include our mission critical technology and application expertise, our leading global footprint with long-term customer relationships, our large installed base of testing equipment and our expanded presence in the rapidly growing sensors market. We believe these competitive advantages position us well in both the test and sensors markets to deliver profitable growth in the years ahead. We are working toward our goals of sustained six to eight percent growth in annual revenue, three to four points of expanded earnings before interest, taxes, depreciation and amortization (EBITDA) and mid-teens for return on invested capital (ROIC). We believe the growth in our end markets, combined with three primary opportunities we are currently pursuing will support these goals: • Realize growth within the rapidly expanding sensors market with strong forecasted growth over the next five years; • Expand service offerings in our Test segment; and • Capture growth in ground vehicle and advance materials testing driven by environmental and energy conservation initiatives. We believe that our business model supports our growth objectives, provided that we continue to move aggressively to build our infrastructure, expand our offerings and execute on opportunities with our key customers around the world. In order to accelerate our revenue growth over the next five years, investments in infrastructure, sales support and field service capacity and capability are essential. Fiscal Year We have a 5-4-4 week, quarterly accounting cycle with the fiscal year ending on the Saturday closest to September 30. Fiscal years 2016, 2015 and 2014 ended October 1, 2016, October 3, 2015 and September 27, 2014, respectively. Fiscal years 2016 and 2014 both included 52 weeks, while fiscal year 2015 included 53 weeks. Restructuring Initiative During the third quarter of fiscal year 2016, we initiated restructuring actions to further reduce our cost structure by eliminating certain positions, primarily in our Corporate area and Test segment, through terminations, elimination of certain open positions as a result of employees leaving voluntarily throughout fiscal year 2016 and reductions in contractors. These restructuring activities resulted in severance and related expense of $1,237 during fiscal year 2016. During the fourth quarter of fiscal year 2016, we initiated plans to close our Machida, Japan facility by the third quarter of fiscal year 2017. We incurred restructuring expense of $928 in fiscal year 2016 related to the closure of this facility. See Note 12 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Equity Instruments During the third quarter of fiscal year 2016, we issued 1,897 shares of common stock and 1,150 of our 8.75% tangible equity units (TEUs) to finance the acquisition of PCB Group, Inc. (PCB), repay amounts outstanding under our then existing revolving credit facility and to pay related costs, fees and expenses. The common stock and TEU issuances resulted in total net proceeds of $74,301 and $110,926, respectively. Proceeds from the issuance of the TEUs were allocated between equity and debt. The debt plus interest will be repaid in quarterly installments through July 1, 2019, at which time the equity portion of the TEUs will automatically be converted to common shares. These issuances negatively impact our basic and dilutive earnings per share. In connection with the pricing of the TEUs, we entered into capped call transactions with third parties that are expected to reduce the potential dilution to our common stock upon settlement of the TEUs to the extent the market price per share of our common stock exceeds the strike price of the capped calls of $50.40 per share. The capped calls resulted in cash outflow of $7,935 in the third quarter of fiscal year 2016. See Note 9 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Financing On July 5, 2016, we entered into a credit agreement that provides for senior secured credit facilities consisting of a $100,000 revolving credit facility (the Revolving Credit Facility) and a $460,000 tranche B term loan facility (the Term Facility). On July 29, 2016, we amended the credit agreement to increase the Revolving Credit Facility to $120,000. The proceeds of the Term Facility were used for financing the acquisition of PCB. The Revolving Credit Facility can be drawn upon to refinance existing indebtedness and for working capital and other general corporate purposes. The maturity date of the Revolving Credit Facility is July 5, 2021 and the maturity date of the Term Facility is July 5, 2023. See Note 5 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Acquisition On July 5, 2016, we completed the acquisition of PCB. The estimated purchase price we paid in connection with this acquisition was approximately $581,407 subject to certain adjustments that were made at closing for cash, indebtedness, transaction costs and the level of net working capital. We funded the estimated purchase price with existing cash on hand, borrowings under the Term Facility further described above and below under “Liquidity and Capital Resources” and proceeds from our previously announced registered public offerings of TEUs and common stock completed during the third quarter of fiscal year 2016. See Note 13 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Foreign Currency Approximately 75% of our revenue has historically been derived from customers outside of the United States. Our financial results are principally exposed to changes in exchange rates between the U.S. dollar and the Euro, the Japanese yen and the Chinese yuan. A change in foreign exchange rates could positively or negatively affect our reported financial results. The discussion below quantifies the impact of foreign currency translation on our financial results for the periods discussed. Financial Results Fiscal Year 2016 Compared to Fiscal Year 2015 Total Company Results of Operations The following table compares results of operations in fiscal years 2016 and 2015, separately identifying the estimated impact of currency translation, the acquisition of PCB in fiscal year 2016 and restructuring expense incurred in fiscal year 2016. The Acquisition / Restructuring column includes revenues and costs from the acquisition of PCB, costs incurred as part of the acquisition of PCB and restructuring costs ("acquisition and restructuring costs"). Revenue The increased revenue of 15.3% was driven by higher sales volumes in the Test segment and the PCB acquisition. Excluding the impact of higher sales volume attributable to the PCB acquisition and currency translation, revenue increased 8.1%. Test revenue increased $49,385 or 10.7% due to strong project execution and conversion of backlog, partially offset by a 0.7% unfavorable currency translation. Sensors revenue increased $36,828 or 36.4% driven by contributions from the PCB acquisition, partially offset by a decrease in sales volume in our legacy Sensors business and a 0.4% unfavorable impact of currency translation. The following table compares revenue in fiscal years 2016 and 2015 by geography. Although selective product price changes were implemented during each of these fiscal years, the overall impact of pricing changes did not have a material effect on revenue. Gross Profit Gross profit increased 5.4% due to increased sales volumes and backlog conversion in Test and increased sales volume as a result of three months of profit from the PCB acquisition, partially offset by lower sales volumes in our legacy Sensors business and the unfavorable impact of currency translation. Our gross margin rate decreased by 3.3 percentage points primarily as a result of higher compensation expense from the investment in resources in Test and Sensors, the acquisition of PCB, which included a $7,916 fair value adjustment related to the acquired inventory, and inefficiencies in executing complex projects in Test resulting in higher than expected costs. The decrease was further expanded by unfavorable leverage from lower sales volumes in Sensors due to industrial market weakness across the globe in fiscal year 2016. The decrease was partially offset by an increase in Test revenues. Excluding the impact of currency translation, three months of profit from the acquisition of PCB, and acquisition and restructuring costs, the gross margin rate decreased 2.7 percentage points. Selling and Marketing Expense Selling and marketing expenses increased 14.5% primarily due to three months of expenses from the PCB acquisition, restructuring costs and higher compensation expense in Test, offset by lower compensation expense and cost containment measures in Sensors. Excluding the impact of currency translation, acquisition and restructuring costs, selling and marketing expense increased 3.9%. General and Administrative Expense General and administrative expense increased 34.8% driven by $11,867 of PCB acquisition-related expenses, three months of expenses from the PCB acquisition, restructuring costs and higher professional fees. Excluding the impact of currency translation, PCB acquisition-related expenses, acquisition and restructuring costs, general and administrative expenses increased 3.1%. Research and Development Expense Research and development (R&D) expense increased 6.9% primarily due to higher compensation expense from Test employee headcount additions, three months of expenses from the PCB acquisition and restructuring costs, partially offset by employee headcount reductions and R&D project spending cost containment measures in our legacy Sensors business. Excluding the impact of currency, acquisition and restructuring costs, R&D expenses decreased 3.3%. Income from Operations Income from operations declined 32.1% due to higher gross profit being more than offset by higher operating expenses which included PCB acquisition-related expenses, three months of expenses related to the acquisition of PCB and restructuring costs of $28,807. Excluding the impact of currency translation, acquisition and restructuring costs, income from operations decreased 4.6%. Interest Income (Expense), net Interest expense, net increased primarily due to interest incurred related to our new tranche B term loan facility and TEUs. Interest expense included $5,750 related to the tranche B term loan, $1,389 from amortization of capitalized debt issuance costs, $562 related to the TEUs, $502 from writing-off capitalized debt issuance costs related to the previous credit facility and $323 of interest expense from borrowings under the previous credit facility. Other Income (Expense), net The increase in other income (expense), net was primarily driven by sales and use tax refunds and a decrease in the losses on foreign currency transactions. Provision for Income Taxes The provision for income taxes declined during fiscal year 2016 primarily due to a decrease in income before taxes. The effective tax rate was lower during fiscal year 2016 primarily due to tax benefits from the enactment of legislation on December 18, 2015 that made the U.S. R&D tax credit permanent as of January 1, 2015. Fiscal year 2016 includes a discrete tax benefit of $2,283 related to the reinstatement of the R&D tax credit. The rate was also lower due to a favorable geographic mix of earnings, with foreign income generally taxed at lower rates than domestic income. These benefits were partially offset by nondeductible PCB acquisition-related costs. Fiscal year 2015 included a tax benefit of $1,836 due to the resolution of audit matters in connection with the IRS examination of tax years ending October 1, 2011 and September 29, 2012. We also recognized a tax benefit of $2,098 during fiscal year 2015 due to the enactment of tax legislation on December 19, 2014 that retroactively extended the R&D tax credit. Net Income Net income declined due to higher operating expenses, partially offset by higher gross profit and a lower income tax provision. The year-to-date diluted EPS decline was driven by acquisition and restructuring costs, the issuance of common stock and TEUs, higher compensation expense from the investment in resources in Test and Sensors and inefficiencies in executing complex projects in Test. Backlog Backlog of undelivered orders at October 1, 2016 was $370,523, an increase of $17,510 or 5.0%, compared to backlog of $353,013 at October 3, 2015. Test backlog was $331,044 and $339,967 at October 1, 2016 and October 3, 2015, respectively. Sensors backlog was $39,479 and $13,046 at October 1, 2016 and October 3, 2015, respectively. Based on anticipated manufacturing schedules, we expect that approximately $297,000 of the backlog at October 1, 2016 will be converted into revenue during fiscal year 2017 (80% conversion). The conversion rate is up from the prior year rate of 76% due to a shift from larger custom orders to shorter cycle, quicker turning orders in fiscal year 2016 and the completion of certain custom orders. We believe backlog is not an absolute indicator of future revenue because a portion of the orders in backlog could be canceled at the customer’s discretion. While the backlog is subject to order cancellations, we have not historically experienced a significant number of order cancellations. During fiscal year 2016, one custom order in Test totaling approximately $8,567 was canceled. During fiscal year 2015, two custom orders in Test totaling approximately $8,484 were canceled. These canceled orders were booked in a fiscal year prior to the year in which they were canceled. Test Segment Results of Operations The following table compares results of operations in fiscal years 2016 and 2015 for Test, separately identifying the estimated impact of currency translation and restructuring expense incurred in fiscal year 2016. The acquisition of PCB did not have an impact on the results of operations of Test during fiscal year 2016. Revenue Revenue increased 10.7% primarily due to a focus on project execution, backlog conversion and higher service revenue, partially offset by the unfavorable impact of currency translation. Excluding the impact of currency translation, revenue increased 11.4% as the revenue decline in the Americas region was more than offset by improvements in the Asia and Europe regions. The following table compares revenue in fiscal years 2016 and 2015 for Test by geography. Gross Profit Gross profit increased 3.1% primarily due to increased sales volume. The gross margin rate decreased 2.4 percentage points driven by inefficiencies in executing several large complex projects, resulting in higher than expected costs, increased indirect labor headcount and a higher concentration of custom projects which typically have lower margins and restructuring costs. The decrease was partially offset by an increase in revenue. Selling and Marketing Expense Selling and marketing expense increased 8.1% primarily driven by higher compensation expense, higher commission expense from increased revenue, higher incentive compensation and restructuring costs of $129, partially offset by cost containment measures. Excluding the impact of currency translation and restructuring costs, selling and marketing expense increased 8.9%. General and Administrative Expense General and administrative expense increased 4.1% primarily due to higher professional fees, increased compensation expense and restructuring costs of $414, partially offset by a reduction in legal costs. Excluding the impact of currency translation and restructuring costs, general and administrative expense increased 4.4%. Research and Development Expense R&D expense decreased 0.4% primarily due a reduction in R&D project spending driven by redeployment of resources to certain capitalized engineering projects, partially offset by higher compensation expense. Income from Operations Income from operations decreased 3.8% due to higher compensation expense, inefficiencies in executing complex projects, higher concentration of custom projects and restructuring expenses of $847, partially offset by an increase in revenue. Backlog Backlog of undelivered orders at October 1, 2016 was $331,044, a decrease of 2.6% from backlog of $339,967 at October 3, 2015. Based on anticipated manufacturing schedules, we expect that approximately $258,000 of the backlog at October 1, 2016 will be converted into revenue during fiscal year 2017 (78% conversion). The conversion rate is up from the prior year rate of 75% due to a shift from larger custom orders to shorter cycle, quicker turning orders in fiscal year 2016 and a push to complete custom orders. As previously mentioned, backlog at the end of fiscal years 2016 and 2015 was negatively impacted by cancellations of custom orders in Test totaling approximately $8,567 and $8,484, respectively. Sensors Segment Results of Operations The following table compares results of operations in fiscal years 2016 and 2015 for Sensors, separately identifying the estimated impact of currency translation, the acquisition of PCB in fiscal year 2016 and restructuring expense incurred in fiscal year 2016. The Acquisition / Restructuring column includes revenues and costs from the acquisition of PCB, costs incurred as part of the acquisition of PCB and restructuring costs ("acquisition and restructuring costs"). Revenue Revenue increased 36.4% primarily due to increased revenue from sales volume as a result of the acquisition of PCB, partially offset by lower sales volumes in our legacy Sensors business. Excluding the impact of currency translation and the impact of the PCB acquisition, revenue decreased 7.1%. Sensors sales continue to be negatively impacted by industrial market weakness around the globe, specifically in the heavy industrial machine steel, fluid power and oil and gas markets. The following table compares revenue in fiscal years 2016 and 2015 for Sensors by geography. Gross Profit Gross profit increased 12.1% primarily due to increased sales volumes as a result of the PCB acquisition, partially offset by lower sales volumes in our legacy Sensors business and restructuring costs of $762. The gross margin rate decreased 9.7 percentage points due to the acquisition of PCB, which included a $7,916 fair value adjustment related to the acquired inventory, unfavorable leverage from lower sales volumes and higher indirect labor expense in our legacy Sensors business and restructuring costs. Excluding the impact of currency translation, acquisition and restructuring costs, the gross margin rate declined 1.7 percentage points. Selling and Marketing Expense Selling and marketing expense increased 36.8% primarily driven by three months of expenses from the PCB acquisition and restructuring costs, partially offset by lower compensation expense, reduced travel expense as part of cost containment measures and lower commission expense. Excluding the impact of currency translation, acquisition and restructuring costs, selling and marketing expense decreased 13.6%. General and Administrative Expense General and administrative expense increased 149.2% primarily due to PCB acquisition-related expenses of $11,867, three months of expenses from the acquisition of PCB and restructuring costs. Excluding the impact of currency translation and acquisition and restructuring costs, general and administrative expenses decreased 1.8%. Research and Development Expense R&D expense increased 27.8% primarily driven by three months of expenses from the acquisition of PCB, partially offset by lower compensation from headcount reductions and a decline in R&D project spending as part of cost containment measures. Excluding the impact of currency translation, acquisition and restructuring costs, R&D expense decreased 11.8%. Income from Operations Income from operations declined 94.3% primarily due to PCB acquisition-related expenses of $12,514, loss on operations from PCB and restructuring costs. Excluding the impact of currency translation and acquisition and restructuring costs, income from operations would have decreased 10.5%. Backlog Backlog of undelivered orders at October 1, 2016 was $39,479, an increase of 202.6% compared to backlog of $13,046 at October 3, 2015. The increase in backlog was primarily due to the acquisition of PCB. Fiscal Year 2015 Compared to Fiscal Year 2014 Total Company Results of Operations The following table compares results of operations in fiscal years 2015 and 2014, separately identifying the estimated impact of currency translation and the acquisition of Roehrig Engineering, Inc. (REI) in fiscal year 2014. Severance and Related Costs We initiated workforce reductions and other cost reduction actions during fiscal year 2014. As a result of these actions, we incurred severance and related costs of $6,336 in fiscal year 2014, of which $3,507, $1,805, and $1,024 were reported in cost of sales, selling and marketing, and general and administrative expense, respectively. No severance and related costs were recognized in fiscal year 2015. Revenue Revenue was essentially flat. Increases in revenue from higher sales volumes, the impact of the 53rd week in fiscal year 2015 and $5,432 from the acquisition of REI, which was completed in fiscal year 2014, were more than offset by the negative impact of currency translation. Excluding the impact of currency translation, revenue increased 5.8%. Test revenue increased $4,727 due to higher sales volumes, the impact of the 53rd week in fiscal year 2015 and the acquisition of REI which was completed in fiscal year 2014, partially offset by a 4.6% unfavorable currency translation. Sensors revenue declined $5,121 driven by an 11.3% unfavorable impact of currency translation. The following table compares revenue in fiscal years 2015 and 2014 by geography. Although selective product price changes were implemented during each of these fiscal years, the overall impact of pricing changes did not have a material effect on revenue. Gross Profit Gross profit declined due to the negative impact of currency translation, unfavorable product mix and an investment in labor and systems to improve utilization in the upcoming fiscal year. Due to a higher concentration of manufacturing performed in the U.S., currency had a 0.3 percentage point positive impact on the gross margin rate. Excluding the impact of currency translation, the gross margin rate decreased by 1.0 percentage point primarily driven by unfavorable product mix resulting from a higher number of custom projects which generally have lower margins and an investment in labor and systems to improve utilization in fiscal year 2016. The decrease was partially offset by severance and related costs of $3,507 recognized in fiscal year 2014 and nine months of profit totaling $1,692 from the acquisition of REI in fiscal year 2014. Selling and Marketing Expense Selling and marketing expenses decreased due to a favorable impact of currency translation, severance and related costs of $1,805 during fiscal year 2014 and lower external commissions as a result of revenue timing, partially offset by merit increases and the timing of selling activities to drive future revenue growth. General and Administrative Expense The general and administrative expense increase was driven by an estimated favorable impact of currency translation and $1,024 of severance and related costs incurred in fiscal year 2014 that did not recur in fiscal year 2015, offset by increased professional fees and nine months of expenses totaling $921 related to the acquisition of REI completed in fiscal year 2014. Research and Development Expense Research and development expense declined primarily due to an increase in the capitalization of internally developed software labor of $1,472 as headcount was reallocated to internally developed software activities and a favorable impact of currency translation, partially offset by higher compensation and benefits related to increased headcount. Income from Operations Income from operations increased primarily due to lower operating expenses. Interest Income (Expense), net Interest expense, net was higher due to higher average borrowings on our credit facility. Other Income (Expense), net The decrease in other income (expense), net was primarily driven by increased net losses on foreign currency transactions. Provision for Income Taxes The decreased provision for income taxes during fiscal year 2015 was primarily due to a decrease in the effective tax rate. The decrease in the effective tax rate was primarily driven by the enactment of tax legislation during the three months ended December 27, 2014 that retroactively extended the U.S. research and development tax credit and resulted in a tax benefit of $2,098 in the first quarter of fiscal year 2015. In addition, we recognized a tax benefit of $1,836 associated with the favorable resolution in fiscal year 2015 of audit matters in connection with the Internal Revenue Service examination of tax years ending October 1, 2011 and September 29, 2012. The fiscal year 2015 rate was also favorably impacted by our geographic mix of earnings, with foreign income generally taxed at lower rates than domestic income. The fiscal year 2014 effective tax rate includes a one-time benefit due to the recognition of additional federal and state research and development credit benefits of $2,563 which related to prior years. Net Income A $4,376 charge for severance and related costs negatively impacted fiscal year 2014 earnings per diluted share by $0.28. Excluding the severance and related costs, diluted earnings per share in fiscal year 2014 would have been essentially flat year-over-year. Backlog Backlog of undelivered orders at October 3, 2015 was $353,013, an increase of $26,540 or 8.1%, compared to backlog of $326,473 at September 27, 2014. The majority of this backlog was related to Test. Based on anticipated manufacturing schedules, we estimated that approximately $267,000 of the backlog at October 3, 2015 would be converted into revenue during fiscal year 2016 (76% conversion). The conversion rate was slightly down from the prior year rate of 77% due to a shift from shorter cycle, quicker turning orders to larger custom orders in fiscal year 2015. We believe backlog is not an absolute indicator of future revenue because a portion of the orders in backlog could be canceled at the customer’s discretion. While the backlog is subject to order cancellations, we have not historically experienced a significant number of order cancellations. During fiscal year 2015, two custom orders in Test totaling approximately $8,484 were canceled. During fiscal year 2014, one custom order in Test totaling approximately $11,109 was canceled. These canceled orders were booked in a fiscal year prior to the year in which they were canceled. Test Segment Results of Operations The following table compares results of operations in fiscal years 2015 and 2014 for Test, separately identifying the estimated impact of currency translation and the acquisition of REI in fiscal year 2014. Revenue The increase in revenue was primarily a result of strong engineer-to-order revenue converted from a higher beginning of the year backlog, productivity improvements and the favorable impact of a 53rd week in fiscal year 2015, partially offset by the unfavorable impact of currency translation. Excluding the impact of currency translation, revenue increased 5.6%. The following table compares revenue in fiscal years 2015 and 2014 for Test by geography. Gross Profit Gross profit declined primarily due to the negative impact of currency translation, partially offset by $3,507 of severance and related costs recognized in fiscal year 2014 and nine months of profit related to the fiscal year 2014 acquisition of REI in the amount of $1,692. Excluding the aforementioned, the gross margin rate decreased 1.8 percentage points driven by unfavorable product mix as fiscal year 2015 gross profit included a higher number of large custom projects which generally have lower margins. Selling and Marketing Expense Selling and marketing expense declined primarily due to the favorable impact of currency translation, lower external commissions due to timing of revenue and severance and related costs of $1,799 recognized in fiscal year 2014, partially offset by merit increases and timing of selling activities to drive future revenue growth. General and Administrative Expense The general and administrative expense increase was driven by increased spending related to professional fees and nine months of expenses totaling $921 related to the acquisition of REI completed in fiscal year 2014, partially offset by the favorable impact of currency translation. Research and Development Expense Research and development expense increased primarily due to an increase in headcount resulting in higher compensation expense. Income from Operations Income from operations increased due to lower operating expenses. Backlog Backlog of undelivered orders at October 3, 2015 was $339,967, an increase of 9.7% from backlog of $309,994 at September 27, 2014. As previously mentioned, backlog at the end of fiscal years 2015 and 2014 was negatively impacted by the cancellation of two custom orders in Test totaling approximately $8,484 and cancellation of one custom order totaling approximately $11,109, respectively. Sensors Segment Results of Operations The following table compares results of operations in fiscal years 2015 and 2014 for Sensors, separately identifying the estimated impact of currency translation. Revenue The decrease in revenue was primarily driven by the negative impact of currency translation. Excluding the impact of currency translation, Sensors revenue was up 6.5% driven by a higher beginning of the period backlog for fiscal year 2015 and additional sales in machine markets due to the favorable Euro exchange rates prompting customers to buy. The following table compares revenue in fiscal years 2015 and 2014 for Sensors by geography. Gross Profit Gross profit declined primarily due to the unfavorable impact of currency translation. Excluding the impact of currency translation, the gross margin rate declined 0.8 percentage points due to an unfavorable product mix resulting from sales increases in certain lower margin industrial markets. Selling and Marketing Expense The decrease in selling and marketing expense was primarily driven by the favorable impact of currency translation, partially offset by higher compensation and benefits resulting from increased headcount to support future revenue growth. General and Administrative Expense The decrease in general and administrative expense was primarily driven by the favorable impact of currency translation and cost containment measures, partially offset by increased compensation. Research and Development Expense The decrease in research and development expense was primarily driven by the favorable impact of currency translation and cost containment measures, partially offset by increased compensation and benefits expense resulting from increased headcount. Income from Operations Income from operations decreased primarily as a result of decreased gross profit, partially offset by lower operating expenses. Backlog Backlog of undelivered orders at October 3, 2015 was $13,046, a decrease of 20.8% compared to backlog of $16,479 at September 27, 2014. Cash Flow Comparison - Fiscal Years 2016, 2015 and 2014 Total cash and cash equivalents increased $33,012 for fiscal year 2016. The increase was primarily due to $440,163 in net proceeds from the issuance of long-term debt, $110,926 in net cash received from the issuance of TEUs, $74,301 in net proceeds from the issuance of common stock, $27,494 of net income and $24,077 in depreciation and amortization. The cash receipts were partially offset by a payment of $580,920, net of cash received, for the purchase of PCB, $21,343 of net repayments under short-term borrowings, investment in property and equipment of $20,806, $18,414 in purchases of shares of common stock under our share purchase program and for stock-based compensation arrangements and dividend payments of $13,932. Total cash and cash equivalents decreased $8,629 for fiscal year 2015. The decrease was primarily due to $50,026 in repayments of short-term borrowings and debt issuance costs, purchases of our common stock of $29,115, dividend payments of $22,445 and investment in property and equipment of $18,445. The decrease was partially offset by net income of $45,462, $21,106 in depreciation and amortization, $19,040 for decreased working capital requirements, $11,183 received through short- term borrowings, $7,351 in stock-based compensation and $4,847 of proceeds received from the exercise of stock options and share purchases under our employee stock purchase plan. Total cash and cash equivalents increased $12,064 during fiscal year 2014. This increase was driven by net income of $42,009, $24,102 in net proceeds received from borrowings on the credit facility, $19,279 in depreciation and amortization and $7,590 of proceeds from the exercise of stock options and stock purchases under our employee stock purchase plan. These increases were partially offset by purchases of our common stock of $31,013, investment in property and equipment of $20,038, dividend payments of $18,330 and $14,192 in cash payments associated with the acquisition of REI. Cash flow from operating activities provided cash totaling $67,881 during fiscal year 2016 compared to $100,436 during fiscal year 2015 and $64,669 in fiscal year 2014. Fiscal year 2016 was lower than fiscal year 2015 primarily due to lower net income and higher accounts and unbilled contracts receivable. Fiscal year 2016 cash flow from operating activities was primarily generated from $27,494 in net income, $24,077 of depreciation and amortization, a $9,057 increase in accrued payroll and related costs, a $7,916 fair value adjustment related to acquired inventory in connection with the PCB acquisition, $7,224 of stock-based compensation, a $5,701 increase in advanced payments from customers due to a focus on early collection efforts, a $5,647 increase in accounts payable resulting from general timing of purchases and payments and a $3,365 decrease in inventories. The cash received was partially offset by a $22,059 increase in accounts and unbilled contracts receivable resulting from general timing and collections and $5,274 in deferred income taxes. Fiscal year 2015 cash flow from operating activities was primarily driven by $45,462 in net income, $21,106 of depreciation and amortization, a $13,065 increase in advance payments received from customers driven by the mix of orders, a $6,772 increase in accounts payable resulting from general timing of purchases and payments, a $3,308 decrease in accounts and unbilled receivables resulting from general timing of billing and collections, partially offset by a $4,105 increase in inventories to support future revenue. Fiscal year 2014 cash flow from operating activities was primarily driven by net income of $42,009 and $19,279 in depreciation and amortization. Cash flow from investing activities required $600,212, $19,112 and $34,230 use of cash during fiscal years 2016, 2015 and 2014, respectively. Fiscal year 2016 cash usage was due to payments of $580,920, net of cash received, for the acquisition of PCB and $20,806 in investments in property and equipment to support business growth, partially offset by proceeds received from the sale of property and equipment of $1,514. Fiscal year 2015 cash usage was due to $18,445 in investments in property and equipment and payments of $667 associated with the acquisition of Instrument and Calibration Sweden AB (ICS). The cash usage for fiscal year 2014 was due to $20,038 in investments in property and equipment and $14,192 in payments associated with the acquisition of REI. See Note 13 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information regarding the acquisitions. Cash flow from financing activities provided cash of $564,479 in fiscal year 2016, compared to cash used of $84,785 and $15,928 during fiscal years 2015 and 2014, respectively. Cash provided in fiscal year 2016 was primarily driven by $440,163 in net proceeds from the issuance of long-term debt, $110,926 in net cash received from the issuance of TEUs, $74,301 in net cash received from the issuance of common stock and $20,000 from receipts under short-term borrowings. These increases were partially offset by $41,343 in repayments of short-term borrowings, $19,837 in payments of debt issuance costs, the purchase of shares of common stock under our share purchase program and stock-based compensation arrangements in an aggregate amount of $18,414, dividend payments of $13,932 and $7,935 related to payments for the capped call transactions made in connection with the issuance of the TEUs. Cash was used in fiscal year 2015 to repay $50,026 of short-term borrowings, purchase shares under our share purchase program and stock-based compensation arrangements in an aggregate amount of $29,115 and to pay dividends of $22,445. The usage of cash was partially offset by $11,183 received through short-term borrowings and $4,847 of proceeds received in connection with stock option exercises and share purchases under our employee stock purchase plan. Cash used in fiscal year 2014 was primarily due to the purchase of shares of our common stock in an amount of $31,013, which includes purchases of shares related to stock-based compensation arrangements in the amount of $374, and to pay $18,330 in cash dividends. The usage of cash was partially offset by $24,102 in net proceeds from short-term borrowings and $7,590 received from stock option exercises and stock purchases under our employee stock purchase plan. Liquidity and Capital Resources We had cash and cash equivalents of $84,780 as of October 1, 2016. Of this amount, approximately $32,406 was located in North America, $23,610 in Europe and $28,764 in Asia. Of the $52,374 of cash located outside of the U.S., approximately $30,613 is not available for use in the U.S. without U.S. federal and state income tax consequences. The North American balance was primarily invested in bank deposits. In Europe and Asia, the balances were primarily invested in money market funds and bank deposits. In accordance with our investment policy, we place cash equivalent investments with issuers who have high-quality investment credit ratings. In addition, we limit the amount of investment exposure we have with any particular issuer. Our investment objectives are to preserve principal, maintain liquidity and achieve the best available return consistent with our primary objectives of safety and liquidity. At October 1, 2016, we held no short-term investments. At October 1, 2016, our capital structure was comprised of $13,141 in short-term debt, $471,844 in long-term debt and $405,260 in shareholders’ equity. The Consolidated Balance Sheet also includes $20,134 of unamortized debt issuance costs. Total interest-bearing debt at October 1, 2016 was $484,985. On July 5, 2016, we entered into a credit agreement with a consortium of financial institutions (the Credit Agreement). The Credit Agreement provides for senior secured credit facilities consisting of a Revolving Credit Facility and a Term Facility. In connection with the Credit Agreement, we terminated our existing credit agreement dated September 27, 2014. The maturity date of the Revolving Credit Facility is July 5, 2021 and the maturity date of the loans under the Term Facility is July 5, 2023, unless a term loan lender agrees to extend the maturity date pursuant to a loan modification agreement made in accordance with the terms of the Credit Agreement. Under the Credit Agreement, we are subject to customary affirmative and negative covenants, including restrictions on our ability to incur debt, create liens, dispose of assets, make investments, loans, advances, guarantees and acquisitions, enter into transactions with affiliates and enter into any restrictive agreements and customary events of default (including payment defaults, covenant defaults, change of control defaults and bankruptcy defaults). The Credit Agreement also contains financial covenants, including the ratio of consolidated total indebtedness to consolidated earnings before interest, taxes, depreciation and amortization (EBITDA), as well as the ratio of consolidated EBITDA to consolidated interest expense. Under certain circumstances, these covenants restrict our ability to pay dividends and purchase outstanding shares of common stock. At October 1, 2016, we were in compliance with these financial covenants and on October 3, 2015, were in compliance with similar financial covenants in the credit agreement existing at that date. Shareholders’ equity increased by $147,118 during fiscal year 2016, primarily due to $84,511 in issuance of TEUs, $74,301 in issuance of common stock, net income of $27,494, stock based compensation of $7,156, employee exercise of stock options of $2,799 and employee stock purchases of $1,048. The increase was partially offset by $18,874 in dividends declared, $18,414 in purchases of our common stock, payments related to our capped call transactions of $7,935 and an other comprehensive loss of $4,796. We believe that our liquidity, represented by funds available from cash, cash equivalents, our credit facility and anticipated cash from operations are adequate to fund ongoing operations for the short-term and long-term internal growth opportunities, capital expenditures, dividends and share purchases, as well as to fund strategic acquisitions. Contractual Obligations As of October 1, 2016, our contractual obligations were as follows: Long-term debt includes Term Facility debt and the debt component of the TEUs. Refer to Note 5 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional Term Facility information and Note 9 for additional information regarding the TEUs. Interest payable on long-term debt includes interest on both the Term Facility and the TEUs. Operating leases are primarily for office space and automobiles. Refer to Note 14 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional lease information. Other long-term obligations include liabilities under pension and other retirement plans and warehouse fee obligations. Long-term income tax liabilities for uncertain tax positions have been excluded from the contractual obligations table as we are not able to make a reasonably reliable estimate of the amount and period of related future payments. At October 1, 2016, our long-term liability for uncertain tax positions was $6,232. Refer to Note 8 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional income tax information. At October 1, 2016, we had letters of credit and guarantees outstanding totaling $46,765 and $26,536, respectively, primarily to bond advance payments and performance guarantees related to customer contracts in Test. Off-Balance Sheet Arrangements As of the end of fiscal year 2016, we did not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Critical Accounting Policies The Consolidated Financial Statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP), which require us to make estimates and assumptions in certain circumstances that affect amounts reported. The preparation of these financial statements requires us to make estimates and assumptions, giving due consideration to materiality, that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of any contingent assets and liabilities at the date of the financial statements. We regularly review our estimates and assumptions, which are based on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that of our significant accounting policies, the following are particularly important to the portrayal of our results of operations and financial position and are subject to an inherent degree of uncertainty as they may require the application of a higher level of judgment by us. For further information see “Summary of Significant Accounting Policies” under Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Revenue Recognition We are required to comply with a variety of technical accounting requirements in order to achieve consistent and accurate revenue recognition. The most significant area of judgment and estimation is percentage-of-completion contract accounting. We develop cost estimates that include materials, component parts, labor and overhead costs. Detailed costs plans are developed for all aspects of the contracts during the bidding phase. Cost estimates are largely based on actual historical performance of similar projects combined with current knowledge of the projects in progress. Significant factors that impact the cost estimates include technical risk, inflationary cost of materials and labor, changes in scope and schedule and internal and subcontractor performance. Actual costs incurred during the project phase are monitored and compared to the estimates on a monthly basis. Cost estimates are revised based on changes in circumstances. Anticipated losses on long-term contracts are recognized when such losses become evident. Inventories We maintain a material amount of inventory to support our engineering and manufacturing operations. This inventory is stated at the lower of cost or market. On a regular basis, we review our inventory and identify which is excess, slow moving or obsolete by considering factors such as inventory levels, expected product life and forecasted sales demand. Any identified excess, slow moving or obsolete inventory is written down to its market value through a charge to income from operations. It is possible that additional inventory write-down charges may be required in the future if there is a significant decline in demand for our products and we do not adjust our manufacturing production accordingly. Impairment of Long-Lived Assets We review the carrying value of long-lived assets or asset groups, such as property and equipment and intangible assets subject to amortization, when events or changes in circumstances such as asset utilization, physical change, legal factors or other matters indicate that the carrying value may not be recoverable. We review the carrying value of indefinite lived intangible assets annually or when events or changes in circumstances occur that would indicate that the carrying value may not be recoverable. When this review indicates the carrying value of an asset or asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group, we recognize an asset impairment charge against income from operations. The amount of the impairment loss recorded is the amount by which the carrying value of the impaired asset or asset group exceeds its fair value. Goodwill Goodwill represents the excess of cost over the fair value of the identifiable net assets of businesses acquired and allocated to our reporting units at the time of acquisition. Goodwill is tested for impairment annually and when an event occurs or circumstances change that indicate the carrying value of the reporting unit may not be recoverable. Evaluating goodwill for impairment involves the determination of the fair value of each reporting unit in which goodwill is recorded using a two-step process. A reporting unit is an operating segment or a component of an operating segment for which discrete financial information is available and reviewed by management on a regular basis. Prior to completing the two-step process described below, we have the option to perform a qualitative assessment of goodwill for impairment to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, including goodwill and other intangible assets. If we conclude the fair value is more likely than not less than the carrying value, we would perform the two-step process. Otherwise, no further testing would be needed. If the two-step process is required, the first step of the impairment test is to compare the calculated fair value of each reporting unit to its carrying value, including goodwill. We estimate the fair value of a reporting unit using a discounted cash flow model that requires input of certain estimates and assumptions requiring judgment, including projections of economic conditions and customer demand, revenue and margins, changes in competition, operating costs and new product introductions. If the fair value exceeds the carrying value, no further work is required and no impairment loss is recognized. If the carrying value exceeds the fair value, the goodwill of the reporting unit is potentially impaired and step 2 would need to be performed to measure the impairment loss. In step 2, we would calculate the implied fair value of goodwill by deducting the fair value of all tangible and intangible net assets, including unrecognized intangible assets, of the reporting unit from the fair value of the reporting unit. If the implied fair value of goodwill is less than the carrying value of goodwill, an impairment loss equal to the difference would be recognized in the period identified. The loss recognized cannot exceed the carrying amount of goodwill. While we believe the estimates and assumptions used in determining the fair value of our reporting units are reasonable, significant changes in estimates of future cash flows, such as those caused by unforeseen events or changes in market conditions, could materially impact the fair value of a reporting unit which could result in the recognition of a goodwill impairment charge. Software Development Costs We incur costs associated with the development of software to be sold, leased or otherwise marketed. Software development costs are expensed as incurred until technological feasibility has been established, at which time future costs incurred are capitalized until the product is available for general release to the public. A certain amount of judgment and estimation is required to assess when technological feasibility is established, as well as the ongoing assessment of the recoverability of capitalized costs. In evaluating the recoverability of capitalized software costs, we compare expected product performance, utilizing forecasted revenue amounts, to the total costs incurred to date and estimates of additional costs to be incurred. If revised forecasted product revenue is less than, and/or revised forecasted costs are greater than, the previously forecasted amounts, the net realizable value may be lower than previously estimated, which could result in the recognition of an impairment charge in the period in which such a determination is made. Warranty Obligations We are subject to warranty obligations on sales of our products. We record general warranty provisions based on an estimated warranty expense percentage applied to current period revenue. The percentage applied reflects our historical warranty claims experience over the preceding twelve-month period. Both the experience percentage and the warranty liability are evaluated on an ongoing basis for adequacy. In addition, warranty provisions are also recognized for certain nonrecurring product claims that are individually significant. A certain amount of judgment is required in determining appropriate reserve levels for anticipated warranty claims. While these reserve levels are based on our historical warranty claims experience, they may not reflect the actual claims that will occur over the upcoming warranty period and additional warranty reserves may be required. Income Taxes We record a tax provision for the anticipated tax consequences of the reported results of operations. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those deferred tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. We believe it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining net realizable value of its deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our financial condition and operating results. See Note 8 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information on income taxes. Business Acquisitions We account for acquired businesses using the acquisition method of accounting which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. The judgments made in determining the estimated fair value assigned to each class of assets acquired and liabilities assumed, as well as asset lives, can materially impact net income. Accordingly, for significant items, we typically obtain assistance from a third-party valuation firm. There are several methods that can be used to determine the fair value of assets acquired and liabilities assumed in a business combination. For intangible assets, we normally utilize the “income method.” This method starts with a forecast of all of the expected future net cash flows attributable to the subject intangible asset. These cash flows are then adjusted to present value by applying an appropriate discount rate that reflects the risk factors associated with the cash flow streams. Some of the more significant estimates and assumptions inherent in the income method (or other methods) include the projected future cash flows (including timing) and the discount rate reflecting the risks inherent in the future cash flows. Estimating the useful life of an intangible asset also requires judgment. For example, different types of intangible assets will have different useful lives, influenced by the nature of the asset, competitive environment and rate of change in the industry. Certain assets may even be considered to have indefinite useful lives. All of these judgments and estimates can significantly impact the determination of the amortization period of the intangible asset, and thus net income. In connection with the acquisition of PCB consummated in fiscal year 2016, the final valuation of assets acquired and liabilities assumed is expected to be completed as soon as possible, but no later than one year from the acquisition date. Given the size and complexity of the acquisition, the valuation of certain assets and liabilities, is still being completed, and is subject to final review. Specifically, certain tax accounts are provisional pending the completion and review of such assets and liabilities. To the extent that our estimates require adjustment, we will modify the values accordingly. Recently Issued Accounting Pronouncements Information regarding new accounting pronouncements is included in “Recently Issued Accounting Pronouncements” under Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Quarterly Financial Information Revenue and operating results reported on a quarterly basis do not necessarily reflect trends in demand for our products or our operating efficiency. Revenue and operating results in any quarter may be significantly affected by customer shipments, installation timing or the timing of the completion of one or more contracts where revenue is recognized upon shipment or customer acceptance rather than on the percentage-of-completion method of revenue recognition. Our use of the percentage-of-completion revenue recognition method for large, long-term projects generally has the effect of minimizing significant fluctuations quarter-over-quarter. See Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information on our revenue recognition policy. Quarterly earnings also vary as a result of the use of estimates including, but not limited to, the rates used in recording federal, state and foreign income tax expense. See Notes 1 and 8 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information on our use of estimates and income tax related matters, respectively. Selected quarterly financial information for the fiscal years ended October 1, 2016 and October 3, 2015 was as follows: In the fourth quarter of fiscal year 2016, we recorded out-of-period adjustments that increased net income in the fourth quarter by $968. The adjustments relate to prior quarters in fiscal years 2016 and 2015. We have evaluated the out-of-period adjustments and have determined that they are not material to our financial position or results of operations for any quarterly period in fiscal year 2016 or 2015. The earnings per share amounts for each quarter may not sum to the fiscal year amounts due to rounding and the effect of weighting. Forward-Looking Statements Statements contained in this Annual Report on Form 10-K including, but not limited to, the discussion under Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, that are not statements of historical fact are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the Act). In addition, certain statements in our future filings with the SEC, in press releases, and in oral and written statements made by us or with our approval that are not statements of historical fact constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenue, ROIC, EBITDA, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure, the adequacy of our liquidity and reserves, the continued listing of our shares of common stock on NASDAQ, the anticipated level of expenditures required and other statements concerning future financial performance; (ii) statements of our plans and objectives by our management or Board of Directors, including those relating to products or services, merger or acquisition activity and the potential impact of newly acquired businesses; (iii) statements of assumptions underlying such statements; (iv) statements regarding business relationships with vendors, customers or collaborators or statements relating to our order cancellation history, our ability to convert our backlog of undelivered orders into revenue, the timing of purchases, competitive advantages and growth in end markets; (v) statements relating to the potential business and financial impact that our internal investigation in China may have on our financial condition, results of operations and internal controls; (vi) statements regarding our ability to report additional operating segments in the future; and (vii) statements regarding products, their characteristics, fluctuations in the costs of raw materials for products, our geographic footprint, performance, sales potential or effect in the hands of customers. Words such as “believes,” “anticipates,” “expects,” “intends,” “targeted,” “should,” “potential,” “goals,” “strategy,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, those described in Item 1A, Risk Factors. The performance of our business and our securities may be adversely affected by these factors and by other factors common to other businesses and investments, or to the general economy. Forward-looking statements are qualified by some or all of these risk factors. Therefore, you should consider these forward looking statements with caution and form your own critical and independent conclusions about the likely effect of these risk factors on our future performance. Forward-looking statements speak only as of the date on which statements are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made to reflect the occurrence of unanticipated events or circumstances. Readers should carefully review the disclosures and the risk factors described in this and other documents we file from time to time with the SEC, including our reports on Forms 10-Q and 8-K.

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in nine sections: Overview Financial Results Cash Flow Comparison Liquidity and Capital Resources OffBalance Sheet Arrangements Critical Accounting Policies Recently Issued Accounting Pronouncements Quarterly Financial Information Forward Looking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8 of Part II of this Annual Report on Form 10K. All dollar amounts are in thousands (unless otherwise noted). Overview MTS Systems Corporation is a leading global supplier of highperformance test systems and sensors. Our testing hardware and software solutions help customers accelerate and improve design, development and manufacturing processes and are used for determining the mechanical behavior of materials, products and structures. Our highperformance sensors provide controls for a variety of applications measuring acceleration, position, vibration, motion, pressure, force and sound. Our goal is to grow profitably, generate strong cash flow and deliver a strong return on invested capital to our shareholders by leveraging our leadership position in the research and development and industrial global end markets for high performance test systems and sensors. Our desire is to be the innovation leader in creating test and measurement solutions and provide total customer satisfaction. We believe we can create value for our customers by helping to enhance the precision, improve the reliability and create superior safety for their products, while reducing the delivery time to market for their products. Our competitive advantages include our mission critical technology and application expertise, our leading global footprint with longterm customer relationships, our large installed base of testing equipment and our expanded presence in the rapidly growing sensors market. We believe these competitive advantages position us well in both the test and sensors markets to deliver profitable growth in the years ahead. We are working toward our goals of sustained six to eight percent growth in annual revenue, three to four points of expanded earnings before interest, taxes, depreciation and amortization (EBITDA) and midteens for return on invested capital (ROIC). We believe the growth in our end markets, combined with three primary opportunities we are currently pursuing will support these goals: Realize growth within the rapidly expanding sensors market with strong forecasted growth over the next five years; Expand service offerings in our Test segment; and Capture growth in ground vehicle and advance materials testing driven by environmental and energy conservation initiatives. We believe that our business model supports our growth objectives, provided that we continue to move aggressively to build our infrastructure, expand our offerings and execute on opportunities with our key customers around the world. In order to accelerate our revenue growth over the next five years, investments in infrastructure, sales support and field service capacity and capability are essential. Fiscal Year We have a 544 week, quarterly accounting cycle with the fiscal year ending on the Saturday closest to September 30. Fiscal years 2016, 2015 and 2014 ended October 1, 2016, October 3, 2015 and September 27, 2014, respectively. Fiscal years 2016 and 2014 both included 52 weeks, while fiscal year 2015 included 53 weeks. Restructuring Initiative During the third quarter of fiscal year 2016, we initiated restructuring actions to further reduce our cost structure by eliminating certain positions, primarily in our Corporate area and Test segment, through terminations, elimination of certain open positions as a result of employees leaving voluntarily throughout fiscal year 2016 and reductions in contractors. These restructuring activities resulted in severance and related expense of $1,237 during fiscal year 2016. During the fourth quarter of fiscal year 2016, we initiated plans to close our Machida, Japan facility by the third quarter of fiscal year 2017. We incurred restructuring expense of $928 in fiscal year 2016 related to the closure of this facility. See [/INST] Negative. </s>

MTS SYSTEMS CORP

2017-11-27

2017-09-30

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in nine sections: • Overview • Financial Results • Cash Flow Comparison • Liquidity and Capital Resources • Off-balance Sheet Arrangements • Critical Accounting Policies • Recently Issued Accounting Pronouncements • Quarterly Financial Information • Forward-looking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8 of Part II of this Annual Report on Form 10-K. All dollar amounts are in thousands unless otherwise noted. Overview MTS Systems Corporation is a leading global supplier of high performance test systems and sensors. Our testing hardware and software solutions help customers accelerate and improve design, development and manufacturing processes and are used for determining the mechanical behavior of materials, products and structures. Our high performance sensors provide controls for a variety of applications measuring acceleration, position, vibration, motion, pressure, force and sound. Our goal is to sustain profitable enterprise growth, consistently generate strong cash flow and deliver a strong return on invested capital to our shareholders by leveraging our leadership position in the research and development and industrial global end markets for high-performance test systems and sensors. Our desire is to be the innovation leader in creating test and measurement solutions and to provide total customer satisfaction. We believe we can create value for our customers by helping to enhance the precision, improve the reliability and create superior safety for their products, while reducing the delivery time to market for their products. Our competitive advantages include our proprietary technology and advanced application expertise, our expansive global footprint with long-term customer relationships, our large installed base of testing equipment and our expanded presence in the rapidly growing sensors market. We believe these competitive advantages position us well in both the test and sensors markets to deliver profitable growth in the years ahead. We are working toward our goals of sustained five to seven percent growth in annual revenue; three to four points of expanded earnings before interest, taxes, depreciation and amortization (EBITDA); and mid-teens for return on invested capital (ROIC). We believe the growth in our end markets, combined with four primary opportunities we are currently pursuing, will support these goals: • Realize growth within the rapidly expanding Sensors market through an increase in our global market share and new product development; • Expand Test services offerings into our large installed base of Test equipment; • Capitalize on growth opportunities in the Test materials sector spurred by new manufacturing processes, focus on light-weight materials in aerospace and ground vehicle markets, and trends in energy exploration; and • Adapt our industry-leading ground vehicle testing applications to align with emerging trends in vehicle electrification, autonomous vehicles, and simulation. We believe that our business model supports our growth objectives, provided that we continue to move aggressively to build our infrastructure, expand our offerings and execute on opportunities with our key customers around the world. In order to accelerate our revenue growth over the next five years, investments in infrastructure, sales support and field service capacity and capability are essential. Fiscal Year We have a 5-4-4 week, quarterly accounting cycle with the fiscal year ending on the Saturday closest to September 30. Fiscal years 2017, 2016 and 2015 ended September 30, 2017, October 1, 2016 and October 3, 2015, respectively. Fiscal years 2017, 2016 and 2015 include 52, 52 and 53 weeks, respectively. Debt Repricing In the fourth quarter of fiscal year 2017, we completed the repricing of our $455,400 tranche B term loan facility to reduce the applicable rate by 100 basis points. We also repriced our revolving credit facility of up to $120,000 to reduce the applicable rate by 100 basis points and make certain reductions to the commitment fee rates. Currently, there are no borrowings against the revolving credit facility. See Note 5 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Conversion of 8.75% Tangible Equity Units (TEUs) During the third quarter of fiscal year 2016, we issued 1,150 TEUs in a registered public offering primarily to finance the acquisition of PCB. The equity component of our TEUs will automatically settle upon expiration on July 1, 2019, unless converted earlier at the election of the holder. During fiscal year 2017, holders of our TEUs elected to early convert the equity component on 473 of our outstanding TEUs at the minimum conversion rate of 1.9841 which resulted in the issuance of 939 shares of our common stock. See Note 9 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Settlement of Capped Calls In connection with the pricing of our TEUs sold in our public offering in fiscal year 2016, we purchased capped calls from third party banking institutions (Capped Calls) for $7,935. During fiscal year 2017, we settled approximately 10% of the Capped Calls, which resulted in us receiving and retiring 12 shares of our common stock. As of September 30, 2017, the range of shares of our common stock to be received under the outstanding Capped Calls was 0 to 293 shares, subject to market conditions. See Note 9 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Restructuring Initiatives In fiscal year 2017, we initiated a series of Test workforce reductions and facility closures intended to increase organizational effectiveness, gain manufacturing efficiencies and provide cost savings that can be reinvested in our growth initiatives. As a result, during the fourth quarter of fiscal year 2017, we recorded $2,899 of pre-tax severance and related expense and $23 of pre-tax facility closure costs. During the fourth quarter of fiscal year 2016, we initiated plans to reduce costs in Sensors by closing our Machida, Japan manufacturing facility in the third quarter of fiscal year 2017. We incurred severance and related pre-tax expense of $1,036 in fiscal year 2017 related to this action. During the fourth quarter of fiscal year 2017, in an effort to further reduce costs and create economic efficiencies, we initiated plans to close our Machida, Japan sales office in the second quarter of fiscal year 2018. We incurred additional severance and related pre-tax expense of $121 in fiscal year 2017 related to this action. See Note 12 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Foreign Currency Approximately 70% of our revenue has historically been derived from customers outside of the U.S. Our financial results are principally exposed to changes in exchange rates between the U.S. dollar and the Euro, the Japanese yen and the Chinese yuan. A change in foreign exchange rates could positively or negatively affect our reported financial results. The discussion below quantifies the impact of foreign currency translation on our financial results for the periods discussed. Financial Results Fiscal Year 2017 Compared to Fiscal Year 2016 Total Company Results of Operations The following table compares results of operations in fiscal years 2017 and 2016, separately identifying the estimated impact of currency translation, the acquisition of PCB for the first three quarters of fiscal year 2017 for comparability, and restructuring expenses incurred in fiscal year 2017. The Acquisition / Restructuring column includes revenues and costs from the acquisition of PCB for the first three quarters of fiscal year 2017, including the fair value adjustment to acquired inventory of $7,975, costs incurred as part of the acquisition of PCB, and restructuring expenses incurred in fiscal year 2017. The first three quarters of fiscal year 2016 did not include PCB results since the acquisition closed in the fourth quarter of fiscal year 2016; therefore, the estimated impact of PCB for the first three quarters of fiscal year 2017 is separately identified herein for comparability. Revenue The increase in revenue of 21.2% was driven by the PCB acquisition and overall growth in our Sensors business, partially offset by a decrease in Test primarily due to the unfavorable impact of currency translation. Test revenue decreased $8,178 or 1.6% primarily driven by lower orders in the last half of fiscal year 2016 and the first half of fiscal year 2017. Sensors revenue increased $145,986 or 105.9% primarily driven by the PCB acquisition and overall growth in our Sensors business. Excluding the impact of currency translation and the contribution of PCB for the first three quarters of fiscal year 2017, revenue increased 1.8%. Revenue by geography was as follows: Although selective product price changes were implemented during each of these fiscal years, the overall impact of pricing changes did not have a material effect on revenue. Gross Profit Gross profit increased 30.6% primarily due to the gross profit contribution from the PCB acquisition, higher revenue volume in Sensors, and a continued focus on Test project execution, partially offset by reduced Test revenue volume. Gross margin rate increased 2.8 percentage points primarily due to the gross profit contribution from the PCB acquisition, the fair value adjustment on the acquired inventory in the fourth quarter of the prior year of $7,916, and a continued focus on Test project execution, partially offset by a $7,975 fair value adjustment on acquired inventory recognized in the first quarter of fiscal year 2017, nonrecurring restructuring costs incurred in the current year of $3,140, and higher compensation expenses. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, nonrecurring restructuring costs incurred in both fiscal years, and fair value adjustment on acquired inventory recorded in the fourth quarter of the prior year, gross profit increased 3.9% and the gross margin rate increased 0.8 percentage points. Selling and Marketing Expense Selling and marketing expenses increased 31.5% primarily due to the addition of PCB expenses, higher commission and compensation expenses, and China investigation expenses. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, nonrecurring restructuring costs incurred in both fiscal years, and China investigation expenses, selling and marketing expense increased 1.0%. General and Administrative Expense General and administrative expense increased 26.3% primarily due to the addition of PCB expenses, China investigation expenses of $8,451, higher professional and legal fees, and increased compensation expenses, partially offset by nonrecurring PCB acquisition-related expenses of $11,867 incurred in the prior year. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, nonrecurring restructuring costs incurred in both years, and China investigation expenses, general and administrative expense increased 3.3%. Research and Development Expense Research and development (R&D) expense increased 38.1% primarily due to the addition of PCB expenses, focused R&D spending to meet certain Test market needs, and continued investments in Sensors product development. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, and China investigation expenses, R&D expenses increased 9.1%. Income from Operations Income from operations increased 31.3% primarily due to the contribution of PCB to income from operations, nonrecurring PCB acquisition-related expenses of $12,514 incurred in the prior year, leverage on higher revenue volume in our Sensors business, improved Test gross margin driven by a continued focus on project execution, and nonrecurring restructuring costs of $2,165 incurred in the prior year, partially offset by China investigation expenses of $9,209 and nonrecurring restructuring costs of $4,079 incurred in the current year. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, nonrecurring restructuring costs and acquisition-related expenses incurred in both years, fair value adjustment on acquired inventory recorded in the fourth quarter of the prior year, and China investigation expenses, income from operations increased 6.5%. Interest Expense, Net The increase in interest expense is due to a full year of interest expense recognized in fiscal year 2017 on the debt incurred to finance the acquisition of PCB. Current year interest expense, net included $23,643 interest expense for the tranche B term loan facility, $3,863 amortization of capitalized debt issuance costs, and $1,521 interest expense for TEU debt. As a result of the repricing of the tranche B term loan facility in the fourth quarter of fiscal year 2017, current year interest expense, net also included $1,147 repricing costs and $503 in non-cash charges for the loss on debt extinguishment resulting from the write-off of existing unamortized debt financing costs. Prior year interest expense, net included $5,750 interest expense for the tranche B term loan facility, $1,389 amortization of capitalized debt issuance costs, $562 interest expense for TEU debt, $502 in non-cash charges for the loss on debt extinguishment from the write-off of existing capitalized debt issuance costs related to the revolving credit facility, and $323 of interest expense on the revolving credit facility. Other Income (Expense), Net The decrease in other income (expense), net was primarily driven by current year losses on foreign currency transactions. Income Tax Provision (Benefit) The provision for income taxes declined during fiscal year 2017 primarily due to a decrease in income before taxes. The effective tax rate was lower during fiscal year 2017 primarily due to certain discrete benefits of $2,801 recognized during the third quarter of fiscal year 2017, which consisted of additional U.S. tax benefits for prior fiscal years associated with domestic manufacturing, deductible PCB acquisition-related expenses, and the U.S. R&D tax credit. Excluding the impact of these discrete benefits, the effective tax rate for fiscal year 2017 was 3.2%, and declined compared to the prior year due to lower income before taxes and a more favorable geographic mix of earnings. The effective tax rate of 18.0% during fiscal year 2016 included a $2,283 discrete tax benefit for retroactive reinstatement of the U.S. R&D tax credit, which was partially offset by a one-time tax cost of $1,834 associated with nondeductible PCB acquisition-related expenses. Excluding the impact of these items, the effective tax rate for fiscal year 2016 was 19.3%. Net Income Net income declined due to higher operating expenses and increased interest expense, partially offset by higher gross profit and the current year tax benefit resulting primarily from nonrecurring discrete items. Diluted earnings per share was negatively impacted by increased interest expense, higher amortization expense related to the PCB acquisition, and the issuance of common stock and TEUs in fiscal year 2016, partially offset by increased income from operations and the current year tax benefit. Backlog Backlog of undelivered orders at September 30, 2017 was $360,016, a decrease of $10,507 or 2.8%, compared to backlog of $370,523 at October 1, 2016. Based on anticipated manufacturing schedules, we expect approximately 85% of the backlog as of September 30, 2017 will be converted into revenue during fiscal year 2018. The conversion rate was up from the prior year rate of 80% due to a shift in Test backlog composition from larger custom orders to shorter cycle, more rapidly turning orders and the completion of certain custom orders. We believe backlog is not an absolute indicator of future revenue because a portion of the orders in backlog could be canceled at the customer's discretion. While the backlog is subject to order cancellations, we have not historically experienced a significant number of order cancellations. During fiscal year 2017, order cancellations did not have a material effect on backlog. During fiscal year 2016, one custom order in Test totaling $8,567 was canceled. This canceled order was booked in a fiscal year prior to the year in which it was canceled. Test Segment Results of Operations The following table compares results of operations in fiscal years 2017 and 2016 for Test, separately identifying the estimated impact of currency translation and restructuring expenses incurred in fiscal year 2017. The Acquisition / Restructuring column includes restructuring expenses incurred in fiscal year 2017. The acquisition of PCB did not have an impact on Test results of operations during fiscal year 2017. Revenue Revenue decreased 1.6% primarily due to lower orders in the last half of fiscal year 2016 and the first half of fiscal year 2017 and the unfavorable impact of currency translation, partially offset by a continued focus on project execution and growth in service revenue. Excluding the impact of currency translation, revenue decreased 0.8%. Sales momentum in the Americas was offset by declines in Europe and Asia primarily driven by automotive manufacturers. Revenue by geography was as follows: Gross Profit Gross profit decreased 0.5%. The gross margin rate increased by 0.4 percentage points primarily due a continued focus on project execution and effective cost containment, partially offset by higher compensation expenses, nonrecurring restructuring costs incurred in the current year, and investment in product performance. Excluding the impact of currency translation and nonrecurring restructuring costs incurred in both years, gross profit increased 1.1% and gross margin rate increased 0.7 percentage points. Selling and Marketing Expense Selling and marketing expense increased 0.2% primarily due to increased compensation expenses and China investigation expenses, partially offset by lower commission expense commensurate with lower revenue, cost containment measures, and the favorable impact of currency translation. Excluding the impact of currency translation, nonrecurring restructuring costs incurred in both fiscal years, and China investigation expenses, selling and marketing expense decreased 0.1%. General and Administrative Expense General and administrative expense increased 21.7% primarily due to China investigation expenses of $8,451 and increased professional and legal fees, partially offset by the favorable impact of currency translation. Excluding the impact of currency translation, nonrecurring restructuring costs incurred in both years, and China investigation expenses, general and administrative expense increased 2.8%. Research and Development Expense R&D expense increased 11.2% primarily due to additional focused R&D spending to meet certain market needs, higher compensation expenses and China investigation expenses. Excluding the impact of currency translation and China investigation expenses, R&D expense increased 10.0%. Income from Operations Income from operations decreased 29.6% primarily due to higher operating expenses which included $9,209 of China investigation expenses and $2,922 of nonrecurring restructuring costs incurred in the current year, partially offset by $847 of nonrecurring restructuring costs incurred in the prior year. Excluding the impact of currency translation, nonrecurring restructuring costs incurred in both fiscal years, and China investigation expenses, income from operations decreased 2.4%. Backlog Backlog of undelivered orders at September 30, 2017 was $311,551, a decrease of 5.9% from backlog of $331,044 at October 1, 2016. Based on anticipated manufacturing schedules, we expect approximately 83% of the backlog as of September 30, 2017 will be converted into revenue during fiscal year 2018. The conversion rate was up from the prior year rate of 78% due to a shift from larger custom orders to shorter cycle, more rapidly turning orders and a push to complete custom orders. Order cancellations in fiscal year 2017 did not have a material effect on backlog. At the end of fiscal year 2016, backlog was negatively impacted by cancellations of custom orders in Test totaling $8,567. Sensors Segment Results of Operations The following table compares results of operations in fiscal years 2017 and 2016 for Sensors, separately identifying the estimated impact of currency translation, the acquisition of PCB for the first three quarters of fiscal year 2017 for comparability, and restructuring expense incurred in fiscal year 2017. The Acquisition / Restructuring column includes revenues and costs from the acquisition of PCB for the first three quarters of fiscal year 2017, including the fair value adjustment to acquired inventory of $7,975, costs incurred as part of the acquisition of PCB, and restructuring expenses incurred in fiscal year 2017. The first three quarters of fiscal year 2016 did not include PCB results since the acquisition closed in the fourth quarter of fiscal year 2016; therefore, the estimated impact of PCB for the first three quarters of fiscal year 2017 is separately identified herein for comparability. Revenue Revenue increased 105.9% primarily due to increased volume as a result of the PCB acquisition. Excluding the impact of currency translation and PCB revenue for the first three quarters of fiscal year 2017, revenue growth was 11.7%. Strong demand in the positional sensors sector, particularly in the heavy industrial markets, and new revenue opportunities in the test sensors sector drove revenue growth. Revenue by geography was as follows: Gross Profit Gross profit increased 116.8% primarily due to gross profit contribution from the PCB acquisition and growth in our positional and test sensors sectors. The gross margin rate increased 2.4 percentage points primarily due to the $7,916 fair value adjustment on acquired inventory in the fourth quarter of the prior year and leverage on increased revenue volume. The increase was partially offset by the gross margin contribution from the PCB acquisition in the first three quarters of fiscal year 2017, which included a $7,975 fair value adjustment on acquired inventory recognized in the first quarter of fiscal year 2017, and additional labor costs from the movement of production in Machida, Japan to the U.S. due to the closure of the Machida manufacturing facility. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, nonrecurring restructuring costs incurred in both fiscal years, and the fair value adjustments on acquired inventory recorded in both fiscal years, gross profit increased 10.7% and the gross margin rate declined 0.4 percentage points. Selling and Marketing Expense Selling and marketing expense increased 117.5% primarily driven by the addition of PCB expenses and higher commission and compensation expenses. Excluding the impact of currency translation, PCB expenses for the first three quarters of fiscal year 2017, and nonrecurring restructuring costs incurred in both fiscal years, selling and marketing expense increased 4.1%. General and Administrative Expense General and administrative expense increased 33.5% primarily driven by the addition of PCB expenses and investments in infrastructure, partially offset by nonrecurring PCB acquisition-related expenses of $11,867 incurred in the prior year. Excluding the impact of currency translation, PCB expenses for the first three quarters of fiscal year 2017, nonrecurring restructuring costs incurred in both fiscal years, and prior year acquisition-related expenses, general and administrative expense increased 4.9%. Research and Development Expense R&D expense increased 98.4% primarily driven by the addition of PCB expenses and continued investments in product development. Excluding the impact of currency translation and PCB expenses for the first three quarters of fiscal year 2017, R&D expense increased 7.0%. Income from Operations Income from operations increased $25,103 primarily due to PCB acquisition-related expenses of $12,514 incurred in the prior year, the contribution of PCB to income from operations, and leverage on increased revenue volume. Excluding the impact of currency translation, PCB expenses for the first three quarters of fiscal year 2017, nonrecurring restructuring costs and acquisition-related expenses incurred in both years, and the fair value adjustment on acquired inventory recorded both fiscal years, income from operations increased $5,224. Backlog Backlog of undelivered orders at September 30, 2017 was $48,465, an increase of 22.8% compared to backlog of $39,479 at October 1, 2016. Fiscal Year 2016 Compared to Fiscal Year 2015 Total Company Results of Operations The following table compares results of operations in fiscal years 2016 and 2015, separately identifying the estimated impact of currency translation, the acquisition of PCB in fiscal year 2016 and restructuring expense incurred in fiscal year 2016. The Acquisition / Restructuring column includes revenues and costs from the acquisition of PCB, costs incurred as part of the acquisition of PCB and restructuring costs (acquisition and restructuring costs). Revenue The increased revenue of 15.3% was driven by higher sales volumes in the Test segment and the PCB acquisition. Excluding the impact of higher sales volume attributable to the PCB acquisition and currency translation, revenue increased 8.1%. Test revenue increased $49,385 or 10.7% due to strong project execution and conversion of backlog, partially offset by a 0.7% unfavorable currency translation. Sensors revenue increased $36,828 or 36.4% driven by contributions from the PCB acquisition, partially offset by a decrease in sales volume in our legacy Sensors business and a 0.4% unfavorable impact of currency translation. Revenue by geography was as follows: Although selective product price changes were implemented during each of these fiscal years, the overall impact of pricing changes did not have a material effect on revenue. Gross Profit Gross profit increased 5.4% due to increased sales volumes and backlog conversion in Test and increased sales volume as a result of three months of profit from the PCB acquisition, partially offset by lower sales volumes in our legacy Sensors business and the unfavorable impact of currency translation. Our gross margin rate decreased by 3.3 percentage points primarily as a result of higher compensation expense from the investment in resources in Test and Sensors, the acquisition of PCB, which included a $7,916 fair value adjustment related to the acquired inventory, and inefficiencies in executing complex projects in Test resulting in higher than expected costs. The decrease was further expanded by unfavorable leverage from lower sales volumes in Sensors due to industrial market weakness across the globe in fiscal year 2016. The decrease was partially offset by an increase in Test revenues. Excluding the impact of currency translation, three months of profit from the acquisition of PCB, and acquisition and restructuring costs, the gross margin rate decreased 2.7 percentage points. Selling and Marketing Expense Selling and marketing expenses increased 14.5% primarily due to three months of expenses from the PCB acquisition, restructuring costs and higher compensation expense in Test, offset by lower compensation expense and cost containment measures in Sensors. Excluding the impact of currency translation, acquisition and restructuring costs, selling and marketing expense increased 3.9%. General and Administrative Expense General and administrative expense increased 34.8% driven by $11,867 of PCB acquisition-related expenses, three months of expenses from the PCB acquisition, restructuring costs and higher professional fees. Excluding the impact of currency translation, PCB acquisition-related expenses, acquisition and restructuring costs, general and administrative expenses increased 3.1%. Research and Development Expense Research and development (R&D) expense increased 6.9% primarily due to higher compensation expense from Test employee headcount additions, three months of expenses from the PCB acquisition and restructuring costs, partially offset by employee headcount reductions and R&D project spending cost containment measures in our legacy Sensors business. Excluding the impact of currency, acquisition and restructuring costs, R&D expenses decreased 3.3%. Income from Operations Income from operations declined 32.1% due to higher gross profit being more than offset by higher operating expenses which included PCB acquisition-related expenses, three months of expenses related to the acquisition of PCB and restructuring costs of $28,807. Excluding the impact of currency translation, acquisition and restructuring costs, income from operations decreased 4.6%. Interest Expense, Net Interest expense, net increased primarily due to interest incurred related the tranche B term loan and the TEUs originated in fiscal year 2016. Interest expense included $5,750 related to the tranche B term loan, $1,389 from amortization of capitalized debt issuance costs, $562 related to the TEUs, $502 from the write-off of capitalized debt issuance costs related to the previous credit facility and $323 of interest expense from borrowings under the previous credit facility. Other Income (Expense), Net The increase in other income (expense), net was primarily driven by sales and use tax refunds and a decrease in the losses on foreign currency transactions. Income Tax Provision (Benefit) The provision for income taxes declined during fiscal year 2016 primarily due to a decrease in income before taxes. The effective tax rate was lower during fiscal year 2016 primarily due to tax benefits from the enactment of legislation on December 18, 2015 that made the U.S. R&D tax credit permanent as of January 1, 2015. Fiscal year 2016 includes a discrete tax benefit of $2,283 related to the reinstatement of the R&D tax credit. The rate was also lower due to a favorable geographic mix of earnings, with foreign income generally taxed at lower rates than domestic income. These benefits were partially offset by nondeductible PCB acquisition-related costs. Fiscal year 2015 included a tax benefit of $1,836 due to the resolution of audit matters in connection with the Internal Revenue Service examination of tax years ended October 1, 2011 and September 29, 2012. We also recognized a tax benefit of $2,098 during fiscal year 2015 due to the enactment of tax legislation on December 19, 2014 that retroactively extended the R&D tax credit. Net Income Net income declined due to higher operating expenses, partially offset by higher gross profit and a lower income tax provision. The year-to-date diluted earnings per share decline was driven by acquisition and restructuring costs, the issuance of common stock and TEUs, higher compensation expense from the investment in resources in Test and Sensors and inefficiencies in executing complex projects in Test. Backlog Backlog of undelivered orders at October 1, 2016 was $370,523, an increase of $17,510 or 5.0%, compared to backlog of $353,013 at October 2, 2015. Test backlog was $331,044 and $339,967 at October 1, 2016 and October 2, 2015, respectively. Sensors backlog was $39,479 and $13,046 at October 1, 2016 and October 2, 2015, respectively. Based on anticipated manufacturing schedules as of October 1, 2016, we estimated approximately 80% of the backlog as of October 1, 2016 would be converted into revenue during fiscal year 2017. The conversion rate was up from the prior year rate of 76% due to a shift from larger custom orders to shorter cycle, quicker turning orders in fiscal year 2016 and the completion of certain custom orders. We believe backlog is not an absolute indicator of future revenue because a portion of the orders in backlog could be canceled at the customer’s discretion. While the backlog is subject to order cancellations, we have not historically experienced a significant number of order cancellations. During fiscal year 2016, one custom order in Test totaling $8,567 was canceled. During fiscal year 2015, two custom orders in Test totaling $8,484 were canceled. These canceled orders were booked in a fiscal year prior to the year in which they were canceled. Test Segment Results of Operations The following table compares results of operations in fiscal years 2016 and 2015 for Test, separately identifying the estimated impact of currency translation and restructuring expense incurred in fiscal year 2016. The acquisition of PCB did not have an impact on the results of operations of Test during fiscal year 2016. Revenue Revenue increased 10.7% primarily due to a focus on project execution, backlog conversion and higher service revenue, partially offset by the unfavorable impact of currency translation. Excluding the impact of currency translation, revenue increased 11.4% as the revenue decline in the Americas region was more than offset by improvements in the Asia and Europe regions. Revenue by geography was as follows: Gross Profit Gross profit increased 3.1% primarily due to increased sales volume. The gross margin rate decreased 2.4 percentage points driven by inefficiencies in executing several large complex projects, resulting in higher than expected costs, increased indirect labor headcount and a higher concentration of custom projects which typically have lower margins and restructuring costs. The decrease was partially offset by an increase in revenue. Selling and Marketing Expense Selling and marketing expense increased 8.1% primarily driven by higher compensation expense, higher commission expense from increased revenue, higher incentive compensation and restructuring costs of $129, partially offset by cost containment measures. Excluding the impact of currency translation and restructuring costs, selling and marketing expense increased 8.9%. General and Administrative Expense General and administrative expense increased 4.1% primarily due to higher professional fees, increased compensation expense and restructuring costs of $414, partially offset by a reduction in legal costs. Excluding the impact of currency translation and restructuring costs, general and administrative expense increased 4.4%. Research and Development Expense R&D expense decreased 0.4% primarily due a reduction in R&D project spending driven by redeployment of resources to certain capitalized engineering projects, partially offset by higher compensation expense. Income from Operations Income from operations decreased 3.8% due to higher compensation expense, inefficiencies in executing complex projects, higher concentration of custom projects and restructuring expenses of $847, partially offset by an increase in revenue. Backlog Backlog of undelivered orders at October 1, 2016 was $331,044, a decrease of 2.6% from backlog of $339,967 at October 2, 2015. Based on anticipated manufacturing schedules as of October 1, 2016, we estimated approximately 78% of the backlog as of October 1, 2016 would be converted into revenue during fiscal year 2017. The conversion rate was up from the prior year rate of 75% due to a shift from larger custom orders to shorter cycle, quicker turning orders in fiscal year 2016 and a push to complete custom orders. As previously mentioned, backlog at the end of fiscal years 2016 and 2015 was negatively impacted by cancellations of custom orders in Test totaling $8,567 and $8,484, respectively. Sensors Segment Results of Operations The following table compares results of operations in fiscal years 2016 and 2015 for Sensors, separately identifying the estimated impact of currency translation, the acquisition of PCB in fiscal year 2016 and restructuring expense incurred in fiscal year 2016. The Acquisition / Restructuring column includes revenues and costs from the acquisition of PCB, costs incurred as part of the acquisition of PCB and restructuring costs (acquisition and restructuring costs). Revenue Revenue increased 36.4% primarily due to increased revenue from sales volume as a result of the acquisition of PCB, partially offset by lower sales volumes in our legacy Sensors business. Excluding the impact of currency translation and the impact of the PCB acquisition, revenue decreased 7.1%. Sensors sales continue to be negatively impacted by industrial market weakness around the globe, specifically in the heavy industrial machine steel, fluid power and oil and gas markets. Revenue by geography was as follows: Gross Profit Gross profit increased 12.1% primarily due to increased sales volumes as a result of the PCB acquisition, partially offset by lower sales volumes in our legacy Sensors business and restructuring costs of $762. The gross margin rate decreased 9.7 percentage points due to the acquisition of PCB, which included a $7,916 fair value adjustment related to the acquired inventory, unfavorable leverage from lower sales volumes and higher indirect labor expense in our legacy Sensors business and restructuring costs. Excluding the impact of currency translation, acquisition and restructuring costs, the gross margin rate declined 1.7 percentage points. Selling and Marketing Expense Selling and marketing expense increased 36.8% primarily driven by three months of expenses from the PCB acquisition and restructuring costs, partially offset by lower compensation expense, reduced travel expense as part of cost containment measures and lower commission expense. Excluding the impact of currency translation, acquisition and restructuring costs, selling and marketing expense decreased 13.6%. General and Administrative Expense General and administrative expense increased 149.2% primarily due to PCB acquisition-related expenses of $11,867, three months of expenses from the acquisition of PCB and restructuring costs. Excluding the impact of currency translation and acquisition and restructuring costs, general and administrative expenses decreased 1.8%. Research and Development Expense R&D expense increased 27.8% primarily driven by three months of expenses from the acquisition of PCB, partially offset by lower compensation from headcount reductions and a decline in R&D project spending as part of cost containment measures. Excluding the impact of currency translation, acquisition and restructuring costs, R&D expense decreased 11.8%. Income from Operations Income from operations declined 94.3% primarily due to PCB acquisition-related expenses of $12,514, loss on operations from PCB and restructuring costs. Excluding the impact of currency translation and acquisition and restructuring costs, income from operations would have decreased 10.5%. Backlog Backlog of undelivered orders at October 1, 2016 was $39,479, an increase of 202.6% compared to backlog of $13,046 at October 2, 2015. The increase in backlog was primarily due to the acquisition of PCB. Cash Flow Comparison - Fiscal Years 2017, 2016 and 2015 Total cash and cash equivalents increased $23,953 for fiscal year 2017. The increase was primarily driven by $35,523 in depreciation and amortization, $25,084 of net income, a $10,785 increase in working capital resulting from general timing of purchases and payments, a $7,975 fair value adjustment related to acquired inventory in connection with the PCB acquisition, $5,600 of stock-based compensation, $5,579 of proceeds from the exercise of stock options and share purchases under our employee stock purchase plan (ESPP) and $4,781 in accrued payroll and related costs. The cash receipts were partially offset by dividend payments of $20,079, investment in property and equipment of $17,798, a decrease in other assets and liabilities of $15,617, $9,127 in deferred income taxes and payments of TEU debt of $8,541. Total cash and cash equivalents increased $33,012 for fiscal year 2016. The increase was primarily due to $440,163 in net proceeds from the issuance of long-term debt, $110,926 in net cash received from the issuance of TEUs, $74,301 in net proceeds from the issuance of common stock, $27,494 of net income and $24,077 in depreciation and amortization. The cash receipts were partially offset by a payment of $580,920, net of cash received, for the acquisition of PCB, $21,343 of net repayments under short-term borrowings, investment in property and equipment of $20,806, purchases of shares of common stock under our share purchase program and stock-based compensation arrangements of $18,414 and dividend payments of $13,932. Total cash and cash equivalents decreased $8,629 for fiscal year 2015. The decrease was primarily due to $50,026 in repayments of short-term borrowings and debt issuance costs, $29,115 in purchases of our common stock, dividend payments of $22,445 and investment in property and equipment of $18,445. The decrease was partially offset by net income of $45,462, $21,106 in depreciation and amortization, $19,040 for decreased working capital requirements, $11,183 received through short-term borrowings, $7,351 in stock-based compensation and $4,847 of proceeds received from the exercise of stock options and share purchases under our ESPP. Cash flows from operating activities provided cash totaling $71,652 during fiscal year 2017 compared to $67,881 during fiscal year 2016 and $100,436 during fiscal year 2015. Fiscal year 2017 cash flow from operating activities was primarily generated from $35,523 of depreciation and amortization,$25,084 in net income, $7,652 decrease in accounts receivable and unbilled accounts receivable resulting from general timing and collections, $7,975 fair value adjustment related to acquired inventory in connection with the PCB acquisition, $5,600 of stock-based compensation and $4,781 increase in accrued payroll and related costs. The cash received was partially offset by $15,617 decrease in other assets and liabilities and a $9,127 decrease in deferred income taxes. Fiscal year 2016 cash flow from operating activities was primarily generated from $27,494 in net income, $24,077 of depreciation and amortization, $9,057 increase in accrued payroll and related costs, $7,916 fair value adjustment related to acquired inventory in connection with the PCB acquisition, $7,224 of stock-based compensation, $5,701 increase in advanced payments from customers due to a focus on early collection efforts, $5,647 increase in accounts payable resulting from general timing of purchases and payments and $3,365 decrease in inventories. The cash received was partially offset by $22,059 increase in accounts and unbilled contracts receivable resulting from general timing and collections and $5,274 in deferred income taxes. Fiscal year 2015 cash flow from operating activities was primarily driven by $45,462 in net income, $21,106 of depreciation and amortization, $13,065 increase in advance payments received from customers driven by the mix of orders, $6,772 increase in accounts payable resulting from general timing of purchases and payments, $3,308 decrease in accounts and unbilled receivables resulting from general timing of billing and collections, partially offset by $4,105 increase in inventories to support future revenue. Cash flows from investing activities required $18,606, $600,212 and $19,112 use of cash during fiscal years 2017, 2016 and 2015, respectively. Fiscal year 2017 cash usage was primarily due to $17,798 in investments in property and equipment to support business growth and a $853 payment related to the acquisition of PCB. Fiscal year 2016 cash usage was due to payments of $580,920, net of cash received, for the acquisition of PCB and $20,806 in investments in property and equipment to support business growth, partially offset by proceeds received from the sale of property and equipment of $1,514. Fiscal year 2015 cash usage was due to $18,445 in investments in property and equipment and payments of $667 associated with the acquisition of Instrument and Calibration Sweden AB (ICS). Cash flows from financing activities used cash of $30,481 in fiscal year 2017, compared to cash provided of $564,479 in fiscal year 2016 and cash used of $84,785 in fiscal year 2015. Cash used in fiscal year 2017 was primarily driven by dividend payments of $20,079, $8,541 in payments of TEU debt and $4,881 of payments of long-term debt, partially offset by $5,579 of proceeds from the exercise of stock options and share purchases under our ESPP. Cash provided in fiscal year 2016 was primarily driven by $440,163 in net proceeds from the issuance of long-term debt, $110,926 in net cash received from the issuance of TEUs, $74,301 in net cash received from the issuance of common stock and $20,000 from receipts under short-term borrowings. These increases were partially offset by $41,343 in repayments of short-term borrowings, $19,837 in payments of debt issuance costs, the purchase of shares of common stock under our share purchase program and stock-based compensation arrangements in an aggregate amount of $18,414, dividend payments of $13,932 and $7,935 related to payments for the Capped Calls purchased in connection with the issuance of the TEUs. Cash was used in fiscal year 2015 to repay $50,026 of short-term borrowings, purchase shares under our share purchase program and stock-based compensation arrangements in an aggregate amount of $29,115 and to pay dividends of $22,445. The usage of cash was partially offset by $11,183 received through short-term borrowings and $4,847 of proceeds received in connection with stock option exercises and share purchases under our ESPP. Liquidity and Capital Resources We had cash and cash equivalents of $108,733 as of September 30, 2017. Of this amount, $33,528 was located in North America, $31,208 in Europe and $43,997 in Asia. Of the $75,205 of cash located outside of North America, approximately $58,234 is not available for use in the U.S. without the incurrence of U.S. federal and state income tax consequences. The North American balance was primarily invested in bank deposits. The balances in Europe and Asia were primarily invested in money market funds and bank deposits. In accordance with our investment policy, we place cash equivalent investments with issuers who have high-quality investment credit ratings. In addition, we limit the amount of investment exposure we have with any particular issuer. Our investment objectives are to preserve principal, maintain liquidity and achieve the best available return consistent with our primary objectives of safety and liquidity. As of September 30, 2017, we held no short-term investments. As of September 30, 2017, our capital structure was comprised of $43,274 in short-term debt, $431,035 in long-term debt and $428,777 in shareholders' equity. The Consolidated Balance Sheet also includes $16,670 of unamortized debt issuance costs. Total interest-bearing debt at September 30, 2017 was $474,309. On July 5, 2016, we entered into a credit agreement with a consortium of financial institutions (the Credit Agreement). The Credit Agreement provides for senior secured credit facilities consisting of a Revolving Credit Facility and a Term Facility. The maturity date of the Revolving Credit Facility is July 5, 2021 and the maturity date of the loans under the Term Facility is July 5, 2023, unless a term loan lender agrees to extend the maturity date pursuant to a loan modification agreement made in accordance with the terms of the Credit Agreement. The Credit Agreement also requires mandatory prepayments on our Term Facility in certain circumstances, including a required prepayment of a certain percentage of our excess cash flow for each fiscal year, beginning with fiscal year 2017. The excess cash flow payment that will be due in the first quarter of fiscal year 2018 based on fiscal year 2017 results is reflected in the contractual obligations chart below as a payment obligation due on long-term debt in less than one year. Under the Credit Agreement, we are subject to customary affirmative and negative covenants, including, among others, restrictions on our ability to incur debt, create liens, dispose of assets, make investments, loans, advances, guarantees and acquisitions, enter into transactions with affiliates, and enter into any restrictive agreements and customary events of default (including payment defaults, covenant defaults, change of control defaults and bankruptcy defaults). The Credit Agreement also contains financial covenants, including the ratio of consolidated total indebtedness to adjusted consolidated earnings before income, taxes, depreciation and amortization (Adjusted EBITDA), as defined in the Credit Agreement, as well as the ratio of Adjusted EBITDA to consolidated interest expense. These covenants restrict our ability to pay dividends and purchase outstanding shares of common stock. As of September 30, 2017 and October 1, 2016, we were in compliance with these financial covenants. Shareholders' equity increased by $23,517 during fiscal year 2017 primarily due to net income of $25,084, other comprehensive income of $9,820, stock-based compensation of $5,620, employee exercise of stock options of $4,559 and employee stock purchases of $1,020. The increase was partially offset by $20,415 in dividends declared and $1,785 in purchases of our common stock. We believe that our liquidity, represented by funds available from cash, cash equivalents, our Revolving Credit Facility and anticipated cash from operations is adequate to fund ongoing operations for our short-term and long-term internal growth opportunities, capital expenditures, dividends and share purchases. Contractual Obligations As of September 30, 2017, our contractual obligations were as follows: Long-term debt includes the tranche B term loan facility (Term Facility) debt and the debt component of the TEUs. The Term Facility amounts due in less than one year consist of the 1% annual payment and the calculated required annual excess cash flow prepayment based on fiscal year 2017 results due in the first quarter of fiscal year 2018. The Term Facility amounts for periods subsequent to less than one year exclude excess cash flow prepayments which may be required under the provisions of the Term Facility based on fiscal year 2018 and subsequent fiscal year results as future prepayment amounts, if any, are not reasonably estimable as of September 30, 2017. Refer to Note 5 and Note 9 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information regarding our financing arrangements and our TEUs. Interest payable on long-term debt includes interest on the Term Facility, the debt component of TEUs and capital lease obligations. Capital lease obligations represent contractual vehicle leases. Refer to Note 1 and Note 5 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information regarding our capital lease obligations. Operating leases are primarily for office space, as well as vehicles and equipment. Refer to Note 14 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional lease information. Other long-term obligations include liabilities under pension and other retirement plans and warehouse fee obligations. Long-term income tax liabilities for uncertain tax positions have been excluded from the contractual obligations table as we are unable to make a reasonably reliable estimate of the amount and period of related future payments. As of September 30, 2017, our long-term liability for uncertain tax positions was $5,849. Refer to Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional income tax information. As of September 30, 2017, we had letters of credit and guarantees outstanding totaling $47,086 and $22,800, respectively, primarily to bond advance payments and performance guarantees related to customer contracts in Test. Off-balance Sheet Arrangements As of September 30, 2017, we did not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Critical Accounting Policies The Consolidated Financial Statements have been prepared in accordance with GAAP, which require us to make estimates and assumptions in certain circumstances that affect amounts reported. The preparation of these financial statements requires us to make estimates and assumptions, giving due consideration to materiality, that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of any contingent assets and liabilities at the date of the financial statements. We regularly review our estimates and assumptions, which are based on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that of our significant accounting policies, the following are particularly important to the portrayal of our results of operations and financial position and are subject to an inherent degree of uncertainty as they may require the application of a higher level of judgment by us. For further information see "Summary of Significant Accounting Policies" under Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Revenue Recognition We are required to comply with a variety of technical accounting requirements in order to achieve consistent and accurate revenue recognition. The most significant area of judgment and estimation is percentage-of-completion contract accounting. We develop cost estimates that include materials, component parts, labor and overhead costs. Detailed costs plans are developed for all aspects of the contracts during the bidding phase. Cost estimates are largely based on actual historical performance of similar projects combined with current knowledge of the projects in progress. Significant factors that impact the cost estimates include technical risk, inflationary cost of materials and labor, changes in scope, and schedule and internal and subcontractor performance. Actual costs incurred during the project phase are monitored and compared to the estimates on a monthly basis. Cost estimates are revised based on changes in circumstances. Anticipated losses on long-term contracts are recognized when such losses become evident. Inventories We maintain a material amount of inventory to support our engineering and manufacturing operations. This inventory is stated at the lower of cost or market. We establish a reserve for excess, slow-moving and obsolete inventory that is equal to the difference between the cost and estimated net realizable value for that inventory. These reserves are based on a regular review and comparison of current inventory levels to planned production, planned and historical sales of the inventory, and expected product lives. It is possible changes to inventory reserves may be required in the future resulting in charges to cost of sales if there is a significant decline in demand for our products and we do not adjust our manufacturing production accordingly. Impairment of Long-lived Assets We review the carrying value of long-lived assets or asset groups, such as property and equipment and intangible assets subject to amortization, when events or changes in circumstances such as asset utilization, physical change, legal factors or other matters indicate that the carrying value may not be recoverable. We review the carrying value of indefinite-lived intangible assets annually or when events or changes in circumstances occur that would indicate that the carrying value may not be recoverable. When this review indicates the carrying value of an asset or asset group exceeds the sum of the undiscounted cash flows expected to result from the use and eventual disposition of the asset or asset group, we recognize an asset impairment charge against income from operations. The amount of the impairment loss recorded is the amount by which the carrying value of the impaired asset or asset group exceeds its fair value. Goodwill Goodwill represents the excess of cost over the fair value of the identifiable net assets of businesses acquired and allocated to our reporting units at the time of acquisition. Goodwill is tested for impairment annually and when an event occurs or circumstances change that indicate the carrying value of the reporting unit may not be recoverable. Evaluating goodwill for impairment involves the determination of the fair value of each reporting unit in which goodwill is recorded using a qualitative o quantitative analysis. A reporting unit is an operating segment or a component of an operating segment for which discrete financial information is available and reviewed by management on a regular basis. Prior to completing the quantitative analysis described below, we have the option to perform a qualitative assessment of goodwill for impairment to determine whether it is more likely than not (i.e. a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, including goodwill and other intangible assets. If we conclude the fair value is more likely than not less than the carrying value, we perform the quantitative analysis. Otherwise, no further testing is needed. If the quantitative analysis is required, the impairment test is used to compare the calculated fair value of each reporting unit to its carrying value, including goodwill. We estimate the fair value of a reporting unit using both the income approach and the market approach. The income approach uses a discounted cash flow model that requires input of certain estimates and assumptions requiring judgment, including projections of economic conditions and customer demand, revenue and margins, changes in competition, operating costs and new product introductions. The market approach uses a multiple of earnings and revenue based on guidelines for publicly traded companies. Fair value calculations contain significant judgments and estimates. If the fair value exceeds the carrying value, no further work is required and no impairment loss is recognized. If the carrying value exceeds the fair value, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. We performed our annual test of goodwill impairment during the fourth quarter of fiscal year 2017. As of September 30, 2017, we determined there was no impairment of our goodwill. While we believe the estimates and assumptions used in determining the fair value of our reporting units are reasonable, significant changes in estimates of future cash flows, such as those caused by unforeseen events or changes in market conditions, could materially impact the fair value of a reporting unit which could result in the recognition of a goodwill impairment charge. See Note 1 and Note 2 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Software Development Costs We incur costs associated with the development of software to be sold, leased or otherwise marketed. Software development costs are expensed as incurred until technological feasibility has been established, at which time future costs incurred are capitalized until the product is available for general release to the public. A certain amount of judgment and estimation is required to assess when technological feasibility is established, as well as the ongoing assessment of the recoverability of capitalized costs. In evaluating the recoverability of capitalized software costs, we compare expected product performance utilizing forecasted revenue amounts to the total costs incurred to date and estimates of additional costs to be incurred. If revised forecasted product revenue is less than and/or revised forecasted costs are greater than the previously forecasted amounts, the net realizable value may be lower than previously estimated, which could result in the recognition of an impairment charge in the period in which such a determination is made. Warranty Obligations We are subject to warranty obligations on sales of our products. We record general warranty provisions based on an estimated warranty expense percentage applied to current period revenue. The percentage applied reflects our historical warranty claims experience over the preceding 12-month period. Both the experience percentage and the warranty liability are evaluated on an ongoing basis for adequacy. In addition, warranty provisions are also recognized for certain nonrecurring product claims that are individually significant. A certain amount of judgment is required in determining appropriate reserve levels for anticipated warranty claims. While these reserve levels are based on our historical warranty claims experience, they may not reflect the actual claims that will occur over the upcoming warranty period and additional warranty reserves may be required. Income Taxes We record a tax provision for the anticipated tax consequences of the reported results of operations. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those deferred tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. We believe it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining net realizable value of its deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our financial condition and operating results. See Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on income taxes. Business Acquisitions We account for acquired businesses using the acquisition method of accounting which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. The judgments made in determining the estimated fair value assigned to each class of assets acquired and liabilities assumed, as well as asset lives, can materially impact net income. Accordingly, for significant items, we typically obtain assistance from a third-party valuation firm. There are several methods that can be used to determine the fair value of assets acquired and liabilities assumed in a business combination. For intangible assets, we historically have utilized the "income method." This method starts with a forecast of all of the expected future net cash flows attributable to the subject intangible asset. These cash flows are then adjusted to present value by applying an appropriate discount rate that reflects the risk factors associated with the cash flow streams. Some of the more significant estimates and assumptions inherent in the income method (or other methods) include the projected future cash flows (including timing) and the discount rate reflecting the risks inherent in the future cash flows. Estimating the useful life of an intangible asset also requires judgment. For example, different types of intangible assets will have different useful lives, influenced by the nature of the asset, competitive environment and rate of change in the industry. Certain assets may even be considered to have indefinite useful lives. All of these judgments and estimates can significantly impact the determination of the amortization period of the intangible asset, and thus net income. In connection with the acquisition of PCB consummated in fiscal year 2016, the final valuation of assets acquired and liabilities assumed was completed during the third quarter of fiscal year 2017. Recently Issued Accounting Pronouncements Information regarding new accounting pronouncements is included in "Recently Issued Accounting Pronouncements" under Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Quarterly Financial Information Revenue and operating results reported on a quarterly basis do not necessarily reflect trends in demand for our products or our operating efficiency. Revenue and operating results in any quarter may be significantly affected by customer shipments, installation timing or the timing of the completion of one or more contracts where revenue is recognized upon shipment or customer acceptance rather than on the percentage-of-completion method of revenue recognition. Our use of the percentage-of-completion revenue recognition method for large, long-term projects generally has the effect of minimizing significant fluctuations quarter-over-quarter. See Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our revenue recognition policy. Quarterly earnings also vary as a result of the use of estimates including, but not limited to, the rates used in recording federal, state and foreign income tax expense. See Note 1 and Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our use of estimates and income tax related matters, respectively. Selected quarterly financial information was as follows: In the fourth quarter of fiscal year 2016, we recorded out-of-period adjustments that increased net income in the fourth quarter by $968. The adjustments relate to prior quarters in fiscal years 2016 and 2015. We have evaluated the out-of-period adjustments and have determined that they are not material to our financial position or results of operations for any quarterly period in fiscal years 2016 or 2015. The earnings per share amounts for each quarter may not sum to the fiscal year amounts due to rounding and the effect of weighting. Forward-looking Statements Statements contained in this Annual Report on Form 10-K including, but not limited to, the discussion under Item 7 of Part II, Management's Discussion and Analysis of Financial Condition and Results of Operations, that are not statements of historical fact are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the Act). In addition, certain statements in our future filings with the SEC, in press releases, and in oral and written statements made by us or with our approval that are not statements of historical fact constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenue, ROIC, EBITDA, income or loss, earnings or loss per share, the payment or nonpayment of dividends, capital structure, the adequacy of our liquidity and reserves, the anticipated level of expenditures required and other statements concerning future financial performance; (ii) statements of our plans and objectives by our management or Board of Directors, including those relating to products or services, merger or acquisition activity and the potential impact of newly acquired businesses; (iii) statements of assumptions underlying such statements; (iv) statements regarding business relationships with vendors, customers or collaborators or statements relating to our order cancellation history, our ability to convert our backlog of undelivered orders into revenue, the timing of purchases, competitive advantages and growth in end markets; (v) statements relating to the potential business and financial impact that the findings of our completed investigation in China may have on our financial condition, results of operations and internal controls; (vi) statements regarding our ability to report additional operating segments, to raise capital in a timely manner or to complete acquisitions in the future; and (vii) statements regarding products, their characteristics, fluctuations in the costs of raw materials for products, our geographic footprint, performance, sales potential or effect in the hands of customers. Words such as "believes," "anticipates," "expects," "intends," "targeted," "should," "potential," "goals," "strategy," and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, those described in Item 1A of Part I, Risk Factors, of this Annual Report on Form 10-K. The performance of our business and our securities may be adversely affected by these factors and by other factors common to other businesses and investments, or to the general economy. Forward-looking statements are qualified by some or all of these risk factors. Therefore, you should consider these forward-looking statements with caution and form your own critical and independent conclusions about the likely effect of these risk factors on our future performance. Forward-looking statements speak only as of the date on which statements are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made to reflect the occurrence of unanticipated events or circumstances. Readers should carefully review the disclosures and the risk factors described in this and other documents we file from time to time with the SEC, including our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.

<s>[INST] Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in nine sections: Overview Financial Results Cash Flow Comparison Liquidity and Capital Resources Offbalance Sheet Arrangements Critical Accounting Policies Recently Issued Accounting Pronouncements Quarterly Financial Information Forwardlooking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8 of Part II of this Annual Report on Form 10K. All dollar amounts are in thousands unless otherwise noted. Overview MTS Systems Corporation is a leading global supplier of high performance test systems and sensors. Our testing hardware and software solutions help customers accelerate and improve design, development and manufacturing processes and are used for determining the mechanical behavior of materials, products and structures. Our high performance sensors provide controls for a variety of applications measuring acceleration, position, vibration, motion, pressure, force and sound. Our goal is to sustain profitable enterprise growth, consistently generate strong cash flow and deliver a strong return on invested capital to our shareholders by leveraging our leadership position in the research and development and industrial global end markets for highperformance test systems and sensors. Our desire is to be the innovation leader in creating test and measurement solutions and to provide total customer satisfaction. We believe we can create value for our customers by helping to enhance the precision, improve the reliability and create superior safety for their products, while reducing the delivery time to market for their products. Our competitive advantages include our proprietary technology and advanced application expertise, our expansive global footprint with longterm customer relationships, our large installed base of testing equipment and our expanded presence in the rapidly growing sensors market. We believe these competitive advantages position us well in both the test and sensors markets to deliver profitable growth in the years ahead. We are working toward our goals of sustained five to seven percent growth in annual revenue; three to four points of expanded earnings before interest, taxes, depreciation and amortization (EBITDA); and midteens for return on invested capital (ROIC). We believe the growth in our end markets, combined with four primary opportunities we are currently pursuing, will support these goals: Realize growth within the rapidly expanding Sensors market through an increase in our global market share and new product development; Expand Test services offerings into our large installed base of Test equipment; Capitalize on growth opportunities in the Test materials sector spurred by new manufacturing processes, focus on lightweight materials in aerospace and ground vehicle markets, and trends in energy exploration; and Adapt our industryleading ground vehicle testing applications to align with emerging trends in vehicle electrification, autonomous vehicles, and simulation. We believe that our business model supports our growth objectives, provided that we continue to move aggressively to build our infrastructure, expand our offerings and execute on opportunities with our key customers around the world. In order to accelerate our revenue growth over the next five years, investments in infrastructure, sales support and field service capacity and capability are essential. Fiscal Year We have a 544 week, quarterly accounting cycle with the fiscal year ending on the Saturday closest to September 30. Fiscal years 2017, 2016 and 2015 ended September 30, 2017, October 1, 2016 and October 3, 2015, respectively. Fiscal years 2017, 2016 and 2015 include 52, 52 and 53 weeks, respectively. Debt Repricing In the fourth quarter of fiscal year 2017, we completed the repricing of our $455,400 tranche B term loan facility to reduce the applicable rate by 100 basis points. We also repriced our revolving credit facility of up to $120,000 to reduce the applicable rate by 100 basis points and make certain reductions to the commitment fee rates. Currently, there are no borrowings against the revolving credit facility. See Note [/INST] Negative. </s>

MTS SYSTEMS CORP

2018-11-26

2018-09-29

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in nine sections: • Overview • Financial Results • Cash Flow Comparison • Liquidity and Capital Resources • Off-balance Sheet Arrangements • Critical Accounting Policies • Recently Issued Accounting Pronouncements • Quarterly Financial Information • Forward-looking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8 of Part II of this Annual Report on Form 10-K. All dollar amounts are in thousands unless otherwise noted. Overview MTS Systems Corporation's testing hardware, software and service solutions help customers accelerate and improve their design, development and manufacturing processes and are used for determining the mechanical behavior of materials, products and structures. Our high-performance sensors provide measurements of vibration, pressure, position, force and sound in a variety of applications. Further globalization and expansion of many industries along with growth in emerging markets, such as China and India, provide a strong and vibrant market base from which we can grow revenue. We have aligned our organizational structure to be more flexible to the demands of globalized and volatile markets by adjusting our structure to be more cost effective and nimble in responding to our customers' needs. We are looking ahead to delivering distinctive business performance through our commitment to sustain the differentiated competitive advantage that comes from offering an innovative portfolio of Test and Sensor solutions that create value for customers and are delivered with total customer satisfaction. Fiscal Year We have a 5-4-4 week, quarterly accounting cycle with the fiscal year ending on the Saturday closest to September 30. Fiscal years 2018, 2017 and 2016 ended September 29, 2018, September 30, 2017 and October 1, 2016, respectively. Fiscal years 2018, 2017 and 2016 all include 52 weeks. Tax Cuts and Jobs Act The Tax Cuts and Jobs Act (the Tax Act) was signed into law on December 22, 2017. The Tax Act made numerous changes to U.S. federal corporate tax law and reduced our effective tax rate for fiscal year 2018 and future periods. Effective January 1, 2018, the Tax Act lowers the U.S. corporate tax rate from 35% to 21% and prompts various other changes to U.S. federal corporate tax law, including the establishment of a territorial-style system for taxing foreign-source income of domestic multinational corporations. We have completed our initial analysis to quantify the tax impacts of the Tax Act and have recorded the estimated impact in our fiscal year 2018 results. See Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for further discussion of the impact of the Tax Act. Restructuring Initiatives In fiscal year 2018, we initiated a Test workforce reduction intended to increase organizational effectiveness and provide cost savings. As a result, during the fourth quarter of fiscal year 2018, we recorded $880 of pre-tax severance and related expense. During the fourth quarter of fiscal year 2017, we initiated a series of Test workforce reductions and facility closures intended to increase organizational effectiveness, gain manufacturing efficiencies and provide cost savings that can be reinvested in our growth initiatives. These actions include the transfer of certain production operations in China to a contract manufacturing partner throughout fiscal years 2018 and 2019. As a result, in fiscal year 2018, we recorded $1,550 of pre-tax severance and related expense, and $269 of pre-tax facility closure costs. In fiscal year 2017, we recorded $2,899 of pre-tax severance and related expense and $23 of pre-tax facility closure costs. See Note 12 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for further discussion of restructuring initiatives. Foreign Currency Approximately 70% of our revenue has historically been derived from customers outside of the U.S. Our financial results are principally exposed to changes in exchange rates between the U.S. dollar and the Euro, the Japanese yen and the Chinese yuan. A change in foreign exchange rates could positively or negatively affect our reported financial results. The discussion below quantifies the impact of foreign currency translation on our financial results for the periods discussed. Financial Results Fiscal Year 2018 Compared to Fiscal Year 2017 Total Company Results of Operations The following table compares results of operations in fiscal years 2018 and 2017, separately identifying the estimated impact of currency translation and restructuring expenses incurred in fiscal year 2018. See Note 12 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on restructuring and related costs. In the fourth quarter of fiscal year 2016, we completed the acquisition of PCB Group, Inc. (PCB). As a result of the PCB acquisition, we incurred certain non-recurring costs during fiscal year 2017 including acquisition integration costs and a fair value adjustment on acquired PCB inventory (PCB acquisition inventory adjustment). The decrease in revenue of 1.3% was primarily driven by lower Test revenue, partially offset by growth in our Sensors business and the favorable impact of currency translation. Test revenue decreased $39,163 or 7.8% primarily driven by a decline in equipment volume resulting from weakness in the ground vehicles sector that continues to operate in a rapidly changing environment. Current year Test revenue was also impacted by custom project backlog which takes longer to convert to revenue and lower order volume in the first half of fiscal year 2018. This was partially offset by the favorable impact of currency translation, growth in Test service revenue and continued growth in the Test materials sector. Sensors revenue increased $30,401 or 10.7% primarily driven by continued growth in the Sensors position sector and broad demand across the remaining Sensors sectors, along with continued momentum from new revenue opportunities in the Sensors test sector and the favorable impact of currency translation. Excluding the impact of currency translation, revenue decreased 3.4%. Sales momentum in Europe was more than offset by decline in Asia primarily driven by weakness in the Test ground vehicles sector. Gross profit increased 1.1% primarily driven by increased Sensors revenue volume and the prior year PCB acquisition inventory adjustment of $7,975, as well as the favorable impact of currency translation, partially offset by reduced Test revenue volume. Gross margin rate increased 0.9 percentage points primarily due to the prior year PCB acquisition inventory adjustment and leverage on increased Sensors revenue volume, partially offset by the lower contribution from product mix and unfavorable leverage on lower Test revenue volume. Excluding the impact of currency translation, the prior year PCB acquisition inventory adjustment, prior year PCB acquisition integration expenses and restructuring costs incurred in both fiscal years, gross profit declined 3.8% and the gross margin rate was flat. Selling and marketing expenses increased 1.1% primarily driven by the unfavorable impact of currency translation and increased compensation and commission expense in Sensors, partially offset by lower commission expense and cost containment measures in Test. Excluding the impact of currency translation, prior year PCB acquisition integration expenses, prior year China investigation expenses, and restructuring costs incurred in both fiscal years, selling and marketing expense was flat. General and administrative expense decreased 9.5% primarily due to prior year China investigation expenses of $8,451, prior year PCB acquisition integration expenses of $3,039 and decreased compensation expense in Sensors, partially offset by an increase in professional fees and the unfavorable impact of currency translation. Excluding the impact of currency translation, prior year PCB acquisition integration expenses, prior year China investigation expenses and restructuring costs incurred in both fiscal years, general and administrative expense increased 3.4%. Research and development (R&D) expense decreased 0.6% primarily due to lower compensation expense in Test and prior year focused R&D spending to meet certain Test market needs, partially offset by continued investment in product development in Sensors. Excluding the impact of currency translation, prior year China investigation expenses and current year restructuring costs, R&D expense decreased 2.2%. Income from operations increased 18.9% primarily driven by leverage on volume growth in Sensors, prior year China investigation expenses of $9,209, the prior year PCB acquisition inventory adjustment of $7,975 and prior year non-recurring PCB acquisition integration expenses of $3,577. The increase was partially offset by the lower gross margin contribution from unfavorable leverage on lower Test revenue volume and overall product mix. Excluding the impact of currency translation, the prior year PCB acquisition inventory adjustment, prior year non-recurring PCB acquisition integration expenses, prior year China investigation expenses and restructuring costs incurred in both fiscal years, income from operations decreased 16.9%. Interest expense decreased primarily due to reduced interest rates on the tranche B term loan facility as a result of the debt repricing completed in the fourth quarter of fiscal year 2017, lower current year average debt outstanding and current year gains on interest rate swaps. The increase in other income (expense), net was primarily driven by the gain on the sale of one of our China manufacturing facilities and a relative decrease in losses on foreign currency transactions. The effective tax rate decreased primarily due to certain discrete benefits of $25,008 from the estimated impact of the Tax Act, including $31,647 of estimated benefit from the remeasurement of our estimated net deferred tax liabilities, partially offset by $6,639 of estimated expense associated with the mandatory deemed repatriation tax. Fiscal year 2017 included certain discrete benefits of $2,801 which consisted of additional U.S. tax benefits for prior fiscal years associated with domestic manufacturing, deductible PCB acquisition-related expenses and U.S. R&D tax credit. Excluding the impact of these discrete benefits, the effective tax rate for fiscal years 2018 and 2017 would have been 17.9% and 3.2%, respectively. The increase in the effective tax rate was primarily due to higher earnings before taxes, partially offset by the lower U.S. corporate tax rate under the Tax Act. Net income increased due to a reduction in the effective tax rate driven by discrete benefits stemming from the Tax Act, as well as lower operating expenses and increased gross profit. Backlog Backlog of undelivered orders as of September 29, 2018 was $415,155, an increase of $55,139 or 15.3%, compared to backlog of $360,016 as of September 30, 2017. Based on anticipated manufacturing schedules, we expect approximately 87% of the backlog as of September 29, 2018 will be converted into revenue during fiscal year 2019. The expected conversion rate is relatively flat compared to the prior year rate of 85%. We believe backlog is not an absolute indicator of future revenue because a portion of the orders in backlog could be canceled at the customer's discretion. While certain contracts within backlog are subject to order cancellation, we have not historically experienced a significant number of order cancellations. During fiscal year 2018, order cancellations did not have a material effect on backlog. Test Segment Results of Operations The following table compares results of operations in fiscal years 2018 and 2017 for Test, separately identifying the estimated impact of currency translation and restructuring expenses incurred in fiscal year 2018. See Note 11 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our operating segments. Revenue decreased 7.8% primarily driven by a decline in equipment volume resulting from weakness in the ground vehicles sector that continues to operate in a rapidly changing environment. Current year Test revenue was also impacted by custom project backlog which takes longer to convert to revenue and lower order volume in the first half of fiscal year 2018. This was partially offset by the favorable impact of currency translation, growth in service revenue and continued growth in the materials sector. Excluding the impact of currency translation, revenue decreased 9.6%. Sales momentum in Europe was more than offset by declines in Asia and the Americas primarily driven by weakness in the ground vehicles sector. Gross profit decreased 11.3% primarily due to lower equipment volume. The gross margin rate decreased by 1.3 percentage points primarily driven by unfavorable leverage on lower revenue volume and the lower contribution from product mix, partially offset by the impact of lower compensation expense and restructuring costs. Excluding the impact of currency translation and restructuring costs incurred in both fiscal years, gross profit declined 12.7% and gross margin rate declined 1.2 percentage points. Selling and marketing expense decreased 1.3% primarily due to a decrease in commission expense and cost containment measures, partially offset by the unfavorable impact of currency translation. Excluding the impact of currency translation, prior year China investigation expenses and restructuring costs incurred in both fiscal years, selling and marketing expense decreased 2.5%. General and administrative expense decreased 13.1% primarily due to prior year China investigation expenses of $8,451, partially offset by the unfavorable impact of currency translation. Excluding the impact of currency translation, prior year China investigation expenses and restructuring costs incurred in both fiscal years, general and administrative expense increased 2.8%. R&D expense decreased 10.6% primarily due to prior year focused R&D spending to meet certain Test market needs and lower compensation expense. Excluding the impact of currency translation, prior year China investigation expenses and current year restructuring costs, R&D expense decreased 12.4%. Income from operations decreased 32.8% primarily due to the decrease in gross profit driven by the decline in equipment volume resulting from weakness in the ground vehicles sector and the lower contribution from product mix. The decrease was partially offset by prior year China investigation expenses of $9,209, lower compensation expense and prior year focused R&D spending to meet certain Test market needs. Excluding the impact of currency translation, prior year China investigation expenses and restructuring costs incurred in both fiscal years, income from operations decreased 46.3%. Backlog Backlog of undelivered orders at September 29, 2018 was $346,006, an increase of 11.1% from backlog of $311,551 at September 30, 2017. Based on anticipated manufacturing schedules, we expect approximately 85% of the backlog as of September 29, 2018 will be converted into revenue during fiscal year 2019. The expected conversion rate is relatively flat compared to the prior year rate of 83%. Order cancellations in fiscal year 2018 did not have a material effect on backlog. Sensors Segment Results of Operations The following table compares results of operations in fiscal years 2018 and 2017 for Sensors, separately identifying the estimated impact of currency translation and restructuring expenses incurred in fiscal year 2018. See Note 11 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our operating segments. Revenue increased 10.7% primarily driven by continued growth in the Sensors position sector and broad demand across the remaining Sensors sectors, along with continued momentum from new revenue opportunities in the Sensors test sector and the favorable impact of currency translation. Strong demand in the Sensors position sector, particularly in the heavy industrial markets, and new revenue opportunities in the Sensors test sector from advanced technology sensors to be used in systems for the U.S. Department of Defense drove revenue growth. Excluding the impact of currency translation, revenue growth was 8.0%. Gross profit increased 16.8% primarily due to increased revenue volume, the prior year PCB acquisition inventory adjustment of $7,975 and the favorable impact of currency translation, partially offset by an increase in compensation expense. The gross margin rate increased 2.5 percentage points primarily driven by the prior year PCB acquisition inventory adjustment and favorable leverage on increased revenue volume, partially offset by the lower gross margin contribution from product mix. Excluding the impact of currency translation, the prior year PCB acquisition inventory adjustment, prior year non-recurring PCB acquisition integration expenses and prior year restructuring costs, gross profit increased 7.0% and the gross margin rate declined 0.4 percentage points. Selling and marketing expense increased 4.2% primarily driven by the unfavorable impact of currency translation, increased compensation expense and increased commission expense on higher revenue volume. Excluding the impact of currency translation, prior year PCB acquisition integration expenses and restructuring costs incurred in both fiscal years, selling and marketing expense increased 2.8%. General and administrative expense declined 4.4% primarily driven by prior year PCB acquisition integration expenses of $3,039 and decreased compensation expense, partially offset by an increase in professional fees. Excluding the impact of currency translation, prior year PCB acquisition integration expenses and prior year restructuring costs, general and administrative expense increased 4.1%. R&D expense increased 11.8% primarily driven by continued investment in product development. Excluding the impact of currency translation, R&D expense increased 10.3%. Income from operations increased 75.5% primarily driven by leverage on increased revenue volume, the prior year PCB acquisition inventory adjustment of $7,975, prior year PCB acquisition integration expenses of $3,577 and the favorable impact of currency translation. The increase was partially offset by an increase in professional fees, higher compensation and commission expense and investments in product development. Excluding the impact of currency translation, the prior year PCB acquisition inventory adjustment, prior year PCB acquisition integration expenses and restructuring costs incurred in both fiscal years, income from operations increased 14.0%. Backlog Backlog of undelivered orders at September 29, 2018 was $69,149, an increase of 42.7% compared to backlog of $48,465 at September 30, 2017. We generally expect Sensors backlog to convert to revenue in less than one year. Fiscal Year 2017 Compared to Fiscal Year 2016 Total Company Results of Operations The following table compares results of operations in fiscal years 2017 and 2016, separately identifying the estimated impact of currency translation, the acquisition of PCB for the first three quarters of fiscal year 2017 for comparability, and restructuring expenses incurred in fiscal year 2017. The Acquisition / Restructuring column includes revenues and costs from the acquisition of PCB for the first three quarters of fiscal year 2017, including the PCB acquisition inventory adjustment, costs incurred as part of the acquisition of PCB, and restructuring expenses incurred in fiscal year 2017. The first three quarters of fiscal year 2016 did not include PCB results since the acquisition closed in the fourth quarter of fiscal year 2016; therefore, the estimated impact of PCB for the first three quarters of fiscal year 2017 is separately identified herein for comparability. The increase in revenue of 21.2% was driven by the PCB acquisition and overall growth in our Sensors business, partially offset by a decrease in Test primarily due to the unfavorable impact of currency translation. Test revenue decreased $8,178 or 1.6% primarily driven by lower orders in the last half of fiscal year 2016 and the first half of fiscal year 2017. Sensors revenue increased $145,986 or 105.9% primarily driven by the PCB acquisition and overall growth in our Sensors business. Excluding the impact of currency translation and the contribution of PCB for the first three quarters of fiscal year 2017, revenue increased 1.8%. Although selective product price changes were implemented during each of these fiscal years, the overall impact of pricing changes did not have a material effect on revenue. Gross profit increased 30.6% primarily due to the gross profit contribution from the PCB acquisition, higher revenue volume in Sensors, and a continued focus on Test project execution, partially offset by reduced Test revenue volume. Gross margin rate increased 2.8 percentage points primarily due to the gross profit contribution from the PCB acquisition, the PCB acquisition inventory adjustment in the fourth quarter of fiscal year 2016 of $7,916, and a continued focus on Test project execution, partially offset by the PCB acquisition inventory adjustment in the first quarter of fiscal year 2017 of $7,975, nonrecurring restructuring costs incurred in the current year of $3,140, and higher compensation expenses. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, nonrecurring restructuring costs incurred in both fiscal years, and the PCB acquisition inventory adjustment recorded in both fiscal years, gross profit increased 3.9% and the gross margin rate increased 0.8 percentage points. Selling and marketing expenses increased 31.5% primarily due to the addition of PCB expenses, higher commission and compensation expenses, and China investigation expenses. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, nonrecurring restructuring costs incurred in both fiscal years, and China investigation expenses, selling and marketing expense increased 1.0%. General and administrative expense increased 26.3% primarily due to the addition of PCB expenses, China investigation expenses of $8,451, higher professional and legal fees, and increased compensation expenses, partially offset by nonrecurring PCB acquisition-related expenses of $11,867 incurred in fiscal year 2016. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, nonrecurring restructuring costs incurred in both years, and China investigation expenses, general and administrative expense increased 3.3%. R&D expense increased 38.1% primarily due to the addition of PCB expenses, focused R&D spending to meet certain Test market needs, and continued investments in Sensors product development. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, and China investigation expenses, R&D expenses increased 9.1%. Income from operations increased 31.3% primarily due to the contribution of PCB to income from operations, nonrecurring PCB acquisition-related expenses of $12,514 incurred in fiscal year 2016, leverage on higher revenue volume in our Sensors business, improved Test gross margin driven by a continued focus on project execution, and nonrecurring restructuring costs of $2,165 incurred in fiscal year 2016, partially offset by China investigation expenses of $9,209 and nonrecurring restructuring costs of $4,079 incurred in fiscal year 2017. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, nonrecurring restructuring costs and acquisition-related expenses incurred in both years, the PCB acquisition inventory adjustment recorded in both fiscal years, and China investigation expenses, income from operations increased 6.5%. The increase in interest expense is due to a full year of interest expense recognized in fiscal year 2017 on the debt incurred to finance the acquisition of PCB. Fiscal year 2017 interest expense, net included $23,643 interest expense for the tranche B term loan facility, $3,863 amortization of capitalized debt issuance costs, and $1,521 interest expense for TEU debt. As a result of the repricing of the tranche B term loan facility in the fourth quarter of fiscal year 2017, fiscal year 2017 interest expense, net also included $1,147 repricing costs and $503 in non-cash charges for the loss on debt extinguishment resulting from the write-off of existing unamortized debt financing costs. Fiscal year 2016 interest expense, net included $5,750 interest expense for the tranche B term loan facility, $1,389 amortization of capitalized debt issuance costs, $562 interest expense for TEU debt, $502 in non-cash charges for the loss on debt extinguishment from the write-off of existing capitalized debt issuance costs related to the revolving credit facility, and $323 of interest expense on the revolving credit facility. The decrease in other income (expense), net was primarily driven by fiscal year 2017 losses on foreign currency transactions. The provision for income taxes declined during fiscal year 2017 primarily due to a decrease in income before taxes. The effective tax rate was lower during fiscal year 2017 primarily due to certain discrete benefits of $2,801 recognized during the third quarter of fiscal year 2017, which consisted of additional U.S. tax benefits for prior fiscal years associated with domestic manufacturing, deductible PCB acquisition-related expenses, and the U.S. R&D tax credit. Excluding the impact of these discrete benefits, the effective tax rate for fiscal year 2017 was 3.2%, and declined compared to fiscal year 2016 due to lower income before taxes and a more favorable geographic mix of earnings. The effective tax rate of 18.0% during fiscal year 2016 included a $2,283 discrete tax benefit for retroactive reinstatement of the U.S. R&D tax credit, which was partially offset by a one-time tax cost of $1,834 associated with nondeductible PCB acquisition-related expenses. Excluding the impact of these items, the effective tax rate for fiscal year 2016 was 19.3%. Net income declined due to higher operating expenses and increased interest expense, partially offset by higher gross profit and the fiscal year 2017 tax benefit resulting primarily from nonrecurring discrete items. Diluted earnings per share was negatively impacted by increased interest expense, higher amortization expense related to the PCB acquisition, and the issuance of common stock and TEUs in fiscal year 2016, partially offset by increased income from operations and the fiscal year 2017 tax benefit. Backlog Backlog of undelivered orders at September 30, 2017 was $360,016, a decrease of $10,507 or 2.8%, compared to backlog of $370,523 at October 1, 2016. Based on anticipated manufacturing schedules as of September 30, 2017, we estimated approximately 85% of the backlog as of September 30, 2017 would be converted into revenue during fiscal year 2018. The estimated conversion rate was up from the prior year rate of 80% due to a shift in Test backlog composition from larger custom orders to shorter cycle, more rapidly turning orders and the completion of certain custom orders. We believe backlog is not an absolute indicator of future revenue because a portion of the orders in backlog could be canceled at the customer's discretion. While certain contracts within backlog are subject to order cancellation, we have not historically experienced a significant number of order cancellations. During fiscal year 2017, order cancellations did not have a material effect on backlog. During fiscal year 2016, one custom order in Test totaling $8,567 was canceled. This canceled order was booked in a fiscal year prior to the year in which it was canceled. Test Segment Results of Operations The following table compares results of operations in fiscal years 2017 and 2016 for Test, separately identifying the estimated impact of currency translation and restructuring expenses incurred in fiscal year 2017. The Acquisition / Restructuring column includes restructuring expenses incurred in fiscal year 2017. The acquisition of PCB did not have an impact on Test results of operations during fiscal year 2017. Revenue decreased 1.6% primarily due to lower orders in the last half of fiscal year 2016 and the first half of fiscal year 2017 and the unfavorable impact of currency translation, partially offset by a continued focus on project execution and growth in service revenue. Excluding the impact of currency translation, revenue decreased 0.8%. Sales momentum in the Americas was offset by declines in Europe and Asia primarily driven by automotive manufacturers. Gross profit decreased 0.5%. The gross margin rate increased by 0.4 percentage points primarily due a continued focus on project execution and effective cost containment, partially offset by higher compensation expenses, nonrecurring restructuring costs incurred in fiscal year 2017, and investment in product performance. Excluding the impact of currency translation and nonrecurring restructuring costs incurred in both years, gross profit increased 1.1% and gross margin rate increased 0.7 percentage points. Selling and marketing expense increased 0.2% primarily due to increased compensation expenses and China investigation expenses, partially offset by lower commission expense commensurate with lower revenue, cost containment measures, and the favorable impact of currency translation. Excluding the impact of currency translation, nonrecurring restructuring costs incurred in both fiscal years, and China investigation expenses, selling and marketing expense decreased 0.1%. General and administrative expense increased 21.7% primarily due to China investigation expenses of $8,451 and increased professional and legal fees, partially offset by the favorable impact of currency translation. Excluding the impact of currency translation, nonrecurring restructuring costs incurred in both years, and China investigation expenses, general and administrative expense increased 2.8%. R&D expense increased 11.2% primarily due to additional focused R&D spending to meet certain market needs, higher compensation expenses and China investigation expenses. Excluding the impact of currency translation and China investigation expenses, R&D expense increased 10.0%. Income from operations decreased 29.6% primarily due to higher operating expenses which included $9,209 of China investigation expenses and $2,922 of nonrecurring restructuring costs incurred in fiscal year 2017, partially offset by $847 of nonrecurring restructuring costs incurred in fiscal year 2016. Excluding the impact of currency translation, nonrecurring restructuring costs incurred in both fiscal years, and China investigation expenses, income from operations decreased 2.4%. Backlog Backlog of undelivered orders at September 30, 2017 was $311,551, a decrease of 5.9% from backlog of $331,044 at October 1, 2016. Based on anticipated manufacturing schedules as of September 30, 2017, we estimated approximately 83% of the backlog as of September 30, 2017 would be converted into revenue during fiscal year 2018. The estimated conversion rate was up from the prior year rate of 78% due to a shift from larger custom orders to shorter cycle, more rapidly turning orders and a push to complete custom orders. Order cancellations in fiscal year 2017 did not have a material effect on backlog. At the end of fiscal year 2016, backlog was negatively impacted by cancellations of custom orders in Test totaling $8,567. Sensors Segment Results of Operations The following table compares results of operations in fiscal years 2017 and 2016 for Sensors, separately identifying the estimated impact of currency translation, the acquisition of PCB for the first three quarters of fiscal year 2017 for comparability, and restructuring expense incurred in fiscal year 2017. The Acquisition / Restructuring column includes revenues and costs from the acquisition of PCB for the first three quarters of fiscal year 2017, including the PCB acquisition inventory adjustment, costs incurred as part of the acquisition of PCB, and restructuring expenses incurred in fiscal year 2017. The first three quarters of fiscal year 2016 did not include PCB results since the acquisition closed in the fourth quarter of fiscal year 2016; therefore, the estimated impact of PCB for the first three quarters of fiscal year 2017 is separately identified herein for comparability. Revenue increased 105.9% primarily due to increased volume as a result of the PCB acquisition. Excluding the impact of currency translation and PCB revenue for the first three quarters of fiscal year 2017, revenue growth was 11.7%. Strong demand in the Sensors position sector, particularly in the heavy industrial markets, and new revenue opportunities in the Sensors test sector drove revenue growth. Gross profit increased 116.8% primarily due to gross profit contribution from the PCB acquisition and growth in our position and test Sensors sectors. The gross margin rate increased 2.4 percentage points primarily due to the $7,916 PCB acquisition inventory adjustment in the fourth quarter of fiscal year 2016 and leverage on increased revenue volume. The increase was partially offset by the gross margin contribution from the PCB acquisition in the first three quarters of fiscal year 2017, which included the $7,975 PCB acquisition inventory adjustment recognized in the first quarter of fiscal year 2017, and additional labor costs from the movement of production in Machida, Japan to the U.S. due to the closure of the Machida manufacturing facility. Excluding the impact of currency translation, the contribution of PCB for the first three quarters of fiscal year 2017, nonrecurring restructuring costs incurred in both fiscal years, and the PCB acquisition inventory adjustment recorded in both fiscal years, gross profit increased 10.7% and the gross margin rate declined 0.4 percentage points. Selling and marketing expense increased 117.5% primarily driven by the addition of PCB expenses and higher commission and compensation expenses. Excluding the impact of currency translation, PCB expenses for the first three quarters of fiscal year 2017, and nonrecurring restructuring costs incurred in both fiscal years, selling and marketing expense increased 4.1%. General and administrative expense increased 33.5% primarily driven by the addition of PCB expenses and investments in infrastructure, partially offset by nonrecurring PCB acquisition-related expenses of $11,867 incurred in fiscal year 2016. Excluding the impact of currency translation, PCB expenses for the first three quarters of fiscal year 2017, nonrecurring restructuring costs incurred in both fiscal years, and prior year nonrecurring PCB acquisition-related expenses, general and administrative expense increased 4.9%. R&D expense increased 98.4% primarily driven by the addition of PCB expenses and continued investments in product development. Excluding the impact of currency translation and PCB expenses for the first three quarters of fiscal year 2017, R&D expense increased 7.0%. Income from operations increased $25,103 primarily due to PCB acquisition-related expenses of $12,514 incurred in the prior year, the contribution of PCB to income from operations, and leverage on increased revenue volume. Excluding the impact of currency translation, PCB expenses for the first three quarters of fiscal year 2017, nonrecurring restructuring costs and acquisition-related expenses incurred in both years, and the PCB acquisition inventory adjustment recorded in both fiscal years, income from operations increased $5,224. Backlog Backlog of undelivered orders at September 30, 2017 was $48,465, an increase of 22.8% compared to backlog of $39,479 at October 1, 2016. Cash Flow Comparison The following table summarizes our cash flows from total operations: Fiscal Year 2018 Compared to Fiscal Year 2017 Operating Activities The decrease in cash provided by operating activities was primarily due to an increase in cash used by working capital associated with timing fluctuations from inventory purchases, accounts payable payments, accounts receivable payments received, unbilled accounts receivable accruals and billings and advanced payments from customers. Timing of payroll-related payments also contributed to the decrease in cash provided by operating activities. This decrease in cash provided by operating activities was partially offset by a decrease in cash used by other assets and liabilities primarily driven by an increase in income taxes payable, as well as an increase in net income offset by a decrease in deferred income taxes due to the remeasurement of our estimated deferred tax liabilities as a result of the Tax Act. Investing Activities The decrease in cash used in investing activities was primarily due to an increase in proceeds from sale of property and equipment as a result of the sale of one of our China manufacturing facilities as well as timing of investments in property and equipment in the current year. Financing Activities The increase in cash used in financing activities was primarily due to the annual required excess cash flow payment and planned prepayments on the tranche B term loan made in fiscal year 2018. Fiscal Year 2017 Compared to Fiscal Year 2016 Operating Activities The increase in cash provided by operating activities was primarily due to an increase in cash provided from working capital associated with timing fluctuations mainly from accounts receivable payments received and unbilled accounts receivable accruals and billings, partially offset by an increase in cash used for inventory purchases and a decrease in cash provided from accounts payable payments and advance payments from customers. Also contributing to the increase was an increase in net income offset by a decrease in deferred income taxes. This increase in cash provided by operating activities was partially offset by an increase in cash used by other assets and liabilities primarily driven by a decrease in accrued interest payable, as well as a decrease in cash provided due to timing of payments of accrued payroll and related costs. Investing Activities The decrease in cash used in investing activities was primarily due to the acquisition of PCB in fiscal year 2016 and lower investments in property and equipment in fiscal year 2017. Financing Activities The increase in cash used in financing activities was primarily due to the acquisition of PCB in fiscal year 2016, including the net proceeds from issuance of long-term debt, issuance of TEUs and issuance of common stock, as well as the timing of dividends paid in fiscal year 2016. This increase is cash used in financing activities was partially offset by higher payments of debt issuance costs related to the PCB acquisition, higher stock repurchases and retirements and the fiscal year 2016 purchase of capped calls associated with the issuance of the TEUs. Liquidity and Capital Resources We had cash and cash equivalents of $71,804 as of September 29, 2018. Of this amount, $16,236 was located in North America, $17,209 in Europe and $38,359 in Asia. Repatriation of certain foreign earnings is restricted by local law. The North American cash balance was primarily invested in bank deposits. The cash balances in Europe and Asia were primarily invested in money market funds and bank deposits. In accordance with our investment policy, we place cash equivalent investments with issuers who have high-quality investment credit ratings. In addition, we limit the amount of investment exposure we have with any particular issuer. Our investment objectives are to preserve principal, maintain liquidity and achieve the best available return consistent with our primary objectives of safety and liquidity. As of September 29, 2018, we held no short-term investments. As a result of the transition tax related to the enactment of the Tax Act, we repatriated a significant amount of the cash held in our foreign subsidiaries without such funds being subject to additional U.S. federal income tax liability during fiscal year 2018. Due to the Tax Act, we plan to continue to repatriate certain amounts of our existing offshore cash and future earnings back to the U.S. As of September 29, 2018, our capital structure was comprised of $36,443 in short-term debt, $364,263 in long-term debt and $477,932 in shareholders' equity. The Consolidated Balance Sheets also included $12,328 of unamortized debt issuance costs as of September 29, 2018. Total interest-bearing debt as of September 29, 2018 was $400,706. We have a credit agreement with a consortium of financial institutions (the Credit Agreement) which provides for senior secured credit facilities consisting of a Revolving Credit Facility and a Term Facility. The maturity date of the Revolving Credit Facility is July 5, 2021 and the maturity date of the loans under the Term Facility is July 5, 2023, unless a term loan lender agrees to extend the maturity date pursuant to a loan modification agreement made in accordance with the terms of the Credit Agreement. On November 21, 2018, the maturity date of the Revolving Credit Facility was extended to June 5, 2022. The Credit Agreement also requires mandatory prepayments on our Term Facility in certain circumstances, including the potential for an annual required prepayment of a certain percentage of our excess cash flow. Under the Credit Agreement, we are subject to customary affirmative and negative covenants, including, among others, restrictions on our ability to incur debt, create liens, dispose of assets, make investments, loans, advances, guarantees and acquisitions, enter into transactions with affiliates and enter into any restrictive agreements and customary events of default (including payment defaults, covenant defaults, change of control defaults and bankruptcy defaults). The Credit Agreement also contains financial covenants, including the ratio of consolidated total indebtedness to adjusted consolidated earnings before income, taxes, depreciation and amortization (Adjusted EBITDA), as defined in the Credit Agreement, as well as the ratio of Adjusted EBITDA to consolidated interest expense. These covenants restrict our ability to pay dividends and purchase outstanding shares of common stock. As of September 29, 2018 and September 30, 2017, we were in compliance with these financial covenants. See Note 5 and Note 15 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our financing arrangements. Shareholders' equity increased by $49,155 during fiscal year 2018 primarily due to net income of $61,328, stock-based compensation of $7,243 and other comprehensive income of $1,389. This increase was partially offset by $21,394 in dividends declared and $1,403 in purchases of our common stock. As of September 29, 2018, we believe our current capital resources will be sufficient to fund working capital requirements, capital expenditures and operations for the foreseeable future, including at least the next twelve months. Contractual Obligations As of September 29, 2018, our contractual obligations are as follows: Long-term debt includes the tranche B term loan facility (Term Facility) and the debt component of the TEUs. For the above period of less than one year, no excess cash flow prepayment is required under the provisions of the Term Facility based on fiscal year 2018 results due to the planned prepayments made during fiscal year 2018. The Term Facility amounts for periods subsequent to less than one year exclude excess cash flow prepayments, which may be required under the provisions of the Term Facility based on fiscal year 2019 and subsequent fiscal year results as future prepayment amounts, if any, are not reasonably estimable as of September 29, 2018. Refer to Note 5 and Note 9 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information regarding our financing arrangements and our TEUs, respectively. Interest payable on long-term debt includes interest on the Term Facility, the debt component of TEUs and capital lease obligations. Capital lease obligations represent contractual vehicle leases. Refer to Note 1 and Note 5 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information regarding our capital lease obligations. Operating leases are primarily for office space, as well as vehicles and equipment. Refer to Note 14 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional lease information. Other long-term obligations include liabilities under pension and other retirement plans and warehouse fee obligations. Long-term income tax liabilities for uncertain tax positions have been excluded from the contractual obligations table as we are unable to make a reasonably reliable estimate of the amount and period of related future payments. As of September 29, 2018, our long-term liability for uncertain tax positions was $6,158. Refer to Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional income tax information. As of September 29, 2018, we had letters of credit and guarantees outstanding totaling $26,753 and $17,572, respectively, primarily to bond advance payments and performance guarantees related to customer contracts in Test. Off-balance Sheet Arrangements As of September 29, 2018, we did not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Critical Accounting Policies The Consolidated Financial Statements have been prepared in accordance with GAAP, which require us to make estimates and assumptions in certain circumstances that affect amounts reported. The preparation of these financial statements requires us to make estimates and assumptions, giving due consideration to materiality, that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of any contingent assets and liabilities at the date of the financial statements. We regularly review our estimates and assumptions, which are based on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that of our significant accounting policies, the following are particularly important to the portrayal of our results of operations and financial position and are subject to an inherent degree of uncertainty as they may require the application of a higher level of judgment by us. Our significant accounting policies are fully described in Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Revenue Recognition We are required to comply with a variety of technical accounting requirements in order to achieve consistent and accurate revenue recognition. The most significant area of judgment and estimation is percentage-of-completion contract accounting. We develop cost estimates that include materials, component parts, labor and overhead costs. Detailed costs plans are developed for all aspects of the contracts during the bidding phase. Cost estimates are largely based on actual historical performance of similar projects combined with current knowledge of the projects in progress. Significant factors that impact the cost estimates include technical risk, inflationary cost of materials and labor, changes in scope, and schedule and internal and subcontractor performance. Actual costs incurred during the project phase are monitored and compared to the estimates on a monthly basis. Cost estimates are revised based on changes in circumstances. Anticipated losses on long-term contracts are recognized when such losses become evident. See Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Goodwill Goodwill represents the excess of cost over the fair value of the identifiable net assets of businesses acquired and allocated to our reporting units at the time of acquisition. Goodwill is tested for impairment annually and when an event occurs or circumstances change that indicate the carrying value of the reporting unit may not be recoverable. Evaluating goodwill for impairment involves the determination of the fair value of each reporting unit in which goodwill is recorded using a qualitative or quantitative analysis. A reporting unit is an operating segment or a component of an operating segment for which discrete financial information is available and reviewed by management on a regular basis. Prior to completing the quantitative analysis described below, we have the option to perform a qualitative assessment of goodwill for impairment to determine whether it is more likely than not (i.e. a likelihood of more than 50%) that the fair value of a reporting unit is less than its carrying amount, including goodwill and other intangible assets. If we conclude the fair value is more likely than not less than the carrying value, we perform the quantitative analysis. Otherwise, no further analysis is needed. If the quantitative analysis is required, the impairment test is used to compare the calculated fair value of each reporting unit to its carrying value, including goodwill. We estimate the fair value of a reporting unit using both the income approach and the market approach. The income approach uses a discounted cash flow model that requires input of certain estimates and assumptions requiring judgment, including projections of economic conditions and customer demand, revenue and margins, changes in competition, operating costs and new product introductions. The market approach uses a multiple of earnings and revenue based on guidelines for publicly traded companies. Fair value calculations contain significant judgments and estimates. If the fair value exceeds the carrying value, no further work is required and no impairment loss is recognized. If the carrying value exceeds the fair value, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. We performed our annual test of goodwill impairment during the fourth quarter of fiscal year 2018. As of September 29, 2018, we determined there was no impairment of our goodwill. While we believe the estimates and assumptions used in determining the fair value of our reporting units are reasonable, significant changes in estimates of future cash flows, such as those caused by unforeseen events or changes in market conditions, could materially impact the fair value of a reporting unit which could result in the recognition of a goodwill impairment charge. See Note 1 and Note 2 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Income Taxes We record a tax provision for the anticipated tax consequences of the reported results of operations. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those deferred tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. We believe it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining net realizable value of our deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our financial condition and operating results. See Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Recently Issued Accounting Pronouncements Information regarding new accounting pronouncements is included in "Recently Issued Accounting Pronouncements" under Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Quarterly Financial Information Revenue and operating results reported on a quarterly basis do not necessarily reflect trends in demand for our products or our operating efficiency. Revenue and operating results in any quarter may be significantly affected by customer shipments, installation timing or the timing of the completion of one or more contracts where revenue is recognized upon shipment or customer acceptance rather than on the percentage-of-completion method of revenue recognition. Our use of the percentage-of-completion revenue recognition method for large, long-term projects generally has the effect of minimizing significant fluctuations quarter-over-quarter. See Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our revenue recognition policy. Quarterly earnings also vary as a result of the use of estimates including, but not limited to, the rates used in recording federal, state and foreign income tax expense. See Note 1 and Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our use of estimates and income tax related matters, respectively. Selected quarterly financial information is as follows: The earnings per share amounts for each quarter may not sum to the fiscal year amounts due to rounding and the effect of weighting. Forward-looking Statements Statements contained in this Annual Report on Form 10-K including, but not limited to, the discussion under Item 7 of Part II, Management's Discussion and Analysis of Financial Condition and Results of Operations, that are not statements of historical fact are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 (the Act). In addition, certain statements in our future filings with the SEC, in press releases and in oral and written statements made by us or with our approval that are not statements of historical fact constitute forward-looking statements within the meaning of the Act. Examples of forward-looking statements include, but are not limited to: (i) projections of revenue, ROIC, Adjusted EBITDA, net income or loss, earnings or loss per share, the payment or nonpayment of dividends, our capital structure, the adequacy of our liquidity and reserves, the anticipated level of expenditures required and other statements concerning future financial performance; (ii) statements of our plans and objectives by our management or Board of Directors, including those relating to products or services, our restructuring initiatives, merger or acquisition activity and the potential impact of newly acquired businesses; (iii) statements of assumptions underlying such statements; (iv) statements regarding business relationships with vendors, customers or collaborators or statements relating to our order cancellation history, our ability to convert our backlog of undelivered orders into revenue, the timing of purchases, competitive advantages and growth in end markets; (v) statements regarding our products and their characteristics, fluctuations in the costs of raw materials for products, our geographic footprint, performance, sales potential or effect in the hands of customers; and (vi) statements regarding the regarding the estimated tax benefits we may receive under the Tax Act and our expectations concerning recorded adjustments. Words such as "believes," "anticipates," "expects," "intends," "targeted," "should," "potential," "goals," "strategy" and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, those described in Item 1A of Part I, Risk Factors, of this Annual Report on Form 10-K. The performance of our business and our securities may be adversely affected by these factors and by other factors common to other businesses and investments, or to the general economy. Forward-looking statements are qualified by some or all of these risk factors. Therefore, you should consider these forward-looking statements with caution and form your own critical and independent conclusions about the likely effect of these risk factors on our future performance. Forward-looking statements speak only as of the date on which statements are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made to reflect the occurrence of unanticipated events or circumstances. You should carefully review the disclosures and the risk factors described in this Annual Report on Form 10-K and in other documents we file from time to time with the SEC, including our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.

<s>[INST] Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in nine sections: Overview Financial Results Cash Flow Comparison Liquidity and Capital Resources Offbalance Sheet Arrangements Critical Accounting Policies Recently Issued Accounting Pronouncements Quarterly Financial Information Forwardlooking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8 of Part II of this Annual Report on Form 10K. All dollar amounts are in thousands unless otherwise noted. Overview MTS Systems Corporation's testing hardware, software and service solutions help customers accelerate and improve their design, development and manufacturing processes and are used for determining the mechanical behavior of materials, products and structures. Our highperformance sensors provide measurements of vibration, pressure, position, force and sound in a variety of applications. Further globalization and expansion of many industries along with growth in emerging markets, such as China and India, provide a strong and vibrant market base from which we can grow revenue. We have aligned our organizational structure to be more flexible to the demands of globalized and volatile markets by adjusting our structure to be more cost effective and nimble in responding to our customers' needs. We are looking ahead to delivering distinctive business performance through our commitment to sustain the differentiated competitive advantage that comes from offering an innovative portfolio of Test and Sensor solutions that create value for customers and are delivered with total customer satisfaction. Fiscal Year We have a 544 week, quarterly accounting cycle with the fiscal year ending on the Saturday closest to September 30. Fiscal years 2018, 2017 and 2016 ended September 29, 2018, September 30, 2017 and October 1, 2016, respectively. Fiscal years 2018, 2017 and 2016 all include 52 weeks. Tax Cuts and Jobs Act The Tax Cuts and Jobs Act (the Tax Act) was signed into law on December 22, 2017. The Tax Act made numerous changes to U.S. federal corporate tax law and reduced our effective tax rate for fiscal year 2018 and future periods. Effective January 1, 2018, the Tax Act lowers the U.S. corporate tax rate from 35% to 21% and prompts various other changes to U.S. federal corporate tax law, including the establishment of a territorialstyle system for taxing foreignsource income of domestic multinational corporations. We have completed our initial analysis to quantify the tax impacts of the Tax Act and have recorded the estimated impact in our fiscal year 2018 results. See Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10K for further discussion of the impact of the Tax Act. Restructuring Initiatives In fiscal year 2018, we initiated a Test workforce reduction intended to increase organizational effectiveness and provide cost savings. As a result, during the fourth quarter of fiscal year 2018, we recorded $880 of pretax severance and related expense. During the fourth quarter of fiscal year 2017, we initiated a series of Test workforce reductions and facility closures intended to increase organizational effectiveness, gain manufacturing efficiencies and provide cost savings that can be reinvested in our growth initiatives. These actions include the transfer of certain production operations in China to a contract manufacturing partner throughout fiscal years 2018 and 2019. As a result, in fiscal year 2018, we recorded $1,550 of pretax severance and related expense, and $269 of pretax facility closure costs. In fiscal year 2017, we recorded $2,899 of pretax severance and related expense and $23 of pretax facility closure costs. [/INST] Negative. </s>

MTS SYSTEMS CORP

2019-11-25

2019-09-28

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in nine sections: • Overview • Financial Results • Cash Flow Comparison • Liquidity and Capital Resources • Off-balance Sheet Arrangements • Critical Accounting Policies and Estimates • Recently Issued Accounting Pronouncements • Quarterly Financial Information • Forward-looking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8 of Part II of this Annual Report on Form 10-K. All dollar amounts are in thousands unless otherwise noted. The following discussion includes a comparison of our Financial Results, Cash Flow Comparisons and Liquidity and Capital Resources for fiscal year 2019 and fiscal year 2018. A discussion of changes in our financial results and cash flow comparisons from fiscal year 2017 to fiscal year 2018 has been omitted from this Form 10-K, but may be found in Item 7 of Part II of our Annual Report on Form 10-K for the fiscal year ended September 29, 2018, filed with the SEC on November 26, 2018. Overview MTS Systems Corporation's testing and simulation hardware, software and service solutions simulate real world environments in other than real world settings thereby enabling customers to improve design, development and manufacturing processes, determine the mechanical behavior of materials, products and structures, or create a desired human experience such as amusement rides, vehicle simulators or flight training simulators. Our high-performance sensors provide measurements of vibration, pressure, position, force and sound in a variety of applications. Further globalization and expansion of many industries along with growth in emerging markets, such as China and India, provide a strong and vibrant market base from which we can grow revenue. We have aligned our organizational structure to be more flexible to the demands of globalized and volatile markets by adjusting our structure to be more cost effective and nimble in responding to our customers' needs. We continue to deliver distinctive business performance through our commitment to sustain the differentiated competitive advantage that comes from offering an innovative portfolio of Test & Simulation and Sensor solutions that create value for customers and are delivered with total customer satisfaction. Fiscal Year We have a 5-4-4 week, quarterly accounting cycle with the fiscal year ending on the Saturday closest to September 30. Fiscal years 2019 and 2018 ended September 28, 2019 and September 29, 2018, respectively, and both included 52 weeks. Issuance of Senior Unsecured Notes On July 16, 2019, we issued $350,000 in aggregate principal amount of 5.750% senior unsecured notes due 2027 (the Notes). The Notes will mature on August 15, 2027. We used the net proceeds to repay all outstanding debt under the revolving credit facility, to repay a portion of the tranche B term loan facility and for general corporate purposes. See Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for further discussion of our financing activities. Acquisitions On November 21, 2018, we acquired E2M Technologies B.V. (E2M) for a cash purchase price of $80,287. The acquisition of E2M expands our technology and product offerings for human-rated simulation systems and brings key regulatory approvals and customers in the flight simulation and entertainment markets. We funded the E2M acquisition through borrowings on our revolving credit facility. On August 5, 2019, we acquired the Endevco sensors business from Meggitt PLC for a cash purchase price of $68,330. This strategic product line purchase brings together two iconic brands in the test and measurement sensors market, in PCB and Endevco, and further enhances our long-term strategy of growth and market leadership in our core businesses. We funded the Endevco acquisition through cash on hand. See Note 16 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for further discussion of the acquisitions of E2M and Endevco. Foreign Currency Over the past 15 years, approximately 70% of our revenue has been derived from customers outside of the U.S. Our financial results are principally exposed to changes in exchange rates between the U.S. dollar and the Euro, the Japanese yen and the Chinese yuan. A change in foreign exchange rates could positively or negatively affect our reported financial results. The discussion below quantifies the impact of foreign currency translation on our financial results for the periods discussed. Adoption of New Revenue Recognition Standard In fiscal year 2019, we adopted Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606), followed by related amendments (collectively, "the new revenue standard" or "ASC 606"). See Notes 2 and 3 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for the impact of this adoption on Consolidated Income Statements and Consolidated Balance Sheets. Financial Results Total Company Results of Operations The following table compares results of operations, separately identifying the estimated impact of currency translation and the acquisitions of E2M and Endevco in the first and fourth quarter of fiscal year 2019, respectively, and restructuring expenses incurred in fiscal year 2019. Financial results for fiscal year 2019 are presented in accordance with the new revenue standard adopted in the first quarter of fiscal year 2019. Prior period results have not been restated to reflect this change. Fiscal year 2019 includes a favorable impact on income from operations of $12,584 related to the ASC 606 adoption. See Note 3 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on the new revenue standard. The Acquisition / Restructuring column includes operating results and costs incurred as part of the acquisitions of E2M and Endevco and restructuring expenses. See Note 16 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on the E2M and Endevco acquisitions. The increase in revenue of 14.7% was primarily driven by growth in both the Test & Simulation and Sensors businesses, partially offset by the unfavorable impact of currency translation. Test & Simulation revenue increased $93,984 or 20.2%, primarily driven by volume growth from the conversion of robust beginning-of-year backlog across all sectors and geographies and contributions from the acquisition of E2M, partially offset by the unfavorable impact of currency translation. Sensors revenue increased $20,707, or 6.6%, primarily driven by growth in the Sensors test sector from a multi-year contract with the U.S. Department of Defense, growth in the Sensors position sector in the first half of fiscal year 2019, contributions from the acquisition of Endevco and growth in the Sensors industrial sector from a continued rebound in the energy market, partially offset by the unfavorable impact of currency translation. Excluding the impact of currency translation and the E2M and Endevco acquisitions, revenue increased 12.4%. Gross profit increased 7.7% primarily driven by higher revenue volume in both segments and contributions from the E2M acquisition, partially offset by higher compensation expense in both segments, the unfavorable impact of currency translation and the E2M and Endevco inventory acquisition adjustments of $1,601. Gross margin decreased 2.4 percentage points primarily due to higher compensation expense, the impact from the acquisition of E2M and Endevco and the E2M and Endevco inventory acquisition adjustments, partially offset by leverage on currency translation. Excluding the impact of currency translation, the E2M and Endevco acquisitions and restructuring costs incurred in both fiscal years, gross profit increased 5.9% and the gross margin declined 2.3 percentage points. Selling and marketing expenses increased 4.2% primarily due to higher compensation and commissions expense to support sales growth and the addition of E2M and Endevco expenses, partially offset by the favorable impact of currency translation. Excluding the impact of currency translation, the E2M and Endevco expenses and restructuring costs incurred in both fiscal years, selling and marketing expense increased 4.9%. General and administrative expense increased 9.4% primarily due to the addition of E2M expenses, acquisition-related expenses of $2,697 and higher professional fees. Excluding the impact of currency translation, E2M and Endevco expenses and restructuring costs incurred in both fiscal years, general and administrative expense decreased 0.3%. Research and development (R&D) expense decreased 11.1% primarily due to the shift of internal resources to larger, capitalizable, Test & Simulation projects as we continue to invest in our technology to support current and future customer needs and overall lower Test & Simulation compensation expense. This decline was partially offset by the addition of E2M expenses and continued investment in new product development in Sensors. Excluding the impact of currency translation, E2M and Endevco expenses and restructuring costs incurred in the prior fiscal year, R&D expense decreased 13.0%. Income from operations increased 22.3% primarily due to increased gross profit from higher revenue volume and contributions from the E2M acquisition, partially offset by higher compensation expense in both segments, acquisition-related expenses of $2,938 and the unfavorable impact of foreign currency translation. Excluding the impact of currency translation, E2M and Endevco expenses and restructuring costs incurred in both fiscal years, income from operations increased 24.2%. Interest expense increased primarily due to additional interest expense recognized on the revolving credit facility drawn on in the first quarter of fiscal year 2019 to fund the acquisition of E2M, which was paid down in the fourth quarter of fiscal year 2019, the acceleration of non-cash debt issuance costs related to the pre-payment on the tranche B term loan facility and incurring interest expense on an increased debt position related to the issuance of the Notes in the fourth quarter of fiscal year 2019. The decrease in other income (expense), net was primarily driven by the gain on the sale of one of our China manufacturing facilities recognized in the prior year. The effective tax rate increased primarily due to certain discrete benefits of $25,008 in the prior year for the estimated impact of the Tax Act. The current year also included $3,547 for the favorable true-up of our previously recorded transition tax estimate, successful closure of prior year audit activity and a reduction in the Netherlands income tax rate resulting in remeasurement of the deferred tax liability associated with certain intangible assets acquired in the E2M acquisition. Excluding the impact of these discrete benefits, the effective tax rate for fiscal years 2019 and 2018 would have been 18.7% and 17.9%, respectively. Factors that increased the effective tax rate for fiscal year 2019 included impacts of the Tax Act, such as elimination of the domestic manufacturing deduction and the implementation of the global intangible low-taxed income (GILTI) provision. These increases were partially offset by favorable aspects of the Tax Act, such as the decrease in the U.S. income tax rate and provisions for incentivizing foreign-derived intangible income (FDII). Net income declined primarily due to an increase in the effective tax rate and lower income from operations in Sensors, partially offset by higher income from operations in Test & Simulation. Backlog Backlog of undelivered orders as of September 28, 2019 was $420,115, an increase of $4,960, or 1.2%, compared to backlog of $415,155 as of September 29, 2018. Based on anticipated manufacturing schedules, we expect to convert approximately 82% of the backlog as of September 28, 2019 into revenue during fiscal year 2020. The expected conversion rate is slightly lower than the prior year rate of 87% primarily due to timing of long-term contracts in Test & Simulation. We believe backlog is not an absolute indicator of future revenue because a portion of the orders in backlog could be canceled at the customer's discretion. While certain contracts within backlog are subject to order cancellation, we have not historically experienced a significant number of order cancellations. During fiscal year 2019, order cancellations did not have a material effect on backlog. Test & Simulation Segment Results of Operations The following table compares results of operations for Test & Simulation, separately identifying the estimated impact of currency translation and the acquisition of E2M in the first quarter of fiscal year 2019 and restructuring expenses incurred in fiscal year 2019. See Note 15 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our reportable segments. Financial results for fiscal year 2019 are presented in accordance with the new revenue standard adopted in the first quarter of fiscal year 2019. Prior period results have not been restated to reflect this change. Fiscal year 2019 includes a favorable impact on income from operations of $12,584 related to the ASC 606 adoption. See Note 3 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on the new revenue standard. The Acquisition / Restructuring column includes operating results and costs incurred as part of the acquisition of E2M and restructuring costs. See Note 16 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on the E2M acquisition. Revenue increased 20.2% primarily driven by volume growth across all sectors and geographies from the conversion of robust beginning-of-year backlog and contributions from the acquisition of E2M, partially offset by the unfavorable impact of currency translation. Excluding the impact of currency translation and the E2M acquisition, revenue increased 16.0%. Gross profit increased 11.5% primarily due to higher revenue volume and contributions from the E2M acquisition, partially offset by increased compensation expense. The gross margin decreased by 2.3 percentage points primarily driven by higher compensation expense and the $1,141 E2M inventory acquisition adjustment. This decrease was partially offset by favorable operating leverage on higher revenue volume and favorable currency translation. Excluding the impact of currency translation, the E2M acquisition and restructuring costs incurred in both fiscal years, gross profit increased 6.2% and gross margin declined 2.8 percentage points. Selling and marketing expense increased 5.7% primarily due to higher commissions and compensation expense, as well as the addition of E2M expenses, partially offset by the favorable impact of currency translation. Excluding the impact of currency translation, E2M expenses and restructuring costs incurred in both fiscal years, selling and marketing expense increased 5.9%. General and administrative expense increased 6.9% primarily driven by the addition of E2M expenses and $1,046 of acquisition-related expenses, partially offset by lower compensation costs and favorable currency translation. Excluding the impact of currency translation, E2M expenses and restructuring costs incurred in both fiscal years, general and administrative expense decreased 6.6%. R&D expense decreased 26.4% primarily due to the shift of internal resources to larger, capitalizable projects as we continue to invest in our technology to support current and future customer needs and lower compensation expense, partially offset by the addition of E2M expenses. Excluding the impact of currency translation, E2M expenses and restructuring costs incurred in the prior fiscal year, R&D expense decreased 31.3%. Income from operations increased 77.3% primarily due to increased gross profit on higher revenue volume, the shift of internal resources to capital projects and contributions from the E2M acquisition, partially offset by higher compensation and commissions expense, acquisition-related expenses of $1,287 and the E2M inventory acquisition adjustment of $1,141. Excluding the impact of currency translation, the E2M acquisition and restructuring costs incurred in both fiscal years, income from operations increased 61.9%. Backlog Backlog of undelivered orders at September 28, 2019 was $342,652, a decrease of 1.0% from backlog of $346,006 at September 29, 2018. Based on anticipated manufacturing schedules, we expect to convert approximately 79% of the backlog as of September 28, 2019 into revenue during fiscal year 2020. The expected conversion rate is lower than the prior year rate of 85% primarily due to timing of long-term contracts. Order cancellations in fiscal year 2019 did not have a material effect on backlog. Sensors Segment Results of Operations The following table compares results of operations for Sensors, separately identifying the estimated impact of currency translation and the acquisition of Endevco in the fourth quarter of fiscal year 2019. See Note 15 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our reportable segments. The Acquisition column includes operating results and costs incurred as part of the acquisition of Endevco. See Note 16 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on the Endevco acquisition. Revenue increased 6.6% primarily driven by growth in the Sensors test sector from a multi-year contract with the U.S. Department of Defense, growth in the Sensors position sector in the first half of the fiscal year, contributions from the acquisition of Endevco and growth in the Sensors industrial sector from a continued rebound in the energy market, partially offset by the unfavorable impact of currency translation. Excluding the impact of currency translation and the Endevco acquisition, revenue growth was 7.2%. Gross profit increased 3.9% primarily due to increased revenue volume and contributions from the Endevco acquisition, partially offset by higher compensation expenses, unfavorable impact of currency translation and the Endevco inventory acquisition adjustment of $460. The gross margin declined 1.2 percentage points primarily driven by higher compensation expense during the ramp-up of manufacturing capacity to support both new products and growth in order volume in a tight labor market and impact from the acquisition of Endevco. Excluding the impact of currency translation and the Endevco acquisition, gross profit increased 5.5% and the gross margin declined 0.7 percentage points. Selling and marketing expense increased 2.4% primarily driven by higher compensation expense from headcount additions to support sales growth, the addition of Endevco expenses and higher marketing expenses, partially offset by the favorable impact of currency translation. Excluding the impact of currency translation and Endevco expenses, selling and marketing expense increased 3.8%. General and administrative expense increased 12.6% primarily driven by higher compensation expense, acquisition-related expenses of $1,651 and higher professional fees. Excluding the impact of currency translation and Endevco expenses, general and administrative expense increased 7.9%. R&D expense increased 4.3% primarily driven by continued investment in new product development and the impact of the Endevco acquisition. Excluding the impact of currency translation and Endevco expenses, R&D expense increased 4.8%. Income from operations declined 0.8% primarily due to increased compensation expense, acquisition-related expenses of $1,651, the unfavorable impact of currency translation, higher professional fees and the Endevco inventory acquisition adjustment of $460, partially offset by increased gross profit on higher revenue volume. Excluding the impact of currency translation and the Endevco acquisition, income from operations increased 6.2%. Backlog Backlog of undelivered orders at September 28, 2019 was $77,463, an increase of 12.0% compared to backlog of $69,149 at September 29, 2018. We expect to convert approximately 97% of Sensors backlog to revenue in fiscal year 2020. Cash Flow Comparison The following table summarizes our cash flows from total operations: Operating Activities The increase in cash provided by operating activities was primarily due to a reduction in cash used by deferred income taxes due to the Tax Act in fiscal year 2018, an increase in cash provided by other assets and liabilities primarily related to accrued project costs, and an increase in cash provided by payroll-related accruals. This increase was partially offset by an increase in cash used by working capital associated with timing fluctuations from advanced payments received from customers, accounts receivable payments received and unbilled accounts receivable accruals, accounts payable payments, and inventory purchases, as well as a decrease in net income due to the remeasurement of our estimated deferred tax liabilities as a result of the Tax Act in fiscal year 2018. Investing Activities The increase in cash used in investing activities was primarily due to the acquisition of E2M in the first quarter of fiscal year 2019 and Endevco in the fourth quarter of fiscal year 2019 as well as an increase in cash used to purchase property and equipment for continued strategic investments in the business. Financing Activities The increase in cash provided by financing activities was primarily due to the issuance of the Notes. This was partially offset by the use of the proceeds to repay all outstanding debt under the revolving credit facility and to repay a portion of the tranche B term loan facility. Liquidity and Capital Resources We had cash and cash equivalents of $57,937 as of September 28, 2019. Of this amount, $13,197 was located in North America, $24,365 in Europe and $20,375 in Asia. Repatriation of certain foreign earnings is restricted by local law. The North American cash balance was primarily invested in bank deposits. The cash balances in Europe and Asia were primarily invested in money market funds and bank deposits. In accordance with our investment policy, we place cash equivalent investments with issuers who have high-quality investment credit ratings. In addition, we limit the amount of investment exposure we have with any particular issuer. Our investment objectives are to preserve principal, maintain liquidity and achieve the best available return consistent with our primary objectives of safety and liquidity. As of September 28, 2019, we held no short-term investments. As a result of the transition tax related to the enactment of the Tax Act, we are able to repatriate cash held in our foreign subsidiaries without such funds being subject to additional federal income tax liability. We plan to continue to repatriate certain amounts of our existing offshore cash and future earnings back to the U.S. As of September 28, 2019, our capital structure was comprised of $30,170 in short-term debt, $494,961 in long-term debt and $484,059 in shareholders' equity. The Consolidated Balance Sheets also included $12,514 of unamortized debt issuance costs as of September 28, 2019. Total interest-bearing debt as of September 28, 2019 was $525,131. We have a credit agreement with a consortium of financial institutions (the Credit Agreement) that provides for senior secured credit facilities consisting of a revolving credit facility and a tranche B term loan facility. The maturity date of the revolving credit facility is July 5, 2022 and the maturity date of the loans under the tranche B term facility is July 5, 2023, unless a term loan lender agrees to extend the maturity date pursuant to a loan modification agreement made in accordance with the terms of the Credit Agreement. The Credit Agreement also requires mandatory prepayments on our tranche B term loan facility in certain circumstances, including the potential for an annual required prepayment of a certain percentage of our excess cash flow. Under the Credit Agreement, we are subject to customary affirmative and negative covenants, including, among others, restrictions on our ability to incur debt; create liens; dispose of assets; make investments, loans, advances, guarantees and acquisitions; enter into transactions with affiliates; and enter into any restrictive agreements and customary events of default (including payment defaults, covenant defaults, change of control defaults and bankruptcy defaults). The Credit Agreement also contains financial covenants, including the ratio of consolidated total indebtedness to adjusted consolidated earnings before income, taxes, depreciation and amortization (Adjusted EBITDA), as defined in the Credit Agreement, as well as the ratio of Adjusted EBITDA to consolidated interest expense. These covenants restrict our ability to pay dividends and purchase outstanding shares of common stock. As of September 28, 2019 and September 29, 2018, we were in compliance with these financial covenants. On July 16, 2019, we issued $350,000 in aggregate principal amount of 5.750% senior unsecured notes due in 2027 (the Notes). The Notes were issued pursuant to an Indenture dated as of July 16, 2019 among us, the Guarantors (as defined therein) and Wells Fargo Bank, National Association, as trustee (the Indenture). The Notes will mature on August 15, 2027. The Indenture governing the Notes contains covenants that limit, among other things, our ability and the ability of our restricted subsidiaries to incur additional indebtedness or issue certain preferred shares; create liens; pay dividends, redeem stock or make other distributions; make investments; for our restricted subsidiaries to pay dividends to us or make other intercompany transfers; transfer or sell assets; merge or consolidate; enter into certain transactions with our affiliates; and designate subsidiaries as unrestricted subsidiaries. As of September 28, 2019 and September 29, 2018, we were in compliance with these financial covenants. See Notes 8 and 18 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our financing arrangements and changes to our capital structure, respectively, subsequent to the end of fiscal year 2019. Shareholders' equity increased by $6,127 during fiscal year 2019 primarily due to $43,067 net income and $9,430 stock-based compensation. This increase was partially offset by $22,096 dividends declared and other comprehensive loss of $19,949. Also contributing to the decrease was a cumulative effect of accounting change reduction to our opening retained earnings balance of $6,227 related to the adoption of the new revenue recognition standard, ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). As of September 28, 2019, we believe our current capital resources will be sufficient to fund working capital requirements, capital expenditures and operations for the foreseeable future, including at least the next twelve months. Contractual Obligations As of September 28, 2019, our contractual obligations are as follows: Long-term debt includes the tranche B term loan facility (Term Facility) and the Notes. For the above period of less than one year, no excess cash flow prepayment is required under the provisions of the Term Facility based on fiscal year 2019 results due to the prepayments made during fiscal year 2019. The Term Facility amounts for periods subsequent to less than one year exclude excess cash flow prepayments, which may be required under the provisions of the Term Facility based on fiscal year 2020 and subsequent fiscal year results as future prepayment amounts, if any, are not reasonably estimable as of September 28, 2019. Refer to Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information regarding our financing arrangements. Interest payable on long-term debt includes interest on the Term Facility, the Notes and capital lease obligations. Capital lease obligations represent contractual vehicle leases. Refer to Note 1 and Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information regarding our capital lease obligations. Operating leases are primarily for office space, as well as vehicles and equipment. Refer to Note 17 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional lease information. Other long-term obligations include liabilities under pension and other retirement plans. Long-term income tax liabilities for uncertain tax positions have been excluded from the contractual obligations table as we are unable to make a reasonably reliable estimate of the amount and period of related future payments. As of September 28, 2019, our long-term liability for uncertain tax positions was $4,414. Refer to Note 11 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional income tax information. As of September 28, 2019, we had letters of credit and guarantees outstanding totaling $23,121 and $26,665, respectively, primarily to bond advance payments and performance guarantees related to customer contracts in Test & Simulation. Off-balance Sheet Arrangements As of September 28, 2019, we did not have any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that are material to investors. Critical Accounting Policies and Estimates The Consolidated Financial Statements have been prepared in accordance with GAAP, which require us to make estimates and assumptions in certain circumstances that affect amounts reported, giving due consideration to materiality, that affect the reported amounts of assets and liabilities, revenues and expenses and related disclosures of any contingent assets and liabilities at the date of the financial statements. We regularly review our estimates and assumptions, which are based on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that of our significant accounting policies, the following is particularly important to the portrayal of our results of operations and financial position and is subject to an inherent degree of uncertainty as it may require the application of a higher level of judgment by us. Our significant accounting policies are fully described in Note 1 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Revenue Recognition (Over Time) Revenue is recognized either over time as work progresses or at a point-in-time, dependent upon contract-specific terms and the pattern of transfer of control of the product or service to the customer. Contracts with equipment revenue recognized over time use costs incurred to date relative to total estimated costs at completion to measure progress toward satisfying the performance obligation. Incurred cost represents work performed, which corresponds with, and thereby best depicts, the transfer of control to the customer. Equipment contract costs include materials, component parts, labor and overhead costs. For contracts recognized over time, we estimate the profit on a contract as the difference between the total estimated revenue and expected costs to complete a contract and recognize that profit over the life of the contract. Contract estimates are based on various assumptions to determine the outcome of future events that may span several years. These assumptions include labor productivity and availability, the complexity of the work to be performed, the cost and availability of materials, and internal and subcontractor performance. As a significant change in one or more of these estimates could affect the profitability of our contracts, we review and update our contract-related estimates regularly. We recognize adjustments in estimated profit on contracts under the cumulative catch-up method. Under this method, the impact of the adjustment on profit recorded to date is recognized in the period the adjustment is identified. Revenue and profit in future periods of contract performance is recognized using the adjusted estimate. If at any time the estimate of contract profitability indicates an anticipated loss on the contract, we recognize the total loss in the period it is identified. Our review of contract-related estimates has not resulted in adjustments that are significant to our results of operations. See Note 3 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Business Acquisitions We account for acquired businesses using the acquisition method of accounting which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective fair values. The judgments made in determining the estimated fair value assigned to each class of assets acquired and liabilities assumed, as well as asset lives, can materially impact net income. Accordingly, for significant items, we typically engage a third-party valuation firm. There are several methods that can be used to determine the fair value of assets acquired and liabilities assumed in a business combination. For intangible assets, we historically have utilized the "income method." This method starts with a forecast of all of the expected future net cash flows attributable to the subject intangible asset. These cash flows are then adjusted to present value by applying an appropriate discount rate that reflects the risk factors associated with the cash flow streams. Some of the more significant estimates and assumptions inherent in the income method (or other methods) include the projected future cash flows (including timing) and the discount rate reflecting the risks inherent in the future cash flows. Estimating the useful life of an intangible asset also requires judgment. For example, different types of intangible assets will have different useful lives, influenced by the nature of the asset, competitive environment and rate of change in the industry. All of these judgments and estimates can significantly impact the determination of the amortization period of the intangible asset, and thus net income. In connection with the acquisition of E2M, the final valuation of assets acquired and liabilities assumed was completed during the fourth quarter of fiscal year 2019. The valuation of assets acquired and purchase price allocation related to the Endevco acquisition which closed in the fourth quarter of fiscal year 2019 are considered preliminary and expected to be finalized as soon as possible, but no later than one year from the acquisition date. See Note 16 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Recently Issued Accounting Pronouncements Information regarding new accounting pronouncements is included in Note 2 and Note 3 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K. Quarterly Financial Information Revenue and operating results reported on a quarterly basis do not necessarily reflect trends in demand for our products or our operating efficiency. Revenue and operating results in any quarter may be significantly affected by the timing of revenue recognition for the various performance obligations included in a contract based on transfer of control resulting in revenue being recognized at a point in time rather than over time. Recognition of revenue over time for large, long-term projects generally has the effect of minimizing significant fluctuations quarter-over-quarter. See Note 3 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our revenue recognition policy. Quarterly earnings also vary as a result of the use of estimates including, but not limited to, the rates used in recording federal, state and foreign income tax expense. See Note 1 and Note 11 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10-K for additional information on our use of estimates and income tax related matters, respectively. Selected quarterly financial information is as follows: The earnings per share amounts for each quarter may not sum to the fiscal year amounts due to rounding and the effect of weighting. Forward-looking Statements Statements contained in this Annual Report on Form 10-K including, but not limited to, the discussion under Item 7 of Part II, that are not statements of historical fact are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In addition, certain statements in our future filings with the SEC, in press releases and in oral and written statements made by us or with our approval that are not statements of historical fact also constitute forward-looking statements. Examples of forward-looking statements include, but are not limited to: (i) projections of revenue, ROIC, Adjusted EBITDA, net income or loss, earnings or loss per share, the payment or nonpayment of dividends, our capital structure, the adequacy of our liquidity and reserves, the anticipated level of expenditures required and other statements concerning future financial performance; (ii) statements of our plans and objectives by our management or Board of Directors, including those relating to products or services, our restructuring initiatives, merger or acquisition activity and the potential impact of newly acquired businesses; (iii) statements of assumptions underlying such statements; (iv) statements regarding business relationships with vendors, customers or collaborators or statements relating to our order cancellation history, our ability to convert our backlog of undelivered orders into revenue, the timing of purchases, competitive advantages and growth in end markets; and (v) statements regarding our products and their characteristics, fluctuations in the costs of raw materials for products, our geographic footprint, performance, sales potential or effect in the hands of customers. Words such as "believes," "anticipates," "expects," "intends," "targeted," "should," "potential," "goals," "strategy" and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. Forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from those in such statements. Factors that could cause actual results to differ from those discussed in the forward-looking statements include, but are not limited to, those described in Item 1A of Part I of this Annual Report on Form 10-K. The performance of our business and our securities may be adversely affected by these factors and by other factors common to other businesses and investments, or to the general economy. Forward-looking statements are qualified by some or all of these risk factors. Therefore, you should consider these forward-looking statements with caution and form your own critical and independent conclusions about the likely effect of these risk factors on our future performance. Forward-looking statements speak only as of the date on which such statements are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made to reflect the occurrence of unanticipated events or circumstances. You should carefully review the disclosures and the risk factors described in this Annual Report on Form 10-K and in other documents we file from time to time with the SEC, including our Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.

<s>[INST] Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is designed to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Our MD&A is presented in nine sections: Overview Financial Results Cash Flow Comparison Liquidity and Capital Resources Offbalance Sheet Arrangements Critical Accounting Policies and Estimates Recently Issued Accounting Pronouncements Quarterly Financial Information Forwardlooking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8 of Part II of this Annual Report on Form 10K. All dollar amounts are in thousands unless otherwise noted. The following discussion includes a comparison of our Financial Results, Cash Flow Comparisons and Liquidity and Capital Resources for fiscal year 2019 and fiscal year 2018. A discussion of changes in our financial results and cash flow comparisons from fiscal year 2017 to fiscal year 2018 has been omitted from this Form 10K, but may be found in Item 7 of Part II of our Annual Report on Form 10K for the fiscal year ended September 29, 2018, filed with the SEC on November 26, 2018. Overview MTS Systems Corporation's testing and simulation hardware, software and service solutions simulate real world environments in other than real world settings thereby enabling customers to improve design, development and manufacturing processes, determine the mechanical behavior of materials, products and structures, or create a desired human experience such as amusement rides, vehicle simulators or flight training simulators. Our highperformance sensors provide measurements of vibration, pressure, position, force and sound in a variety of applications. Further globalization and expansion of many industries along with growth in emerging markets, such as China and India, provide a strong and vibrant market base from which we can grow revenue. We have aligned our organizational structure to be more flexible to the demands of globalized and volatile markets by adjusting our structure to be more cost effective and nimble in responding to our customers' needs. We continue to deliver distinctive business performance through our commitment to sustain the differentiated competitive advantage that comes from offering an innovative portfolio of Test & Simulation and Sensor solutions that create value for customers and are delivered with total customer satisfaction. Fiscal Year We have a 544 week, quarterly accounting cycle with the fiscal year ending on the Saturday closest to September 30. Fiscal years 2019 and 2018 ended September 28, 2019 and September 29, 2018, respectively, and both included 52 weeks. Issuance of Senior Unsecured Notes On July 16, 2019, we issued $350,000 in aggregate principal amount of 5.750% senior unsecured notes due 2027 (the Notes). The Notes will mature on August 15, 2027. We used the net proceeds to repay all outstanding debt under the revolving credit facility, to repay a portion of the tranche B term loan facility and for general corporate purposes. See Note 8 to the Consolidated Financial Statements included in Item 8 of Part II of this Annual Report on Form 10K for further discussion of our financing activities. Acquisitions On November 21, 2018, we acquired E2M Technologies B.V. (E2M) for a cash purchase price of $80,287. The acquisition of E2M expands our technology and product offerings for humanrated simulation systems and brings key regulatory approvals and customers in the flight simulation and entertainment markets. We funded the E2M acquisition through borrowings on our revolving credit facility. On August 5, 2019, we acquired the Endevco sensors business from Meggitt PLC for a cash purchase price of $68,330. This strategic product line purchase brings together two iconic brands in the test and measurement sensors market, in [/INST] Negative. </s>

STEPAN CO

2015-02-27

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The matters discussed in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) include forward-looking statements that are subject to certain risks, uncertainties and assumptions. Such forward-looking statements are intended to be identified in this document by the words, “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “objective,” “outlook,” “plan,” “project,” “possible,” “potential,” “should” and similar expressions. Actual results may vary materially. Forward-looking statements speak only as of the date they are made, and the Company does not undertake any obligation to update them to reflect changes that occur after that date. Factors that could cause actual results to differ materially include the items described in Item 1A of this Annual Report on Form 10-K. Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: ● Surfactants - Surfactants, which accounted for 67 percent of consolidated net sales in 2014, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at six North American sites (five in the U.S. and one in Canada), three European sites (United Kingdom, France and Germany), three Latin American sites (Mexico, Brazil and Colombia) and two Asian sites (Philippines and Singapore). The Company also holds a 50 percent ownership interest in a joint venture, TIORCO, LLC (TIORCO), that markets chemical solutions for increasing the production of crude oil and natural gas from existing fields (enhanced oil recovery or EOR). The joint venture is accounted for under the equity method, and its financial results are excluded from the Surfactants segment operating results. Sales and related profits of the Company’s surfactants to enhanced oil recovery customers are included in Surfactants segment results. ● Polymers - Polymers, which accounted for 29 percent of consolidated net sales in 2014, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively, CASE products) and flexible foams. Polyester resins, which include liquid and powdered resins, are used in CASE and polyurethane systems house applications. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the U.S., polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site and polyester resins are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyols are manufactured at the Company’s subsidiaries in Germany and Poland. In Asia, polyols are currently toll produced for the Company’s 80-percent owned joint venture in Nanjing, China. The Company is currently building a new plant in Nanjing, China, that is expected to be operational in the first half of 2016. ● Specialty Products - Specialty Products, which accounted for 4 percent of consolidated net sales in 2014, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty Products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, at outside contractors. Acquisition Agreement On July 15, 2014, the Company announced that it reached an agreement with Procter & Gamble do Brasil S.A. to acquire (through the Company’s Brazilian subsidiary) a sulfonation production facility in Bahia, Brazil, subject to customary closing conditions. The facility is located in northeastern Brazil and has 30,000 metric tons of surfactants capacity. The acquisition is expected to expand the Company’s capabilities in Brazil, which is the world’s fifth most populous country and has a growing middle class. As the country’s usage of laundry products transitions from soap bars to powders to liquids, surfactant use expands. Surfactants used in functional applications, including the large Brazilian agricultural industry, are also increasing. Brazil is a strategic priority for the Company. The acquired facility will become a part of the Company’s Surfactants segment. This acquisition is synergistic with the Company’s existing Vespasiano, Brazil, plant, and provides an opportunity to serve growing northeastern Brazil. The transaction is projected to close in the first or second quarter of 2015. Deferred Compensation Plans The accounting for the Company’s deferred compensation plans can cause period-to-period fluctuations in Company expenses and profits. Compensation expense results when the values of Company common stock and mutual fund investment assets held for the plans increase, and compensation income results when the values of Company common stock and mutual fund investment assets decline. The pretax effect of all deferred compensation-related activities (including realized and unrealized gains and losses on the mutual fund assets held to fund the deferred compensation obligations) and the income statement line items in which the effects of the activities were recorded are presented in the following table: (1) See the applicable Corporate Expenses section of this MD&A for details regarding the period-to-period changes in deferred compensation. Effects of Foreign Currency Translation The Company’s foreign subsidiaries transact business and report financial results in their respective local currencies. As a result, foreign subsidiary income statements are translated into U.S. dollars at average foreign exchange rates appropriate for the reporting period. Because foreign exchange rates fluctuate against the U.S. dollar over time, foreign currency translation affects year-to-year comparisons of financial statement items (i.e., because foreign exchange rates fluctuate, similar year-to-year local currency results for a foreign subsidiary may translate into different U.S. dollar results). The following tables present the effects that foreign currency translation had on the year-over-year changes in consolidated net sales and various income line items for 2014 compared to 2013 and 2013 compared to 2012: RESULTS OF OPERATIONS 2014 Compared with 2013 Summary Net income attributable to the Company for 2014 declined 22 percent year over year to $57.1 million, or $2.49 per diluted share, compared to $72.8 million, or $3.18 per diluted share, for 2013. Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2014 follows the summary. Consolidated net sales for 2014 increased $46.4 million, or two percent, over consolidated net sales for 2013. Higher average selling prices favorably affected the year-over-year net sales change by $131.2 million. A four percent decline in sales volume and the effects of foreign currency translation unfavorably affected the net sales change by $74.0 million and $10.8 million, respectively. The increase in average selling prices was attributable to higher raw material costs, primarily for Surfactants. The sales volume decline was mainly driven by the Surfactants segment, which reported an eight percent year-over-year volume decrease. Most of the sales volume decline was attributable to North American operations. Sales volume for the Polymers segment increased 13 percent due to solid organic growth in North America and Europe and growth from the North American polyester resins business acquired from Bayer MaterialScience LLC (BMS) in June 2013. Sales volume for Specialty Products declined four percent. Operating income for 2014 declined $18.5 million, or 17 percent, from operating income for 2013. Gross profit decreased $32.1 million, or 11 percent, largely due to lower profits for Surfactants caused by reduced sales volumes and higher expenses for North American operations. Polymers gross profit improved nine percent between years due to sales volume growth that more than offset the effect of a $3.7 million business interruption insurance recovery that benefited the prior year. Specialty Products reported a five percent year-over-year gross profit decline. Operating expenses, including business restructuring and asset impairment charges, declined $13.7 million, or eight percent, year over year. Lower deferred compensation and incentive-based compensation expenses were the major contributors to the decrease. The following summarizes the year-over-year changes in the individual income statement line items that comprise the Company’s operating expenses: · Selling expenses increased $1.5 million, or three percent, year over year. The increase was primarily attributable to $3.2 million in additional bad debt expense, most of which related to a $2.4 million bad debt charge necessitated when a major Polymer customer filed for bankruptcy protection in September 2014. The remainder of the bad debt expense increase reflected changes in allowances for certain high risk customers. A decline in incentive-based compensation, due to lower Company earnings, partially offset the effect of higher bad debt expense. · Administrative expenses declined $16.8 million, or 24 percent, year over year primarily due to a $21.4 million reduction in deferred compensation expense and to a decline in incentive-based compensation partially offset by $7.2 million of higher corporate legal and environmental expenses. A decrease in the value of Company stock for 2014 compared to an increase in the value of Company common stock 2013 led to the year-over-year decline in deferred compensation expense (see the ‘Overview’ and ‘Corporate Expenses’ sections of this MD&A for further details). The decline in incentive-based compensation reflected lower 2014 Company earnings. A $7.1 million charge to increase the best estimate of the remediation liability for the Company’s Maywood, New Jersey, site accounted for the higher corporate legal and environmental expenses. The issuance of the final record of decision for the site in September 2014 by the U.S. Environmental Protection Agency (USEPA) as well as other subsequent communications with the USEPA led to the increase in the best estimate of the remediation liability. · R&D expenses declined $1.4 million, or three percent, year over year. Lower incentive-based compensation, partially offset by higher salary expense accounted for most of the decline. · Business Restructuring and Asset Impairments - Expenses for business restructuring and asset impairments were $4.0 million in 2014 compared to $1.0 million in 2013. The following are brief descriptions of the restructuring and impairment activities for each year. See Note 21, Business Restructuring and Asset Impairments, in the Notes to Consolidated Financial Statements for additional details. In the fourth quarter of 2014, a restructuring plan was approved that affects certain Company functions, principally the R&D function and to a lesser extent product safety and compliance and plant-site accounting functions. The objective of the plan is to better align staffing resources with the needs of the Company’s diversification and growth initiatives. In connection with the plan, the Company recognized a $1.7 million charge against income for the three and twelve months ended December 31, 2014. In the fourth quarter of 2014, the Company wrote off the net book values of three assets, resulting in a charge against income of $2.3 million for the three and twelve months ended December 31, 2014. All three assets were part of the Company’s Surfactants segment, although the write-off charges were excluded from Surfactants segment results. For the three and twelve months ended December 31, 2013, the Company recorded a $1.0 million restructuring charge for estimated severance expense related to an approved plan to reduce future costs and increase operating efficiencies by consolidating a portion of its North American Surfactants manufacturing operations (part of the Surfactants reportable segment). In the third quarter of 2014, the Company shut down certain production areas at its Canadian manufacturing site. The future savings resulting from the restructuring are expected to run approximately $2.5 million per year. Net interest expense for 2014 increased $1.1 million, or 10 percent, over net interest expense for 2013. The increase reflected the recognition of a full year’s interest on the $100.0 million private placement loan the Company executed in June 2013 to finance the BMS North American polyester resins acquisition and other capital expenditures. The loss from the Company’s 50-percent equity joint venture (TIORCO) declined $0.3 million year over year largely due to higher commission income. Other, net for 2014 was $1.3 million of income compared to $2.2 million of income for 2013. Investment income (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets declined $2.2 million between years to $1.5 million for 2014 from $3.7 million for 2013. Foreign exchange losses declined $1.3 million to $0.2 million for 2014 from $1.5 million for 2013. The effective tax rate was 24.4 percent in 2014 compared to 24.4 percent in 2013. Even though the tax rate remained the same year over year, there were significant offsetting items that impacted the rate. The tax rate was driven higher by certain retroactive tax benefits recorded in 2013 that were nonrecurring in 2014. The 2013 benefits included the income exclusion of certain biodiesel excise tax credits for the 2010 through 2012 tax periods and the federal research and development tax credit for the 2012 tax period. The 2014 tax rate was also negatively impacted by a lower domestic production activities deduction as a result of lower U.S. taxable income and by higher state taxes as a result of certain tax benefits recorded in 2013 that were nonrecurring in 2014. These items were offset by a greater percentage of consolidated income being generated outside the U.S. in 2014 where the effective tax rates are lower. See Note 9 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results Surfactants Surfactants net sales for 2014 declined $20.5 million, or two percent, from net sales for 2013. An eight percent decrease in sales volume and the effects of foreign currency translation accounted for $103.0 million and $11.1 million, respectively, of the net sales decline. All regions contributed to the drop in sales volume, although most of the decline was attributable to North American operations. An increase in average selling prices favorably affected the net sales change by $93.6 million. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined one percent due to a 10 percent drop in sales volume and the unfavorable effects of foreign currency translation, which accounted for $82.8 million and $4.3 million, respectively, of the net sales decrease. Lower year-over-year sales of products used in biodiesel, laundry and cleaning, personal care and agricultural chemical applications accounted for the North American sales volume decline. These sales volume decreases were partially offset by sales volume growth for products used in oil field and household, industrial and institutional (HI&I) applications and for surfactants sold through distributors. The Company chose not to manufacture and sell biodiesel products in 2014 because to do so would not have been economically advantageous. The decline in laundry and cleaning sales volume was largely attributable to customers bringing surfactant production in-house to more fully utilize their internal capacity. Sales volumes for laundry and cleaning and personal care products were negatively affected by the severe winter weather earlier in the year that caused production issues at some Company and customer manufacturing facilities. The decline in agricultural chemical sales volume reflected lower customer demand resulting from a shortened spring planting season resulting from prolonged winter weather in parts of the U.S. Average selling prices increased 11 percent, which offset the effects of the sales volume decline and unfavorable foreign currency translation by $76.8 million. The higher average selling prices were primarily attributable to higher raw material costs. Net sales for European operations increased less than one percent between years due to a $5.5 million favorable effect of foreign currency translation offset by lower average selling prices and sales volume. The foreign currency translation effect was primarily the result of a year-over-year stronger British pound sterling relative to the U.S. dollar. Average unit selling prices and sales volumes declined one percent each, reducing the year-over-year net sales change by $3.6 million and $1.7 million, respectively. The one percent decline in sales volume reflected lower demand for laundry and cleaning and fuel additive products offset by sales volume improvements for HI&I, agricultural chemicals and emulsion polymers and foamers products. Net sales for Latin American operations declined less than one percent due to the unfavorable effects of foreign currency translation ($9.9 million unfavorable effect) and a two percent decline in sales volume ($3.4 million unfavorable effect) offset by the impact of higher average selling prices ($12.9 million favorable effect). The foreign currency translation effect resulted from the year-over-year weakening of the Brazilian real and the Mexican and Colombian pesos against the U.S. dollar. The sales volume decline was attributable to lower sales out of Brazil, mainly due to decreased demand for laundry and cleaning products and to lower sales of agricultural chemical products resulting from drought conditions in Brazil. Higher raw material costs led to the increase in average selling prices. Net sales for Asian operations declined 15 percent due to an 18 percent decline in sales volume and to a $2.4 million unfavorable foreign currency translation effect. Sales volume in 2013 included one-time shipments of low-margin methyl ester and biodiesel products from the Company’s Singapore plant to customers in Asia and Europe that did not recur in 2014. Singapore sales volume of products to U.S. operations was up 46 percent, and sales volume for operations in the Philippines increased one percent. Surfactants operating income for 2014 declined $39.4 million, or 39 percent, from operating income for 2013. Gross profit decreased $40.2 million largely due to lower sales volume and higher expenses in North America. Foreign currency translation contributed $2.1 million to the gross profit decline. Operating expenses decreased $0.8 million, or one percent. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: North American gross profit declined 35 percent due to the effects of a 10 percent decline in sales volume and higher expenses. Manufacturing expenses were up $11.1 million, or eight percent, largely due to increased maintenance and depreciation costs. Prolonged inclement winter weather early in 2014 and a significant planned fourth quarter maintenance shutdown in a major production area at the Millsdale, Illinois, plant led to the increase in maintenance expenses. In addition to higher manufacturing costs, the Company incurred incremental transportation expenses for the transfer of some production from weather-affected locations to other less impacted North American plants. Transportation expenses continued to be higher throughout the balance of the year due to increased general freight rates and a planned infrastructure upgrade project at the Company’s Anaheim, California, plant. Further to all of the foregoing, a fourth quarter charge for a customer claim against the Company and higher year-over-year accelerated depreciation ($1.8 million in 2014 compared to $0.3 million in 2013) related to the restructuring plan approved in last year’s fourth quarter also contributed to the gross profit decline. Gross profit for European operations increased 10 percent year over year, reflecting a more favorable mix of sales and lower material and manufacturing costs that more than offset the impact of the one percent decline in sales volume. Gross profit for Latin American operations declined 11 percent due to lower sales volume, a less favorable mix of sales, higher raw material costs and an unfavorable $1.5 million foreign currency translation effect. The year-over-year increase in gross profit for Asian operations was driven by the sales volume increase to U.S. operations from the Company’s Singapore plant. Operating expenses for the Surfactants segment declined $0.8 million, or one percent, between years. Lower incentive-based compensation and the favorable effects of foreign currency translation ($0.7 million), partially offset by higher expenses in Latin America primarily due to increased spending to support the Company’s growing organization in Brazil, accounted for the year-over-year decline. Polymers Polymers net sales for 2014 increased $67.6 million, or 14 percent, over net sales for 2013. A 13 percent increase in sales volume, higher average selling prices and the effects of foreign currency translation accounted for $61.2 million, $6.3 million and $0.1 million, respectively, of the year-over-year net sales improvement. Sales volume was up between years for North American and European operations. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased 18 percent due to a 16 percent increase in sales volume. Specialty polyols, which includes the polyester resin business acquired from BMS in June 2013, accounted for about 56 percent of the sales volume increase (2014 included twelve months of sales related to the acquisition from BMS compared to seven months of sales in 2013). Sales volume for polyols used in rigid foam applications improved 13 percent, principally due to increased demand for greater insulation usage to conserve energy and to an improved economy. Sales volume of phthalic anhydride was essentially unchanged between years, as the impact of reduced business with a large phthalic anhydride customer was largely offset by new business. Net sales for European operations grew nine percent due to a nine percent increase in sales volume. Demand was strong for the Company’s polyol products used in rigid insulation board and metal panels in the first half of 2014. Sales volumes for the second half of 2014 were down slightly (less than one percent) from volumes for the second half of 2013 primarily due to the effects of the unsteady European economy. Net sales for Asia and Other regions were essentially unchanged between years. Higher average selling prices due to a more favorable sales mix offset the effects of a five percent sales volume decline. The sales mix reflected a year-over-year sales volume decrease in Asia and an increase in polymers sold in Latin America. Polymers operating income for 2014 increased $6.2 million, or 11 percent, over operating income for 2013. Most of the profit improvement was attributable to the sales volume increase for North American operations. The 2014 operating income growth was tempered by a $2.4 million bad debt charge resulting from the bankruptcy filing of a large North American phthalic anhydride customer. In addition, the 2013 results for European operations included the receipt of a $3.7 million business insurance recovery related to business interruption losses resulting from a 2011 fire that damaged equipment at the Company’s Germany plant. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: Gross profit for North American operations increased 20 percent principally due to the 16 percent increase in sales volume. All product lines contributed to the year-over-year gross profit growth. Specialty polyols, which includes the polyester resin business acquired from BMS in June 2013, accounted for 55 percent of the year-over-year gross profit improvement. Twelve months of financial activity for the new polyester resin activity were included in the 2014 financial results compared to seven months in the 2013 results. Gross profit for European operations declined 19 percent year over year in large part due to the non-recurring benefit of $3.7 million of business interruption insurance income recognized in 2013. In addition, current year margins declined from 2013 due to higher raw material costs, competitive pressures on selling prices and higher manufacturing expenses. The increase in gross profit for Asia and Other regions was primarily due to lower plant costs, higher selling prices and a more favorable mix of sales. Plant costs in 2013 included costs associated with the winding down of manufacturing operations at the Company’s Nanjing, China. In addition, a $0.6 million charge for accelerated depreciation was recognized in the first half of 2013 that did not recur in 2014. The results for 2014 were tempered by higher costs related to outsourcing products to sell. The outsourcing arrangement will continue until a new plant in China is operational, which is currently projected to be in the first half of 2016. Operating expenses for the Polymers segment were up $1.5 million, or six percent, between years due to the $2.4 million bad debt charge for a phthalic anhydride customer that filed for bankruptcy (the original bad debt allowance of $3.4 million recorded in the third quarter of 2014 was reduced to $2.4 million in the fourth quarter due to new information arising from the bankruptcy proceedings). The effect of the bad debt charge was partially offset by lower 2014 incentive-based compensation attributable to lower total Company operating results. Specialty Products Net sales for 2014 declined $0.7 million, or one percent, from net sales for 2013 primarily due to a four percent decline in sales volume and to lower sales of products used in pharmaceutical applications, partially offset by increased selling prices. Operating income declined $0.4 million, or four percent, principally due to lower sales volume partially offset by lower operating expenses. Most of the net sales and operating income declines were attributable to the fourth quarter when sales volume was down 12 percent and margins fell due to competitive pressure on prices and to a less favorable mix of sales. Corporate Expenses Corporate expenses declined $18.2 million to $37.2 million for 2014 from $55.4 million for 2013. The decline in corporate expenses was primarily due to decreased deferred compensation ($21.4 million) and fringe benefit ($2.8 million) expenses partially offset by increased legal and environmental ($7.2 million) expenses. The decrease in deferred compensation expense ($11.9 million of income in 2014 compared to $9.5 million of expense in 2013) reflected a $25.55 per share decline in the value of Company stock for 2014 compared to an increase of $10.09 per share for 2013. Lower year-over-year mutual fund investment appreciation contributed to the decline in deferred compensation expense. The following table presents the year-end Company common stock prices used in the computation of deferred compensation expense: December 31 Company Stock Price $ 40.08 $ 65.63 $ 55.54 The decrease in fringe benefit expenses was largely attributable to a decline in 2014 incentive-based compensation, which reflected lower Company financial operating results. The higher year-over-year legal and environmental expense was due to a $7.1 million increase in the best estimate of the remediation liability for the Company’s Maywood site. The USEPA issued its final record of decision for the site in September 2014, which led to a $4.3 million third quarter 2014 charge to increase the Company’s remediation liability for the site. After additional subsequent communications with the USEPA, the Company increased the remediation liability by an additional $2.8 million in the fourth quarter of 2014. 2013 Compared with 2012 Summary Net income attributable to the Company for 2013 declined eight percent to $72.8 million, or $3.18 per diluted share, compared to $79.4 million, or $3.49 per diluted share, for 2012. Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2013 follows the summary. Consolidated net sales increased $77.0 million, or four percent, year over year due to a seven percent improvement in sales volume and to the favorable effects of foreign currency translation, which accounted for $118.6 million and $2.3 million, respectively, of the net sales increase. Sales volumes for all three segments improved - six percent for Surfactants, eight percent for Polymers and two percent for Specialty Products. A decline in average selling prices had a $43.9 million unfavorable impact on the year-over-year net sales change. Decreased raw material costs and a less favorable mix of sales for Surfactants led to the drop in average selling prices. Operating income for 2013 declined $19.6 million, or 15 percent, from operating income for 2012. Gross profit decreased $9.9 million, or three percent. The Polymers segment reported higher year-over-year gross profit, but the improvement was more than offset by gross profit declines for the Surfactants and Specialty Products segments. The higher Polymers gross profit was largely due to greater sales volume for European and North American operations. In addition, 2013 European Polymer profits benefited from insurance recovery income that was $2.5 million greater than that for 2012. Gross profit for Surfactants was negatively impacted by lower margins that more than offset the effect of higher sales volume. Included in 2013 Surfactants gross profit were approximately $9.0 million of expenses resulting from the consumption of higher cost raw material inventory built to support the Company’s Singapore plant start-up, contractual timing differences between changes in raw material costs and selling prices and non-recurring costs to secure a strategic raw material for specialty surfactant growth. Specialty Products profits were negatively impacted by lower sales volumes and lower margins for medium-chain triglyceride products used in food ingredient applications. Operating expenses increased $9.7 million, or six percent, between years. The following summarizes the year-over-year changes in the individual income statement line items that comprise the Company’s operating expenses: ● Selling expenses increased $0.1 million, or less than one percent, year over year. The only significant year-over-year variance was a $1.6 million reduction in U.S. fringe benefit expenses largely due to declines in short and long-term incentive expenses. Increases in a number of small expense items offset the decrease in U.S. benefit expense. ● Administrative expenses increased $7.5 million, or twelve percent, year over year. Much of the increase reflected the Company’s continued investment in growth and innovation initiatives. Increases in corporate and other Company entity legal (including intellectual property), acquisition (actual and exploratory) and salary expenses accounted for $2.4 million, $1.0 million and $0.9 million, respectively, of the year-over-year change in corporate expenses. In addition, 2013 expenses included a $0.7 million charge for estimated dismantling costs for the manufacturing site in Nanjing, China. Other contributors to the increase in consolidated administrative expenses included hardware and software maintenance ($0.5 million), hiring ($0.3 million) and temporary help ($0.3 million). The remaining year-over-year variance is attributable to the accumulation of small increases across the Company’s global organization. The above increases were partially offset by a $0.7 million year-over-year decline in deferred compensation expense. The decline reflected a year-over-year increase in the value of Company stock that was smaller in 2013 than in 2012. See the ‘Overview’ and ‘Corporate Expenses’ sections of this MD&A for further details. ● Research, development and technical service (R&D) expenses were up $1.1 million, or two percent, year over year. Most of the increase was attributable to higher personnel, outside contract service and consulting expenses required to pursue the Company’s growth and innovation opportunities. Lower product registration costs under Europe’s REACH (Registration, Evaluation, Authorization and Restriction of Chemicals) regulation favorably affected the year-over-year change in R&D expenses by $0.6 million. ● Business Restructuring -- In the fourth quarter of 2013, the Company approved a plan to consolidate a portion of its North American Surfactants manufacturing operations (part of the surfactants reportable segment) to reduce future costs and optimize asset utilization. The Company will shut down sulfonation production at its Canadian manufacturing site, which will result in the elimination of an estimated 20 North American positions. Production of affected products currently manufactured in Canada will be moved to U.S. plants. As a result of the approved plan, the Company recognized $1.0 million of one-time severance expenses in the fourth quarter of 2013. It should be noted that in addition to the restructuring costs, the Company reduced the useful lives of the manufacturing assets in the affected areas of the Canada plant. As a result, the Company recognized $0.3 million of additional depreciation expense in the fourth quarter of 2013. The expense was included in the cost of sales line of the consolidated statement of income. The change in the useful lives of the assets will add about $1.8 million of depreciation expense in the first half of 2014. The loss from the Company’s 50-percent equity joint venture (TIORCO) increased $0.6 million year over year primarily due to lower commission income. Net interest expense in 2013 increased $0.8 million over net interest expense in 2012. The increase reflected higher average debt levels. On June 27, 2013, the Company borrowed $100.0 million pursuant to a private placement note purchase agreement that matures in 2025. The Company borrowed the funds primarily to finance the 2013 second quarter acquisition of the North American polyester resins business of BMS and expects to use the remaining proceeds for related capital expenditures and working capital as well as for general corporate purposes. Other, net was $2.2 million of income for 2013 compared to $1.3 million of income for 2012. Net investment income (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets was up $2.1 million year over year. Foreign exchange losses were $1.5 million for 2013 compared to $0.3 million for 2012. The effective tax rate was 24.4 percent in 2013 compared to 31.1 percent in 2012. The decrease was primarily attributable to a favorable IRS ruling published in the fourth quarter of 2013 that allowed the Company to exclude certain biodiesel excise tax credits from income retroactive to January 1, 2010. The decrease was also attributable to the federal research and development tax credit and the small agri-biodiesel producer tax credit which were extended retroactively from January 1, 2012 through December 31, 2013 when The American Taxpayer Relief Act of 2012 was signed into law on January 2, 2013. Also contributing to the effective tax rate decline was a greater percentage of consolidated income being generated outside the U.S. where the effective tax rates are lower. See Note 9 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results Surfactants Surfactants net sales for 2013 increased $11.4 million, or one percent, over net sales for 2012. Sales volume increased by six percent, which favorably affected the year-over-year net sales change by $83.2 million. All regions reported sales volume improvements. A decline in average selling prices and the unfavorable effects of foreign currency translation offset the impact of sales volume by $69.0 million and $2.8 million, respectively. The decrease in average selling prices was largely due to reduced raw material costs. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined one percent. Sales volume increased three percent, which favorably affected the year-over-year change in net sales by $21.9 million. The increase in sales volume reflected greater sales of functional surfactants used in agricultural and biodiesel applications and increased U.S. consumer product sales. Sales volume of oil field chemicals declined between years. Average selling prices declined three percent, which had a $28.6 million negative effect on the year-over-year net sales change. Lower raw material costs and the effects of customer contract selling price lags led to the decline in average selling prices. The effects of foreign currency translation had a $1.7 million unfavorable effect on the net sales change. Net sales for European operations increased less than one percent between years. Sales volume increased six percent, which had a $15.8 million favorable effect on the year-over-year net sales change. Increased sales of Company products used in personal care, HI&I (household, institution and industrial) and agricultural chemical applications drove the sales volume improvement. Most of the improvement came from additional business from existing customers. A six percent decline in average selling prices had a negative $18.8 million effect on the year-over-year net sales change. Lower raw material costs and price competition led to the reduction in selling prices. The effects of foreign currency translation had a $4.3 million positive effect on the net sales change. Net sales for Latin American operations increased three percent as a result of a 12 percent increase in sales volume partially offset by a five percent decline in average selling prices and a four percent negative effect of foreign currency translation. The increased sales volume had an $18.0 million positive effect on the year-over-year net sales change, while the decreased selling prices and impact of foreign currency translation had negative effects of $9.0 million and $5.1 million, respectively. Sales volume for all three Latin American locations improved between years, with most of the increase derived from Brazil, where the Company has focused on expanding its surfactants franchise. The decrease in average selling prices reflected declines in raw material costs. Net sales for Asia operations increased 28 percent due to a 33 percent increase in sales volume, reflecting sales from the Singapore subsidiary that was not commercially operational until the fourth quarter of 2012. Surfactants operating income for 2013 declined $18.4 million, or 16 percent, from operating income for 2012. Gross profit fell $17.7 million, or nine percent. Included in 2013 surfactants gross profit were approximately $9.0 million of expenses resulting from the consumption of higher cost raw material inventory built to support the Company’s Singapore plant start-up, contractual timing differences between changes in raw material costs and selling prices and non-recurring costs to secure a strategic raw material for specialty surfactant growth. The effects of foreign currency translation contributed $1.0 million to the gross profit decline. Operating expenses increased $0.7 million, or one percent. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: North American gross profit declined 17 percent year over year due to reduced margins that more than offset the effect of the three percent improvement in sales volume. Factors that contributed to the lower sales margins included customer contract selling price lags (which unfavorably impacted selling margins in 2013 while favorably impacting margins in 2012), the consumption of high priced methyl ester inventories (built up in the prior fourth quarter to support the Singapore start-up) and non-recurring costs to secure a strategic raw material for specialty surfactant growth. In addition, manufacturing expenses increased $4.2 million (three percent) between years primarily due to higher maintenance and depreciation costs. Fourth quarter 2013 gross profit declined $13.1 million from gross profit for the fourth quarter of 2012 despite a six percent increase in sales volume. The decline in quarter-over-quarter gross profit was due to the factors cited above and also due to the fact that costs for a number of key raw materials began rising in the fourth quarter, which had a further negative effect on margins. Gross profit for European operations increased one percent year over year. The effect of the six percent sales volume increase was largely offset by a less favorable mix of sales. In addition, competitive pressures led to some selling price reductions. Gross profit for Latin American operations increased nine percent primarily due to the 12 percent increase in sales volume. Average unit margins have also improved between years as a result of greater utilization of the Brazil site’s new manufacturing capacity. The effects of foreign currency translation had a $1.2 million unfavorable effect on the year-over-year change in gross profit. Asia operations gross profit improvement was principally due to the Singapore subsidiary, which was not commercially operational until the fourth quarter of 2012. Operating expenses for the Surfactants segment were up $0.7 million, or one percent, year over year. Administrative expenses increased $1.5 million, and R&D and marketing expenses declined $0.6 million and $0.2 million, respectively. Approximately $1.0 million of the increase in administrative expenses reflected higher costs necessary to support the Company’s growth initiatives in Asia and Latin America. The decline in R&D expenses was attributable to a decrease in product registration expenses ($0.6 million) under Europe’s REACH initiative. Polymers Polymers net sales for 2013 increased $59.4 million, or 14 percent, over net sales for 2012. An eight percent increase in sales volume, higher average selling prices and the favorable effects of foreign currency translation accounted for $33.6 million, $21.2 million and $4.6 million, respectively, of the net sales improvement. The acquired BMS North American polyester resins business contributed $31.9 million to 2013 net sales. A year-over-year comparison of net sales by region is displayed below: Net sales for North American operations increased 12 percent between years. The increase in net sales was largely attributable to the contribution of the BMS North American polyester resins acquisition made in June. The acquired business accounted for $31.9 million of the year-over-year change in net sales. Net sales for the Company’s pre-acquisition polymer business were unchanged between years on sales volume that declined three percent. Phthalic anhydride volume was down six percent due primarily to continued weak demand from polyester resin customers. Sales volume for rigid polyol products used in insulation applications was down one percent. Also affecting the year-over-year change in net sales was a significant 2012 sale of a urethane systems product used in a new aircraft carrier that did not recur in 2013. Average selling prices for the pre-acquisition business were up three percent year over year due to higher average raw material costs and a more favorable product mix of sales. Net sales for European operations increased 19 percent due to a 16 percent improvement in sales volume and the favorable effects of foreign currency translation, which accounted for $22.0 million and $4.1 million, respectively, of the growth in net sales. Increased business from a number of major polyol customers, due in part to increased sales of polyols for metal panel applications, and the addition of a new customer accounted for the sales volume increase. The strengthening of the Polish zloty against the U.S. dollar led to the foreign currency translation effect. Net sales for Asia and Other operations improved five percent between years due to a more favorable customer sales mix and to a $0.5 million positive foreign currency translation effect. Sales volume was down one percent year over year. Polymer operating income for 2013 increased $6.4 million, or 13 percent, over operating income for 2012. Gross profit improved $9.0 million due to year-over-year improvement for European and North American operations. In addition, current year profits benefited from insurance recovery income that was $2.5 million greater in 2013 than in 2012. The insurance recoveries in both years were for lost business resulting from a 2011 fire that damaged polyol equipment at the Germany site. Operating expenses increased $2.6 million, or 11 percent. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: Gross profit for North American operations increased seven percent between years mainly due to higher margins and to the contribution derived from the BMS business acquisition. The higher margins resulted from a combination of selling price increases and a more favorable mix of sales. The year-over-year improvement in gross profit for North American operations was tempered by a large 2012 sale of a urethane systems product used in a new aircraft carrier. There were no such sales in 2013. The 47 percent increase in gross profit for European operations was primarily driven by the previously mentioned 16 percent improvement in sales volume and the $2.5 million year-over-year increase in insurance recovery income. Increased unit margins and a $0.9 million favorable effect of foreign currency also contributed. The decline in gross profit for Asia and Other operations was due to reduced selling margins, higher expenses and the one percent decrease in sales volume. As a result of ceasing manufacturing at the plant site in Nanjing, China, products are now being outsourced from other Company locations or outside processors, which leads to reduced selling margins. In addition, during 2013 the Company accelerated $0.6 million of depreciation on all assets that were not projected to be moved to the new site. Polymer operating expenses increased $2.6 million, or 11 percent, year over year. Higher R&D ($0.9 million) and selling ($0.3 million) expenses, a $0.7 million charge for estimated dismantling costs for the manufacturing site in Nanjing, China, and the unfavorable effects of foreign currency translation ($0.3 million) accounted for most of the operating expense increase. North American operations accounted for $0.8 million of the increase in R&D expenses. Approximately $0.2 million of the increase was attributable to resources needed to support the acquired BMS business. The remainder of the increase in North American R&D expenses was due to planned additional spending for polyol and CASE research projects. European operations accounted for the rise in selling expenses. Specialty Products Net sales for 2013 increased $6.3 million, or eight percent, over net sales for 2012. Operating income declined $1.3 million due to higher raw material costs, increased manufacturing and operating expenses and competitive pricing pressures, especially for the Company’s medium-chain triglyceride products used in food ingredient applications. Corporate Expenses Corporate expenses increased $5.2 million to $55.4 million for 2013 from $50.2 million for 2012. In large part, the increase in corporate expenses reflected the Company’s continued investment in its growth and innovation initiatives. Increases in legal, acquisition (actual and exploratory) and salary expenses accounted for $1.6 million, $1.0 million and $0.9 million, respectively, of the year-over-year change in corporate expenses. In addition, statutory profit sharing expense in France was up $1.6 million, and corporate computer hardware and software expenses were up $0.5 million. The increase in statutory profit sharing expense resulted from the transfer of ownership of the Company’s European polymer intangibles from its France subsidiary to its Poland subsidiary. A $0.7 million decline in deferred compensation expense partially offset the foregoing increases. The value of Company common stock increased less in 2013 than in 2012, which drove the reduction in deferred compensation expense. The market price of Company stock increased $10.09 per share in 2013 compared to $15.46 per share in 2012. Higher year-over-year mutual fund investment earnings partially offset the impact of the change in Company common stock values. The following table presents the year-end per share Company common stock prices used in the computation of deferred compensation expense: December 31 Company Stock Price $ 65.63 $ 55.54 $ 40.08 Liquidity and Financial Condition For the year ended December 31, 2014, operating activities were a cash source of $82.0 million versus a source of $150.3 million for the comparable period in 2013. In 2014, investing cash outflows totaled $109.2 million and financing activities consumed $14.9 million. Cash decreased by $48.1 million with exchange rates decreasing cash by $6.0 million. For 2014, net income was down by $15.3 million and working capital consumed $46.5 million more than for 2013. Cash outflows for investing activities were down by $58.3 million year over year. Cash flow for financing activities was a use of $14.9 million in 2014 compared to a source of $76.3 million in 2013. For 2014, accounts receivable were a use of $21.2 million compared to a use of $12.7 million for 2013. Inventories were a use of $18.5 million in 2014 versus a use of $3.8 million in 2013. Accounts payable and accrued liabilities were a use of $4.4 million in 2014 compared to a source of $26.3 million for the same period in 2013. Working capital requirements were higher during 2014 compared to 2013 mainly due to a larger increase in inventory quantities year over year combined with a larger increase in raw material costs in 2014 versus 2013. The Company’s working capital investment is heavily influenced by the cost of crude oil and natural oils, from which many of its raw materials are derived. Fluctuations in raw material costs translate directly to inventory carrying costs and indirectly to customer selling prices and accounts receivable. The accounts receivable increase for the year was driven mainly by higher selling prices, partially offset by improved accounts receivable turnover since December 31, 2013. The inventory cash use for the year was driven mainly by higher quantities to support customer service levels for the U.S. The Company has not changed its own payment practices related to its payables. It is management’s opinion that the Company’s liquidity is sufficient to provide for potential increases in working capital during 2015. Investing cash outflows for the current year included capital expenditures of $101.8 million compared to $92.9 million for the comparable period last year. Prior year investing outflows also included $68.2 million for the acquisition of the North American polyester resins business of BMS. Other investing activities consumed $7.4 million in 2014 versus $6.5 million in 2013. For 2015, the Company estimates that capital expenditures will range from $120 million to $140 million including capacity expansions in the United States, China, Europe and Brazil. The Company purchases its common shares in the open market from time to time to fund its own benefit plans and also to mitigate the dilutive effect of new shares issued under its benefit plans. The Company may also make open market repurchases as cash flows permit. For the twelve months ended December 31, 2014, the Company purchased 154,633 shares in the open market at a total cost of $7.9 million. At December 31, 2014, there were 803,679 shares remaining under the current share repurchase authorization. As of December 31, 2014, the Company’s cash and cash equivalents totaled $85.2 million. Cash in U.S. demand deposit accounts totaled $8.4 million and cash of the Company’s non-U.S. subsidiaries held outside the U.S. totaled $76.8 million at December 31, 2014. Consolidated balance sheet debt increased by $3.3 million for the current year, from $270.6 million to $273.9 million. Since last year-end, domestic debt increased by $10.0 million and foreign debt decreased by $6.7 million. Net debt (which is defined as total debt minus cash) increased by $51.4 million for the current year, from $137.3 million to $188.7 million. As of December 31, 2014, the ratio of total debt to total debt plus shareholders’ equity was 33.8 percent compared to 32.8 percent at December 31, 2013. As of December 31, 2014, the ratio of net debt to net debt plus shareholders’ equity was 26.0 percent compared to 19.9 percent at December 31, 2013. At December 31, 2014, the Company’s debt included $232.1 million of unsecured private placement loans with maturities extending from 2015 through 2025. These loans are the Company’s primary source of long-term debt financing and are supplemented by bank credit facilities to meet short and medium-term needs. On July 10, 2014, the Company amended its committed $125.0 million multi-currency five-year revolving credit agreement. The credit agreement allows the Company to make unsecured borrowings, as requested from time to time, for working capital and other corporate purposes. The amendment extends the maturity date of the credit agreement from September 20, 2017 to July 10, 2019. This unsecured facility is the Company’s primary source of short-term borrowings with terms and conditions that are substantially equivalent to those of the Company’s other U.S. loan agreements. As of December 31, 2014, the Company had outstanding borrowings of $20.0 million and letters of credit of $2.7 million under the credit agreement, with $102.3 million remaining available. The Company anticipates that cash from operations, committed credit facilities and cash on hand will be sufficient to fund anticipated capital expenditures, working capital, dividends and other planned financial commitments for the foreseeable future. Certain foreign subsidiaries of the Company maintain term loans and short-term bank lines of credit in their respective local currencies to meet working capital requirements as well as to fund capital expenditure programs and acquisitions. At December 31, 2014, the Company’s European subsidiaries had bank term loans of $7.6 million with maturities through 2021 and short-term bank debt of $13.5 million with remaining short-term borrowing capacity of $15.1 million. The Company’s Latin American subsidiaries had no short-term bank debt with $13.8 million of unused short-term borrowing capacity. The Company’s Philippine subsidiary had $0.7 million of short-term bank loans, which were guaranteed by the Company, with $7.3 million of unused borrowing capacity. The Company has material debt agreements that require the maintenance of minimum interest coverage and minimum net worth. These agreements also limit the incurrence of additional debt as well as the payment of dividends and repurchase of treasury shares. Testing for these agreements is based on the combined financial statements of the U.S. operations of the Company, Stepan Canada Inc., Stepan Quimica Ltda., Stepan Specialty Products, LLC, Stepan Specialty Products B.V. and Stepan Asia Pte. Ltd. (the “Restricted Group”). Under the most restrictive of these debt covenants: 1. The Restricted Group must maintain a minimum interest coverage ratio, as defined within the agreements, of 2.0 to 1.0, for the preceding four calendar quarters. 2. The Restricted Group must maintain net worth of at least $325.0 million. 3. The Restricted Group must maintain a ratio of long-term debt to total capitalization, as defined in the agreements, not to exceed 55 percent. 4. The Restricted Group may pay dividends and purchase treasury shares after December 31, 2013, in amounts of up to $100.0 million plus 100 percent of net income and cash proceeds of stock option exercises, measured cumulatively after June 30, 2014. The maximum amount of dividends that could have been paid within this limitation is disclosed as unrestricted retained earnings in Note 6, Debt, in the Notes to Consolidated Financial Statements. The Company believes it was in compliance with all of its loan agreements as of December 31, 2014. Based on current projections, the Company believes it will be in compliance with its loan agreements throughout 2015. Contractual Obligations At December 31, 2014, the Company’s contractual obligations, including estimated payments by period, were as follows: (a) Interest payments on debt obligations represent interest on all Company debt at December 31, 2014. The interest payment amounts related to the variable rate component of the Company’s debt assume that interest will be paid at the rates prevailing at December 31, 2014. Future interest rates may change, and, therefore, actual interest payments would differ from those disclosed in the above table. (b) Purchase obligations consist of raw material, utility and telecommunication service purchases made in the normal course of business. (c) The “Other” category comprises deferred revenues that represent commitments to deliver products, expected 2015 required contributions to the Company’s funded defined benefit pension plans, estimated payments related to the Company’s unfunded defined benefit supplemental executive and outside director pension plans, estimated payments (undiscounted) related to the Company’s asset retirement obligations, and environmental remediation payments for which amounts and periods can be reasonably estimated. The above table does not include $98.9 million of other non-current liabilities recorded on the balance sheet at December 31, 2014, as summarized in Note 15 to the consolidated financial statements. The significant non-current liabilities excluded from the table are defined benefit pension, deferred compensation, environmental and legal liabilities and unrecognized tax benefits for which payment periods cannot be reasonably determined. In addition, deferred income tax liabilities are excluded from the table due to the uncertainty of their timing. Pension Plans The Company sponsors a number of defined benefit pension plans, the most significant of which cover employees in its U.S. and U.K. locations. The U.S. and U.K. plans are frozen, and service benefit accruals are no longer being made. The funded status (pretax) of the Company’s defined benefit pension plans declined $33.1 million year over year, from $10.1 million underfunded at December 31, 2013, to $43.2 million underfunded at December 31, 2014. Approximately $31.8 million of the decline in funded status was due to changes in U.S. plan assumptions used to measure pension obligations, the most significant of which were as follows: a 78-basis point decline in discount rate ($15.8 million unfavorable effect); a change in mortality assumptions based on the recently released RP-2014 mortality tables ($9.5 million unfavorable effect); changes to certain demographic assumptions ($2.4 million favorable effect); and other assumptions ($3.5 million favorable effect). In addition to the assumption changes for plan obligations, actual plan asset returns compared to expected returns were unfavorable by $12.4 million. The U.K. plan accounted for the remainder of the change in funded status. The Company contributed $2.4 million to its funded defined benefit plans in 2014. In 2015, the Company expects to contribute a total of $1.0 million to the U.K. defined benefit plan. As a result of pension funding relief included in the Highway and Transportation Funding Act of 2014, the Company has no 2015 contribution requirement to the U.S. pension plans. Payments to participants in the unfunded non-qualified plans should approximate $0.2 million in 2015, which is the same as payments made in 2014. Letters of Credit The Company maintains standby letters of credit under its workers’ compensation insurance agreements and for other purposes as needed. The insurance letters of credit are renewed annually and amended to the amounts required by the insurance agreements. As of December 31, 2014, the Company had a total of $2.7 million in outstanding standby letters of credit. Off-Balance Sheet Arrangements The Securities and Exchange Commission requires disclosure of off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. During the periods covered by this Form 10-K, the Company was not party to any such off-balance sheet arrangements. Environmental and Legal Matters The Company’s operations are subject to extensive local, state and federal regulations. Although the Company’s environmental policies and practices are designed to ensure compliance with these regulations, future developments and increasingly stringent environmental regulation could require the Company to make additional environmental expenditures. The Company will continue to invest in the equipment and facilities necessary to comply with existing and future regulations. During 2014, the Company’s expenditures for capital projects related to the environment were $7.0 million. These projects are capitalized and depreciated over their estimated useful lives, which are typically 10 years. Recurring costs associated with the operation and maintenance of facilities for waste treatment and disposal and managing environmental compliance in ongoing operations at the Company’s manufacturing locations were approximately $21.2 million for 2014, $18.7 million for 2013 and $18.3 million for 2012. While difficult to project, it is not anticipated that these recurring expenses will increase significantly in the future. Over the years, the Company has received requests for information related to or has been named by the government as a potentially responsible party at a number of waste disposal sites where cleanup costs have been or may be incurred under CERCLA and similar state statutes. In addition, damages are being claimed against the Company in general liability actions for alleged personal injury or property damage in the case of some disposal and plant sites. The Company believes that it has made adequate provisions for the costs it may incur with respect to the sites. See the Critical Accounting Policies section that follows for a discussion of the Company’s environmental liabilities accounting policy. After partial remediation payments at certain sites, the Company has estimated a range of possible environmental and legal losses from $21.9 million to $41.8 million at December 31, 2014, compared to $9.7 million to $28.9 million at December 31, 2013. At December 31, 2014, the Company’s accrued liability for such losses, which represented the Company’s best estimate within the estimated range of possible environmental and legal losses, was $22.0 million compared to $14.7 million at December 31, 2013. The increase in the environmental and legal liability was primarily attributable to a $7.1 million increase in the estimate to remediate the Company’s Maywood, New Jersey site. Because the liabilities accrued are estimates, actual amounts could differ from the amounts reported. During 2014, cash outlays related to legal and environmental matters approximated $1.2 million compared to $2.4 million expended in 2013. For certain sites, the Company has responded to information requests made by federal, state or local government agencies but has received no response confirming or denying the Company’s stated positions. As such, estimates of the total costs, or range of possible costs, of remediation, if any, or the Company’s share of such costs, if any, cannot be determined with respect to these sites. Consequently, the Company is unable to predict the effect thereof on the Company’s financial position, cash flows and results of operations. Given the information available, management believes the Company has no liability at these sites. However, in the event of one or more adverse determinations with respect to such sites in any annual or interim period, the effect on the Company’s cash flows and results of operations for those periods could be material. Based upon the Company’s present knowledge with respect to its involvement at these sites, the possibility of other viable entities’ responsibilities for cleanup, and the extended period over which any costs would be incurred, the Company believes that these matters, individually and in the aggregate, will not have a material effect on the Company’s financial position. See Item 3, Legal Proceedings, in this Form 10-K and Note 16, Contingencies, in the Notes to Consolidated Financial Statements for a summary of the significant environmental proceedings related to certain environmental sites. Subsequent Event - Sale of Specialty Polyurethane Systems Product Lines In January 2015, the Company sold its specialty polyurethane systems product lines (kits) to J6 Polymers, LLC (J6). Kit products were part of the Company’s Polymers segment and accounted for approximately $2,800,000 of the Company’s 2014 net sales. The sale to J6 was for cash and included inventory as well as customer and supplier lists, formulations, manufacturing procedures and all other intellectual property associated with the manufacturing and selling of kits. This transaction is expected to allow the Company’s Polymers segment to redeploy resources to further improve growth and innovation in its line of polyols for CASE applications. Prior to the sale, kits were produced by the Company and by third-party toll manufacturers on the Company’s behalf. The products manufactured by the Company will continue to be produced for J6 during a transition period. As a result of the kits sales transaction, the Company expects to report a pretax gain of $2,500,000 to $3,000,000 in the first quarter of 2015. Outlook In 2015, the Company is positioned to re-establish earnings momentum. Continued income growth in Polymers, higher functional surfactant volumes, improved operations, recovery of higher freight costs and benefits from falling raw material prices should favorably impact 2015. Commodity consumer product and biodiesel volumes in North America remain a challenge, but opportunities to improve Surfactant asset utilization are being aggressively pursued. Conversely, consumer product volumes in Brazil should increase in 2015 supported by the Company’s planned plant acquisition, now anticipated to close in the first or second quarter. Globally, Surfactant volumes sold for functional applications should benefit from a recovery in the segment’s agricultural business. Polymer income should grow in 2015 from continued energy conservation efforts throughout the world and the introduction of new specialty CASE resins and polyols. Additional polyol capacity is planned for 2016 in China, Poland and the United States. The Company’s internal efficiency program, using internal and external resources, is advancing and should deliver meaningful results in 2015 and beyond. Climate Change Legislation Based on currently available information, the Company does not believe that existing or pending climate change legislation or regulation is reasonably likely to have a material effect on the Company’s financial condition, results of operations or cash flows. Critical Accounting Policies The Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of America (generally accepted accounting principles). Preparation of financial statements in accordance with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The following is a summary of the accounting policies the Company believes are the most important to aid in understanding its financial results: Deferred Compensation The Company sponsors deferred compensation plans that allow management employees to defer receipt of their annual bonuses and outside directors to defer receipt of their fees until retirement, departure from the Company or as elected by the participant. The plans allow for the deferred compensation to grow or decline based on the results of investment options chosen by the participants. The investment options include Company common stock and a limited selection of mutual funds. The Company funds the obligations associated with these plans by purchasing investment assets that match the investment choices made by the plan participants. A sufficient number of shares of treasury stock are maintained on hand to cover the equivalent number of shares that result from participants electing the Company common stock investment option. As a result, the Company must periodically purchase its common shares in the open market. Upon retirement or departure from the Company, participants receive cash amounts equivalent to the payment date value of the investment choices they have made or Company common stock shares equal to the number of share equivalents held in the accounts. Some plan distributions may be made in cash or Company common stock at the option of the participant. Other plan distributions can only be made in Company common stock. For deferred compensation obligations that may be settled in cash, the Company must record appreciation in the market value of the investment choices made by participants as additional compensation expense. Conversely, declines in the value of Company stock or the mutual funds result in a reduction of compensation expense since such declines reduce the cash obligation of the Company as of the date of the financial statements. These market price movements may result in significant period-to-period fluctuations in the Company’s income. The increases or decreases in compensation expenses attributable to market price movements are reported in the administrative expense line of the consolidated statements of income. Because the obligations that must be settled only in Company common stock are treated as equity instruments, fluctuations in the market price of the underlying Company stock do not affect earnings. At December 31, 2014, the Company’s deferred compensation liability was $38.7 million, of which approximately 52 percent represented deferred compensation tied to the performance of the Company’s common stock; the remainder was tied to the mutual fund investment choices. A $1.00 increase in the market price of the Company’s common stock will result in approximately $0.6 million of additional compensation expense. A $1.00 reduction in the market price of the common stock will reduce compensation expense by a like amount. The expense or income associated with the mutual fund component will generally fluctuate in line with the overall percentage increase or decrease of the U.S. stock markets. The mutual fund assets related to the deferred compensation plans are recorded on the Company’s balance sheet at cost when acquired and adjusted to their market values at the end of each reporting period. As allowed by generally accepted accounting principles, the Company elected the fair value option for recording the mutual fund investment assets. Therefore, market value changes for the mutual fund investment assets are recorded in the income statement in the same periods that the offsetting changes in the deferred compensation liabilities are recorded. Dividends, capital gains distributed by the mutual funds, unrealized gains and losses and realized gains and losses from sales of mutual fund shares, are recognized as investment income or loss in the other, net line of the consolidated statements of income. Environmental Liabilities It is the Company’s accounting policy to record environmental liabilities when environmental assessments and/or remedial efforts are probable and the cost or range of possible costs can be reasonably estimated. When no amount within a range of possible costs is a better estimate than any other amount, the minimum amount in the range is accrued. Some of the factors on which the Company bases its estimates include information provided by feasibility studies, potentially responsible party negotiations and the development of remedial action plans. Estimates for environmental liabilities are subject to significant fluctuations as new facts emerge related to the various sites where the Company is exposed to liability for the remediation of environmental contamination. See the Environmental and Legal Matters section of this MD&A for discussion of the Company’s recorded liabilities and range of loss estimates. Revenue Recognition Revenue is recognized upon shipment of goods to customers, at which time title and risk of loss pass to the customer. For arrangements where the Company consigns product to a customer location, revenue is recognized when the customer uses the inventory. The Company records shipping and handling billed to a customer in a sales transaction as revenue. Costs incurred for shipping and handling are recorded in cost of sales. Volume discounts due customers are estimated and recorded in the same period as the sales to which the discounts relate and reported as reductions of revenue in the consolidated statements of income. Recent Accounting Pronouncements See Note 1 to the consolidated financial statements, included in Part II, Item 8, for information on recent accounting pronouncements which affect the Company.

<s>[INST] The matters discussed in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) include forwardlooking statements that are subject to certain risks, uncertainties and assumptions. Such forwardlooking statements are intended to be identified in this document by the words, “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “objective,” “outlook,” “plan,” “project,” “possible,” “potential,” “should” and similar expressions. Actual results may vary materially. Forwardlooking statements speak only as of the date they are made, and the Company does not undertake any obligation to update them to reflect changes that occur after that date. Factors that could cause actual results to differ materially include the items described in Item 1A of this Annual Report on Form 10K. Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: Surfactants Surfactants, which accounted for 67 percent of consolidated net sales in 2014, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at six North American sites (five in the U.S. and one in Canada), three European sites (United Kingdom, France and Germany), three Latin American sites (Mexico, Brazil and Colombia) and two Asian sites (Philippines and Singapore). The Company also holds a 50 percent ownership interest in a joint venture, TIORCO, LLC (TIORCO), that markets chemical solutions for increasing the production of crude oil and natural gas from existing fields (enhanced oil recovery or EOR). The joint venture is accounted for under the equity method, and its financial results are excluded from the Surfactants segment operating results. Sales and related profits of the Company’s surfactants to enhanced oil recovery customers are included in Surfactants segment results. Polymers Polymers, which accounted for 29 percent of consolidated net sales in 2014, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively, CASE products) and flexible foams. Polyester resins, which include liquid and powdered resins, are used in CASE and polyurethane systems house applications. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the U.S., polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site and polyester resins are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyols are manufactured at the Company’s subsidiaries in Germany and Poland. In Asia, polyols are currently toll produced for the Company’s 80percent owned joint venture in Nanjing, China. The Company is currently building a new plant in Nanjing, China, that is expected to be operational in the first half of 2016. Specialty Products Specialty Products, which accounted for 4 percent of consolidated net sales in 2014, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty Products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, at outside contractors. Acquisition Agreement On July 15, 2014, the Company announced that it reached an agreement with Procter & Gamble [/INST] Positive. </s>

STEPAN CO

2016-02-24

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following is management’s discussion and analysis (MD&A) of certain significant factors that have affected the Company’s financial condition and results of operations during the annual periods included in the accompanying consolidated financial statements. Certain matters discussed in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) include forward-looking statements that are subject to certain risks, uncertainties and assumptions. Such forward-looking statements are intended to be identified in this document by the words, “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “objective,” “outlook,” “plan,” “project,” “possible,” “potential,” “should” and similar expressions. Actual results may vary materially. Forward-looking statements speak only as of the date they are made, and the Company does not undertake any obligation to update them to reflect changes that occur after that date. Factors that could cause actual results to differ materially include the items described in Item 1A of this Annual Report on Form 10-K. Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: · Surfactants - Surfactants, which accounted for 68 percent of consolidated net sales in 2015, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at six North American sites (five in the U.S. and one in Canada), three European sites (United Kingdom, France and Germany), four Latin American sites (Mexico, Colombia and two sites in Brazil) and two Asian sites (Philippines and Singapore). The Company also holds a 50 percent ownership interest in a joint venture, TIORCO, LLC, that markets chemical solutions for increasing the production of crude oil and natural gas from existing fields (enhanced oil recovery or EOR). The joint venture is accounted for under the equity method, and its financial results are excluded from surfactant segment operating results. See the ‘2015 Business Developments’ section that follows for additional information about the dissolution of the TIORCO venture. · Polymers - Polymers, which accounted for 28 percent of consolidated net sales in 2015, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively CASE products) and flexible foams. Polyester resins, which include liquid and powdered products, are used in CASE and polyurethane systems house applications. CASE, polyester resins and flexible foam are collectively referred to as specialty polyols. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the U.S., polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site and specialty polyols are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyols are manufactured at the Company’s subsidiary in Germany and specialty polyols are manufactured at the Company’s Poland subsidiary. In Asia, polyols are currently toll produced for the Company’s 80-percent owned joint venture in Nanjing, China. The Company is building a new plant in Nanjing that is expected to be operational in the first quarter of 2016. · Specialty Products - Specialty products, which accounted for four percent of consolidated net sales in 2015, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, at outside contractors. 2015 Business Developments Business Acquisition On June 15, 2015, the Company completed its previously announced acquisition of Procter & Gamble do Brasil S.A.’s (P&G Brazil’s) sulfonation production facility in Bahia, Brazil. The facility is located in northeastern Brazil and has 30,000 metric tons of surfactants capacity. The acquisition expands the Company’s capabilities in Brazil, which is the world’s fifth most populous country and has a growing population. As the country’s usage of laundry products transitions from soap bars to powders to liquids, surfactant use is expected to expand. Surfactants usage in functional applications, including the large Brazilian agricultural industry, is also expected to increase. Brazil is a strategic priority for the Company. The new business complements the Company’s existing Vespasiano, Brazil, plant and provides opportunities to serve growing northeastern Brazil. The acquired business is included in the Company’s Surfactants segment. See Note 20 to the consolidated financial statements for further information regarding the business acquisition. Supply Agreement and Asset Acquisition In July 2015, the Company signed a long-term supply agreement with The Sun Products Corporation (SUN). Under this agreement the Company will supply SUN's anionic surfactant requirements for laundry in North America. The agreement commenced in the third quarter of 2015. The demand from this agreement is being serviced from the Company’s existing North American manufacturing assets. The supply agreement was made possible due to the strength of the Company’s sulfonation expertise and North American supply network that provide this customer with multiple source locations and increased surfactant flexibility. This agreement should enable the Company to improve its North American capacity utilization. In September 2015, the Company closed on the previously announced agreement to purchase select chemical manufacturing assets from SUN's Pasadena, Texas manufacturing site. An option to purchase the land at this site was also exercised. See Note 20 to the consolidated financial statements for further information regarding the asset purchase. TIORCO Joint Venture Given the current and forecasted price of crude oil, the Company and Nalco Company (Nalco) decided in October 2015 to dissolve their TIORCO enhanced oil recovery joint venture. The Company expects to continue to participate in the enhanced oil recovery business, but through operations within its organization. With this change, the Company seeks to reduce the unfavorable financial statement impact of TIORCO’s losses, which have averaged about $5.0 million per year over the last three years. The Company expects its own operating expenses to increase to support its enhanced oil recovery activities, but the net impact to earnings of the dissolution is expected to be positive. As a result of the dissolution, TIORCO incurred fourth quarter 2015 exit costs to wind down the entity. The Company’s share of the exit costs was $2.4 million pretax. The exit costs were included in the ‘Loss from equity in joint ventures’ line in the consolidated statement of income for the year ended December 31, 2015. See Note 25 to the consolidated financial statements for further information. Deferred Compensation Plans The accounting for the Company’s deferred compensation plans can cause period-to-period fluctuations in Company expenses and profits. Compensation expense results when the values of Company common stock and mutual fund investment assets held for the plans increase, and compensation income results when the values of Company common stock and mutual fund investment assets decline. The pretax effect of all deferred compensation-related activities (including realized and unrealized gains and losses on the mutual fund assets held to fund the deferred compensation obligations) and the income statement line items in which the effects of the activities were recorded are presented in the following table: (1) See the applicable Corporate Expenses section of this MD&A for details regarding the period-to-period changes in deferred compensation. Effects of Foreign Currency Translation The Company’s foreign subsidiaries transact business and report financial results in their respective local currencies. As a result, foreign subsidiary income statements are translated into U.S. dollars at average foreign exchange rates appropriate for the reporting period. Because foreign exchange rates fluctuate against the U.S. dollar over time, foreign currency translation affects year-to-year comparisons of financial statement items (i.e., because foreign exchange rates fluctuate, similar year-to-year local currency results for a foreign subsidiary may translate into different U.S. dollar results). The following tables present the effects that foreign currency translation had on the year-over-year changes in consolidated net sales and various income line items for 2015 compared to 2014 and 2014 compared to 2013: RESULTS OF OPERATIONS 2015 Compared with 2014 Summary Net income attributable to the Company for 2015 increased 33 percent to $76.0 million, or $3.32 per diluted share, from $57.1 million, or $2.49 per diluted share, for 2014. Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2015 compared to 2014 follows the summary. Consolidated net sales declined $151.0 million, or eight percent, between years. A five percent increase in sales volume favorably affected the year-over-year net sales change by $96.6 million. All three segments contributed to the consolidated sales volume improvement. Sales volumes for Surfactants and Polymers grew five percent each, and sales volumes for the Specialty Products segment increased two percent. The positive effect of increased sales volume was more than offset by the unfavorable effects of foreign currency translation and lower selling prices, which accounted for $131.8 million and $115.8 million, respectively, of the year-over-year net sales decline. The unfavorable foreign currency translation effect reflected a stronger U.S. dollar against all currencies of countries where the Company has foreign operations. Selling prices were lower primarily related to certain pass-through contract requirements associated with lower raw materials costs. Overall margins improved slightly. The decline in raw material costs reflected the impacts of decreases in the cost of crude oil and of sluggish economies in China and other emerging market countries. Operating income for 2015 increased $32.1 million, or 35 percent, over operating income reported for 2014, largely due to improved results for Surfactants and Polymers. Increased deferred compensation expense and the effects of foreign currency translation negatively affected the year-over-year operating income change by $18.4 million and $13.2 million, respectively. Included in the 2015 results was a $2.9 million gain on the divestiture of the Company’s specialty polyurethane systems product line (part of the Polymers segment). See Note 21 to the consolidated financial statements for additional information regarding the sale. In addition, last year’s operating income was unfavorably affected by $4.0 million of restructuring and asset impairment charges and a $2.4 million bad debt charge necessitated when a major Polymer customer filed for bankruptcy protection. Operating expenses increased $33.5 million, or 22 percent, year over year. Higher deferred compensation, incentive-based compensation and consulting expenses were the major contributors to the increase. The following summarizes the year-over-year changes in the individual income statement line items that comprise the Company’s operating expenses: · Selling expenses increased $0.8 million, or one percent, year over year primarily due to higher global fringe benefit expenses, largely offset by the favorable impact of foreign currency translation ($3.9 million) and a reduction in bad debt expense. U.S. fringe benefit expenses, which accounted for the largest share of the fringe benefit expense increase, were up $5.8 million primarily due to increased incentive-based compensation (i.e., bonuses, profit sharing and stock-based compensation). Prior year bad debt expense included a $2.4 million charge for a Polymer customer that filed for bankruptcy protection. · Administrative expenses increased $9.5 million, or 14 percent, year over year due to increases for consulting ($5.9 million), fringe benefits ($4.7 million), talent acquisition/relocation ($1.5 million), expatriate ($0.8 million), salaries ($0.7 million) and the accumulation of a number of smaller expense increases. Administrative expenses were up $0.7 million in China, where a new plant is being constructed. Administrative expenses for both Europe and Brazil operations were generally up, but the increases were offset by the favorable effects of foreign currency translation. Partially offsetting the increases were lower environmental remediation expenses ($6.4 million). The increase in consulting expenses was related to the Company’s ongoing initiative to improve efficiency across the Company’s global organization (the initiative is referred to as DRIVE within the Company). The contract with the consulting company advising on the DRIVE initiative has expired, so it is expected that such expenses will decline in 2016. Higher incentive-based compensation costs accounted for the increase in fringe benefit expenses. With respect to the decline in environmental remediation expenses, 2014 included a $7.1 million charge to increase the remediation liability for the Company’s Maywood, New Jersey, site. The U.S. Environmental Protection Agency issued its record of decision for soil remediation at that site in September 2014, which led to the liability increase. · Research, development and technical service (R&D) expenses increased $4.8 million, or 11 percent, year over year primarily due to higher fringe benefit expenses ($6.2 million) partially offset by the favorable effects of foreign currency translation ($1.1 million). Increased incentive-based compensation expenses accounted for most of the higher fringe benefit expenses. · Deferred compensation plan activity resulted in $6.5 million of expense in 2015 compared to $11.9 million of income in 2014. An increase in the value of Company stock for 2015 compared to a decrease in the value of Company common stock for 2014 led to the year-over-year swing in deferred compensation results (see the ‘Overview’ and ‘Corporate Expenses’ sections of this MD&A for further details). Net interest expense for 2015 increased $3.1 million, or 27 percent, over net interest expense for 2014. Higher average debt levels resulting from the July 2015 issuance of $100.0 million in unsecured debt was the principal contributor to the increase. See Note 6 to the consolidated financial statements for further information regarding the new private placement debt. The loss from the Company’s 50-percent equity joint venture (TIORCO) increased $2.0 million year over year largely due to the Company’s $2.4 million-share of exit costs recorded by TIORCO in the fourth quarter of 2015. The costs were precipitated by the joint venture partners’ agreement to dissolve the venture. See Note 25 to the consolidated financial statements for further information regarding the dissolution of TIORCO. Other, net income for 2015 increased $0.3 million, or 23 percent, over other, net income for 2014. Foreign exchange activity resulted in a $0.7 million gain in 2015 compared to a $0.2 million loss in 2014. Investment income (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets declined $0.6 million between years to $0.9 million in 2015 from $1.5 million in 2014. The effective tax rate was 26.1 percent in 2015 compared to 24.4 percent in 2014. The increase was attributable to certain favorable foreign tax benefits recorded in 2014 that were nonrecurring in 2015, an unrecognized tax benefit recorded in 2015 for prior tax years, and a less favorable geographical mix of income in 2015. The 2015 tax rate was also negatively impacted by the lower tax benefit realized on nontaxable foreign interest income due to higher consolidated income. These items were partially offset by higher U.S. tax credits recorded in 2015. U.S. tax credits included the current year R&D credit, which was permanently extended on December 18, 2015, and the Agricultural Chemicals Security Credit related to the 2011 and 2012 tax returns. See Note 9 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results Surfactants Surfactants 2015 net sales declined $90.8 million, or seven percent, from 2014 net sales. Sales volume increased five percent between years, which had a $67.0 million positive effect on the year-over-year net sales change. All regions contributed to the sales volume improvement. Foreign currency translation and decreased selling prices had negative effects of $97.9 million and $59.9 million, respectively, on the net sales change. Compared to 2014, the U.S. dollar was stronger against all currencies of the segment’s foreign operations. Selling prices were lower primarily related to certain pass-through contract requirements associated with lower raw materials costs. Overall margins improved slightly. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined seven percent between years. Sales volume increased three percent, which favorably affected the change in net sales by $26.2 million. The sales volume impact was more than offset by a nine percent decline in average selling prices and the unfavorable effects of foreign currency translation, which led to year-over-year net sales decreases of $72.8 million and $7.9 million, respectively. The improved sales volume resulted from increased sales of laundry and cleaning and personal care products, partially offset by decreased sales of functional surfactants and household, industrial and institutional (HI&I) products. The increase in laundry and cleaning sales volume was largely due to additional volumes resulting from the Company’s new long-term supply agreement with SUN. Personal care sales volumes increased principally due to higher demand from existing customers. The decline in sales volumes for functional surfactants was principally due to lower sales of products used in oil field and agricultural applications. Decreased sales volumes to EOR customers, driven by the decline in crude oil prices, led to the lower oil field sales volume. The decline in agricultural chemicals sales volume was largely due to customers’ carryover inventory from 2014 and to farmers’ efforts to reduce spraying costs due to lower crop prices. HI&I sales volume was down mainly due to some lost business. The drop in selling prices was primarily attributable to decreases in raw material costs. The negative foreign currency translation effect reflected a stronger U.S. dollar relative to the Canadian dollar. Net sales for European operations declined ten percent between years. Sales volume was up six percent, which favorably affected year-over-year net sales by $16.8 million. The sales volume impact was more than offset by the unfavorable effects of foreign currency translation and a two percent decline in selling prices, which accounted for $40.7 million and $4.9 million of the year-over- year net sales decline. An increase in sales of laundry and cleaning and agricultural chemical products, due to stronger demand from existing customers and new business, led to the improvement in sales volume. A stronger U.S. dollar against the European euro and British pound sterling led to the foreign currency translation result. Net sales for Latin American operations declined seven percent between years due to a $48.0 million unfavorable effect of foreign currency translation. A 12 percent increase in sales volume and a 10 percent increase in selling prices offset the foreign currency translation impact by $18.8 million and $17.9 million, respectively. Brazil operations accounted for most of the increased Latin American sales volume, with stronger demand from existing customers and business gained as a result of the P&G Brazil acquisition finalized in the second quarter of 2015. Sales volume was up for Colombia operations but was partially offset by a decline in sales volume in Mexico. The foreign currency translation effect resulted from the year-over-year weakening of the Brazilian real as well as the Colombian and Mexican pesos against the U.S. dollar. Net sales for Asian operations increased seven percent due to increased selling prices and a three percent increase in sales volume, which accounted for $3.4 million and $1.7 million, respectively, of the year-over-year increase in net sales. The increase in sales volume was primarily attributable to the Company’s Philippines operation, partially offset by lower sales volume for Singapore operations. The unfavorable effects of foreign currency translation offset the effects of higher sales volume and selling prices by $1.3 million. Surfactants operating income for 2015 increased $43.3 million, or 71 percent, over operating income for 2014. Gross profit increased $48.0 million largely due to strong improvement for North American operations. All other regions except Asia also reported increased profits. Foreign currency translation reduced the year-over-year gross profit and operating income increase by $16.7 million and $10.4 million, respectively. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: Gross profit for North American operations increased 48 percent year over year primarily due to improved operations, the three percent sales volume increase and better sales margins. The improved sales margin resulted from lower raw material and transportation costs. Costs for all major surfactant raw materials declined year-over-year. In 2014, the Company incurred additional transportation expenses due to higher fuel costs and to carrier delays and suboptimal supply chain movements related to the effects of severe winter weather and to upgrades at the Anaheim, California, plant that resulted in shifting production to other Company locations. Other items contributing to the year-over-year increase in gross profit were the favorable 2015 resolution of a previously recorded customer claim and $1.8 million of accelerated depreciation recorded in 2014 related to the Company’s 2013 restructuring plan. The effect of foreign currency translation on the year-over-year change in gross profit was an unfavorable $1.7 million. Gross profit for European operations increased 14 percent between years principally due to the six percent increase in sales volume and to sales margin improvement. The margin improvement reflected a more favorable mix of sales (growth in agricultural sales volume) and declines in raw material costs. Foreign currency translation had a $5.4 million unfavorable effect on the year-over-year change in gross profit. Gross profit for Latin American operations increased 28 percent largely due to a more profitable mix of sales, higher selling prices and the 12 percent increase in sales volume that more than offset an unfavorable foreign currency translation impact of $9.5 million. Asia gross profit declined 14 percent largely due to a less profitable mix of sales reflecting lower sales out of Singapore. Operating expenses for the Surfactants segment increased $4.7 million, or six percent, year over year. Excluding the effects of foreign currency translation, operating expenses increased $11.1 million. North American operations, European operations and Latin American operations accounted for $7.1 million, $1.9 million and $1.7 million of the increase, respectively. Higher fringe benefits, particularly incentive-based compensation, accounted for a large portion of the operating expense increases. Reimbursement from new consortium members of past European product registration fees ($1.3 million) favorably impacted current year expenses. Polymers Polymers net sales for 2015 declined $59.5 million, or 11 percent, from net sales for 2014. Sales volume was up five percent, which had a $25.2 million favorable effect on the year-over-year change in net sales. All regions reported improved volumes. Lower selling prices and the effects of foreign currency translation negatively impacted the year-over-year net sales change by $53.4 million and $31.3 million, respectively. Selling prices were lower primarily related to certain pass-through contract requirements associated with lower raw materials costs. Overall margins improved slightly. The foreign currency translation effect reflected a stronger U.S. dollar against the currencies of the segment’s foreign operations. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined nine percent. Sales volume increased three percent, which had a $10.0 million favorable effect on the year-over-year net sales change. Selling prices declined 11 percent, which unfavorably affected year-over-year net sales by $39.9 million. Sales volume of polyols used in rigid foam applications increased one percent, while sales volume of specialty polyols declined five percent. A drop in sales for products used in lower-margin flexible foam applications led to the decline in specialty polyol sales volume. Phthalic anhydride sales volume increased 10 percent as the result of new business coupled with stronger demand from existing customers. The reduction in sales prices reflected decreases in the costs of major raw materials. Net sales for European operations declined 14 percent between years. Sales volume increased eight percent, which positively affected the year-over-year net sales change by $14.3 million. Increased sales of rigid polyols used in insulation board and metal panels accounted for the volume improvement. The unfavorable effects of foreign currency translation and a five percent decline in selling prices negatively affected the year-over-year change in net sales by $29.7 million and $9.8 million, respectively. The foreign currency translation effect reflected a stronger U.S. dollar relative to the Polish zloty. The selling price decline was principally attributable to decreases in raw material costs. Net sales for Asia and Other operations declined 16 percent due to lower selling prices and the unfavorable effects of foreign currency translation, which accounted for $3.3 million and $1.5 million of the year-over-year net sales decrease, respectively. Reduced raw material costs led to the lower selling prices. Sales volume increased two percent, which had a $0.5 million positive impact on the net sales change. The volume gain reflected increased sales volume in Asia. Polymer 2015 operating income increased $20.3 million, or 33 percent, over 2014 operating income. The $2.9 million gain on the sale of the Company’s specialty polyurethane systems product line, the effects of lower raw material costs, the five percent sales volume increase and reduced 2015 bad debt expense, partially offset by a $3.1 million unfavorable effect of foreign currency translation and higher incentive-based pay compensation, led to the improvement in operating income. Last year’s bad debt expense included a $2.4 million charge for a customer that filed for bankruptcy protection. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: Gross profit for North American operations increased 29 percent year over year due to improved sales margins, increased sales volume and operating efficiencies. The sales margin improvement reflected lower costs for all major raw materials, better inventory cost positions throughout the year and manufacturing fee increases aimed at partially offsetting the increasing cost of maintaining the polymer production facilities. Less outsourcing during the year also contributed to the more favorable results. In addition to the foregoing, 2015 gross profit included the recognition of $1.0 million of previously deferred revenue due to the satisfaction of contractual requirements. Gross profit for European operations increased one percent. The effects of the eight percent sales volume increase and lower raw material costs were largely offset by an unfavorable $4.4 million foreign currency translation impact. The increase in gross profit for Asia and Other operations was primarily due to lower outsourcing and raw material costs and increased sales volume that more than offset the negative effects of foreign currency translation. Operating expenses for the Polymers segment (excluding the $2.9 million gain on the product line sale) increased $1.9 million, or seven percent, year over year. Much of the increase was attributable to higher incentive-based pay. In addition, operating expenses in China, where a new plant is being constructed, increased $1.1 million year over year. The higher expenses were partially offset by a $2.2 million decrease in bad debt expense. Last year’s bad debt expense included a $2.4 million bad debt charge for a customer that filed for bankruptcy. Foreign exchange translation had a favorable $1.6 million effect on the year-over-year operating expense change. Specialty Products Net sales for 2015 declined $0.8 million, or one percent, from net sales for 2014. The decline in net sales was due to a $2.7 million unfavorable foreign currency translation effect partially offset by higher average selling prices and a two percent increase in sales volume. All product lines reported slightly improved sales volumes year over year, principally due to a stronger fourth quarter. The increase in average selling prices reflected a more favorable mix of sales. Operating income decreased $6.1 million, or 58 percent, between years due to higher raw material costs and operating expenses, particularly for the food ingredient and nutritional supplement product lines. Fourth quarter 2015 operating income improved $1.0 million over fourth quarter 2014 operating income largely due to a 26 percent increase in sales volume and to a more profitable mix of sales. Corporate Expenses Corporate expenses, which comprise deferred compensation and other operating expenses that are not allocated to the reportable segments, increased $29.4 million to $66.6 million for 2015 from $37.2 million for 2014. The significant contributors to the year-over-year increase in corporate expenses included higher deferred compensation ($18.4 million), consulting ($5.9 million), fringe benefit ($5.4 million), talent acquisition/relocation ($1.5 million), expatriate ($0.8 million) and salaries ($0.7 million) expenses, along with the accumulation of a number of smaller expense increases. The increased expenses were partially offset by lower environmental remediation charges ($6.4 million). Deferred compensation was $6.5 million of expense for 2015 compared to $11.9 million of income for 2014. The change between years was largely attributable to a $9.61 per share increase in the value of Company common stock in 2015 compared to a $25.55 per share decrease in 2014. The following table presents the year-end Company common stock market prices used in the computation of deferred compensation expense: The increase in fringe benefit expenses resulted primarily from higher incentive-based compensation (both short- and long-term). In 2014, a limited amount of annual bonuses were paid because the Company failed to meet its financial performance targets. Consulting expenses increased largely due to the Company’s ongoing DRIVE initiative to improve efficiency across the Company’s global organization. The contract with the consulting company advising on the DRIVE initiative has expired, so it is expected that such expenses will decline in 2016. With respect to the decline in environmental remediation expenses, 2014 included $7.1 million of charges to increase the best estimate of the remediation liability for the Company’s Maywood site. The U.S. Environmental Protection Agency issued its record of decision for soil remediation at that site in September 2014, which led to the liability increase. 2014 Compared with 2013 Summary Net income attributable to the Company for 2014 declined 22 percent year over year to $57.1 million, or $2.49 per diluted share, compared to $72.8 million, or $3.18 per diluted share, for 2013. Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2014 follows the summary. Consolidated net sales for 2014 increased $46.4 million, or two percent, over consolidated net sales for 2013. Higher average selling prices favorably affected the year-over-year net sales change by $131.2 million. A four percent decline in sales volume and the effects of foreign currency translation unfavorably affected the net sales change by $74.0 million and $10.8 million, respectively. The increase in average selling prices was attributable to higher raw material costs, primarily for Surfactants. The sales volume decline was mainly driven by the Surfactants segment, which reported an eight percent year-over-year volume decrease. Most of the sales volume decline was attributable to North American operations. Sales volume for the Polymers segment increased 13 percent due to solid organic growth in North America and Europe and growth from the North American polyester resins business acquired from Bayer MaterialScience LLC (BMS) in June 2013. Sales volume for Specialty Products declined four percent. Operating income for 2014 declined $18.5 million, or 17 percent, from operating income for 2013. Gross profit decreased $32.1 million, or 11 percent, largely due to lower profits for Surfactants caused by reduced sales volumes and higher expenses for North American operations. Polymers gross profit improved nine percent between years due to sales volume growth that more than offset the effect of a $3.7 million business interruption insurance recovery that benefited 2013. Specialty Products reported a five percent year-over-year gross profit decline. Operating expenses, including business restructuring and asset impairment charges, declined $13.7 million, or eight percent, year over year. Lower deferred compensation and incentive-based compensation expenses were the major contributors to the decrease. The following summarizes the year-over-year changes in the individual income statement line items that comprise the Company’s operating expenses: · Selling expenses increased $1.5 million, or three percent, year over year. The increase was primarily attributable to $3.2 million in additional bad debt expense, most of which related to a $2.4 million bad debt charge necessitated when a major Polymer customer filed for bankruptcy protection in September 2014. The remainder of the bad debt expense increase reflected changes in allowances for certain high risk customers. A decline in incentive-based compensation, due to lower Company earnings, partially offset the effect of higher bad debt expense. · Administrative expenses increased $4.6 million, or seven percent, year over year primarily due to a $7.2 million increase in corporate legal and environmental expenses. A $7.1 million charge to increase the best estimate of the remediation liability for the Company’s Maywood, New Jersey, site accounted for the higher corporate legal and environmental expenses. The issuance of the final record of decision for the site in September 2014 by the U.S. Environmental Protection Agency (USEPA) as well as other subsequent communications with the USEPA led to the increase in the best estimate of the remediation liability. Lower year-over-year incentive-based compensation partially offset the impact of the increased remediation liability. · R&D expenses declined $1.4 million, or three percent, year over year. Lower incentive-based compensation, partially offset by higher salary expense accounted for most of the decline. · Deferred compensation plan activity resulted in $11.9 million of income in 2014 compared to $9.5 million of expense in 2013. A decrease in the value of Company stock for 2014 compared to an increase in the value of Company common stock for 2013 led to the year-over-year swing in deferred compensation results (see the ‘Overview’ and ‘Corporate Expenses’ sections of this MD&A for further details). · Business Restructuring and Asset Impairments - Expenses for business restructuring and asset impairments were $4.0 million in 2014 compared to $1.0 million in 2013. The following are brief descriptions of the restructuring and impairment activities for each year. See Note 22 to the consolidated financial statements for additional details. In the fourth quarter of 2014, a restructuring plan was approved that affects certain Company functions, principally the R&D function and to a lesser extent product safety and compliance and plant-site accounting functions. The objective of the plan was to better align staffing resources with the needs of the Company’s diversification and growth initiatives. In connection with the plan, the Company recognized a $1.7 million charge against income for the three and twelve months ended December 31, 2014. In the fourth quarter of 2014, the Company wrote off the net book values of three assets, resulting in a charge against income of $2.3 million for the three and twelve months ended December 31, 2014. All three assets were part of the Company’s Surfactants segment, although the write-off charges were excluded from Surfactants segment results. For the three and twelve months ended December 31, 2013, the Company recorded a $1.0 million restructuring charge for estimated severance expense related to an approved plan to reduce future costs and increase operating efficiencies by consolidating a portion of its North American Surfactants manufacturing operations (part of the Surfactants reportable segment). In the third quarter of 2014, the Company shut down certain production areas at its Canadian manufacturing site. The future savings resulting from the restructuring are expected to run approximately $2.5 million per year. Net interest expense for 2014 increased $1.1 million, or 10 percent, over net interest expense for 2013. The increase reflected the recognition of a full year’s interest on the $100.0 million private placement loan the Company executed in June 2013 to finance the BMS North American polyester resins acquisition and other capital expenditures. The loss from the Company’s 50-percent equity joint venture (TIORCO) declined $0.3 million year over year largely due to higher commission income. Other, net for 2014 was $1.3 million of income compared to $2.2 million of income for 2013. Investment income (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets declined $2.2 million between years to $1.5 million for 2014 from $3.7 million for 2013. Foreign exchange losses declined $1.3 million to $0.2 million for 2014 from $1.5 million for 2013. The effective tax rate was 24.4 percent in 2014 compared to 24.4 percent in 2013. Even though the tax rate remained the same year over year, there were significant offsetting items that impacted the rate. The tax rate was driven higher by certain retroactive tax benefits recorded in 2013 that were nonrecurring in 2014. The 2013 benefits included the income exclusion of certain biodiesel excise tax credits for the 2010 through 2012 tax periods and the federal research and development tax credit for the 2012 tax period. The 2014 tax rate was also negatively impacted by a lower domestic production activities deduction as a result of lower U.S. taxable income and by higher state taxes as a result of certain tax benefits recorded in 2013 that were nonrecurring in 2014. These items were offset by a greater percentage of consolidated income being generated outside the U.S. in 2014 where the effective tax rates are lower. See Note 9 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results Surfactants Surfactants net sales for 2014 declined $20.5 million, or two percent, from net sales for 2013. An eight percent decrease in sales volume and the effects of foreign currency translation accounted for $103.0 million and $11.1 million, respectively, of the net sales decline. All regions contributed to the drop in sales volume, although most of the decline was attributable to North American operations. An increase in average selling prices favorably affected the net sales change by $93.6 million. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined one percent due to a 10 percent drop in sales volume and the unfavorable effects of foreign currency translation, which accounted for $82.8 million and $4.3 million, respectively, of the net sales decrease. Lower year-over-year sales of products used in biodiesel, laundry and cleaning, personal care and agricultural chemical applications accounted for the North American sales volume decline. These sales volume decreases were partially offset by sales volume growth for products used in oil field and household, industrial and institutional (HI&I) applications and for surfactants sold through distributors. The Company chose not to manufacture and sell biodiesel products in 2014 because to do so would not have been economically advantageous. The decline in laundry and cleaning sales volume was largely attributable to customers bringing surfactant production in-house to more fully utilize their internal capacity. Sales volumes for laundry and cleaning and personal care products were negatively affected by the severe winter weather earlier in the year that caused production issues at some Company and customer manufacturing facilities. The decline in agricultural chemical sales volume reflected lower customer demand resulting from a shortened spring planting season resulting from prolonged winter weather in parts of the U.S. Average selling prices increased 11 percent, which offset the effects of the sales volume decline and unfavorable foreign currency translation by $76.8 million. The higher average selling prices were primarily attributable to higher raw material costs. Net sales for European operations increased less than one percent between years due to a $5.5 million favorable effect of foreign currency translation offset by lower average selling prices and sales volume. The foreign currency translation effect was primarily the result of a year-over-year stronger British pound sterling relative to the U.S. dollar. Average unit selling prices and sales volumes declined one percent each, reducing the year-over-year net sales change by $3.6 million and $1.7 million, respectively. The one percent decline in sales volume reflected lower demand for laundry and cleaning and fuel additive products offset by sales volume improvements for HI&I, agricultural chemicals and emulsion polymers and foamers products. Net sales for Latin American operations declined less than one percent due to the unfavorable effects of foreign currency translation ($9.9 million unfavorable effect) and a two percent decline in sales volume ($3.4 million unfavorable effect) offset by the impact of higher average selling prices ($12.9 million favorable effect). The foreign currency translation effect resulted from the year-over-year weakening of the Brazilian real and the Mexican and Colombian pesos against the U.S. dollar. The sales volume decline was attributable to lower sales out of Brazil, mainly due to decreased demand for laundry and cleaning products and to lower sales of agricultural chemical products resulting from drought conditions in Brazil. Higher raw material costs led to the increase in average selling prices. Net sales for Asian operations declined 15 percent due to an 18 percent decline in sales volume and to a $2.4 million unfavorable foreign currency translation effect. Sales volume in 2013 included one-time shipments of low-margin methyl ester and biodiesel products from the Company’s Singapore plant to customers in Asia and Europe that did not recur in 2014. Singapore sales volume of products to U.S. operations was up 46 percent, and sales volume for operations in the Philippines increased one percent. Surfactants operating income for 2014 declined $39.4 million, or 39 percent, from operating income for 2013. Gross profit decreased $40.2 million largely due to lower sales volume and higher expenses in North America. Foreign currency translation contributed $2.1 million to the gross profit decline. Operating expenses decreased $0.8 million, or one percent. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: North American gross profit declined 35 percent due to the effects of a 10 percent decline in sales volume and higher expenses. Manufacturing expenses were up $11.1 million, or eight percent, largely due to increased maintenance and depreciation costs. Prolonged inclement winter weather early in 2014 and a significant planned fourth quarter maintenance shutdown in a major production area at the Millsdale, Illinois, plant led to the increase in maintenance expenses. In addition to higher manufacturing costs, the Company incurred incremental transportation expenses for the transfer of some production from weather-affected locations to other less impacted North American plants. Transportation expenses continued to be higher throughout the balance of the year due to increased general freight rates and a planned infrastructure upgrade project at the Company’s Anaheim, California, plant. Further to all of the foregoing, a fourth quarter charge for a customer claim against the Company and higher year-over-year accelerated depreciation ($1.8 million in 2014 compared to $0.3 million in 2013) related to the restructuring plan approved in the fourth quarter of 2013 also contributed to the gross profit decline. Gross profit for European operations increased 10 percent year over year, reflecting a more favorable mix of sales and lower material and manufacturing costs that more than offset the impact of the one percent decline in sales volume. Gross profit for Latin American operations declined 11 percent due to lower sales volume, a less favorable mix of sales, higher raw material costs and an unfavorable $1.5 million foreign currency translation effect. The year-over-year increase in gross profit for Asian operations was driven by the sales volume increase to U.S. operations from the Company’s Singapore plant. Operating expenses for the Surfactants segment declined $0.8 million, or one percent, between years. Lower incentive-based compensation and the favorable effects of foreign currency translation ($0.7 million), partially offset by higher expenses in Latin America primarily due to increased spending to support the Company’s growing organization in Brazil, accounted for the year-over-year decline. Polymers Polymers net sales for 2014 increased $67.6 million, or 14 percent, over net sales for 2013. A 13 percent increase in sales volume, higher average selling prices and the effects of foreign currency translation accounted for $61.2 million, $6.3 million and $0.1 million, respectively, of the year-over-year net sales improvement. Sales volume was up between years for North American and European operations. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased 18 percent due to a 16 percent increase in sales volume. Specialty polyols, which includes the polyester resin business acquired from BMS in June 2013, accounted for about 56 percent of the sales volume increase (2014 included twelve months of sales related to the acquisition from BMS compared to seven months of sales in 2013). Sales volume for polyols used in rigid foam applications improved 13 percent, principally due to increased demand for greater insulation usage to conserve energy and to an improved economy. Sales volume of phthalic anhydride was essentially unchanged between years, as the impact of reduced business with a large phthalic anhydride customer was largely offset by new business. Net sales for European operations grew nine percent due to a nine percent increase in sales volume. Demand was strong for the Company’s polyol products used in rigid insulation board and metal panels in the first half of 2014. Sales volumes for the second half of 2014 were down slightly (less than one percent) from volumes for the second half of 2013 primarily due to the effects of the unsteady European economy. Net sales for Asia and Other regions were essentially unchanged between years. Higher average selling prices due to a more favorable sales mix offset the effects of a five percent sales volume decline. The sales mix reflected a year-over-year sales volume decrease in Asia and an increase in polymers sold in Latin America. Polymers operating income for 2014 increased $6.2 million, or 11 percent, over operating income for 2013. Most of the profit improvement was attributable to the sales volume increase for North American operations. The 2014 operating income growth was tempered by a $2.4 million bad debt charge resulting from the bankruptcy filing of a large North American phthalic anhydride customer. In addition, the 2013 results for European operations included the receipt of a $3.7 million business insurance recovery related to business interruption losses resulting from a 2011 fire that damaged equipment at the Company’s Germany plant. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: Gross profit for North American operations increased 20 percent principally due to the 16 percent increase in sales volume. All product lines contributed to the year-over-year gross profit growth. Specialty polyols, which includes the polyester resin business acquired from BMS in June 2013, accounted for 55 percent of the year-over-year gross profit improvement. Twelve months of financial activity for the new polyester resin activity were included in the 2014 financial results compared to seven months in the 2013 results. Gross profit for European operations declined 19 percent year over year in large part due to the non-recurring benefit of $3.7 million of business interruption insurance income recognized in 2013. In addition, current year margins declined from 2013 due to higher raw material costs, competitive pressures on selling prices and higher manufacturing expenses. The increase in gross profit for Asia and Other regions was primarily due to lower plant costs, higher selling prices and a more favorable mix of sales. Plant costs in 2013 included costs associated with the winding down of manufacturing operations at the Company’s Nanjing, China. In addition, a $0.6 million charge for accelerated depreciation was recognized in the first half of 2013 that did not recur in 2014. The results for 2014 were tempered by higher costs related to outsourcing products to sell. Operating expenses for the Polymers segment were up $1.5 million, or six percent, between years due to the $2.4 million bad debt charge for a phthalic anhydride customer that filed for bankruptcy. The effect of the bad debt charge was partially offset by lower 2014 incentive-based compensation attributable to lower total Company operating results. Specialty Products Net sales for 2014 declined $0.7 million, or one percent, from net sales for 2013 primarily due to a four percent decline in sales volume and to lower sales of products used in pharmaceutical applications, partially offset by increased selling prices. Operating income declined $0.4 million, or four percent, principally due to lower sales volume partially offset by lower operating expenses. Corporate Expenses Corporate expenses declined $18.2 million to $37.2 million for 2014 from $55.4 million for 2013. The decline in corporate expenses was primarily due to decreased deferred compensation ($21.4 million) and fringe benefit ($2.8 million) expenses partially offset by increased legal and environmental ($7.2 million) expenses. The decrease in deferred compensation expense ($11.9 million of income in 2014 compared to $9.5 million of expense in 2013) reflected a $25.55 per share decline in the value of Company stock for 2014 compared to an increase of $10.09 per share for 2013. Lower year-over-year mutual fund investment appreciation contributed to the decline in deferred compensation expense. The following table presents the year-end Company common stock prices used in the computation of deferred compensation expense: The decrease in fringe benefit expenses was largely attributable to a decline in 2014 incentive-based compensation, which reflected lower Company financial operating results. The higher year-over-year legal and environmental expense was due to a $7.1 million increase in the best estimate of the remediation liability for the Company’s Maywood site. The USEPA issued its final record of decision for the site in 2014, which led to the increase in the remediation liability. Liquidity and Financial Condition For the year ended December 31, 2015, operating activities were a cash source of $183.3 million versus a source of $82.0 million for the comparable period in 2014. For the current year period, investing cash outflows totaled $126.0 million and financing activities were a source of $42.9 million. Cash increased by $90.9 million with exchange rates reducing cash by $9.3 million. For 2015, net income was up by $19.0 million and working capital was a source of $24.8 million versus a cash use of $42.7 for the comparable year-ago period. Cash outflows for investing activities were up by $16.7 million year over year. Cash flow for financing activities was a source of $42.9 million in 2015 compared to a use of $14.9 million in 2014. For 2015, accounts receivable were a source of $4.2 million compared to a use of $21.2 million for the comparable period in 2014. Inventories were a source of $2.9 million in 2015 versus a use of $18.5 million in 2014. Accounts payable and accrued liabilities were a source of $21.2 million in 2015 compared to a use of $4.4 million in 2014. Working capital requirements were lower in 2015 compared to 2014 primarily due to lower raw material prices. The Company’s working capital investment is heavily influenced by the cost of crude oil and natural oils, from which many of its raw materials are derived. Fluctuations in raw material costs translate directly to inventory carrying costs and indirectly to customer selling prices and accounts receivable. The accounts receivable decrease for 2015 was driven mainly by lower sales prices partially offset by higher sales quantities. The inventory cash source for the year was driven mainly by lower raw material prices. The Company has not changed its own payment practices related to its payables. It is management’s opinion that the Company’s liquidity is sufficient to provide for potential increases in working capital during 2016. Investing cash outflows for the current year included capital expenditures of $119.3 million compared to $101.8 million for the comparable period last year. Other investing activities consumed $6.6 million in 2015 versus $7.4 million in 2014. Other investing activities in 2015 included $5.1 million used to purchase the production facility in Bahia, Brazil and $3.3 million from proceeds on the sale of the specialty polyurethane systems product line. For 2016, the Company estimates that capital expenditures will range from $115 million to $135 million including capacity expansions in the United States, Brazil and China. The Company purchases its common shares in the open market from time to time to fund its own benefit plans and also to mitigate the dilutive effect of new shares issued under its benefit plans. The Company may also make open market repurchases as cash flows permit when, in management’s opinion, the Company’s shares are undervalued in the market. For the twelve months ended December 31, 2015, the Company purchased 41,915 shares in the open market at a total cost of $2.0 million. At December 31, 2015, there were 761,764 shares remaining under the current share repurchase authorization. As of December 31, 2015, the Company’s cash and cash equivalents totaled $176.1 million, including $68.8 million in two separate U.S. money market funds, each of which was rated AAA by Standard and Poor’s and Aaa by Moody’s. Cash in U.S. demand deposit accounts totaled $20.2 million and cash of the Company’s non-U.S. subsidiaries held outside the U.S. totaled $87.1 million at December 31, 2015. Consolidated balance sheet debt increased by $58.7 million for the current year, from $273.9 million to $332.6 million. Since last year-end, domestic debt increased by $70.0 million and foreign debt decreased by $11.3 million. Net debt (which is defined as total debt minus cash) decreased by $32.2 million for the current year, from $188.7 million to $156.5 million. As of December 31, 2015, the ratio of total debt to total debt plus shareholders’ equity was 37.3 percent compared to 33.8 percent at December 31, 2014. As of December 31, 2015, the ratio of net debt to net debt plus shareholders’ equity was 21.9 percent, compared to 26.0 percent at December 31, 2014. At December 31, 2015, the Company’s debt included $322.1 million of unsecured private placement loans with maturities extending from 2016 through 2027. These loans are the Company’s primary source of long-term debt financing and are supplemented by bank credit facilities to meet short and medium-term needs. On July 10, 2015, the Company entered into a $100.0 million unsecured private placement loan. This loan bears interest at a fixed rate of 3.95% with interest to be paid semi-annually and with equal annual principal payments beginning on July 10, 2021, and continuing through final maturity on July 10, 2027. The proceeds of this loan will be used primarily for capital expenditures, to pay down existing debt in accordance with normal payment schedules and for other corporate purposes. This loan agreement requires the maintenance of certain financial ratios and covenants that are substantially identical to the Company’s existing long-term debt and customary events of default. The Company has a committed $125.0 million multi-currency syndicated revolving credit agreement. The credit agreement allows the Company to make unsecured borrowings, as requested from time to time, for working capital and other corporate purposes. This unsecured facility is the Company’s primary source of short-term borrowings and is committed through July 10, 2019, with terms and conditions that are substantially equivalent to those of the Company’s other U.S. loan agreements. As of December 31, 2015, the Company had outstanding letters of credit of $4.7 million under this agreement, and no borrowings, with $120.3 million remaining available. The Company anticipates that cash from operations, committed credit facilities and cash on hand will be sufficient to fund anticipated capital expenditures, working capital, dividends and other planned financial commitments for the foreseeable future. Certain foreign subsidiaries of the Company maintain term loans and short-term bank lines of credit in their respective local currencies to meet working capital requirements as well as to fund capital expenditure programs and acquisitions. At December 31, 2015, the Company’s foreign subsidiaries had outstanding debt of $10.5 million. The Company has material debt agreements that require the maintenance of minimum interest coverage and minimum net worth. These agreements also limit the incurrence of additional debt as well as the payment of dividends and repurchase of treasury shares. Testing for these agreements is based on the combined financial statements of the U.S. operations of the Company, Stepan Canada Inc., Stepan Quimica Ltda., Stepan Specialty Products, LLC, Stepan Specialty Products B.V. and Stepan Asia Pte. Ltd. (the “Restricted Group”). Under the most restrictive of these debt covenants: 1. The Restricted Group must maintain a minimum interest coverage ratio, as defined within the agreements, of 1.75 to 1.00, for the preceding four calendar quarters. 2. The Restricted Group must maintain net worth of at least $325.0 million. 3. The Restricted Group must maintain a ratio of long-term debt to total capitalization, as defined in the agreements, not to exceed 60 percent. 4. The Restricted Group may pay dividends and purchase treasury shares after December 31, 2013, in amounts of up to $100.0 million plus 100 percent of net income and cash proceeds of stock option exercises, measured cumulatively after June 30, 2014. The maximum amount of dividends that could have been paid within this limitation is disclosed as unrestricted retained earnings in Note 6, Debt, in the Notes to Consolidated Financial Statements. The Company believes it was in compliance with all of its loan agreements as of December 31, 2015. Based on current projections, the Company believes it will be in compliance with its loan agreements throughout 2016. Contractual Obligations At December 31, 2015, the Company’s contractual obligations, including estimated payments by period, were as follows: (a) Interest payments on debt obligations represent interest on all Company debt at December 31, 2015. The interest payment amounts related to the variable rate component of the Company’s debt assume that interest will be paid at the rates prevailing at December 31, 2015. Future interest rates may change, and, therefore, actual interest payments could differ from those disclosed in the above table. (b) Purchase obligations consist of raw material, utility and telecommunication service purchases made in the normal course of business. (c) The “Other” category comprises deferred revenues that represent commitments to deliver products, expected 2016 required contributions to the Company’s funded defined benefit pension plans, estimated payments related to the Company’s unfunded defined benefit supplemental executive and outside director pension plans, estimated payments (undiscounted) related to the Company’s asset retirement obligations, and environmental remediation payments for which amounts and periods can be reasonably estimated. The above table does not include $101.9 million of other non-current liabilities recorded on the balance sheet at December 31, 2015, as summarized in Note 15 to the consolidated financial statements. The significant non-current liabilities excluded from the table are defined benefit pension, deferred compensation, environmental and legal liabilities and unrecognized tax benefits for which payment periods cannot be reasonably determined. In addition, deferred income tax liabilities are excluded from the table due to the uncertainty of their timing. Pension Plans The Company sponsors a number of defined benefit pension plans, the most significant of which cover employees in its U.S. and U.K. locations. The U.S. and U.K. plans are frozen, and service benefit accruals are no longer being made. The funded status (pretax) of the Company’s defined benefit pension plans improved $5.7 million year over year, from $43.2 million underfunded at December 31, 2014, to $37.5 million underfunded at December 31, 2015. The effects of year-over-year increases in the discount rates used to measure pension obligations (30- and 50-point increases for the U.S. and U.K. plans, respectively) and a change in mortality assumptions, partially offset by less than expected pension asset performance, accounted for the improvement. The Company contributed $0.6 million to its funded defined benefit plans in 2015. In 2016, the Company expects to contribute a total of $0.4 million to the U.K. defined benefit plan. As a result of pension funding relief included in the Highway and Transportation Funding Act of 2014, the Company has no 2016 contribution requirement to the U.S. pension plans. Payments to participants in the unfunded non-qualified plans should approximate $0.2 million in 2016, which is the same as payments made in 2015. Letters of Credit The Company maintains standby letters of credit under its workers’ compensation insurance agreements and for other purposes as needed. The insurance letters of credit are renewed annually and amended to the amounts required by the insurance agreements. As of December 31, 2015, the Company had a total of $4.7 million in outstanding standby letters of credit. Off-Balance Sheet Arrangements The Securities and Exchange Commission requires disclosure of off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. During the periods covered by this Form 10-K, the Company was not party to any such off-balance sheet arrangements. Environmental and Legal Matters The Company’s operations are subject to extensive local, state and federal regulations. Although the Company’s environmental policies and practices are designed to ensure compliance with these regulations, future developments and increasingly stringent environmental regulation may require the Company to make additional environmental expenditures. The Company will continue to invest in the equipment and facilities necessary to comply with existing and future regulations. During 2015, the Company’s expenditures for capital projects related to the environment were $1.7 million. These projects are capitalized and depreciated over their estimated useful lives, which are typically 10 years. Recurring costs associated with the operation and maintenance of facilities for waste treatment and disposal and managing environmental compliance in ongoing operations at the Company’s manufacturing locations were approximately $22.1 million for 2015, $21.2 million for 2014 and $18.7 million for 2013. While difficult to project, it is not anticipated that these recurring expenses will increase significantly in the near future. Over the years, the Company has received requests for information related to or has been named by the government as a potentially responsible party at a number of waste disposal sites where cleanup costs have been or may be incurred under CERCLA and similar state statutes. In addition, damages are being claimed against the Company in general liability actions for alleged personal injury or property damage in the case of some disposal and plant sites. The Company believes that it has made adequate provisions for the costs it may incur with respect to the sites. See the Critical Accounting Policies section that follows for a discussion of the Company’s environmental liabilities accounting policy. After partial remediation payments at certain sites, the Company has estimated a range of possible environmental and legal losses from $20.9 million to $41.4 million at December 31, 2015, compared to $21.9 million to $41.8 million at December 31, 2014. At December 31, 2015, the Company’s accrued liability for such losses, which represented the Company’s best estimate within the estimated range of possible environmental and legal losses, was $20.9 million compared to $22.0 million at December 31, 2014. Because the liabilities accrued are estimates, actual amounts could differ from the amounts reported. During 2015, cash outlays related to legal and environmental matters approximated $2.7 million compared to $1.2 million expended in 2014. For certain sites, the Company has responded to information requests made by federal, state or local government agencies but has received no response confirming or denying the Company’s stated positions. As such, estimates of the total costs, or range of possible costs, of remediation, if any, or the Company’s share of such costs, if any, cannot be determined with respect to these sites. Consequently, the Company is unable to predict the effect thereof on the Company’s financial position, cash flows and results of operations. Given the information available, management believes the Company has no liability at these sites. However, in the event of one or more adverse determinations with respect to such sites in any annual or interim period, the effect on the Company’s cash flows and results of operations for those periods could be material. Based upon the Company’s present knowledge with respect to its involvement at these sites, the possibility of other viable entities’ responsibilities for cleanup, and the extended period over which any costs would be incurred, the Company believes that these matters, individually and in the aggregate, will not have a material effect on the Company’s financial position. See Item 3, Legal Proceedings, in this Form 10-K and Note 16, Contingencies, in the Notes to Consolidated Financial Statements for a summary of the significant environmental proceedings related to certain environmental sites. Outlook In 2016, the Company expects to build on the momentum generated in 2015. The business should benefit from a full year of higher commodity sulfonation volumes in North America and continued growth in core polymer markets. Benefits from the Company’s product and end-market diversification efforts, as well as lower costs associated with restructured activities, should positively impact 2016. Start-up expenses and lower growth rates in China will negatively impact Polymer performance. Both Surfactants and Polymers will experience higher costs during the fourth quarter due to a thirty-day government mandated shutdown of the Company’s facility in Germany. Specialty Products should improve on lower costs from structural actions taken in 2015. Climate Change Legislation Based on currently available information, the Company does not believe that existing or pending climate change legislation or regulation is reasonably likely to have a material effect on the Company’s financial condition, results of operations or cash flows. Critical Accounting Policies The Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of America (generally accepted accounting principles). Preparation of financial statements in accordance with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The following is a summary of the accounting policies the Company believes are the most important to aid in understanding its financial results: Deferred Compensation The Company sponsors deferred compensation plans that allow management employees to defer receipt of their annual bonuses and outside directors to defer receipt of their fees until retirement, departure from the Company or as elected by the participant. The plans allow for the deferred compensation to grow or decline based on the results of investment options chosen by the participants. The investment options include Company common stock and a limited selection of mutual funds. The Company funds the obligations associated with these plans by purchasing investment assets that match the investment choices made by the plan participants. A sufficient number of shares of treasury stock are maintained on hand to cover the equivalent number of shares that result from participants electing the Company common stock investment option. As a result, the Company must periodically purchase its common shares in the open market. Upon retirement or departure from the Company, participants receive cash amounts equivalent to the payment date value of the investment choices they have made or Company common stock shares equal to the number of share equivalents held in the accounts. Some plan distributions may be made in cash or Company common stock at the option of the participant. Other plan distributions can only be made in Company common stock. For deferred compensation obligations that may be settled in cash, the Company must record appreciation in the market value of the investment choices made by participants as additional compensation expense. Conversely, declines in the value of Company stock or the mutual funds result in a reduction of compensation expense since such declines reduce the cash obligation of the Company as of the date of the financial statements. These market price movements may result in significant period-to-period fluctuations in the Company’s income. The increases or decreases in compensation expenses attributable to market price movements are reported in the operating expenses section of the consolidated statements of income. Because the obligations that must be settled only in Company common stock are treated as equity instruments, fluctuations in the market price of the underlying Company stock do not affect earnings. At December 31, 2015, the Company’s deferred compensation liability was $44.0 million, of which approximately 57 percent represented deferred compensation tied to the performance of the Company’s common stock; the remainder was tied to the mutual fund investment choices. A $1.00 increase in the market price of the Company’s common stock will result in approximately $0.5 million of additional compensation expense. A $1.00 reduction in the market price of the common stock will reduce compensation expense by a like amount. The expense or income associated with the mutual fund component will generally fluctuate in line with the overall percentage increase or decrease of the U.S. stock markets. The mutual fund assets related to the deferred compensation plans are recorded on the Company’s balance sheet at cost when acquired and adjusted to their market values at the end of each reporting period. As allowed by generally accepted accounting principles, the Company elected the fair value option for recording the mutual fund investment assets. Therefore, market value changes for the mutual fund investment assets are recorded in the income statement in the same periods that the offsetting changes in the deferred compensation liabilities are recorded. Dividends, capital gains distributed by the mutual funds, unrealized gains and losses and realized gains and losses from sales of mutual fund shares, are recognized as investment income or loss in the other, net line of the consolidated statements of income. Environmental Liabilities It is the Company’s accounting policy to record environmental liabilities when environmental assessments and/or remedial efforts are probable and the cost or range of possible costs can be reasonably estimated. When no amount within a range of possible costs is a better estimate than any other amount, the minimum amount in the range is accrued. Some of the factors on which the Company bases its estimates include information provided by feasibility studies, potentially responsible party negotiations and the development of remedial action plans. Estimates for environmental liabilities are subject to significant fluctuations as new facts emerge related to the various sites where the Company is exposed to liability for the remediation of environmental contamination. See the Environmental and Legal Matters section of this MD&A for discussion of the Company’s recorded liabilities and range of loss estimates. Revenue Recognition Revenue is recognized upon shipment of goods to customers, at which time title and risk of loss pass to the customer. For arrangements where the Company consigns product to a customer location, revenue is recognized when the customer uses the inventory. The Company records shipping and handling billed to a customer in a sales transaction as revenue. Costs incurred for shipping and handling are recorded in cost of sales. Volume discounts due customers are estimated and recorded in the same period as the sales to which the discounts relate and are reported as reductions of revenue in the consolidated statements of income. Recent Accounting Pronouncements See Note 1 to the consolidated financial statements, included in Part II, Item 8, for information on recent accounting pronouncements which affect the Company.

<s>[INST] Certain matters discussed in the following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) include forwardlooking statements that are subject to certain risks, uncertainties and assumptions. Such forwardlooking statements are intended to be identified in this document by the words, “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “objective,” “outlook,” “plan,” “project,” “possible,” “potential,” “should” and similar expressions. Actual results may vary materially. Forwardlooking statements speak only as of the date they are made, and the Company does not undertake any obligation to update them to reflect changes that occur after that date. Factors that could cause actual results to differ materially include the items described in Item 1A of this Annual Report on Form 10K. Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: · Surfactants Surfactants, which accounted for 68 percent of consolidated net sales in 2015, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at six North American sites (five in the U.S. and one in Canada), three European sites (United Kingdom, France and Germany), four Latin American sites (Mexico, Colombia and two sites in Brazil) and two Asian sites (Philippines and Singapore). The Company also holds a 50 percent ownership interest in a joint venture, TIORCO, LLC, that markets chemical solutions for increasing the production of crude oil and natural gas from existing fields (enhanced oil recovery or EOR). The joint venture is accounted for under the equity method, and its financial results are excluded from surfactant segment operating results. See the ‘2015 Business Developments’ section that follows for additional information about the dissolution of the TIORCO venture. · Polymers Polymers, which accounted for 28 percent of consolidated net sales in 2015, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively CASE products) and flexible foams. Polyester resins, which include liquid and powdered products, are used in CASE and polyurethane systems house applications. CASE, polyester resins and flexible foam are collectively referred to as specialty polyols. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the U.S., polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site and specialty polyols are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyols are manufactured at the Company’s subsidiary in Germany and specialty polyols are manufactured at the Company’s Poland subsidiary. In Asia, polyols are currently toll produced for the Company’s 80percent owned joint venture in Nanjing, China. The Company is building a new plant in Nanjing that is expected to be operational in the first quarter of 2016. · Specialty Products Specialty products, which accounted for four percent of consolidated net sales in 2015, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, at outside contractors. 20 [/INST] Positive. </s>

STEPAN CO

2017-02-24

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following is management’s discussion and analysis (MD&A) of certain significant factors that have affected the Company’s financial condition and results of operations during the annual periods included in the accompanying consolidated financial statements. Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: • Surfactants - Surfactants, which accounted for 67 percent of Company consolidated net sales in 2016, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at five North American sites, three European sites (United Kingdom, France and Germany), five Latin American sites (Mexico, Colombia and three sites in Brazil) and two Asian sites (Philippines and Singapore). In 2016, the Company shut down its production facility in Canada, moving the production of goods previously manufactured in Canada to other Company North American production sites. Manufacturing operations at that facility have ceased, but decommissioning activities will continue into 2017. In October 2016, the Company’s subsidiary in Brazil closed on its previously announced agreement to acquire the commercial business of Tebras Tensoativos do Brazil Ltda. and the sulfonation production facility of PBC Industria Quimica Ltda. See Business Acquisition section below. In late 2016, a major customer of the Company’s Bahia, Brazil, plant exited the product line for which the Company was supplying them product. As a result, asset impairments were required (see Note 22 to the consolidated financial statements for additional information). Prior to 2016, the Company also held a 50 percent ownership interest in a joint venture, TIORCO, LLC (TIORCO), that marketed chemical solutions for enhanced oil recovery (EOR). The joint venture was accounted for under the equity method, and its financial results were excluded from surfactant segment operating results. In October 2015, the Company and its partner, Nalco Company (a subsidiary of Ecolab Inc.), made the decision to dissolve TIORCO. No business activities have been conducted since the fourth quarter of 2015. Legal dissolution of TIORCO is finalized. • Polymers - Polymers, which accounted for 28 percent of consolidated net sales in 2016, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively, CASE products) and flexible foams. Polyester resins, which include liquid and powdered products, are used in CASE and polyurethane systems house applications. CASE, polyester resins and flexible foam are collectively referred to as specialty polyols. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the United States, polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site and specialty polyols are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyurethane polyols are manufactured at the Company’s subsidiary in Germany, and specialty polyols are manufactured at the Company’s Poland subsidiary. In China, polyurethane polyols and specialty polyols are manufactured at the Company’s Nanjing, China, manufacturing plant that was commissioned in early 2016. • Specialty Products - Specialty Products, which accounted for five percent of consolidated net sales in 2016, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, at outside contractors. 2016 Business Acquisition On October 3, 2016, the Company’s subsidiary in Brazil acquired the commercial business of Tebras Tensoativos do Brazil Ltda. (Tebras) and the sulfonation production facility of PBC Industria Quimica Ltda. (PBC). The purchase price of the acquisitions, including adjustments for working capital, was approximately $29.1 million. The combined entities have 25,000 metric tons of sulfonation capacity and a large, diverse customer portfolio. The acquisition is expected to expand and diversify the Company’s customer base for sulfonated products in Brazil and to provide an opportunity to sell the Company’s broader surfactant portfolio to over 1,200 new customers who could benefit from the Company’s technical service and formulation support. The acquired businesses are included in the Company’s Surfactants segment. The acquired entities’ contributions to Company net sales and net income for the year ended December 31, 2016, were insignificant. See Note 20 to the consolidated financial statements for further information regarding the business acquisition. Deferred Compensation Plans The accounting for the Company’s deferred compensation plans can cause period-to-period fluctuations in Company expenses and profits. Compensation expense results when the values of Company common stock and mutual fund investment assets held for the plans increase, and compensation income results when the values of Company common stock and mutual fund investment assets decline. The pretax effect of all deferred compensation-related activities (including realized and unrealized gains and losses on the mutual fund assets held to fund the deferred compensation obligations) and the income statement line items in which the effects of the activities were recorded are presented in the following table: (1) See the applicable Corporate Expenses section of this MD&A for details regarding the period-to-period changes in deferred compensation. Below are the year-end Company common stock market prices used in the computation of deferred compensation expense: Effects of Foreign Currency Translation The Company’s foreign subsidiaries transact business and report financial results in their respective local currencies. As a result, foreign subsidiary income statements are translated into U.S. dollars at average foreign exchange rates appropriate for the reporting period. Because foreign exchange rates fluctuate against the U.S. dollar over time, foreign currency translation affects year-over-year comparisons of financial statement items (i.e., because foreign exchange rates fluctuate, similar year-to-year local currency results for a foreign subsidiary may translate into different U.S. dollar results). The following tables present the effects that foreign currency translation had on the year-over-year changes in consolidated net sales and various income line items for 2016 compared to 2015 and 2015 compared to 2014: Results of Operations 2016 Compared with 2015 Summary Net income attributable to the Company for 2016 increased 13 percent to $86.2 million, or $3.73 per diluted share, from $76.0 million, or $3.32 per diluted share, for 2015. Adjusted net income increased 24 percent to $98.2 million, or $4.25 per diluted share, from $79.4 million, or $3.46 per diluted share (See the “Reconciliations of Non-GAAP Adjusted Net Income and Diluted Earnings per Share” section of this MD&A for reconciliations between reported net income attributable to the Company and reported earnings per diluted share and non-GAAP adjusted net income and adjusted earnings per diluted share). Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2016 compared to 2015 follows the summary. Consolidated net sales declined $10.0 million, or one percent, between years. Sales volume increased six percent, which had a $114.0 million favorable effect on the year-over-year change in net sales. All three reportable segments contributed to the consolidated sales volume improvement. By segment, sales volume increased five percent, 12 percent and eight percent for Surfactants, Polymers and Specialty Products, respectively. The effect of increased consolidated sales volume was more than offset by lower selling prices and the unfavorable effects of foreign currency translation, which negatively affected the year-over-year net sales change by $81.1 million and $42.9 million, respectively. The decreased selling prices were primarily attributable to declines in raw material costs. Overall unit margins improved slightly between years. The unfavorable foreign currency translation effect reflected a stronger U.S. dollar against all currencies for countries where the Company has foreign operations. Operating income for 2016 improved $3.4 million, or three percent, over operating income for 2015 despite current year restructuring and asset impairment charges of $7.1 million and increased deferred compensation expense of $10.3 million. Operating income improved for Polymers and Specialty Products. Surfactant segment operating income declined four percent largely due to the settlement of two customer claims and accelerated depreciation related to the cessation of manufacturing operations at the Company’s Canadian plant. Last year’s operating income included a $2.9 million gain on the sale of the Company’s specialty polyurethane systems product line. Foreign currency translation had an unfavorable $3.7 million effect on the year-over-year consolidated operating income change. Operating expenses (including the business restructuring and asset impairment expenses) increased $24.0 million, or 13 percent, between years. Changes in the individual income statement line items that comprise the Company’s operating expenses were as follows: • Selling expenses increased $1.7 million, or three percent, year over year largely due to higher U.S. fringe benefit expenses ($1.0 million), which reflected increased incentive-based compensation (which includes stock-based compensation, bonuses and profit sharing) recognized as a result of the year-over-year improvement in Company financial performance and in Company common stock value. • Administrative expenses declined $0.9 million, or one percent, year over year. The decrease was attributable to lower consulting expense ($5.2 million) as external resources related to the initiative to improve efficiency across the Company’s global organization (referred to as DRIVE) were not used in 2016. Partially offsetting the lower consulting expense were higher fringe benefit ($2.3 million) and salary ($1.2 million) expenses. Higher U.S. incentive-based compensation led to the increase in fringe benefit expense. Legal and environmental expense also increased by $0.9 million primarily due to adjustments to Company environmental liabilities. • Research, development and technical service (R&D) expenses increased $5.8 million, or 12 percent, year over year. Higher expense for U.S. salaries and the related fringe benefits ($3.9 million) was the major contributor to the increase. In addition, foreign R&D expenses grew $0.4 million, as some of the Company’s non-U.S. subsidiaries have added product development resources to support their local needs. The accumulation of increases for a number of other expense items accounted for the remainder of the year-over-year variance. • Deferred compensation plan expense was $10.3 million higher in 2016 than in 2015 due to a significantly larger increase in the value of Company common stock during 2016 than for 2015. See the “Overview” and “Corporate Expenses” sections of this MD&A for further details. • Business restructuring and asset impairment charges totaled $7.1 million in 2016. There were no such charges in 2015. Restructuring expenses related to the closure of the Company’s surfactant plant in Canada amounted to $2.8 million. In addition, the Company recognized impairment charges of $4.3 million. See Note 22 to the consolidated financial statements for additional information. The business restructuring and asset impairment charges were excluded from the determination of segment operating income. Net interest expense for 2016 declined $1.3 million, or nine percent, from net interest expense for 2015. The decline in interest expense was principally attributable to higher interest income earned on excess cash. Lower average debt levels due to scheduled repayments also contributed. In the fourth quarter of 2015, the Company and its partner agreed to dissolve the TIORCO joint venture and, therefore, the Company has reported no results in the loss from equity joint venture line in 2016. The Company’s share of TIORCO’s loss for the 2015 was $7.0 million. Other, net income for 2016 declined $0.8 million, or 48 percent, from other, net income for 2015. Foreign exchange activity resulted in an insignificant loss in 2016 compared to a $0.7 million gain in 2015. Investment income (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets declined $0.1 million between years to $0.8 million in 2016 from $0.9 million in 2015. The effective tax rate was 24.3 percent in 2016 compared to 26.1 percent in 2015. The decrease was attributable to the following items: 1) a tax benefit derived from the early adoption of Accounting Standards Update No. 2016-9, Compensation - Stock Compensation (Topic 718): Improvement to Employee Share-Based Payment Accounting (see Recent Accounting Pronouncements in Note1 to the consolidated financial statements); 2) an unrecognized tax benefit recorded in 2015 that was nonrecurring in 2016; and 3) a more favorable geographical mix of income in 2016. This decrease was partially offset by the 2011 and 2012 Agricultural Chemicals Security Credit tax benefit recorded in 2015 that was nonrecurring in 2016. See Note 9 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results Surfactants Surfactants 2016 net sales declined $24.3 million, or two percent, from net sales reported in 2015. Sales volume increased five percent between years, which had a $58.5 million positive effect on the year-over-year net sales change. All regions, except Europe, contributed to the sales volume improvement. Decreased selling prices and foreign currency translation had negative effects of $48.3 million and $34.5 million, respectively, on the net sales change. North American operations accounted for most of the decline in selling prices, which reflected lower year-over-year costs for major raw materials and a less favorable sales mix. The foreign currency translation effect resulted from a stronger U.S. dollar compared to all currencies of the segment’s foreign operations. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined two percent between years. Sales volume increased seven percent, which favorably affected the year-over-year change in net sales by $49.7 million. The effect of the increased sales volume was more than offset by an eight percent decline in selling prices and the unfavorable impact of foreign currency translation, which negatively affected the change in net sales by $61.1 million and $1.7 million, respectively. Most of the sales volume growth occurred in the first three quarters of 2016. For the full year, laundry and cleaning products were the largest contributors to the sales volume improvement, as the Company derived the full-year benefits of a supply agreement with a large customer that commenced during the third quarter of 2015. Sales volume for products used in personal care applications declined, primarily due to weaker demand in the second half of 2016 coupled with some lost business. In addition, lower crude oil prices led to a decrease in sales volumes of oil field products used in EOR applications. The year-over-year decline in sales prices primarily reflected decreased raw material costs, particularly for the first half of 2016, and a less favorable sales mix. The foreign currency impact reflected a stronger U.S. dollar relative to the Canadian dollar. Net sales for European operations declined eight percent. Reducing 2016 net sales was $7.4 million of settlements for two customer claims (see Note 23 to the consolidated financial statements for further information). In addition, the unfavorable effects of foreign currency translation and a two percent decline in sales volume unfavorably impacted the change in net sales by $12.5 million and $4.6 million, respectively. Selling prices averaged one percent higher, which had a $3.1 million favorable effect on the year-over-year net sales change. A weaker British pound sterling relative to the U.S. dollar accounted for most of the foreign currency effect. The decline in sales volume was mainly attributable to weaker demand for agricultural chemicals, laundry and cleaning products and personal care products. Sales volumes of general surfactants sold through distributors increased year over year. Net sales for Latin American operations increased two percent. Included in fourth quarter and full year 2016 net sales was $4.3 million in compensation for future lost revenue related to a negotiated settlement with a major customer under contract with the region’s Bahia, Brazil, plant that exited the product line for which the Company supplied them product (see Note 22 to the consolidated financial statements for further information). A six percent increase in sales volume and higher selling prices favorably affected the year-over-year change in net sales by $8.7 million and $6.4 million, respectively. The unfavorable effects of currency translation offset the positive impacts of increased sales prices and volumes by $17.0 million. Improved laundry and cleaning and agricultural chemical sales volumes in Brazil accounted for most of the improvement in Latin America. New business related to the fourth quarter 2016 acquisitions of Tebras and PBC also contributed to the growth in sales volumes and net sales dollars. The higher selling prices reflected increased raw material costs and a more favorable mix of sales. The year-over-year weakening of the Brazilian real, Mexican peso and Colombian peso against the U.S. dollar led to the foreign currency translation effect. Net sales for Asian operations increased 13 percent primarily due to a nine percent increase in average selling prices and a seven percent growth in sales volume, which positively affected the year-over-year change in net sales by $6.1 million and $4.4 million, respectively. An improved mix of sales coupled with the effects of increased raw material costs led to the higher average selling prices. Most of the sales volume improvement was attributable to new business and increased demand from existing customers of the Company’s Philippine operations. Sales volume also increased from Singapore. Foreign currency translation had a $2.8 million unfavorable effect on the net sales change. Surfactant operating income for 2016 declined $4.3 million, or four percent, from operating income reported in 2015. Operating income for 2016 was negatively affected by accelerated depreciation related to the Canadian plant shutdown and by the settlement of customer claims in Europe. Gross profit increased $4.5 million, or two percent, largely due to higher sales volumes. The effects of foreign currency translation had an unfavorable $4.6 million impact on the year-over-year gross profit change. Operating expenses increased $8.8 million, or 10 percent. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: Gross profit for North American operations increased one percent principally as the result of the seven percent year-over-year improvement in sales volume. The favorable effect of the growth in sales volume was largely offset by $4.5 million of accelerated depreciation associated with the shutdown of manufacturing operations at the Company’s Canadian plant. Gross profit for European operations declined 26 percent between years largely due to the aforementioned $7.4 million customer claim settlements and a two percent decline in sales volume. The region also incurred approximately $0.6 million of expenses associated with a planned 30-day mandatory inspection shutdown of the Company’s plant in Germany. There was no such inspection in 2015. Foreign currency translation negatively affected the change in gross profit by $1.0 million. Gross profit for Latin American operations improved twelve percent mainly due to the $4.3 million settlement noted earlier and the effects of the six percent increase in sales volume. Foreign currency translation negatively impacted gross profit by $2.8 million. The contribution from the Tebras and PBC acquisitions was insignificant for 2016. Asia gross profit increased 66 percent largely due to the seven percent increase in sales volume and to margin improvement, particularly for the Company’s Philippine operations. A more favorable product mix, higher selling prices and greater utilization of the plant in the Philippines led to the margin improvement. Operating expenses for the Surfactants segment increased $8.8 million, or 10 percent, year over year. Expenses increased for all regions, reflecting the additional resources and expenditures necessary to support the segment’s global organization and growth initiatives. In addition, U.S. incentive-based compensation (which includes stock-based compensation, bonuses and profit sharing) increased between years due to improved Company financial performance and higher common stock prices. The favorable effects of foreign currency translation reduced the year-over-year change in operating expenses by $1.6 million. Polymers Polymer net sales for 2016 increased $7.3 million, or one percent, over net sales for 2015. Sales volume increased 12 percent, which had a $58.5 million favorable effect on the year-over-year net sales change. All regions contributed to the sales volume improvement. Lower selling prices and the effects of foreign currency translation unfavorably affected the net sales change by $42.9 million and $8.3 million, respectively. Year-over-year raw material cost declines led to the decrease in selling prices. The foreign currency translation effect reflected a stronger U.S. dollar against the currencies of the segment’s foreign operations. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased one percent. Sales volume increased nine percent, which had a $29.7 million favorable effect on the year-over-year net sales change. Selling prices declined eight percent, which offset the impact of higher sales volume by $27.5 million. The sales volume improvement was attributable to a 20 percent increase for polyols used in rigid foam applications. New business and the continued growth in demand for rigid foam insulation led to the polyol sales volume growth. Sales volume of phthalic anhydride and specialty polyols declined three and five percent, respectively, between years. Year-over-year decreases in the cost of raw materials drove the decline in selling prices. Net sales for European operations increased two percent. Sales volume grew 14 percent, which had a $20.8 million favorable effect on the year-over-year net sales change. The sales volume improvement was driven by new business and increased demand for polyols used in rigid foam insulation and insulated metal panels. The impact of higher sales volume was partially offset by the effects of lower selling prices and foreign currency translation, which negatively affected the change in net sales by $10.6 million and $6.9 million, respectively. Lower raw material costs led to the decline in selling prices. Net sales for Asia and Other operations increased eight percent between years due to a 29 percent increase in sales volume, which had a $6.8 million positive impact on the year-over-year net sales change. Business gained from efforts to fill the capacity of the Company’s new plant in Nanjing, China, accounted for most of the sales volume increase. The unfavorable effects of lower selling prices and foreign currency translation negatively impacted the change in net sales by $3.5 million and $1.5 million, respectively. Polymer operating income for 2016 increased $15.8 million, or 20 percent, over operating income for 2015. Results for 2015 included a $2.9 million gain from the sale of Company’s specialty polyurethane systems product line. Gross profit increased $20.3 million, or 19 percent, due to the 12 percent increase in sales volume and to improved margins resulting primarily from lower raw material costs and an improved product mix. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: Gross profit for North American operations increased 19 percent year over year. The nine percent increase in sales volume, the positive effects of lower raw material costs and a more favorable mix of sales all contributed to the improved gross profit. Production efficiencies were also a positive factor as unit manufacturing overhead costs declined as a result of production volume increases that outpaced a five percent year-over-year increase in plant expenses. Gross profit for European operations increased 24 percent primarily due to the 14 percent increase in sales volume and to lower raw material costs. The 2016 results were negatively affected by higher plant expenses that resulted from the planned 30-day mandatory inspection shutdown of manufacturing operations in Germany during the third quarter of 2016. As a result of the shutdown, 2016 plant expenses included $2.4 million of inspection and storage expenses not incurred in 2015. The unfavorable effects of foreign currency translation negatively impacted the year-over-year change in gross profit by $1.0 million. Gross profit for Asia and Other operations declined 24 percent despite a 29 percent increase in sales volume. Higher overhead costs due to operating the new China plant at partial capacity led to the decline in gross profit. Most of the decline occurred in the fourth quarter when it was no longer necessary for the plant to manufacture product for other Company locations as it had done for a large period of 2016. Operating expenses for the Polymers segment increased $1.6 million, or five percent, year over year largely due to higher U.S. incentive-based compensation resulting from improved year-over-year Company financial performance and common stock prices. Specialty Products Net sales for 2016 increased $6.9 million, or nine percent, over net sales for 2015. An eight percent increase in sales volume accounted for most of the net sales improvement. Selling prices increased approximately one percent. Most of the sales volume increase was attributable to increased demand for products used in food ingredient applications. Operating income increased $6.3 million year over year due to increased sales volume and lower manufacturing and operating expenses. The decline in expenses reflected actions taken in 2015 to reduce the segment’s cost structure. Approximately half of the year-over-year operating income improvement occurred in the fourth quarter due to higher sales volumes and selling prices and lower costs for food ingredient products. Corporate Expenses Corporate expenses increased $14.5 million to $81.1 million for 2016 from $66.6 million for 2015. The increase was primarily attributable to increased expenses for deferred compensation ($10.3 million), fringe benefits ($1.4 million) and salaries ($1.2 million) expenses and the previously discussed restructuring and impairment charges ($7.1 million). Increased incentive-based compensation expenses, driven by improved year-over-year Company financial results and increased Company common stock values, led to the higher fringe benefit expenses. Consulting expenses declined $5.2 million between years principally due to no external resources being used in 2016 for the Company’s DRIVE efficiency efforts. Deferred compensation was $16.8 million of expense for 2016 compared to $6.5 million of expense for 2015. The higher expense primarily resulted from a $31.79 per share increase in the value of Company common stock over the twelve months ended December 31, 2016, compared to a $9.61 per share increase for the same period of 2015. The following table presents the year-end Company common stock market prices used in the computation of deferred compensation expense: 2015 Compared with 2014 Summary Net income attributable to the Company for 2015 increased 33 percent to $76.0 million, or $3.32 per diluted share, from $57.1 million, or $2.49 per diluted share, for 2014. Adjusted net income for 2015 increased 38 percent to $79.4 million, or $3.46 per diluted share, from $57.7 million, or $2.52 per diluted share, for 2014 (See the “Reconciliations of Non-GAAP Adjusted Net Income and Dilutive Earnings per Share” section of this MD&A for reconciliations between non-GAAP adjusted net income and adjusted earnings per diluted share and reported net income attributable to the Company and reported earnings per diluted share). Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2015 compared to 2014 follows the summary. Consolidated net sales for 2015 declined $151.0 million, or eight percent, from consolidated net sales for 2014. A five percent increase in sales volume favorably affected the year-over-year net sales change by $96.6 million. All three segments contributed to the consolidated sales volume improvement. Sales volumes for Surfactants and Polymers grew five percent each, and sales volumes for the Specialty Products segment increased two percent. The positive effect of increased sales volume was more than offset by the unfavorable effects of foreign currency translation and lower selling prices, which accounted for $131.8 million and $115.8 million, respectively, of the year-over-year net sales decline. The unfavorable foreign currency translation effect reflected a stronger U.S. dollar against all currencies of countries where the Company has foreign operations. Selling prices were lower primarily related to certain pass-through contract requirements associated with lower raw materials costs. Overall margins improved slightly. The decline in raw material costs reflected the impacts of decreases in the cost of crude oil and of diminished demand from sluggish economies in China and other emerging market countries. Operating income for 2015 increased $32.1 million, or 35 percent, over operating income reported for 2014, largely due to improved results for Surfactants and Polymers. Increased deferred compensation expense and the effects of foreign currency translation negatively affected the year-over-year operating income change by $18.4 million and $13.2 million, respectively. Included in the 2015 results was a $2.9 million gain on the divestiture of the Company’s specialty polyurethane systems product line (part of the Polymers segment). See Note 21 to the consolidated financial statements for additional information regarding the sale. In addition, operating income for 2014 was unfavorably affected by $4.0 million of restructuring and asset impairment charges and a $2.4 million bad debt charge necessitated when a major Polymer customer filed for bankruptcy protection. Operating expenses for 2015 increased $33.5 million, or 22 percent, over operating expenses for 2014. Higher deferred compensation, incentive-based compensation and consulting expenses were the major contributors to the increase. The following summarizes the year-over-year changes in the individual income statement line items that comprise the Company’s operating expenses: • Selling expenses increased $0.8 million, or one percent, year over year primarily due to higher global fringe benefit expenses, largely offset by the favorable impact of foreign currency translation ($3.9 million) and a reduction in bad debt expense. U.S. fringe benefit expenses, which accounted for the largest share of the fringe benefit expense increase, were up $5.8 million primarily due to increased incentive-based compensation. Bad debt expense for 2014 included a $2.4 million charge for a Polymer customer that filed for bankruptcy protection. • Administrative expenses increased $9.5 million, or 14 percent, year over year due to increases for consulting ($5.9 million), fringe benefits ($4.7 million), talent acquisition/relocation ($1.5 million), expatriate ($0.8 million), salaries ($0.7 million) and the accumulation of a number of smaller expense increases. Administrative expenses were up $0.7 million in China, where a new plant is being constructed. Administrative expenses for both Europe and Brazil operations were generally up, but the increases were offset by the favorable effects of foreign currency translation. Partially offsetting the increases were lower environmental remediation expenses ($6.4 million). The increase in consulting expenses was related to the Company’s ongoing initiative to improve efficiency across the Company’s global organization (the initiative is referred to as DRIVE within the Company). Higher incentive-based compensation costs accounted for the increase in fringe benefit expenses. With respect to the decline in environmental remediation expenses, 2014 included a $7.1 million charge to increase the remediation liability for the Company’s Maywood, New Jersey, site. The U.S. Environmental Protection Agency issued its record of decision for soil remediation at that site in September 2014, which led to the higher liability compared to 2015. • Research, development and technical service (R&D) expenses increased $4.8 million, or 11 percent, year over year primarily due to higher fringe benefit expenses ($6.2 million) partially offset by the favorable effects of foreign currency translation ($1.1 million). Increased incentive-based compensation expenses accounted for most of the higher fringe benefit expenses. • Deferred compensation plan activity resulted in $6.5 million of expense in 2015 compared to $11.9 million of income in 2014. An increase in the value of Company stock for 2015 compared to a decrease in the value of Company common stock for 2014 led to the year-over-year swing in deferred compensation results (see the ‘Overview’ and ‘Corporate Expenses’ sections of this MD&A for further details). Net interest expense for 2015 increased $3.1 million, or 27 percent, over net interest expense for 2014. Higher average debt levels resulting from the July 2015 issuance of $100.0 million in unsecured debt was the principal contributor to the increase. See Note 6 to the consolidated financial statements for further information regarding the 2015 private placement debt. The loss from the Company’s 50-percent equity joint venture (TIORCO) increased $2.0 million year over year largely due to the Company’s $2.4 million-share of exit costs recorded by TIORCO in the fourth quarter of 2015. The costs were precipitated by the joint venture partners’ agreement to dissolve the venture. See Note 24 to the consolidated financial statements for further information regarding the dissolution of TIORCO. Other, net income for 2015 increased $0.3 million, or 23 percent, over other, net income for 2014. Foreign exchange activity resulted in a $0.7 million gain in 2015 compared to a $0.2 million loss in 2014. Investment income (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets declined $0.6 million between years to $0.9 million in 2015 from $1.5 million in 2014. The effective tax rate was 26.1 percent in 2015 compared to 24.4 percent in 2014. The increase was attributable to certain favorable foreign tax benefits recorded in 2014 that were nonrecurring in 2015, an unrecognized tax benefit recorded in 2015 for prior tax years, and a less favorable geographical mix of income in 2015. The 2015 tax rate was also negatively impacted by the lower tax benefit realized on nontaxable foreign interest income due to higher consolidated income. These items were partially offset by higher U.S. tax credits recorded in 2015. U.S. tax credits included the current year R&D credit, which was permanently extended on December 18, 2015, and the Agricultural Chemicals Security Credit related to the 2011 and 2012 tax returns. See Note 9 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results Surfactants Surfactants 2015 net sales declined $90.8 million, or seven percent, from 2014 net sales. Sales volume increased five percent between years, which had a $67.0 million positive effect on the year-over-year net sales change. All regions contributed to the sales volume improvement. Foreign currency translation and decreased selling prices had negative effects of $97.9 million and $59.9 million, respectively, on the net sales change. Compared to 2014, the U.S. dollar was stronger against all currencies of the segment’s foreign operations. Selling prices were lower primarily related to certain pass-through contract requirements associated with lower raw materials costs. Overall margins improved slightly. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined seven percent between years. Sales volume increased three percent, which favorably affected the change in net sales by $26.2 million. The sales volume impact was more than offset by a nine percent decline in average selling prices and the unfavorable effects of foreign currency translation, which led to year-over-year net sales decreases of $72.8 million and $7.9 million, respectively. The improved sales volume resulted from increased sales of laundry and cleaning and personal care products, partially offset by decreased sales of functional surfactants and household, industrial and institutional (HI&I) products. The increase in laundry and cleaning sales volume was largely due to additional volumes resulting from the Company’s 2015 long-term supply agreement with a large customer. Personal care sales volumes increased principally due to higher demand from existing customers. The decline in sales volumes for functional surfactants was principally due to lower sales of products used in oil field and agricultural applications. Decreased sales volumes to EOR customers, driven by the decline in crude oil prices, led to the lower oil field sales volume. The decline in agricultural chemicals sales volume was largely due to customers’ carryover inventory from 2014 and to farmers’ efforts to reduce spraying costs due to lower crop prices. HI&I sales volume was down mainly due to some lost business. The drop in selling prices was primarily attributable to decreases in raw material costs. The negative foreign currency translation effect reflected a stronger U.S. dollar relative to the Canadian dollar. Net sales for European operations declined ten percent between years. Sales volume was up six percent, which favorably affected year-over-year net sales by $16.8 million. The sales volume impact was more than offset by the unfavorable effects of foreign currency translation and a two percent decline in selling prices, which accounted for $40.7 million and $4.9 million of the year-over-year net sales decline. An increase in sales of laundry and cleaning and agricultural chemical products, due to stronger demand from existing customers and new business, led to the improvement in sales volume. A stronger U.S. dollar against the European euro and British pound sterling led to the foreign currency translation result. Net sales for Latin American operations declined seven percent between years due to a $48.0 million unfavorable effect of foreign currency translation. A 12 percent increase in sales volume and a 10 percent increase in selling prices offset the foreign currency translation impact by $18.8 million and $17.9 million, respectively. Brazil operations accounted for most of the increased Latin American sales volume, with stronger demand from existing customers and business gained as a result of the P&G Brazil acquisition finalized in the second quarter of 2015. Sales volume was up for Colombia operations but was partially offset by a decline in sales volume in Mexico. The foreign currency translation effect resulted from the year-over-year weakening of the Brazilian real as well as the Colombian and Mexican pesos against the U.S. dollar. Net sales for Asian operations increased seven percent due to increased selling prices and a three percent increase in sales volume, which accounted for $3.4 million and $1.7 million, respectively, of the year-over-year increase in net sales. The increase in sales volume was primarily attributable to the Company’s Philippines operation, partially offset by lower sales volume for Singapore operations. The unfavorable effects of foreign currency translation offset the effects of higher sales volume and selling prices by $1.3 million. Surfactants operating income for 2015 increased $43.3 million, or 71 percent, over operating income for 2014. Gross profit increased $48.0 million largely due to strong improvement for North American operations. All other regions except Asia also reported increased profits. Foreign currency translation reduced the year-over-year gross profit and operating income increase by $16.7 million and $10.4 million, respectively. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: Gross profit for North American operations increased 48 percent year over year primarily due to improved operations, the three percent sales volume increase and better sales margins. The improved sales margin resulted from lower raw material and transportation costs. Costs for all major surfactant raw materials declined year-over-year. In 2014, the Company incurred additional transportation expenses due to higher fuel costs and to carrier delays and suboptimal supply chain movements related to the effects of severe winter weather and to upgrades at the Anaheim, California, plant that resulted in shifting production to other Company locations. Other items contributing to the year-over-year increase in gross profit were the favorable 2015 resolution of a previously recorded customer claim and $1.8 million of accelerated depreciation recorded in 2014 related to the Company’s 2013 restructuring plan. The effect of foreign currency translation on the year-over-year change in gross profit was an unfavorable $1.7 million. Gross profit for European operations increased 14 percent between years principally due to the six percent increase in sales volume and to sales margin improvement. The margin improvement reflected a more favorable mix of sales (growth in agricultural sales volume) and declines in raw material costs. Foreign currency translation had a $5.4 million unfavorable effect on the year-over-year change in gross profit. Gross profit for Latin American operations increased 28 percent largely due to a more profitable mix of sales, higher selling prices and the 12 percent increase in sales volume that more than offset an unfavorable foreign currency translation impact of $9.5 million. Asia gross profit declined 14 percent largely due to a less profitable mix of sales reflecting lower sales out of Singapore. Operating expenses for the Surfactants segment increased $4.7 million, or six percent, year over year. Excluding the effects of foreign currency translation, operating expenses increased $11.1 million. North American operations, European operations and Latin American operations accounted for $7.1 million, $1.9 million and $1.7 million of the increase, respectively. Higher fringe benefits, particularly incentive-based compensation, accounted for a large portion of the operating expense increases. Reimbursement from new consortium members of past European product registration fees ($1.3 million) favorably impacted current year expenses. Polymers Polymers net sales for 2015 declined $59.5 million, or 11 percent, from net sales for 2014. Sales volume was up five percent, which had a $25.2 million favorable effect on the year-over-year change in net sales. All regions reported improved volumes. Lower selling prices and the effects of foreign currency translation negatively impacted the year-over-year net sales change by $53.4 million and $31.3 million, respectively. Selling prices were lower primarily related to certain pass-through contract requirements associated with lower raw materials costs. Overall margins improved slightly. The foreign currency translation effect reflected a stronger U.S. dollar against the currencies of the segment’s foreign operations. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined nine percent. Sales volume increased three percent, which had a $10.0 million favorable effect on the year-over-year net sales change. Selling prices declined 11 percent, which unfavorably affected year-over-year net sales by $39.9 million. Sales volume of polyols used in rigid foam applications increased one percent, while sales volume of specialty polyols declined five percent. A drop in sales for products used in lower-margin flexible foam applications led to the decline in specialty polyol sales volume. Phthalic anhydride sales volume increased 10 percent as the result of new business coupled with stronger demand from existing customers. The reduction in sales prices reflected decreases in the costs of major raw materials. Net sales for European operations declined 14 percent between years. Sales volume increased eight percent, which positively affected the year-over-year net sales change by $14.3 million. Increased sales of rigid polyols used in insulation board and metal panels accounted for the volume improvement. The unfavorable effects of foreign currency translation and a five percent decline in selling prices negatively affected the year-over-year change in net sales by $29.7 million and $9.8 million, respectively. The foreign currency translation effect reflected a stronger U.S. dollar relative to the Polish zloty. The selling price decline was principally attributable to decreases in raw material costs. Net sales for Asia and Other operations declined 16 percent due to lower selling prices and the unfavorable effects of foreign currency translation, which accounted for $3.3 million and $1.5 million of the year-over-year net sales decrease, respectively. Reduced raw material costs led to the lower selling prices. Sales volume increased two percent, which had a $0.5 million positive impact on the net sales change. The volume gain reflected increased sales volume in Asia. Polymer 2015 operating income increased $20.3 million, or 33 percent, over 2014 operating income. The $2.9 million gain on the sale of the Company’s specialty polyurethane systems product line, the effects of lower raw material costs, the five percent sales volume increase and reduced 2015 bad debt expense, partially offset by a $3.1 million unfavorable effect of foreign currency translation and by higher incentive-based compensation, led to the improvement in operating income. Bad debt expense for 2014 included a $2.4 million charge for a customer that filed for bankruptcy protection. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: Gross profit for North American operations increased 29 percent year over year due to improved sales margins, increased sales volume and operating efficiencies. The sales margin improvement reflected lower costs for all major raw materials, better inventory cost positions throughout the year and manufacturing fee increases aimed at partially offsetting the increasing cost of maintaining the polymer production facilities. Less outsourcing during the year also contributed to the more favorable results. In addition to the foregoing, 2015 gross profit included the recognition of $1.0 million of previously deferred revenue due to the satisfaction of contractual requirements. Gross profit for European operations increased one percent. The effects of the eight percent sales volume increase and lower raw material costs were largely offset by an unfavorable $4.4 million foreign currency translation impact. The increase in gross profit for Asia and Other operations was primarily due to lower outsourcing and raw material costs and increased sales volume that more than offset the negative effects of foreign currency translation. Operating expenses for the Polymers segment increased $1.9 million, or seven percent, year over year. Much of the increase was attributable to higher incentive-based pay. In addition, operating expenses in China, where a new plant was being constructed, increased $1.1 million year over year. The higher expenses were partially offset by a $2.2 million decrease in bad debt expense. Bad debt expense for 2014 included a $2.4 million bad debt charge for a customer that filed for bankruptcy. Foreign exchange translation had a favorable $1.6 million effect on the year-over-year operating expense change. Specialty Products Net sales for 2015 declined $0.8 million, or one percent, from net sales for 2014. The decline in net sales was due to a $2.7 million unfavorable foreign currency translation effect partially offset by higher average selling prices and a two percent increase in sales volume. All product lines reported slightly improved sales volumes year over year, principally due to a stronger fourth quarter. The increase in average selling prices reflected a more favorable mix of sales. Operating income decreased $6.1 million, or 58 percent, between years due to higher raw material costs and operating expenses, particularly for the food ingredient and nutritional supplement product lines. Fourth quarter 2015 operating income improved $1.0 million over fourth quarter 2014 operating income largely due to a 26 percent increase in sales volume and to a more profitable mix of sales. Corporate Expenses Corporate expenses increased $29.4 million to $66.6 million for 2015 from $37.2 million for 2014. The significant contributors to the year-over-year increase in corporate expenses included higher deferred compensation ($18.4 million), consulting ($5.9 million), fringe benefit ($5.4 million), talent acquisition/relocation ($1.5 million), expatriate ($0.8 million) and salaries ($0.7 million) expenses, along with the accumulation of a number of smaller expense increases. The increased expenses were partially offset by lower environmental remediation charges ($6.4 million). Deferred compensation was $6.5 million of expense for 2015 compared to $11.9 million of income for 2014. The change between years was largely attributable to a $9.61 per share increase in the value of Company common stock in 2015 compared to a $25.55 per share decrease in 2014. The following table presents the year-end Company common stock market prices used in the computation of deferred compensation expense: The increase in fringe benefit expenses resulted primarily from higher incentive-based compensation (both short- and long-term). In 2014, a limited amount of annual bonuses were paid because the Company failed to meet its financial performance targets. Consulting expenses increased largely due to the Company’s ongoing DRIVE initiative to improve efficiency across the Company’s global organization. With respect to the decline in environmental remediation expenses, 2014 included $7.1 million of charges to increase the best estimate of the remediation liability for the Company’s Maywood site. The U.S. Environmental Protection Agency issued its record of decision for soil remediation at that site in September 2014, which led to the higher 2014 liability. Liquidity and Financial Condition Overview Historically, the Company's principal sources of liquidity have included cash flows from operating activities, available cash and cash equivalents and the use of available borrowing facilities. The Company's principal uses of cash have included funding operating activities, capital investments and acquisitions. For the year ended December 31, 2016, operating activities were a source of $212.2 million versus a source of $183.3 million for the comparable period in 2015. For the current year, investing cash outflows totaled $130.5 million and financing activities were a use of $29.8 million. Cash increased by $49.6 million with exchange rates reducing cash by $2.3 million. At December 31, 2016, the Company’s cash and cash equivalents totaled $225.7 million including $38.6 million in two separate money market funds, each of which was rated AAA by Standard and Poor’s and/or Aaa by Moody’s. Cash in U.S. demand deposit accounts totaled $88.9 million and cash of the Company’s non-U.S. subsidiaries held outside the U.S. totaled $98.2 million as of December 31, 2016. Operating Activity For 2016, net income increased by $10.2 million and working capital was a source of $18.8 million versus a source of $24.8 million in 2015. The Company’s working capital investment is heavily influenced by the cost of crude oil and natural oils, from which many of its raw materials are derived. Fluctuations in raw material costs translate directly to inventory carrying costs and indirectly to customer selling prices and accounts receivable. Working capital requirements were lower in 2016 compared to the same period in 2015 due to higher accounts payable and accrued liabilities, partially offset by increased inventory quantities and price. For 2016, accounts receivable were a use of $17.2 million compared to a source of $4.2 million for the comparable period in 2015. Inventories were a use of $3.8 million in 2016 versus a source of $2.9 million in 2015. Accounts payable and accrued liabilities were a source of $38.3 million in 2016 compared to a source of $21.2 million in 2015. The 2016 accounts receivable increase was principally driven by higher sales quantities. The inventory increase for the year was driven by higher raw material prices and higher inventory levels resulting from planned increases to support customer service levels. It is management’s opinion that the Company’s liquidity is sufficient to provide for potential increases in working capital during 2017. Investing Activity Cash outflows for investing activities increased by $4.6 million year over year. Cash outflows from investing activities for the current year included capital expenditures of $103.1 million compared to $119.3 million for the comparable period last year. All other investing activities consumed $27.4 million in 2016 versus $6.6 million in 2015. Other investing activities in 2016 included $23.5 million used to acquire a production facility (Tebras) and a commercial business (PBC) in Brazil. For 2017, the Company estimates that capital expenditures will range from $100 million to $120 million including capacity expansions in the United States and Germany. Financing Activity Cash flow from financing activities was a use of $29.8 million in 2016 compared to a source of $42.9 million in 2015. The year-over-year swing in financing activity was primarily the result of borrowing $100.0 million via an unsecured private placement loan in 2015. No such borrowings were made in 2016. The effect of the borrowing on the year-over-year change in financing activity was partially offset by lower debt repayments made in 2016 compared to 2015. The Company purchases its common stock in the open market from time to time to fund its own benefit plans and also to mitigate the dilutive effect of new shares issued under its benefit plans. The Company may, from time to time, seek to retire or purchase additional amounts of the Company’s outstanding equity and/or debt securities through cash purchases and/or exchanges for other securities, in open market purchases, privately negotiated transactions or otherwise, including pursuant to a Rule 10b5-1 plan. Such repurchases or exchanges, if any, will depend on prevailing market conditions, the Company’s liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. For the twelve months ended December 31, 2016, the Company purchased 43,835 shares in the open market at a total cost of $2.4 million. At December 31, 2016, there were 717,929 shares remaining under the current share repurchase authorization. Debt and Credit Facilities Consolidated balance sheet debt (including debt issuance costs) decreased by $14.4 million for the current year, from $331.4 million to $317.0 million primarily due to a decrease of domestic debt by $11.3 million. Net debt (which is defined as total debt minus cash - See the “Reconciliation of Non-GAAP Net Debt” section of this MD&A) decreased by $63.9 million for the current year, from $155.2 million to $91.3 million. As of December 31, 2016, the ratio of total debt to total debt plus shareholders’ equity was 33.3 percent compared to 37.3 percent at December 31, 2015. As of December 31, 2016, the ratio of net debt to net debt plus shareholders’ equity was 12.6 percent, compared to 21.8 percent at December 31, 2015. At December 31, 2016, the Company’s debt included $310.7 million of unsecured private placement loans with maturities extending from 2017 through 2027. These loans are the Company’s primary source of long-term debt financing and are supplemented by bank credit facilities to meet short and medium-term needs. The Company has a committed $125.0 million multi-currency syndicated revolving credit agreement. The credit agreement allows the Company to make unsecured borrowings, as requested from time to time, for working capital and other corporate purposes. This unsecured facility is the Company’s primary source of short-term borrowings and is committed through July 10, 2019. As of December 31, 2016, the Company had outstanding letters of credit of $4.8 million under this agreement, and no borrowings, with $120.2 million remaining available. The Company anticipates that cash from operations, committed credit facilities and cash on hand will be sufficient to fund anticipated capital expenditures, working capital, dividends and other planned financial commitments for the foreseeable future. Certain foreign subsidiaries of the Company maintain short-term bank lines of credit in their respective local currencies to meet working capital requirements as well as to fund capital expenditure programs and acquisitions. At December 31, 2016, the Company’s foreign subsidiaries had outstanding debt of $7.4 million based on the applicable ending currency exchange rates at that date. The Company has material debt agreements that require the maintenance of minimum interest coverage and minimum net worth. These agreements also limit the incurrence of additional debt as well as the payment of dividends and repurchase of treasury shares. Testing for these agreements is based on the combined financial statements of the U.S. operations of the Company, Stepan Canada Inc., Stepan Quimica Ltda., Stepan Specialty Products, LLC, Stepan Specialty Products B.V. and Stepan Asia Pte. Ltd. (collectively, the “Restricted Group”). Under the most restrictive of these debt covenants: 1. The Restricted Group must maintain a minimum interest coverage ratio, as defined within the agreements, of 1.75 to 1.00, for the preceding four calendar quarters. 2. The Restricted Group must maintain net worth of at least $325.0 million. 3. The Restricted Group must maintain a ratio of long-term debt to total capitalization, as defined in the agreements, not to exceed 60 percent. 4. The Restricted Group may pay dividends and purchase treasury shares after December 31, 2013, in amounts of up to $100.0 million plus 100 percent of net income and cash proceeds of stock option exercises, measured cumulatively after June 30, 2014. The maximum amount of dividends that could have been paid within this limitation is disclosed as unrestricted retained earnings in Note 6 to the consolidated financial statements. The Company believes it was in compliance with all of its loan agreements as of December 31, 2016. Based on current projections, the Company believes it will be in compliance with its loan agreements throughout 2017. Contractual Obligations At December 31, 2016, the Company’s contractual obligations, including estimated payments by period, were as follows: (a) Excludes unamortized debt issuance costs of $1.1 million. (b) Interest payments on debt obligations represent interest on all Company debt at December 31, 2016. The interest payment amounts related to the variable rate component of the Company’s debt assume that interest will be paid at the rates prevailing at December 31, 2016. Future interest rates may change, and, therefore, actual interest payments could differ from those disclosed in the above table. (c) Purchase obligations consist of raw material, utility and telecommunication service purchases made in the normal course of business. (d) The “Other” category comprises deferred revenues that represent commitments to deliver products, expected 2017 required contributions to the Company’s funded defined benefit pension plans, estimated payments related to the Company’s unfunded defined benefit supplemental executive and outside director pension plans, estimated payments (undiscounted) related to the Company’s asset retirement obligations, and environmental remediation payments for which amounts and periods can be reasonably estimated. The above table does not include $106.5 million of other non-current liabilities recorded on the balance sheet at December 31, 2016, as summarized in Note 15 to the consolidated financial statements. The significant non-current liabilities excluded from the table are defined benefit pension, deferred compensation, environmental and legal liabilities and unrecognized tax benefits for which payment periods cannot be reasonably determined. In addition, deferred income tax liabilities are excluded from the table due to the uncertainty of their timing. Pension Plans The Company sponsors a number of defined benefit pension plans, the most significant of which cover employees in its U.S. and U.K. locations. The U.S. and U.K. plans are frozen, and service benefit accruals are no longer being made. The funded status (pretax) of the Company’s defined benefit pension plans improved $10.2 million year over year, from $37.5 million underfunded at December 31, 2015, to $27.3 million underfunded at December 31, 2016. Better pension asset performance led to the improved funded status. A change in the mortality tables also contributed to the better funded status. The impacts of the pension asset returns and the change in mortality tables were partially offset by the effects of year-over-year decreases in the discount rates used to measure pension obligations (22- and 140-basis point decreases for the U.S. and U.K. plans, respectively). The Company contributed $0.4 million to its funded defined benefit plans in 2016. In 2017, the Company expects to contribute a total of $0.3 million to the U.K. defined benefit plan. As a result of pension funding relief included in the Highway and Transportation Funding Act of 2014, the Company has no 2017 contribution requirement to the U.S. pension plans. Payments to participants in the unfunded non-qualified plans should approximate $0.2 million in 2017, which is the same as payments made in 2016. Letters of Credit The Company maintains standby letters of credit under its workers’ compensation insurance agreements and for other purposes as needed. The insurance letters of credit are renewed annually and amended to the amounts required by the insurance agreements. As of December 31, 2016, the Company had a total of $4.8 million available under its outstanding standby letters of credit. Off-Balance Sheet Arrangements The Securities and Exchange Commission requires disclosure of off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. During the periods covered by this Form 10-K, the Company was not party to any such off-balance sheet arrangements. Environmental and Legal Matters The Company’s operations are subject to extensive federal, state and local environmental laws and regulations or similar laws in the other countries in which the Company does business. Although the Company’s environmental policies and practices are designed to ensure compliance with these regulations, future developments and increasingly stringent environmental regulation may require the Company to make additional unforeseen environmental expenditures. The Company will continue to invest in the equipment and facilities necessary to comply with existing and future regulations. During 2016, the Company’s expenditures for capital projects related to the environment were $1.7 million. Expenditures related to capital projects related to the environment projects are capitalized and depreciated over their estimated useful lives, which are typically 10 years. Recurring costs associated with the operation and maintenance of facilities for waste treatment and disposal and managing environmental compliance in ongoing operations at the Company’s manufacturing locations were approximately $25.0 million for 2016, $22.1 million for 2015 and $21.2 million for 2014. While difficult to project, it is not anticipated that these recurring expenses will increase significantly in the near future. Over the years, the Company has received requests for information related to or has been named by government authorities as a potentially responsible party at a number of waste disposal sites where cleanup costs have been or may be incurred under the U.S. Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and similar state or foreign statutes. In addition, damages are being claimed against the Company in general liability actions for alleged personal injury or property damage in the case of some disposal and plant sites. The Company believes that it has made adequate provisions for the costs it may incur with respect to the sites. See the Critical Accounting Policies section that follows for a discussion of the Company’s environmental liabilities accounting policy. After partial remediation payments at certain sites, the Company has estimated a range of possible environmental and legal losses from $25.7 million to $46.5 million at December 31, 2016, compared to $20.9 million to $41.4 million at December 31, 2015. At December 31, 2016, the Company’s accrued liability for such losses, which represented the Company’s best estimate within the estimated range of possible environmental and legal losses, was $25.8 million compared to $20.9 million at December 31, 2015. Because the liabilities accrued are estimates, actual amounts could differ from the amounts reported. During 2016, cash outlays related to legal and environmental matters approximated $1.4 million compared to $2.7 million expended in 2015. For certain sites, the Company has responded to information requests made by federal, state or local government agencies but has received no response confirming or denying the Company’s stated positions. As such, estimates of the total costs, or range of possible costs, of remediation, if any, or the Company’s share of such costs, if any, cannot be determined with respect to these sites. Consequently, the Company is unable to predict the effect thereof on the Company’s financial position, cash flows and results of operations. Given the information available, management believes the Company has no liability at these sites. However, in the event of one or more adverse determinations with respect to such sites in any annual or interim period, the effect on the Company’s cash flows and results of operations for those periods could be material. Based upon the Company’s present knowledge with respect to its involvement at these sites, the possibility of other viable entities’ responsibilities for cleanup, and the extended period over which any costs would be incurred, the Company believes that these matters, individually and in the aggregate, will not have a material effect on the Company’s financial position. See Item 3, Legal Proceedings, in this Form 10-K and Note 16, Contingencies, in the Notes to Consolidated Financial Statements for a summary of the significant environmental proceedings related to certain environmental sites. Outlook After record results in 2016, management believes that the Company is positioned for further growth in 2017. Although the Company had several events that negatively impacted the fourth quarter of 2016, the Company’s base business remains strong. Benefits from the Company’s product and end market diversification efforts, continued growth in core polymer markets, and enhanced internal efficiencies should positively impact the Company’s results in 2017. Climate Change Legislation Based on currently available information, the Company does not believe that existing or pending climate change legislation or regulation is reasonably likely to have a material effect on the Company’s financial condition, results of operations or cash flows. Critical Accounting Policies The Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of America (generally accepted accounting principles or GAAP). Preparation of financial statements in accordance with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The following is a summary of the accounting policies the Company believes are the most important to aid in understanding its financial results: Deferred Compensation The Company sponsors deferred compensation plans that allow management employees to defer receipt of their annual bonuses and outside directors to defer receipt of their fees until retirement, departure from the Company or as elected by the participant. The plans allow for the deferred compensation to grow or decline based on the results of investment options chosen by the participants. The investment options include Company common stock and a limited selection of mutual funds. The Company funds the obligations associated with these plans by purchasing investment assets that match the investment choices made by the plan participants. A sufficient number of shares of treasury stock are maintained on hand to cover the equivalent number of shares that result from participants electing the Company common stock investment option. As a result, the Company must periodically purchase its common shares in the open market. Upon retirement or departure from the Company, participants receive cash amounts equivalent to the payment date value of the investment choices they have made or Company common stock shares equal to the number of share equivalents held in the accounts. Some plan distributions may be made in cash or Company common stock at the option of the participant. Other plan distributions can only be made in Company common stock. For deferred compensation obligations that may be settled in cash, the Company must record appreciation in the market value of the investment choices made by participants as additional compensation expense. Conversely, declines in the value of Company stock or the mutual funds result in a reduction of compensation expense since such declines reduce the cash obligation of the Company as of the date of the financial statements. These market price movements may result in significant period-to-period fluctuations in the Company’s income. The increases or decreases in compensation expenses attributable to market price movements are reported in the operating expenses section of the consolidated statements of income. Because the obligations that must be settled only in Company common stock are treated as equity instruments, fluctuations in the market price of the underlying Company stock do not affect earnings. At December 31, 2016, the Company’s deferred compensation liability was $60.3 million, of which approximately 63 percent represented deferred compensation tied to the performance of the Company’s common stock; the remainder of the deferred compensation liability was tied to the chosen mutual fund investment assets. A $1.00 increase in the market price of the Company’s common stock will result in approximately $0.5 million of additional compensation expense. A $1.00 reduction in the market price of the common stock will reduce compensation expense by a like amount. The expense or income associated with the mutual fund component will generally fluctuate in line with the overall percentage increase or decrease of the U.S. stock markets. The mutual fund assets related to the deferred compensation plans are recorded on the Company’s balance sheet at cost when acquired and adjusted to their market values at the end of each reporting period. As allowed by generally accepted accounting principles, the Company elected the fair value option for recording the mutual fund investment assets. Therefore, market value changes for the mutual fund investment assets are recorded in the income statement in the same periods that the offsetting changes in the deferred compensation liabilities are recorded. Dividends, capital gains distributed by the mutual funds and realized and unrealized gains and losses related to mutual fund shares are recognized as investment income or loss in the other, net line of the consolidated statements of income. Environmental Liabilities It is the Company’s accounting policy to record environmental liabilities when environmental assessments and/or remedial efforts are probable and the cost or range of possible costs can be reasonably estimated. When no amount within a range of possible costs is a better estimate than any other amount, the minimum amount in the range is accrued. Some of the factors on which the Company bases its estimates include information provided by feasibility studies, potentially responsible party negotiations and the development of remedial action plans. Estimates for environmental liabilities are subject to potentially significant fluctuations as new facts emerge related to the various sites where the Company is exposed to liability for the remediation of environmental contamination. See the Environmental and Legal Matters section of this MD&A for discussion of the Company’s recorded liabilities and range of loss estimates. Revenue Recognition Revenue is recognized upon shipment of goods to customers, at which time title and risk of loss pass to the customer. For arrangements where the Company consigns product to a customer location, revenue is recognized when the customer uses the inventory. The Company records shipping and handling billed to a customer in a sales transaction as revenue. Costs incurred for shipping and handling are recorded in cost of sales. Volume discounts due customers are estimated and recorded in the same period as the sales to which the discounts relate and are reported as reductions of revenue in the consolidated statements of income. Recent Accounting Pronouncements See Note 1 to the consolidated financial statements, included in Part II, Item 8, for information on recent accounting pronouncements which affect the Company. Reconciliations of Non-GAAP Adjusted Net Income and Dilutive Earnings per Share The Company believes that certain non-GAAP measures, when presented in conjunction with comparable GAAP measures, are useful for evaluating the Company’s operating performance and provide better clarity on the impact of non-operational items. Internally, the Company uses this non-GAAP information as an indicator of business performance and evaluates management’s effectiveness with specific reference to these indicators. These measures should be considered in addition to, not a substitute for or superior to, measures of financial performance prepared in accordance with GAAP. The cumulative tax effect was calculated using the statutory tax rates for the jurisdictions in which the transactions occurred. Reconciliations of Non-GAAP Net Debt Management uses the non-GAAP net debt metric to gain a more complete picture of the Company’s overall liquidity, financial flexibility and leverage level. This adjusted measure should be considered supplemental to and not a substitute for financial information prepared in accordance with GAAP. The Company's definition of this adjusted measure may differ from similarly titled measures used by other entities.

<s>[INST] Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: Surfactants Surfactants, which accounted for 67 percent of Company consolidated net sales in 2016, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at five North American sites, three European sites (United Kingdom, France and Germany), five Latin American sites (Mexico, Colombia and three sites in Brazil) and two Asian sites (Philippines and Singapore). In 2016, the Company shut down its production facility in Canada, moving the production of goods previously manufactured in Canada to other Company North American production sites. Manufacturing operations at that facility have ceased, but decommissioning activities will continue into 2017. In October 2016, the Company’s subsidiary in Brazil closed on its previously announced agreement to acquire the commercial business of Tebras Tensoativos do Brazil Ltda. and the sulfonation production facility of PBC Industria Quimica Ltda. See Business Acquisition section below. In late 2016, a major customer of the Company’s Bahia, Brazil, plant exited the product line for which the Company was supplying them product. As a result, asset impairments were required (see Note 22 to the consolidated financial statements for additional information). Prior to 2016, the Company also held a 50 percent ownership interest in a joint venture, TIORCO, LLC (TIORCO), that marketed chemical solutions for enhanced oil recovery (EOR). The joint venture was accounted for under the equity method, and its financial results were excluded from surfactant segment operating results. In October 2015, the Company and its partner, Nalco Company (a subsidiary of Ecolab Inc.), made the decision to dissolve TIORCO. No business activities have been conducted since the fourth quarter of 2015. Legal dissolution of TIORCO is finalized. Polymers Polymers, which accounted for 28 percent of consolidated net sales in 2016, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively, CASE products) and flexible foams. Polyester resins, which include liquid and powdered products, are used in CASE and polyurethane systems house applications. CASE, polyester resins and flexible foam are collectively referred to as specialty polyols. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the United States, polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site and specialty polyols are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyurethane polyols are manufactured at the Company’s subsidiary in Germany, and specialty polyols are manufactured at the Company’s Poland subsidiary. In China, polyurethane polyols and specialty polyols are manufactured at the Company’s Nanjing, China, manufacturing plant that was commissioned in early 2016. Specialty Products Specialty Products, which accounted for five percent of consolidated net sales in 2016, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, [/INST] Positive. </s>

STEPAN CO

2018-02-27

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following is management’s discussion and analysis (MD&A) of certain significant factors that have affected the Company’s financial condition and results of operations during the annual periods included in the accompanying consolidated financial statements. Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: • Surfactants - Surfactants, which accounted for 68 percent of Company consolidated net sales in 2017, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at five North American sites, three European sites (United Kingdom, France and Germany), four Latin American sites (Mexico, Colombia and two sites in Brazil) and two Asian sites (Philippines and Singapore). In 2016, the Company shut down its production facility in Canada, moving the production of goods previously manufactured in Canada to other Company North American production sites. Manufacturing operations at that facility ceased in the fourth quarter of 2016 but decommissioning activities continued throughout 2017. In October 2016, the Company’s subsidiary in Brazil acquired the commercial business of Tebras Tensoativos do Brasil Ltda. (Tebras) and the sulfonation production facility of PBC Industria Quimica Ltda. (PBC). In late 2016, a major customer of the Company’s Bahia, Brazil, plant exited the product line for which the Company was supplying them product. As a result, asset impairments were required in 2016 (see Note 22 to the consolidated financial statements for additional information). • Polymers - Polymers, which accounted for 28 percent of consolidated net sales in 2017, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively, CASE products). Powdered polyester resins are used in coating applications. CASE and polyester resins are collectively referred to as specialty polyols. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the United States, polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site and specialty polyols are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyurethane polyols are manufactured by the Company’s subsidiary in Germany, and specialty polyols are manufactured by the Company’s Poland subsidiary. In China, polyurethane polyols and specialty polyols are manufactured at the Company’s Nanjing, China, manufacturing plant. • Specialty Products - Specialty Products, which accounted for four percent of consolidated net sales in 2017, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, at outside contractors. 2017 Acquisition Agreement On June 13, 2017, the Company announced that it had reached an agreement with BASF Mexicana, S.A. DE C.V. (BASF) to acquire BASF’s production facility in Ecatepec, Mexico, and a portion of its related surfactants business. The facility, which is near Mexico City, has over 50,000 metric tons of capacity, 124,000 square feet of warehouse space, a laboratory and office space. The acquisition is currently expected to be completed in 2018, subject to normal closing conditions, including necessary governmental consents. The acquisition supports the Company’s growth strategy in Latin America. The Company believes this acquisition should enhance its market position and supply capabilities for surfactants in Mexico and positions the Company to grow in both the consumer and functional surfactants markets. Deferred Compensation Plans The accounting for the Company’s deferred compensation plans can cause period-to-period fluctuations in Company expenses and profits. Compensation expense results when the values of Company common stock and mutual fund investment assets held for the plans increase, and compensation income results when the values of Company common stock and mutual fund investment assets decline. The pretax effect of all deferred compensation-related activities (including realized and unrealized gains and losses on the mutual fund assets held to fund the deferred compensation obligations) and the income statement line items in which the effects of the activities were recorded are presented in the following table: (1) See the applicable Corporate Expenses section of this MD&A for details regarding the period-to-period changes in deferred compensation. Below are the year-end Company common stock market prices used in the computation of deferred compensation income and expense: Effects of Foreign Currency Translation The Company’s foreign subsidiaries transact business and report financial results in their respective local currencies. As a result, foreign subsidiary income statements are translated into U.S. dollars at average foreign exchange rates appropriate for the reporting period. Because foreign exchange rates fluctuate against the U.S. dollar over time, foreign currency translation affects year-over-year comparisons of financial statement items (i.e., because foreign exchange rates fluctuate, similar year-to-year local currency results for a foreign subsidiary may translate into different U.S. dollar results). The following tables present the effects that foreign currency translation had on the year-over-year changes in consolidated net sales and various income line items for 2017 compared to 2016 and 2016 compared to 2015: Results of Operations 2017 Compared with 2016 Summary Net income attributable to the Company for 2017 increased six percent to $91.6 million, or $3.92 per diluted share, from $86.2 million, or $3.73 per diluted share, for 2016. Adjusted net income increased 11 percent to $108.7 million, or $4.65 per diluted share, from $98.2 million, or $4.25 per diluted share in 2016 (see the “Reconciliations of Non-GAAP Adjusted Net Income and Diluted Earnings per Share” section of this MD&A for reconciliations between reported net income attributable to the Company and reported earnings per diluted share and non-GAAP adjusted net income and adjusted earnings per diluted share). Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2017 compared to 2016 follows the summary. Consolidated net sales increased $158.9 million, or nine percent, between years. Higher average selling prices favorably affected the year-over-year net sales change by $174.5 million. The increase in average selling prices was mostly attributable to the pass through of higher raw material costs within the Surfactants and Polymers segments. Consolidated sales volume declined one percent, which had a $25.5 million unfavorable impact on the year-over-year change in net sales. Sales volume decreased two percent and seven percent for the Surfactants and Specialty Products segments, respectively. Sales volume was flat year-over-year for the Polymers segment. Foreign currency translation positively affected the year-over-year net sales change by $9.9 million. The favorable foreign currency translation effect reflected a weaker U.S. dollar against the majority of currencies for countries where the Company has foreign operations. Unit margins improved for Surfactants and declined for Polymers and Specialty Products. Operating income improved $20.0 million, or 16 percent, between years. Most of this improvement was related to lower 2017 deferred compensation expense and lower business restructuring and asset impairment charges, which declined by $11.9 million and $4.0 million, respectively. Operating income improved for the Surfactant segment and declined for the Polymers and Specialty Products segments. The Surfactant segment operating income increased 20 percent largely due to the non-recurrence of two customer claims incurred in the prior year ($7.4 million), a favorable resolution of one of the prior year claims in 2017 ($4.7 million), improved product mix, higher unit margins, savings from the prior year Canadian plant shutdown and the full year accretive impact of the October 2016 Tebras and PBC acquisitions in Brazil. The Polymers segment operating income declined 14 percent primarily due to lower sales volume and unit margins in North America. Foreign currency translation had a favorable $1.7 million effect on year-over-year consolidated operating income. Operating expenses (including deferred compensation expense and business restructuring and asset impairment expenses) decreased $20.2 million, or 10 percent, between years. Changes in the individual income statement line items that comprise the Company’s operating expenses were as follows: • Selling expenses decreased $2.9 million, or five percent, year over year largely due to lower U.S. fringe benefit expenses ($2.4 million). The lower fringe benefits were primarily due to lower incentive-based compensation expense (stock-based compensation and bonuses). Higher expenses associated with Tebras and PBC, acquired in October 2016, partially offset the consolidated decrease in selling expenses. • Administrative expenses increased $0.9 million, or one percent, year over year. The increase was primarily due to higher legal and consulting expenses, partially offset by lower U.S. fringe benefit expenses resulting from lower incentive-based compensation expense. • Research, development and technical service (R&D) expenses decreased $2.2 million, or four percent, year over year primarily due to lower U.S. fringe benefit expenses resulting from lower incentive-based compensation expense. • Deferred compensation plan expense was $11.9 million lower in 2017 than in 2016 primarily due to a $2.51 per share decrease in the market price of Company common stock in 2017 versus a $31.79 per share increase in 2016. See the “Overview” and “Corporate Expenses” sections of this MD&A for further details. • Business restructuring and asset impairment charges totaled $3.1 million in 2017 versus $7.1 million in 2016. Current year restructuring charges are primarily comprised of decommissioning costs related to the Company’s Canadian plant closure ($2.0 million) and severance costs related to a partial restructuring of the Company’s production facility in Fieldsboro, New Jersey ($0.9 million). The prior year restructuring expenses primarily related to the closure of the Company’s surfactant plant in Canada ($2.8 million) and asset impairment charges of $4.3 million. See Note 22 to the consolidated financial statements for additional information. The business restructuring and asset impairment charges were excluded from the determination of segment operating income. Net interest expense for 2017 declined $1.8 million, or 13 percent, from net interest expense for 2016. The decline in interest expense was principally attributable to higher interest income earned on excess cash and lower average debt levels due to scheduled repayments. Other, net was income of $4.5 million for 2017 versus $0.8 million of income in 2016. Most of this increase was attributable to investment income (including realized and unrealized gains and losses) from the Company’s deferred compensation and supplemental defined contribution mutual fund assets. Investment income (including realized and unrealized gains and losses) was $5.1 million in 2017 versus $0.8 million in 2016, an increase of $4.4 million year-over-year. Partially offsetting this increase was foreign exchange activity which resulted in a $0.6 million loss in 2017 versus an insignificant loss in 2016. The effective tax rate was 34.3 percent in 2017 compared to 24.3 percent in 2016. The increase was primarily attributable to the enactment of the U.S. Tax Cuts and Jobs Act (“Tax Act”) which resulted in a net tax cost of $14.9 million. This net expense consists of a net benefit attributable to the U.S. federal corporate income tax rate reduction of $4.5 million and a net expense attributable to the Transition Tax of $19.4 million. The increase in the effective tax rate attributable to the Tax Act was partially offset by the following favorable nonrecurring items: 1) a foreign tax credit benefit from the repatriation of foreign earnings, and 2) a tax benefit from a change in accounting method related to tax depreciation. See Note 9 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results Surfactants Surfactants 2017 net sales increased $116.0 million, or 10 percent, from net sales reported in 2016. Higher selling prices and the favorable effects of foreign currency translation accounted for $139.7 million and $1.8 million, respectively, of the year-over-year increase in net sales. The increase in selling prices mostly reflected the pass through to customers of higher costs for certain raw materials and more favorable sales mix. The favorable sales mix was primarily attributable to higher sales of products used in household, industrial and institutional (HI&I), agricultural and oilfield applications. Sales volume decreased two percent between years, which had a $25.5 million negative effect on year-over-year net sales. All regions, except Latin America, experienced sales volume declines. The majority of the sales volume decline was attributable to lower commodity surfactant demand. The Latin America sales volume increase was principally due to the full year impact of the region’s October 2016 acquisitions of Tebras and PBC. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased five percent between years. Higher selling prices and the favorable effect of foreign currency translation positively affected the year-over-year change in net sales by $58.8 million and $0.6 million, respectively. A three percent decline in sales volume offset the impacts of selling prices and currency translations by $21.0 million. Selling prices increased eight percent year-over-year mainly due to the pass through of certain increased raw material costs to customers and to a more favorable mix of sales. The three percent decline in sales volume reflected decreased sales of commodity products used in laundry and cleaning and personal care applications partially offset by increased sales of products used in HI&I, agricultural and oilfield applications. The foreign currency impact reflected a weaker U.S. dollar relative to the Canadian dollar. Net sales for European operations increased 16 percent from 2016 to 2017. Most of this increase was attributable to higher selling prices which favorably affected the year-over-year change in net sales by $44.4 million. The increase in selling prices primarily resulted from the pass through of higher costs for certain raw materials. A three percent decline in sales volume and the unfavorable effect of foreign currency translation negatively affected the year-over-year change in net sales by $6.0 million and $0.8 million, respectively. The decline in sales volume was largely attributable to lower demand for personal care commodity anionics and reduced sales volumes of general surfactants sold through our distribution partners, partially offset by higher demand for agricultural chemicals. A weaker British pound sterling, partially offset by a stronger Euro, relative to the U.S. dollar, accounted for the foreign currency effect. Net sales in 2016 were negatively impacted by $7.4 million of expense from two customer claims (see Note 23 to the consolidated financial statements for further information) whereas net sales in 2017 were positively impacted by $4.7 million related to a favorable resolution of one of the prior year claims. Net sales for Latin American operations increased 26 percent due to higher selling prices, a seven percent increase in sales volume and the favorable impact of foreign currency translation, which accounted for $23.2 million, $10.8 million and $5.6 million, respectively, of the year-over-year increase in net sales. Selling prices increased 14 percent due to the pass through to customers of higher raw material costs and a more favorable mix of sales. The improved sales volume reflected new business associated with the October 2016 acquisition of Tebras and PBC and higher demand for agricultural chemicals, partially offset by lower demand and lost commodity business for products used in laundry and cleaning applications. The year-over-year strengthening of the Brazilian real and the Colombian peso against the U.S. dollar generated the favorable foreign currency effect. Net sales in 2016 included $4.3 million of compensation for future lost revenue related to a negotiated settlement with a major customer under contract with the region’s Bahia, Brazil, plant that exited the product line for which the Company supplied them product (see Note 22 to the consolidated financial statements for further information). Net sales for Asian operations increased one percent primarily due to a 23 percent increase in average selling prices. Higher average selling prices, primarily resulting from the pass through of certain increased raw material costs, favorably impacted net sales by $13.3 million. Lower sales volume and the effect of foreign currency translation negatively affected the year-over-year change in net sales by $9.2 million and $3.7 million, respectively. The 14 percent sales volume decline was primarily due to weaker demand for commodity laundry and cleaning products. A weaker Philippine peso relative to the U.S. dollar caused the negative foreign currency translation adjustment. Surfactant operating income for 2017 increased $20.2 million, or 20 percent, from operating income reported in 2016. The operating income increase was due to higher 2017 gross profit of $16.4 million and lower operating expenses of $3.8 million. The eight percent increase in gross profit was largely due to the non-recurrence of the aforementioned European customer claims incurred in 2016, a favorable resolution of one of the customer claims in 2017 and more favorable sales mix resulting from higher sales of products used in HI&I, agricultural and oilfield applications. Gross profit for 2016 was also negatively affected by accelerated depreciation ($4.5 million) related to the Canadian plant shutdown whereas gross profit for 2017 was negatively impacted by accelerated depreciation ($1.3 million) related to the Fieldsboro, New Jersey plant restructuring. Lower manufacturing costs resulting from the prior year plant closures in Canada and Brazil also benefited 2017 gross profit. The effects of foreign currency translation had a favorable $1.2 million impact on the year-over-year gross profit change. Operating expenses decreased $3.8 million, or four percent. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (a) In 2017, the Company changed its internal financial statement classification for certain transportation costs, transferring such costs from operating expenses to cost of sales. In this segment discussion, the 2016 North America gross profit and total operating expenses have been changed from the amounts presented in 2016 to make such amounts consistent with the current year classification. Surfactant segment operating income remained unchanged. Gross profit for North American operations increased seven percent principally due to improved product mix. The improved product mix primarily reflects decreased sales of commodity products used in laundry and cleaning and personal care applications partially offset by increased sales of products used in HI&I, agricultural and oilfield applications. The current year also benefited from lower manufacturing costs resulting from the closure of the Company’s Canada manufacturing operations in the fourth quarter of 2016. The Company incurred $4.5 million of accelerated depreciation associated with the Canadian plant closure in 2016 versus $1.3 million of accelerated depreciation associated with the restructuring of the Fieldsboro, New Jersey plant in 2017. Gross profit for European operations increased 36 percent between years largely due to the aforementioned non-recurring $7.4 million customer claims incurred in 2016 and a favorable customer claim resolution in 2017 of $4.7 million. Gross profit also improved due to more favorable product mix principally resulting from higher demand for agricultural chemicals. Prior year manufacturing costs also included approximately $0.6 million of expenses associated with the planned 30-day mandatory inspection shutdown of the Company’s plant in Germany. There was no such inspection in 2017. Foreign currency translation positively affected the change in gross profit by $0.8 million. Gross profit for Latin American operations improved one percent mainly due to a more profitable mix of sales, the full year contribution of the October 2016 Tebras and PBC acquisitions and lower manufacturing costs resulting from the prior year Bahia, Brazil plant closure. Gross profit in 2016 included $4.3 million of income resulting from a negotiated customer contract termination settlement related to the Bahia, Brazil plant closure. Foreign currency translation positively impacted the change in gross profit by $1.0 million. Asia gross profit decreased five percent largely due to the 14 percent decrease in sales volume mostly related to the Company’s Philippine operations. Foreign currency translation, mostly related to a weaker Philippine peso relative to the U.S. dollar, negatively impacted the change in gross profit by $0.7 million. Operating expenses for the Surfactants segment decreased $3.8 million, or four percent, year-over-year. Most of this decrease was attributable to lower North American expenses. North American expenses were down primarily due to lower U.S. incentive-based compensation, primarily related to stock-based compensation and bonuses. The North American decrease was partially offset by higher Latin American expenses resulting from the full year impact of the October 2016 Tebras and PBC acquisitions. Polymers Polymer net sales for 2017 increased $47.8 million, or 10 percent, over net sales for 2016. Higher selling prices, resulting from the pass through of increased costs for certain raw materials, and the positive effect of foreign currency translation favorably affected the year-over-year net sales change by $40.9 million and $7.9 million, respectively. Sales volume, essentially flat between years, had a $1.0 million unfavorable effect on the year-over-year net sales change. A decline in North American sales volume was offset by sales volume improvement in Europe and Asia. The foreign currency translation effect reflected a weaker U.S. dollar relative to the Polish zloty. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased three percent due to higher selling prices, partially offset by lower sales volumes. Selling prices increased five percent, which had a $15.4 million positive effect on the year-over-year change in net sales. The pass through of certain higher raw material costs to customers led to increased selling prices. Sales volume declined two percent which unfavorably impacted the net sales change by $5.5 million. Sales volume of polyols used in rigid foam applications declined two percent mainly due to lost share from one major customer. Phthalic anhydride sales volume declined seven percent. Sales volume of specialty polyols increased eight percent due to greater demand for product used in CASE applications and powdered resins. Net sales for European operations increased 22 percent due to higher selling prices, the favorable effect of foreign currency translation and a three percent increase in sales volumes, which accounted for $22.4 million, $7.9 million and $4.0 million, respectively, of the year-over-year net sales increase. Selling prices increased 14 percent primarily due to the pass through to customers of cost increases for certain raw materials. The sales volume improvement was primarily attributable to increased sales of specialty polyols, which reflected the Company’s successful efforts to utilize the production capacity of its new reactor in Poland. Sales volume also grew slightly due to increased demand for polyols used in rigid foam insulation and insulated metal panels. Net sales for Asia and Other operations increased 15 percent between years due to higher selling prices, a two percent increase in sales volume and the favorable effect of foreign currency, which accounted for $3.1 million, $0.5 million and $0.1 million, respectively, of the year-over-year net sales increase. Polymer operating income for 2017 declined $14.0 million, or 14 percent, compared to operating income for 2016. Gross profit decreased $14.8 million, or 12 percent, primarily due to reduced margins and lower sales volumes in North American operations. European operations reported a 14 percent gross profit improvement due to sales volume growth and lower manufacturing costs. Operating expenses declined $0.9 million, or three percent, versus prior year. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (a) In 2017, the Company changed its internal financial statement classification for certain transportation costs, transferring such costs from operating expenses to cost of sales. In this segment discussion, the 2016 North America gross profit and total operating expenses have been changed from the amounts presented in 2016 to make such amounts consistent with the current year classification. Polymer segment operating income remained unchanged. Gross profit for North American operations declined 18 percent year over year primarily due to reduced margins and a two percent decline in sales volume. The decline in margins reflected the effect of higher raw material costs that, due to competitive reasons, could not entirely be passed on to customers. Gross profit for European operations increased 14 percent primarily due to a three percent increase in sales volume and lower unit manufacturing costs. The 2016 results were negatively affected by higher plant expenses that resulted from the planned 30-day mandatory inspection shutdown of manufacturing operations in Germany during the third quarter of 2016. As a result of the shutdown, 2016 plant expenses included $2.4 million of inspection and storage expenses not incurred in 2017. The favorable effects of foreign currency translation positively impacted the year-over-year change in gross profit by $1.2 million. Gross profit for Asia and Other operations declined 93 percent despite a two percent increase in sales volume. Most of the decline was attributable to higher overhead costs incurred in 2017. Overhead costs were lower in 2016 as the Nanjing plant benefited from higher throughput to supply material to the Company’s European market to compensate for the mandatory shutdown at the German plant. The intercompany production reduced site overhead in 2016. Operating expenses for the Polymers segment decreased $0.9 million, or three percent, year over year largely due to lower U.S. incentive-based compensation expense. Specialty Products Net sales for 2017 declined $5.0 million, or six percent, compared to net sales for 2016. A seven percent decrease in sales volume accounted for most of the net sales decline. Most of the sales volume decrease was attributable to lower demand for food ingredient applications and nutritional supplemental products. Operating income decreased $0.7 million year over year primarily due to the lower sales volume partially offset by more favorable product mix. Corporate Expenses Corporate expenses, which are comprised of deferred compensation and other operating expenses that are not allocated to the reportable segments, declined $14.5 million year-over-year to $66.6 million in 2017 from $81.1 million in 2016. The decline in corporate expense was primarily attributable to lower deferred compensation expense ($11.9 million), U.S. incentive-based compensation ($2.4 million) and the previously discussed restructuring and impairment charges ($4.0 million). These decreases were partially offset by higher legal and consulting related expenses ($3.6 million) in 2017. Deferred compensation was $4.9 million of expense for 2017 compared to $16.8 million of expense for 2016. The lower expense primarily resulted from a $2.51 per share decrease in the value of Company common stock over the twelve months ended December 31, 2017, compared to a $31.79 per share increase for the same period of 2016. The following table presents the year-end Company common stock market prices used in the computation of deferred compensation expense: 2016 Compared with 2015 Summary Net income attributable to the Company for 2016 increased 13 percent to $86.2 million, or $3.73 per diluted share, from $76.0 million, or $3.32 per diluted share, for 2015. Adjusted net income increased 24 percent to $98.2 million, or $4.25 per diluted share, from $79.4 million, or $3.46 per diluted share (See the “Reconciliations of Non-GAAP Adjusted Net Income and Diluted Earnings per Share” section of this MD&A for reconciliations between reported net income attributable to the Company and reported earnings per diluted share and non-GAAP adjusted net income and adjusted earnings per diluted share). Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2016 compared to 2015 follows the summary. Consolidated net sales declined $10.0 million, or one percent, between years. Sales volume increased six percent, which had a $114.0 million favorable effect on the year-over-year change in net sales. All three reportable segments contributed to the consolidated sales volume improvement. By segment, sales volume increased five percent, 12 percent and eight percent for Surfactants, Polymers and Specialty Products, respectively. The effect of increased consolidated sales volume was more than offset by lower selling prices and the unfavorable effects of foreign currency translation, which negatively affected the year-over-year net sales change by $81.1 million and $42.9 million, respectively. The decreased selling prices were primarily attributable to declines in raw material costs. Overall unit margins improved slightly between years. The unfavorable foreign currency translation effect reflected a stronger U.S. dollar against all currencies for countries where the Company has foreign operations. Operating income for 2016 improved $3.4 million, or three percent, over operating income for 2015 despite 2016 restructuring and asset impairment charges of $7.1 million and increased deferred compensation expense of $10.3 million. Operating income improved for Polymers and Specialty Products. Surfactant segment operating income declined four percent largely due to the settlement of two customer claims and accelerated depreciation related to the cessation of manufacturing operations at the Company’s Canadian plant. 2015 operating income included a $2.9 million gain on the sale of the Company’s specialty polyurethane systems product line. Foreign currency translation had an unfavorable $3.7 million effect on the year-over-year consolidated operating income change. Operating expenses (including the business restructuring and asset impairment expenses) increased $24.0 million, or 13 percent, between years. Changes in the individual income statement line items that comprise the Company’s operating expenses were as follows: • Selling expenses increased $1.7 million, or three percent, year over year largely due to higher U.S. fringe benefit expenses ($1.0 million), which reflected increased incentive-based compensation (which includes stock-based compensation, bonuses and profit sharing) recognized as a result of the year-over-year improvement in Company financial performance and in Company common stock value. • Administrative expenses declined $0.9 million, or one percent, year over year. The decrease was attributable to lower consulting expense ($5.2 million) as external resources related to the initiative to improve efficiency across the Company’s global organization (referred to as DRIVE) were not used in 2016. Partially offsetting the lower consulting expense were higher fringe benefit ($2.3 million) and salary ($1.2 million) expenses. Higher U.S. incentive-based compensation led to the increase in fringe benefit expense. Legal and environmental expense also increased by $0.9 million primarily due to adjustments to Company environmental liabilities. • Research, development and technical service (R&D) expenses increased $5.8 million, or 12 percent, year over year. Higher expense for U.S. salaries and the related fringe benefits ($3.9 million) was the major contributor to the increase. In addition, foreign R&D expenses grew $0.4 million, as some of the Company’s non-U.S. subsidiaries have added product development resources to support their local needs. The accumulation of increases for a number of other expense items accounted for the remainder of the year-over-year variance. • Deferred compensation plan expense was $10.3 million higher in 2016 than in 2015 due to a significantly larger increase in the value of Company common stock during 2016 than for 2015. See the “Overview” and “Corporate Expenses” sections of this MD&A for further details. • Business restructuring and asset impairment charges totaled $7.1 million in 2016. There were no such charges in 2015. Restructuring expenses related to the closure of the Company’s surfactant plant in Canada amounted to $2.8 million. In addition, the Company recognized impairment charges of $4.3 million. See Note 22 to the consolidated financial statements for additional information. The business restructuring and asset impairment charges were excluded from the determination of segment operating income. Net interest expense for 2016 declined $1.3 million, or nine percent, from net interest expense for 2015. The decline in interest expense was principally attributable to higher interest income earned on excess cash. Lower average debt levels due to scheduled repayments also contributed. In the fourth quarter of 2015, the Company and its partner agreed to dissolve the TIORCO joint venture and, therefore, the Company has reported no results in the loss from equity joint venture line in 2016. The Company’s share of TIORCO’s loss for the 2015 was $7.0 million. Other, net income for 2016 declined $0.8 million, or 48 percent, from other, net income for 2015. Foreign exchange activity resulted in an insignificant loss in 2016 compared to a $0.7 million gain in 2015. Investment income (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets declined $0.1 million between years to $0.8 million in 2016 from $0.9 million in 2015. The effective tax rate was 24.3 percent in 2016 compared to 26.1 percent in 2015. The decrease was attributable to the following items: 1) a tax benefit derived from the early adoption of Accounting Standards Update No. 2016-9, Compensation - Stock Compensation (Topic 718): Improvement to Employee Share-Based Payment Accounting; 2) an unrecognized tax benefit recorded in 2015 that was nonrecurring in 2016; and 3) a more favorable geographical mix of income in 2016. This decrease was partially offset by the 2011 and 2012 Agricultural Chemicals Security Credit tax benefit recorded in 2015 that was nonrecurring in 2016. See Note 9 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results Surfactants Surfactants 2016 net sales declined $24.3 million, or two percent, from net sales reported in 2015. Sales volume increased five percent between years, which had a $58.5 million positive effect on the year-over-year net sales change. All regions, except Europe, contributed to the sales volume improvement. Decreased selling prices and foreign currency translation had negative effects of $48.3 million and $34.5 million, respectively, on the net sales change. North American operations accounted for most of the decline in selling prices, which reflected lower year-over-year costs for major raw materials and a less favorable sales mix. The foreign currency translation effect resulted from a stronger U.S. dollar compared to all currencies of the segment’s foreign operations. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined two percent between years. Sales volume increased seven percent, which favorably affected the year-over-year change in net sales by $49.7 million. The effect of the increased sales volume was more than offset by an eight percent decline in selling prices and the unfavorable impact of foreign currency translation, which negatively affected the change in net sales by $61.1 million and $1.7 million, respectively. Most of the sales volume growth occurred in the first three quarters of 2016. For the full year, laundry and cleaning products were the largest contributors to the sales volume improvement, as the Company derived the full-year benefits of a supply agreement with a large customer that commenced during the third quarter of 2015. Sales volume for products used in personal care applications declined, primarily due to weaker demand in the second half of 2016 coupled with some lost business. In addition, lower crude oil prices led to a decrease in sales volumes of oil field products used in EOR applications. The year-over-year decline in sales prices primarily reflected decreased raw material costs, particularly for the first half of 2016, and a less favorable sales mix. The foreign currency impact reflected a stronger U.S. dollar relative to the Canadian dollar. Net sales for European operations declined eight percent. Reducing 2016 net sales was $7.4 million of settlements for two customer claims (see Note 23 to the consolidated financial statements for further information). In addition, the unfavorable effects of foreign currency translation and a two percent decline in sales volume unfavorably impacted the change in net sales by $12.5 million and $4.6 million, respectively. Selling prices averaged one percent higher, which had a $3.1 million favorable effect on the year-over- year net sales change. A weaker British pound sterling relative to the U.S. dollar accounted for most of the foreign currency effect. The decline in sales volume was mainly attributable to weaker demand for agricultural chemicals, laundry and cleaning products and personal care products. Sales volumes of general surfactants sold through distributors increased year over year. Net sales for Latin American operations increased two percent. Included in fourth quarter and full year 2016 net sales was $4.3 million in compensation for future lost revenue related to a negotiated settlement with a major customer under contract with the region’s Bahia, Brazil, plant that exited the product line for which the Company supplied them product (see Note 22 to the consolidated financial statements for further information). A six percent increase in sales volume and higher selling prices favorably affected the year-over-year change in net sales by $8.7 million and $6.4 million, respectively. The unfavorable effects of currency translation offset the positive impacts of increased sales prices and volumes by $17.0 million. Improved laundry and cleaning and agricultural chemical sales volumes in Brazil accounted for most of the improvement in Latin America. New business related to the fourth quarter 2016 acquisitions of Tebras and PBC also contributed to the growth in sales volumes and net sales dollars. The higher selling prices reflected increased raw material costs and a more favorable mix of sales. The year-over-year weakening of the Brazilian real, Mexican peso and Colombian peso against the U.S. dollar led to the foreign currency translation effect. Net sales for Asian operations increased 13 percent primarily due to a nine percent increase in average selling prices and a seven percent growth in sales volume, which positively affected the year-over-year change in net sales by $6.1 million and $4.4 million, respectively. An improved mix of sales coupled with the effects of increased raw material costs led to the higher average selling prices. Most of the sales volume improvement was attributable to new business and increased demand from existing customers of the Company’s Philippine operations. Sales volume also increased from Singapore. Foreign currency translation had a $2.8 million unfavorable effect on the net sales change. Surfactant operating income for 2016 declined $4.3 million, or four percent, from operating income reported in 2015. Operating income for 2016 was negatively affected by accelerated depreciation related to the Canadian plant shutdown and by the settlement of customer claims in Europe. Gross profit increased $4.5 million, or two percent, largely due to higher sales volumes. The effects of foreign currency translation had an unfavorable $4.6 million impact on the year-over-year gross profit change. Operating expenses increased $8.8 million, or 10 percent. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (a) In 2017, the Company changed its internal financial statement classification for certain transportation costs, transferring such costs from operating expenses to cost of sales. In this segment discussion, the 2016 and 2015 North America gross profit and total operating expenses have been changed from the amounts presented before to make such amounts consistent with the current year classification. Surfactant segment operating income remained unchanged. Gross profit for North American operations was flat between years despite the seven percent year-over-year improvement in sales volume. The favorable effect of the growth in sales volume was offset by $4.5 million of accelerated depreciation associated with the shutdown of manufacturing operations at the Company’s Canadian plant. Gross profit for European operations declined 26 percent between years largely due to the aforementioned $7.4 million customer claim settlements and a two percent decline in sales volume. The region also incurred approximately $0.6 million of expenses associated with a planned 30-day mandatory inspection shutdown of the Company’s plant in Germany. There was no such inspection in 2015. Foreign currency translation negatively affected the change in gross profit by $1.0 million. Gross profit for Latin American operations improved twelve percent mainly due to the $4.3 million settlement noted earlier and the effects of the six percent increase in sales volume. Foreign currency translation negatively impacted gross profit by $2.8 million. The contribution from the Tebras and PBC acquisitions was insignificant for 2016. Asia gross profit increased 66 percent largely due to the seven percent increase in sales volume and to margin improvement, particularly for the Company’s Philippine operations. A more favorable product mix, higher selling prices and greater utilization of the plant in the Philippines led to the margin improvement. Operating expenses for the Surfactants segment increased $7.9 million, or 9 percent, year over year. Expenses increased for all regions, reflecting the additional resources and expenditures necessary to support the segment’s global organization and growth initiatives. In addition, U.S. incentive-based compensation (which includes stock-based compensation, bonuses and profit sharing) increased between years due to improved Company financial performance and higher common stock prices. The favorable effects of foreign currency translation reduced the year-over-year change in operating expenses by $1.6 million. Polymers Polymer net sales for 2016 increased $7.3 million, or one percent, over net sales for 2015. Sales volume increased 12 percent, which had a $58.5 million favorable effect on the year-over-year net sales change. All regions contributed to the sales volume improvement. Lower selling prices and the effects of foreign currency translation unfavorably affected the net sales change by $42.9 million and $8.3 million, respectively. Year-over-year raw material cost declines led to the decrease in selling prices. The foreign currency translation effect reflected a stronger U.S. dollar against the currencies of the segment’s foreign operations. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased one percent. Sales volume increased nine percent, which had a $29.7 million favorable effect on the year-over-year net sales change. Selling prices declined eight percent, which offset the impact of higher sales volume by $27.5 million. The sales volume improvement was attributable to a 20 percent increase for polyols used in rigid foam applications. New business and the continued growth in demand for rigid foam insulation led to the polyol sales volume growth. Sales volume of phthalic anhydride and specialty polyols declined three and five percent, respectively, between years. Year-over-year decreases in the cost of raw materials drove the decline in selling prices. Net sales for European operations increased two percent. Sales volume grew 14 percent, which had a $20.8 million favorable effect on the year-over-year net sales change. The sales volume improvement was driven by new business and increased demand for polyols used in rigid foam insulation and insulated metal panels. The impact of higher sales volume was partially offset by the effects of lower selling prices and foreign currency translation, which negatively affected the change in net sales by $10.6 million and $6.9 million, respectively. Lower raw material costs led to the decline in selling prices. Net sales for Asia and Other operations increased eight percent between years due to a 29 percent increase in sales volume, which had a $6.8 million positive impact on the year-over-year net sales change. Business gained from efforts to fill the capacity of the Company’s new plant in Nanjing, China, accounted for most of the sales volume increase. The unfavorable effects of lower selling prices and foreign currency translation negatively impacted the change in net sales by $3.5 million and $1.5 million, respectively. Polymer operating income for 2016 increased $15.8 million, or 20 percent, over operating income for 2015. Results for 2015 included a $2.9 million gain from the sale of Company’s specialty polyurethane systems product line. Gross profit increased $20.3 million, or 19 percent, due to the 12 percent increase in sales volume and to improved margins resulting primarily from lower raw material costs and an improved product mix. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (a) In 2017, the Company changed its internal financial statement classification for certain transportation costs, transferring such costs from operating expenses to cost of sales. In this segment discussion, the 2016 and 2015 North America gross profit and total operating expenses have been changed from the amounts presented before to make such amounts consistent with the current year classification. Polymer segment operating income remained unchanged. Gross profit for North American operations increased 19 percent year over year. The nine percent increase in sales volume, the positive effects of lower raw material costs and a more favorable mix of sales all contributed to the improved gross profit. Production efficiencies were also a positive factor as unit manufacturing overhead costs declined as a result of production volume increases that outpaced a five percent year-over-year increase in plant expenses. Gross profit for European operations increased 24 percent primarily due to the 14 percent increase in sales volume and to lower raw material costs. The 2016 results were negatively affected by higher plant expenses that resulted from the planned 30-day mandatory inspection shutdown of manufacturing operations in Germany during the third quarter of 2016. As a result of the shutdown, 2016 plant expenses included $2.4 million of inspection and storage expenses not incurred in 2015. The unfavorable effects of foreign currency translation negatively impacted the year-over-year change in gross profit by $1.0 million. Gross profit for Asia and Other operations declined 24 percent despite a 29 percent increase in sales volume. Higher overhead costs due to operating the new China plant at partial capacity led to the decline in gross profit. Most of the decline occurred in the fourth quarter when it was no longer necessary for the plant to manufacture product for other Company locations as it had done for a large period of 2016. Operating expenses for the Polymers segment increased $1.6 million, or six percent, year over year largely due to higher U.S. incentive-based compensation resulting from improved year-over-year Company financial performance and common stock prices. Specialty Products Net sales for 2016 increased $6.9 million, or nine percent, over net sales for 2015. An eight percent increase in sales volume accounted for most of the net sales improvement. Selling prices increased approximately one percent. Most of the sales volume increase was attributable to increased demand for products used in food ingredient applications. Operating income increased $6.3 million year over year due to increased sales volume and lower manufacturing and operating expenses. The decline in expenses reflected actions taken in 2015 to reduce the segment’s cost structure. Approximately half of the year-over-year operating income improvement occurred in the fourth quarter due to higher sales volumes and selling prices and lower costs for food ingredient products. Corporate Expenses Corporate expenses increased $14.5 million to $81.1 million for 2016 from $66.6 million for 2015. The increase was primarily attributable to increased expenses for deferred compensation ($10.3 million), fringe benefits ($1.4 million) and salaries ($1.2 million) expenses and the previously discussed restructuring and impairment charges ($7.1 million). Increased incentive-based compensation expenses, driven by improved year-over-year Company financial results and increased Company common stock values, led to the higher fringe benefit expenses. Consulting expenses declined $5.2 million between years principally due to no external resources being used in 2016 for the Company’s DRIVE efficiency efforts. Deferred compensation was $16.8 million of expense for 2016 compared to $6.5 million of expense for 2015. The higher expense primarily resulted from a $31.79 per share increase in the value of Company common stock over the twelve months ended December 31, 2016, compared to a $9.61 per share increase for the same period of 2015. The following table presents the year-end Company common stock market prices used in the computation of deferred compensation expense: Liquidity and Capital Resources Overview Historically, the Company’s principal sources of liquidity have included cash flows from operating activities, available cash and cash equivalents and the use of available borrowing facilities. The Company’s principal uses of cash have included funding operating activities, capital investments and acquisitions. For the twelve months ended December 31, 2017, operating activities were a cash source of $198.9 million versus a source of $212.2 million for the comparable period in 2016. For the current year, investing cash outflows totaled $82.7 million, as compared to an outflow of $130.5 million in the prior year, and financing activities were a use of $50.5 million, as compared to a use of $29.8 million in the prior year. Cash and cash equivalents increased by $73.2 million compared to December 31, 2016, including a favorable exchange rate impact of $7.5 million. As of December 31, 2017, the Company’s cash and cash equivalents totaled $298.9 million, including $15.1 million in a money market fund rated AAAm by Standard and Poor’s. Cash in U.S. demand deposit accounts totaled $131.9 million and cash of the Company’s non-U.S. subsidiaries held outside the U.S. totaled $151.9 million as of December 31, 2017. Operating Activity Net income in 2017 increased by $5.3 million versus the comparable period in 2016. Working capital was a cash source of $19.3 million in 2017 versus a source of $18.8 million in 2016. Accounts receivable were a use of $16.4 million in 2017 compared to a use of $17.2 million in 2016. Inventories were a source of $5.7 million in 2017 versus a use of $3.8 million in 2016. Accounts payable and accrued liabilities were a source of $30.5 million in 2017 compared to a source of $38.3 million for the same period in 2016. Working capital requirements were lower in 2017 compared to 2016 primarily due to the above noted change in inventories. The change in inventories was mainly due to reduced quantities. It is management’s opinion that the Company’s liquidity is sufficient to provide for potential increases in working capital during 2018. Investing Activity Cash outflows for investing activities decreased by $47.8 million year-over-year. Cash outflows from investing activities in 2017 included capital expenditures of $78.6 million compared to $103.1 million in 2016. Other investing activities were a use of $4.1 million in 2017 versus a use of $27.4 million in 2016, when the higher cash usage was primarily attributable to $23.5 million used to acquire a production facility (Tebras) and a commercial business (PBC) in Brazil. For 2018, the Company estimates that total capital expenditures will range from $105 million to $115 million including infrastructure spending and capacity expansions in the United States, Germany and Brazil. Financing Activity Cash flow from financing activities was a use of $50.5 million in 2017 versus a use of $29.8 million in 2016. The higher cash outflow was primarily the result of repayment of foreign credit line borrowing, scheduled principal repayment of private placement debt and increased share repurchases. The Company purchases its common stock in the open market or from its benefit plans from time to time to fund its own benefit plans and also to mitigate the dilutive effect of new shares issued under its benefit plans. The Company may, from time to time, seek to retire or purchase additional amounts of the Company’s outstanding equity and/or debt securities through cash purchases and/or exchanges for other securities, in open market purchases, privately negotiated transactions or otherwise, including pursuant to a Rule 10b5-1 plan. Such repurchases or exchanges, if any, will depend on prevailing market conditions, the Company’s liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. For the twelve months ended December 31, 2017, the Company purchased 76,790 shares at a total cost of $6.0 million. At December 31, 2017, there were 641,139 shares remaining under the current share repurchase authorization. Debt and Credit Facilities Consolidated balance sheet debt decreased by $26.2 million for the current year, from $317.0 million to $290.8 million, due to a decrease of both domestic and foreign debt. In 2017, net debt (which is defined as total debt minus cash - See the “Reconciliation of Non-GAAP Net Debt” section of this MD&A) decreased by $99.4 million, from $91.3 million to a negative $8.1 million. As of December 31, 2017, the ratio of total debt to total debt plus shareholders’ equity was 28.2 percent compared to 33.3 percent at December 31, 2016. As of December 31, 2017, the ratio of net debt to net debt plus shareholders’ equity was a negative 1.1 percent, compared to 12.6 percent at December 31, 2016. At December 31, 2017, the Company’s debt included $290.0 million of unsecured private placement loans with maturities ranging from 2018 through 2027. These loans are the Company’s primary source of long-term debt financing and are supplemented by bank credit facilities to meet short and medium-term needs. On December 31, 2017 the Company had a committed $125.0 million multi-currency syndicated revolving credit agreement. The credit agreement allowed the Company to make unsecured borrowings, as requested from time to time, for working capital and other corporate purposes. This unsecured facility was the Company’s primary source of short-term borrowings and was committed through July 10, 2019, with terms and conditions that were substantially equivalent to those of the Company’s other U.S. loan agreements. As of December 31, 2017, the Company had outstanding letters of credit of $4.7 million under the revolving credit agreement, and no borrowings, with $120.3 million remaining available. On January 30, 2018, the Company entered into a five year committed $350 million multi-currency revolving credit facility that matures on January 30, 2023 with a syndicate of banks. This credit facility replaced the Company’s prior $125 million credit agreement. The Company anticipates that cash from operations, committed credit facilities and cash on hand will be sufficient to fund anticipated capital expenditures, working capital, dividends and other planned financial commitments for the foreseeable future. Certain foreign subsidiaries of the Company maintain term loans and short-term bank lines of credit in their respective local currencies to meet working capital requirements as well as to fund capital expenditure programs and acquisitions. At December 31, 2017, the Company’s foreign subsidiaries had outstanding debt of $1.8 million. The Company has material debt agreements that require the maintenance of minimum interest coverage and minimum net worth. These agreements also limit the incurrence of additional debt as well as the payment of dividends and repurchase of treasury shares. As of December 31, 2017, testing for these agreements was based on the combined financial statements of the U.S. operations of the Company, Stepan Canada Inc., Stepan Quimica Ltda., Tebras Tensoativos do Brasil Ltda., PBC Industria Quimica Ltda., Stepan Specialty Products, LLC, Stepan Specialty Products B.V., Stepan Chemical (Nanjing) Co., Ltd., Stepan (Nanjing) Chemical R&D Co., Ltd., Stepan Holdings Asia Pte. Ltd. and Stepan Asia Pte. Ltd. (the “Restricted Group”). Under the most restrictive of these debt covenants: 1. The Restricted Group was required to maintain a minimum interest coverage ratio, as defined within the agreements, of 1.75 to 1.00, for the preceding four calendar quarters. 2. The Restricted Group was required to maintain net worth of at least $325.0 million. 3. The Restricted Group was required to maintain a ratio of long-term debt to total capitalization, as defined in the agreements, not to exceed 60 percent. 4. The Restricted Group was permitted to pay dividends and purchase treasury shares after December 31, 2013, in amounts of up to $100.0 million plus 100 percent of net income and cash proceeds of stock option exercises, measured cumulatively after June 30, 2014. The maximum amount of dividends that could have been paid within this limitation is disclosed as unrestricted retained earnings in Note 6 to the condensed consolidated financial statements. The Company believes it was in compliance with all of its loan agreements as of December 31, 2017. Contractual Obligations At December 31, 2017, the Company’s contractual obligations, including estimated payments by period, were as follows: (a) Excludes unamortized debt issuance costs of $1.0 million. (b) Interest payments on debt obligations represent interest on all Company debt at December 31, 2017. The interest payment amounts related to the variable rate component of the Company’s debt assume that interest will be paid at the rates prevailing at December 31, 2017. Future interest rates may change, and, therefore, actual interest payments could differ from those disclosed in the above table. (c) Purchase obligations consist of raw material, utility and telecommunication service purchases made in the normal course of business. (d) The “Other” category comprises deferred revenues that represent commitments to deliver products, expected 2018 required contributions to the Company’s funded defined benefit pension plans, estimated payments related to the Company’s unfunded defined benefit supplemental executive and outside director pension plans, estimated payments (undiscounted) related to the Company’s asset retirement obligations, environmental remediation payments for which amounts and periods can be reasonably estimated and income tax liabilities for which payments and periods can be reasonably estimated. The above table does not include $96.6 million of other non-current liabilities recorded on the balance sheet at December 31, 2017, as summarized in Note 15 to the consolidated financial statements. The significant non-current liabilities excluded from the table are defined benefit pension, deferred compensation, environmental and legal liabilities and unrecognized tax benefits for which payment periods cannot be reasonably determined. In addition, deferred income tax liabilities are excluded from the table due to the uncertainty of their timing. Pension Plans The Company sponsors a number of defined benefit pension plans, the most significant of which cover employees in its U.S. and U.K. locations. The U.S. and U.K. plans are frozen, and service benefit accruals are no longer being made. The funded status (pretax) of the Company’s defined benefit pension plans improved $4.0 million year over year, from $27.3 million underfunded at December 31, 2016, to $23.3 million underfunded at December 31, 2017. Better pension asset performance led to the improved funded status. A change in the mortality tables also contributed to the better funded status. The impacts of the pension asset returns and the change in mortality tables were partially offset by the effects of year-over-year decreases in the discount rates used to measure pension obligations (50- and 20-basis point decreases for the U.S. and U.K. plans, respectively). The Company contributed $2.8 million to its funded defined benefit plans in 2017. In 2018, the Company expects to contribute a total of $0.5 million to the U.K. defined benefit plan. As a result of pension funding relief included in the Highway and Transportation Funding Act of 2014, the Company has no 2018 contribution requirement to the U.S. pension plans. Payments to participants in the unfunded non-qualified plans should approximate $0.3 million in 2018, which is the same as payments made in 2017. Letters of Credit The Company maintains standby letters of credit under its workers’ compensation insurance agreements and for other purposes as needed. The insurance letters of credit are renewed annually and amended to the amounts required by the insurance agreements. As of December 31, 2017, the Company had a total of $4.7 million of outstanding standby letters of credit. Off-Balance Sheet Arrangements The Securities and Exchange Commission requires disclosure of off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. During the periods covered by this Form 10-K, the Company was not party to any such off-balance sheet arrangements. Environmental and Legal Matters The Company’s operations are subject to extensive federal, state and local environmental laws and regulations or similar laws in the other countries in which the Company does business. Although the Company’s environmental policies and practices are designed to ensure compliance with these regulations, future developments and increasingly stringent environmental regulation may require the Company to make additional unforeseen environmental expenditures. The Company will continue to invest in the equipment and facilities necessary to comply with existing and future regulations. During 2017, the Company’s expenditures for capital projects related to the environment were $3.2 million. Expenditures related to capital projects related to the environment projects are capitalized and depreciated over their estimated useful lives, which are typically 10 years. Recurring costs associated with the operation and maintenance of facilities for waste treatment and disposal and managing environmental compliance in ongoing operations at the Company’s manufacturing locations were approximately $28.2 million for 2017, $25.0 million for 2016 and $22.1 million for 2015. Over the years, the Company has received requests for information related to or has been named by government authorities as a potentially responsible party at a number of waste disposal sites where cleanup costs have been or may be incurred under the U.S. Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) and similar state or foreign statutes. In addition, damages are being claimed against the Company in general liability actions for alleged personal injury or property damage in the case of some disposal and plant sites. The Company believes that it has made adequate provisions for the costs it may incur with respect to the sites. See the Critical Accounting Policies section that follows for a discussion of the Company’s environmental liabilities accounting policy. After partial remediation payments at certain sites, the Company has estimated a range of possible environmental and legal losses from $24.2 million to $45.4 million at December 31, 2017, compared to $25.7 million to $46.5 million at December 31, 2016. At December 31, 2017, the Company’s accrued liability for such losses, which represented the Company’s best estimate within the estimated range of possible environmental and legal losses, was $24.2 million compared to $25.8 million at December 31, 2016. Because the liabilities accrued are estimates, actual amounts could differ from the amounts reported. During 2017, cash outlays related to legal and environmental matters approximated $2.0 million compared to $1.4 million expended in 2016. For certain sites, the Company has responded to information requests made by federal, state or local government agencies but has received no response confirming or denying the Company’s stated positions. As such, estimates of the total costs, or range of possible costs, of remediation, if any, or the Company’s share of such costs, if any, cannot be determined with respect to these sites. Consequently, the Company is unable to predict the effect thereof on the Company’s financial position, cash flows and results of operations. Given the information available, management believes the Company has no liability at these sites. However, in the event of one or more adverse determinations with respect to such sites in any annual or interim period, the effect on the Company’s cash flows and results of operations for those periods could be material. Based upon the Company’s present knowledge with respect to its involvement at these sites, the possibility of other viable entities’ responsibilities for cleanup, and the extended period over which any costs would be incurred, the Company believes that these matters, individually and in the aggregate, will not have a material effect on the Company’s financial position. See Item 3, Legal Proceedings, in this Form 10-K and Note 16, Contingencies, in the Notes to Consolidated Financial Statements for a summary of the significant environmental proceedings related to certain environmental sites. Outlook After record results in 2016 and 2017, management believes that Surfactants will continue to benefit from the segment’s diversification efforts into functional products, new technologies, expanded sales into its broad customer base globally and the stabilization of commodity surfactant volumes. Management believes that headwinds in the North American Polymer business related to lost share and lower margins will continue to be a challenge in 2018. The Company should positively benefit from the lower U.S. corporate tax rate in 2018. Climate Change Legislation Based on currently available information, the Company does not believe that existing or pending climate change legislation or regulation is reasonably likely to have a material effect on the Company’s financial condition, results of operations or cash flows. Critical Accounting Policies The Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of America (generally accepted accounting principles or GAAP). Preparation of financial statements in accordance with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The following is a summary of the accounting policies the Company believes are the most important to aid in understanding its financial results: Deferred Compensation The Company sponsors deferred compensation plans that allow management employees to defer receipt of their annual bonuses and outside directors to defer receipt of their fees until retirement, departure from the Company or as elected by the participant. The plans allow for the deferred compensation to grow or decline based on the results of investment options chosen by the participants. The investment options include Company common stock and a limited selection of mutual funds. The Company funds the obligations associated with these plans by purchasing investment assets that match the investment choices made by the plan participants. A sufficient number of shares of treasury stock are maintained on hand to cover the equivalent number of shares that result from participants electing the Company common stock investment option. As a result, the Company must periodically purchase its common shares in the open market or in private transactions. Upon retirement or departure from the Company, participants receive cash amounts equivalent to the payment date value of the investment choices they have made or Company common stock shares equal to the number of share equivalents held in the accounts. Some plan distributions may be made in cash or Company common stock at the option of the participant. Other plan distributions can only be made in Company common stock. For deferred compensation obligations that may be settled in cash, the Company must record appreciation in the market value of the investment choices made by participants as additional compensation expense. Conversely, declines in the value of Company stock or the mutual funds result in a reduction of compensation expense since such declines reduce the cash obligation of the Company as of the date of the financial statements. These market price movements may result in significant period-to-period fluctuations in the Company’s income. The increases or decreases in compensation expenses attributable to market price movements are reported in the operating expenses section of the consolidated statements of income. Because the obligations that must be settled only in Company common stock are treated as equity instruments, fluctuations in the market price of the underlying Company stock do not affect earnings. At December 31, 2017 and December 31, 2016, the Company’s deferred compensation liability was $58.9 million and $60.3 million, respectively. In 2017, approximately 55 percent of deferred compensation liability represented deferred compensation tied to the performance of the Company’s common stock. In 2016, approximately 63 percent of deferred liability represented deferred compensation tied to the performance of the Company’s common stock. The remainder of the deferred compensation liability was tied to the chosen mutual fund investment assets. A $1.00 increase in the market price of the Company’s common stock will result in approximately $0.4 million of additional compensation expense. A $1.00 reduction in the market price of the common stock will reduce compensation expense by a like amount. The expense or income associated with the mutual fund component will generally fluctuate in line with the overall percentage increase or decrease of the U.S. stock markets. The mutual fund assets related to the deferred compensation plans are recorded on the Company’s balance sheet at cost when acquired and adjusted to their market values at the end of each reporting period. As allowed by generally accepted accounting principles, the Company elected the fair value option for recording the mutual fund investment assets. Therefore, market value changes for the mutual fund investment assets are recorded in the income statement in the same periods that the offsetting changes in the deferred compensation liabilities are recorded. Dividends, capital gains distributed by the mutual funds and realized and unrealized gains and losses related to mutual fund shares are recognized as investment income or loss in the other, net line of the consolidated statements of income. Environmental Liabilities It is the Company’s accounting policy to record environmental liabilities when environmental assessments and/or remedial efforts are probable and the cost or range of possible costs can be reasonably estimated. When no amount within a range of possible costs is a better estimate than any other amount, the minimum amount in the range is accrued. Some of the factors on which the Company bases its estimates include information provided by feasibility studies, potentially responsible party negotiations and the development of remedial action plans. Estimates for environmental liabilities are subject to potentially significant fluctuations as new facts emerge related to the various sites where the Company is exposed to liability for the remediation of environmental contamination. See the Environmental and Legal Matters section of this MD&A for discussion of the Company’s recorded liabilities and range of loss estimates. Revenue Recognition Revenue is recognized upon shipment of goods to customers at the time title and risk of loss pass to the customer. In the majority of instances, this occurs when goods are provided to a carrier for shipment. For arrangements where the Company consigns product to a customer location, revenue is recognized when the customer uses the inventory. The Company records shipping and handling billed to a customer in a sales transaction as revenue. Costs incurred for shipping and handling are recorded in cost of sales. Volume and cash discounts due customers are estimated and recorded in the same period as the sales to which the discounts relate and are reported as reductions of revenue in the consolidated statements of income. Recent Accounting Pronouncements See Note 1 to the consolidated financial statements, included in Part II, Item 8, for information on recent accounting pronouncements which affect the Company. Reconciliations of Non-GAAP Adjusted Net Income and Dilutive Earnings per Share The Company believes that certain non-GAAP measures, when presented in conjunction with comparable GAAP measures, are useful for evaluating the Company’s operating performance and provide better clarity on the impact of non-operational items. Internally, the Company uses this non-GAAP information as an indicator of business performance and evaluates management’s effectiveness with specific reference to these indicators. These measures should be considered in addition to, not a substitute for or superior to, measures of financial performance prepared in accordance with GAAP. The cumulative tax effect was calculated using the statutory tax rates for the jurisdictions in which the transactions occurred. Reconciliations of Non-GAAP Net Debt Management uses the non-GAAP net debt metric to show a more complete picture of the Company’s overall liquidity, financial flexibility and leverage level. This adjusted measure should be considered supplemental to and not a substitute for financial information prepared in accordance with GAAP. The Company's definition of this adjusted measure may differ from similarly titled measures used by other entities.

<s>[INST] Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: Surfactants Surfactants, which accounted for 68 percent of Company consolidated net sales in 2017, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at five North American sites, three European sites (United Kingdom, France and Germany), four Latin American sites (Mexico, Colombia and two sites in Brazil) and two Asian sites (Philippines and Singapore). In 2016, the Company shut down its production facility in Canada, moving the production of goods previously manufactured in Canada to other Company North American production sites. Manufacturing operations at that facility ceased in the fourth quarter of 2016 but decommissioning activities continued throughout 2017. In October 2016, the Company’s subsidiary in Brazil acquired the commercial business of Tebras Tensoativos do Brasil Ltda. (Tebras) and the sulfonation production facility of PBC Industria Quimica Ltda. (PBC). In late 2016, a major customer of the Company’s Bahia, Brazil, plant exited the product line for which the Company was supplying them product. As a result, asset impairments were required in 2016 (see Note 22 to the consolidated financial statements for additional information). Polymers Polymers, which accounted for 28 percent of consolidated net sales in 2017, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively, CASE products). Powdered polyester resins are used in coating applications. CASE and polyester resins are collectively referred to as specialty polyols. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the United States, polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site and specialty polyols are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyurethane polyols are manufactured by the Company’s subsidiary in Germany, and specialty polyols are manufactured by the Company’s Poland subsidiary. In China, polyurethane polyols and specialty polyols are manufactured at the Company’s Nanjing, China, manufacturing plant. Specialty Products Specialty Products, which accounted for four percent of consolidated net sales in 2017, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, at outside contractors. 2017 Acquisition Agreement On June 13, 2017, the Company announced that it had reached an agreement with BASF Mexicana, S.A. DE C.V. (BASF) to acquire BASF’s production facility in Ecatepec, Mexico, and a portion of its related surfactants business. The facility, which is near Mexico City, has over 50,000 metric tons of capacity, 124,000 square feet of warehouse space, a laboratory and office space. The acquisition is currently expected to be completed in 2018, subject to normal closing conditions, including necessary governmental consents. The acquisition supports the Company’s growth strategy in Latin America. [/INST] Positive. </s>

STEPAN CO

2019-02-27

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following is management’s discussion and analysis (MD&A) of certain significant factors that have affected the Company’s financial condition and results of operations during the annual periods included in the accompanying consolidated financial statements. Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: • Surfactants - Surfactants, which accounted for 70 percent of the Company’s consolidated net sales in 2018, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at five North American sites, two European sites (United Kingdom and France - Germany ceased Surfactant production in the fourth quarter of 2018), five Latin American sites (Colombia and two sites in each of Mexico and Brazil) and two Asian sites (Philippines and Singapore). Recent significant Surfactants events include: o In March 2018, the Company, through a subsidiary in Mexico, acquired a production facility and a portion of its related surfactant business from BASF Mexicana, S.A. DE C.V. (BASF) (see Note 20, Acquisitions, for additional details). o During the third quarter of 2018, the Company approved a plan to shut down Surfactants operations at its plant site in Germany (see Note 22, Business Restructuring and Asset Impairments, for additional details). o During the fourth quarter of 2017, the Company approved a plan to restructure a portion of its Fieldsboro, New Jersey production facility (see Note 22, Business Restructuring and Asset Impairments, for additional details). o In 2016, the Company shut down its production facility in Canada, moving the production of goods previously manufactured in Canada to other Company North American production sites. Manufacturing operations at that facility ceased in the fourth quarter of 2016 but decommissioning activities continued throughout 2018 (see Note 22, Business Restructuring and Asset Impairments, for additional details). • Polymers - Polymers, which accounted for 26 percent of consolidated net sales in 2018, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively, CASE products). Powdered polyester resins are used in coating applications. CASE and polyester resins are collectively referred to as specialty polyols. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the United States, polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site, and specialty polyols are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyurethane polyols are manufactured by the Company’s subsidiary in Germany, and specialty polyols are manufactured by the Company’s Poland subsidiary. In China, polyurethane polyols and specialty polyols are manufactured at the Company’s Nanjing, China, manufacturing plant. • Specialty Products - Specialty Products, which accounted for four percent of consolidated net sales in 2018, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, at outside contractors. 2018 Acquisition On March 26, 2018, the Company, through a subsidiary in Mexico, acquired BASF production facility in Ecatepec, Mexico, and a portion of its related surfactants business. The facility, which is near Mexico City, has over 50,000 metric tons of capacity, 124,000 square feet of warehouse space, a laboratory and office space. The acquisition supports the Company’s growth strategy in Latin America. The Company believes that this acquisition should enhance its market position and supply capabilities for surfactants in Mexico and position the Company to grow in both the consumer and functional surfactants markets. See Note 20, Acquisitions, for additional details. Deferred Compensation Plans The accounting for the Company’s deferred compensation plans can cause period-to-period fluctuations in Company expenses and profits. Compensation expense results when the values of Company common stock and mutual fund investment assets held for the plans increase, and compensation income results when the values of Company common stock and mutual fund investment assets decline. The pretax effect of all deferred compensation-related activities (including realized and unrealized gains and losses on the mutual fund assets held to fund the deferred compensation obligations) and the income statement line items in which the effects of the activities were recorded are presented in the following table: (1) See the applicable Corporate Expenses section of this MD&A for details regarding the period-to-period changes in deferred compensation. Below are the year-end Company common stock market prices used in the computation of deferred compensation income and expense: Effects of Foreign Currency Translation The Company’s foreign subsidiaries transact business and report financial results in their respective local currencies. As a result, foreign subsidiary income statements are translated into U.S. dollars at average foreign exchange rates appropriate for the reporting period. Because foreign exchange rates fluctuate against the U.S. dollar over time, foreign currency translation affects year-over-year comparisons of financial statement items (i.e., because foreign exchange rates fluctuate, similar year-to-year local currency results for a foreign subsidiary may translate into different U.S. dollar results). The following tables present the effects that foreign currency translation had on the year-over-year changes in consolidated net sales and various income line items for 2018 compared to 2017 and 2017 compared to 2016: (1) The 2017 and 2016 gross profit and operating income line items have been immaterially changed from the amounts originally reported as a result of the Company’s first quarter 2018 adoption of ASU No. 2017-07, Compensation-Retirement Benefits (Topic 715). Results of Operations 2018 Compared with 2017 Summary Net income attributable to the Company for 2018 increased 23 percent to $112.8 million, or $4.83 per diluted share, from $91.6 million, or $3.92 per diluted share, for 2017. Adjusted net income increased five percent to $113.8 million, or $4.88 per diluted share, from $108.7 million, or $4.65 per diluted share in 2017 (see the “Reconciliations of Non-GAAP Adjusted Net Income and Diluted Earnings per Share” section of this MD&A for reconciliations between reported net income attributable to the Company and reported earnings per diluted share and non-GAAP adjusted net income and adjusted earnings per diluted share). Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2018 compared to 2017 follows the summary. Consolidated net sales increased $68.9 million, or four percent, between years. Higher sales volume, higher selling prices and the favorable impact of foreign currency translation positively impacted net sales by $64.7 million, $4.1 million and $0.1 million, respectively. Total Company sales volume increased three percent. Sales volume increased five percent and three percent for the Surfactants and Specialty Products segments, respectively. Sales volume declined three percent for the Polymers segment. Unit margins improved for Surfactants and Specialty Products and declined for Polymers. Operating income improved $4.2 million, or 3 percent, between years. Most of this improvement was related to lower 2018 deferred compensation expense which declined by $7.1 million. Operating income improved for the Surfactant and Specialty Products segments and declined for the Polymers segment. Business restructuring expenses were $0.5 million lower in the current year and corporate expenses were up $3.4 million year-over-year. Foreign currency translation had an unfavorable $0.6 million effect on year-over-year consolidated operating income. Operating expenses (including deferred compensation expense and business restructuring expenses) decreased $1.2 million, or one percent, between years. Changes in the individual income statement line items that comprise the Company’s operating expenses were as follows: • Selling expenses increased $2.2 million, or four percent, year over year largely due to higher salaries and cloud-based application expense. A portion of the higher salaries is attributable to the 2018 acquisition in Mexico. • Administrative expenses increased $3.6 million, or five percent, year over year. The increase was primarily due to higher employee separation costs and salaries. • Research, development and technical service (R&D) expenses increased $0.6 million, or one percent, year over year. • Deferred compensation was income of $2.3 million in 2018 versus expense of $4.9 million in 2017. See the “Overview” and “Segment Results - Corporate Expenses” sections of this MD&A for further details. • Business restructuring expenses were $2.6 million in 2018 versus $3.1 million in 2017. Current year restructuring charges are comprised of asset and spare part write-downs related to the Company’s decision to cease Surfactant operations in Germany ($1.4 million) and decommissioning costs associated with the Company’s manufacturing facility in Canada, which ceased operations in the fourth quarter of 2016 ($1.2 million). The 2017 restructuring charges related to decommissioning costs associated with the Canadian plant closure ($2.0 million), severance costs related to a partial restructuring of the Company’s production facility in Fieldsboro, New Jersey ($0.9 million) and workforce reduction expense at the Company’s Singapore plant. These business restructuring charges were excluded from the determination of segment operating income. See Note 22 to the consolidated financial statements for additional information. Net interest expense for 2018 declined $0.7 million, or six percent, from net interest expense for 2017. The decline in interest expense was principally attributable to higher interest income earned on excess cash and lower average debt levels due to scheduled repayments. Other, net was $0.7 million of expense in 2018 versus $3.5 million of income in 2017. The Company recognized $1.4 million of investment losses (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets in 2018 compared to $5.1 million of gains in 2017. Partially offsetting this decrease was foreign exchange gains of $1.9 million in 2018 compared to foreign exchange losses of $0.6 million in 2017. In addition, the Company reported $1.2 million of net periodic pension cost in 2018 versus $1.0 million of net periodic pension cost in 2017. The year-to-date effective tax rate was 19.4 percent in 2018 compared to 34.3 percent in 2017. This decrease was primarily attributable to the following items: (a) a lower U.S. statutory tax rate of 21 percent in 2018 versus a rate of 35 percent in 2017; and (b) the enactment of U.S. tax reform which resulted in a net tax cost of $14.9 million in 2017 that did not recur in 2018. The 2018 benefits were partially offset by certain unfavorable U.S. tax reform changes that became effective on January 1, 2018 (i.e., global intangible low-taxed income, non-deductible executive compensation, and the repeal of the domestic production activities deduction). In addition, during the third quarter of 2018, the Company filed applications to automatically change certain tax accounting methods related to the 2017 tax year. These method changes provided a favorable tax benefit that was partially offset by the negative tax impact recognized as a result of the Company’s decision to repatriate approximately $100.0 million of foreign cash in the fourth quarter of 2018. See Note 9 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results (1) The 2017 segment and total operating income line items have been immaterially changed from the amounts originally reported as a result of the Company’s first quarter 2018 adoption of ASU No. 2017-07, Compensation-Retirement Benefits (Topic 715). Surfactants Surfactants 2018 net sales increased $88.4 million, or seven percent, over net sales reported in 2017. Higher sales volume and selling prices accounted for $69.5 million and $26.2 million, respectively, of the year-over-year increase in net sales. Sales volume increased five percent year-over-year. The unfavorable effects of foreign currency translation negatively impacted the year-over-year change in net sales by $7.3 million. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased nine percent between years. Sales volume increased six percent which favorably impacted the change in net sales by $42.0 million. The sales volume growth was largely driven by higher sales volume of products used in personal care and oilfield applications. Sales volume of general surfactants to our distribution partners also increased. Average selling prices increased three percent between years and positively impacted the year-over-year change in net sales by $26.4 million. The increase in selling prices was largely due to a more favorable mix of sales. Foreign currency translation positively impacted the change in net sales by $0.1 million. The foreign currency impact reflected a weaker U.S. dollar relative to the Canadian dollar. Net sales for European operations increased one percent versus prior year. The favorable effects of foreign currency translation positively impacted the year-over-year change in net sales by $11.8 million. A weaker U.S. dollar relative to the European euro and British pound sterling led to the foreign currency effect. Lower selling prices of four percent unfavorably impacted the year-over-year change in net sales by $10.5 million. Sales volume was flat versus the prior year. Net sales in 2017 were positively impacted by $4.7 million related to a favorable resolution of a prior year customer claim (see Note 23 to the consolidated financial statements for further information). Net sales for Latin American operations increased $22.0 million, or 12 percent, primarily due a 12 percent increase in sales volume and higher selling prices. These two items accounted for $22.5 million and $16.1 million, respectively, of the year-over-year change in net sales. The higher volume is mostly related to the Company’s first quarter acquisition in Ecatepec, Mexico and partially offset by lower demand and lost commodity business in Brazil. The higher selling prices primarily reflect the pass through to customers of increased raw material costs. Foreign currency translation negatively impacted the year-over-year change in net sales by $16.6 million. The foreign currency translation primarily reflects the year-over-year weakening of the Brazilian real and Mexican peso relative to the U.S. dollar. Net sales for Asian operations declined $3.8 million, or six percent, primarily due to the negative impact of foreign currency translation and lower average selling prices. These items negatively impacted the year-over-year change in net sales by $2.5 million and $2.0 million, respectively. The foreign currency impact primarily reflected a weaker Philippine peso relative to the U.S. dollar. Sales volume increased one percent, which positively impacted the year-over year change in net sales by $0.7 million. The sales volume increase was mostly due to higher sales of general surfactants to our distribution partners. Surfactant operating income for 2018 increased $16.6 million, or 14 percent, versus operating income reported in 2017. Gross profit increased $20.1 million, primarily due to improved results for North American operations. Operating expenses increased $3.4 million, or four percent. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (1) The 2017 gross profit, operating expenses and operating income line items have been immaterially changed from the amounts originally reported as a result of the Company’s first quarter 2018 adoption of ASU No. 2017-07, Compensation-Retirement Benefits (Topic 715). Gross profit for North American operations increased 20 percent, or $26.2 million, between years primarily due to higher unit margins and higher sales volumes. These items positively impacted the year-over-year change in gross profit by $18.9 million and $7.3 million, respectively. The higher unit margins were primarily due to a more favorable customer and product mix. Higher year-over-year sales of products used in personal care, agricultural and oilfield applications, along with products sold to our distribution partners contributed to the 2018 volume growth. Gross profit for European operations decreased four percent between years principally due to the aforementioned non-recurring $4.7 million favorable customer claim resolution in 2017. Lower unit margins, principally due to the non-recurrence of the prior year favorable customer claim resolution, negatively impacted the year-over-year change in gross profit by $2.5 million. Foreign currency translation positively affected the change in gross profit by $1.3 million. Sales volume was flat year-over-year. Gross profit for Latin American operations decreased $2.5 million, or nine percent, year-over-year primarily due to lower unit margins and the negative impact of foreign currency translation. These items unfavorably impacted the change in year-over-year gross profit by $3.1 million and $2.8 million, respectively. The lower unit margins principally related to higher integration and start-up costs associated with the Company’s first quarter 2018 acquisition in Ecatepec, Mexico. Sales volume growth of 12 percent positively impacted current year gross profit by $3.4 million. This growth primarily reflects the Company’s first quarter acquisition in Mexico partially offset by lower demand and lost commodity business in Brazil. The Ecatepec, Mexico acquisition was slightly accretive to Latin America gross profit in 2018. Asia gross profit decreased 13 percent largely due to lower unit margins and the unfavorable impact of foreign currency translation. These item unfavorably impacted the year-over-year change in gross profit by $2.3 million and $0.4 million, respectively. Sales volume growth of one percent positively impacted the year-over-year change in gross profit by $0.2 million. Operating expenses for the Surfactants segment increased $3.4 million, or four percent, year-over-year. Most of this increase was attributable to higher North American expenses. The higher North American expenses were primarily due to higher consulting fees, salaries, and cloud-based application expense. Polymers Polymer net sales for 2018 decreased $19.2 million, or four percent, over net sales for 2017. Lower sales volumes and selling prices negatively impacted the year-over-year change in net sales by $16.9 million and $9.0 million, respectively. The favorable effects of foreign currency translation positively impacted the year-over-year change in net sales by $6.7 million. The foreign currency effect reflected a weaker U.S. dollar relative to the Polish zloty. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined two percent due to a sales volume decline of two percent and slightly lower selling prices. These items negatively impacted the year-over-year change in net sales by $5.5 million and $0.8 million, respectively. Sales volume of phthalic anhydride and polyols used in rigid foam applications declined three and one percent, respectively. Sales volume of polyols used in rigid foam applications increased six percent in the second half of 2018 due to recaptured market share. Sales volume of specialty polyols was flat with the prior year. Net sales for European operations decreased eight percent primarily due to a seven percent decline in sales volume and lower selling prices which negatively impacted the year-over-year change in net sales by $12.8 million and $9.5 million, respectively. The lower volume was principally due to customer inventory builds prior to the end of 2017, the carryover effect of the 2017 MDI shortage and extended winter weather which delayed the start of construction projects. The effects of foreign currency translation positively impacted the year-over-year change in net sales by $6.7 million. Net sales for Asia and Other operations increased nine percent between years due a six percent increase in sales volume, higher selling prices and the favorable effects of foreign currency translation. These items accounted for $1.6 million, $1.0 million and $0.1 million, respectively, of the year-over-year net sales increase. Polymer operating income for 2018 declined $18.4 million, or 22 percent, compared to operating income for 2017. Gross profit decreased $18.5 million, or 17 percent, primarily due to a three percent decline in sales volumes and lower unit margins. Operating expenses were flat versus prior year. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (1) The 2017 gross profit, operating expenses and operating income line items have been immaterially changed from the amounts originally reported as a result of the Company’s first quarter 2018 adoption of ASU No. 2017-07, Compensation-Retirement Benefits (Topic 715). Gross profit for North American operations declined 16 percent year-over-year primarily due to lower unit margins and a two percent decline in sales volume. These two items negatively impacted the year-over-year change in gross profit by $11.2 million and $1.3 million, respectively. The decline in margins primarily reflected competitive market pressures. Gross profit for European operations declined 21 percent primarily due to lower unit sales margins and a seven percent decline in sales volume. These items negatively impacted the year-over-year change in gross profit by $5.6 million and $2.1 million, respectively. The lower margins were primarily due to higher overhead resulting from lower production throughput in 2018 versus 2017. The favorable impact of foreign currency translation positively impacted the year-over-year change in gross profit by $1.0 million. Gross profit for Asia and Other operations improved $0.8 million primarily due to higher unit margins and the favorable impact of foreign currency translation. These items positively impacted the year-over-year change in gross profit by $0.7 million and $0.1 million, respectively. Operating expenses for the Polymers segment decreased $0.1 million year-over-year. Specialty Products Net sales for 2018 were flat with the prior year. Sales volume was up three percent versus the prior year. Operating income increased $1.7 million versus prior year primarily due to the higher sales volume and improved unit margins. Corporate Expenses Corporate expenses, which include deferred compensation and other operating expenses that are not allocated to the reportable segments, declined $4.3 million year-over-year to $62.3 million in 2018 from $66.6 million in 2017. The decline in corporate expenses was primarily attributable to lower deferred compensation expense ($7.2 million) and business restructuring expense ($0.5 million). These decreases were partially offset by higher 2018 employee separation costs and salaries. Deferred compensation was $2.3 million of income in 2018 compared to $4.9 million of expense in 2017. The favorable year-over-year change was primarily due to less mutual fund related expense incurred in the current year combined with a steeper drop in Stepan share price in 2018 versus 2017. 2017 Compared with 2016 Summary Net income attributable to the Company for 2017 increased six percent to $91.6 million, or $3.92 per diluted share, from $86.2 million, or $3.73 per diluted share, for 2016. Adjusted net income increased 11 percent to $108.7 million, or $4.65 per diluted share, from $98.2 million, or $4.25 per diluted share in 2016 (see the “Reconciliations of Non-GAAP Adjusted Net Income and Diluted Earnings per Share” section of this MD&A for reconciliations between reported net income attributable to the Company and reported earnings per diluted share and non-GAAP adjusted net income and adjusted earnings per diluted share). Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2017 compared to 2016 follows the summary. Consolidated net sales increased $158.9 million, or nine percent, between years. Higher average selling prices favorably affected the year-over-year net sales change by $174.5 million. The increase in average selling prices was mostly attributable to the pass through of higher raw material costs within the Surfactants and Polymers segments. Consolidated sales volume declined one percent, which had a $25.5 million unfavorable impact on the year-over-year change in net sales. Sales volume decreased two percent and seven percent for the Surfactants and Specialty Products segments, respectively. Sales volume was flat year-over-year for the Polymers segment. Foreign currency translation positively affected the year-over-year net sales change by $9.9 million. The favorable foreign currency translation effect reflected a weaker U.S. dollar against the majority of currencies for countries where the Company has foreign operations. Unit margins improved for Surfactants and declined for Polymers and Specialty Products. Operating income improved $19.4 million, or 15 percent, between years. Most of this improvement was related to lower 2017 deferred compensation expense and lower business restructuring and asset impairment charges, which declined by $11.9 million and $4.0 million, respectively. Operating income improved for the Surfactant segment and declined for the Polymers and Specialty Products segments. The Surfactant segment operating income increased 20 percent largely due to the non-recurrence of two customer claims incurred in 2016 ($7.4 million), a favorable resolution of one of the prior year claims in 2017 ($4.7 million), improved product mix, higher unit margins, savings from the 2016 Canadian plant shutdown and the full year accretive impact of the October 2016 Tebras and PBC acquisitions in Brazil. The Polymers segment operating income declined 15 percent primarily due to lower sales volume and unit margins in North America. Foreign currency translation had a favorable $1.7 million effect on the consolidated operating income. Operating expenses (including deferred compensation expense and business restructuring and asset impairment expenses) decreased $20.1 million, or 10 percent, between years. Changes in the individual income statement line items that comprise the Company’s operating expenses were as follows: • Selling expenses decreased $2.8 million, or five percent, year over year largely due to lower U.S. fringe benefit expenses ($2.4 million). The lower fringe benefits were primarily due to lower incentive-based compensation expense (stock-based compensation and bonuses). Higher expenses associated with Tebras and PBC, acquired in October 2016, partially offset the consolidated decrease in selling expenses. • Administrative expenses increased $0.8 million, or one percent, year over year. The increase was primarily due to higher legal and consulting expenses, partially offset by lower U.S. fringe benefit expenses resulting from lower incentive-based compensation expense. • Research, development and technical service (R&D) expenses decreased $2.1 million, or four percent, year over year primarily due to lower U.S. fringe benefit expenses resulting from lower incentive-based compensation expense. • Deferred compensation plan expense was $11.9 million lower in 2017 than in 2016 primarily due to a $2.51 per share decrease in the market price of Company common stock in 2017 versus a $31.79 per share increase in 2016. See the “Overview” and “Corporate Expenses” sections of this MD&A for further details. • Business restructuring and asset impairment charges totaled $3.1 million in 2017 versus $3.1 million in 2016. 2017 restructuring charges are primarily comprised of decommissioning costs related to the Company’s Canadian plant closure ($2.0 million) and severance costs related to a partial restructuring of the Company’s production facility in Fieldsboro, New Jersey ($0.9 million). The 2016 restructuring expenses primarily related to the closure of the Company’s surfactant plant in Canada ($2.8 million) and severance costs related to a partial restructuring of the Company’s production facility in Fieldsboro. See Note 22 to the consolidated financial statements for additional information. The business restructuring and asset impairment charges were excluded from the determination of segment operating income. Net interest expense for 2017 declined $1.8 million, or 13 percent, from net interest expense for 2016. The decline in interest expense was principally attributable to higher interest income earned on excess cash and lower average debt levels due to scheduled repayments. Other, net was income of $3.5 million for 2017 versus $0.8 million of expense in 2016. Most of the increase in income was attributable to investment income (including realized and unrealized gains and losses) from the Company’s deferred compensation and supplemental defined contribution mutual fund assets. Investment income (including realized and unrealized gains and losses) was $5.1 million in 2017 versus $0.8 million in 2016, an increase of $4.4 million year-over-year. Partially offsetting this increase was foreign exchange activity, which resulted in a $0.6 million loss in 2017 versus an insignificant loss in 2016. Other, net also included net periodic benefit cost, which was $1.0 million expense in 2017 versus $1.6 million expense in 2016. The effective tax rate was 34.3 percent in 2017 compared to 24.3 percent in 2016. The increase was primarily attributable to the enactment of the U.S. Tax Cuts and Jobs Act (Tax Act) which resulted in a net tax cost of $14.9 million. This net expense consists of a net benefit attributable to the U.S. federal corporate income tax rate reduction of $4.5 million and a net expense attributable to the Transition Tax of $19.4 million. The increase in the effective tax rate attributable to the Tax Act was partially offset by the following favorable nonrecurring items: 1) a foreign tax credit benefit from the repatriation of foreign earnings, and 2) a tax benefit from a change in accounting method related to tax depreciation. See Note 9 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results Surfactants Surfactants 2017 net sales increased $116.0 million, or 10 percent, from net sales reported in 2016. Higher selling prices and the favorable effects of foreign currency translation accounted for $139.7 million and $1.8 million, respectively, of the year-over-year increase in net sales. The increase in selling prices mostly reflected the pass through to customers of higher costs for certain raw materials and more favorable sales mix. The favorable sales mix was primarily attributable to higher sales of products used in household, industrial and institutional (HI&I), agricultural and oilfield applications. Sales volume decreased two percent between years, which had a $25.5 million negative effect on year-over-year net sales. All regions, except Latin America, experienced sales volume declines. The majority of the sales volume decline was attributable to lower commodity surfactant demand. The Latin America sales volume increase was principally due to the full year impact of the region’s October 2016 acquisitions of Tebras and PBC. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased five percent between years. Higher selling prices and the favorable effect of foreign currency translation positively affected the year-over-year change in net sales by $58.8 million and $0.6 million, respectively. A three percent decline in sales volume offset the impacts of selling prices and currency translations by $21.0 million. Selling prices increased eight percent year-over-year mainly due to the pass through of certain increased raw material costs to customers and to a more favorable mix of sales. The three percent decline in sales volume reflected decreased sales of commodity products used in laundry and cleaning and personal care applications partially offset by increased sales of products used in HI&I, agricultural and oilfield applications. The foreign currency impact reflected a weaker U.S. dollar relative to the Canadian dollar. Net sales for European operations increased 16 percent from 2016 to 2017. Most of this increase was attributable to higher selling prices which favorably affected the year-over-year change in net sales by $44.4 million. The increase in selling prices primarily resulted from the pass through of higher costs for certain raw materials. A three percent decline in sales volume and the unfavorable effect of foreign currency translation negatively affected the year-over-year change in net sales by $6.0 million and $0.8 million, respectively. The decline in sales volume was largely attributable to lower demand for personal care commodity anionics and reduced sales volumes of general surfactants sold through our distribution partners, partially offset by higher demand for agricultural chemicals. A weaker British pound sterling, partially offset by a stronger Euro, relative to the U.S. dollar, accounted for the foreign currency effect. Net sales in 2016 were negatively impacted by $7.4 million of expense from two customer claims (see Note 23 to the consolidated financial statements for further information) whereas net sales in 2017 were positively impacted by $4.7 million related to a favorable resolution of one of the prior year claims. Net sales for Latin American operations increased 26 percent due to higher selling prices, a seven percent increase in sales volume and the favorable impact of foreign currency translation, which accounted for $23.2 million, $10.8 million and $5.6 million, respectively, of the year-over-year increase in net sales. Selling prices increased 14 percent due to the pass through to customers of higher raw material costs and a more favorable mix of sales. The improved sales volume reflected new business associated with the October 2016 acquisition of Tebras and PBC and higher demand for agricultural chemicals, partially offset by lower demand and lost commodity business for products used in laundry and cleaning applications. The year-over-year strengthening of the Brazilian real and the Colombian peso against the U.S. dollar generated the favorable foreign currency effect. Net sales in 2016 included $4.3 million of compensation for future lost revenue related to a negotiated settlement with a major customer under contract with the region’s Bahia, Brazil, plant that exited the product line for which the Company supplied them product (see Note 22 to the consolidated financial statements for further information). Net sales for Asian operations increased one percent primarily due to a 23 percent increase in average selling prices. Higher average selling prices, primarily resulting from the pass through of certain increased raw material costs, favorably impacted net sales by $13.3 million. Lower sales volume and the effect of foreign currency translation negatively affected the year-over-year change in net sales by $9.2 million and $3.7 million, respectively. The 14 percent sales volume decline was primarily due to weaker demand for commodity laundry and cleaning products. A weaker Philippine peso relative to the U.S. dollar caused the negative foreign currency translation adjustment. Surfactant operating income for 2017 increased $19.8 million, or 20 percent, from operating income reported in 2016. The operating income increase was due to higher 2017 gross profit of $16.0 million and lower operating expenses of $3.7 million. The eight percent increase in gross profit was largely due to the non-recurrence of the aforementioned European customer claims incurred in 2016, a favorable resolution of one of the customer claims in 2017 and more favorable sales mix resulting from higher sales of products used in HI&I, agricultural and oilfield applications. Gross profit for 2016 was also negatively affected by accelerated depreciation ($4.5 million) related to the Canadian plant shutdown whereas gross profit for 2017 was negatively impacted by accelerated depreciation ($1.3 million) related to the Fieldsboro, New Jersey plant restructuring. Lower manufacturing costs resulting from the prior year plant closures in Canada and Brazil also benefited 2017 gross profit. The effects of foreign currency translation had a favorable $1.2 million impact on the year-over-year gross profit change. Operating expenses decreased $3.7 million, or four percent. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (a) In 2017, the Company changed its internal financial statement classification for certain transportation costs, transferring such costs from operating expenses to cost of sales. In this segment discussion, the 2016 North America gross profit and total operating expenses have been changed from the amounts presented before to make such amounts consistent with the current year classification. Surfactant segment operating income remained unchanged. Gross profit for North American operations increased seven percent principally due to improved product mix. The improved product mix primarily reflects decreased sales of commodity products used in laundry and cleaning and personal care applications partially offset by increased sales of products used in HI&I, agricultural and oilfield applications. The current year also benefited from lower manufacturing costs resulting from the closure of the Company’s Canada manufacturing operations in the fourth quarter of 2016. The Company incurred $4.5 million of accelerated depreciation associated with the Canadian plant closure in 2016 versus $1.3 million of accelerated depreciation associated with the restructuring of the Fieldsboro, New Jersey plant in 2017. Gross profit for European operations increased 36 percent between years largely due to the aforementioned non-recurring $7.4 million customer claims incurred in 2016 and a favorable customer claim resolution in 2017 of $4.7 million. Gross profit also improved due to more favorable product mix principally resulting from higher demand for agricultural chemicals. Prior year manufacturing costs also included approximately $0.6 million of expenses associated with the planned 30-day mandatory inspection shutdown of the Company’s plant in Germany. There was no such inspection in 2017. Foreign currency translation positively affected the change in gross profit by $0.8 million. Gross profit for Latin American operations improved one percent mainly due to a more profitable mix of sales, the full year contribution of the October 2016 Tebras and PBC acquisitions and lower manufacturing costs resulting from the prior year Bahia, Brazil plant closure. Gross profit in 2016 included $4.3 million of income resulting from a negotiated customer contract termination settlement related to the Bahia, Brazil plant closure. Foreign currency translation positively impacted the change in gross profit by $1.0 million. Asia gross profit decreased five percent largely due to the 14 percent decrease in sales volume mostly related to the Company’s Philippine operations. Foreign currency translation, mostly related to a weaker Philippine peso relative to the U.S. dollar, negatively impacted the change in gross profit by $0.7 million. Operating expenses for the Surfactants segment decreased $3.7 million, or four percent, year-over-year. Most of this decrease was attributable to lower North American expenses. North American expenses were down primarily due to lower U.S. incentive-based compensation, primarily related to stock-based compensation and bonuses. The North American decrease was partially offset by higher Latin American expenses resulting from the full year impact of the October 2016 Tebras and PBC acquisitions. Polymers Polymer net sales for 2017 increased $47.8 million, or 10 percent, over net sales for 2016. Higher selling prices, resulting from the pass through of increased costs for certain raw materials, and the positive effect of foreign currency translation favorably affected the year-over-year net sales change by $40.9 million and $7.9 million, respectively. Sales volume, essentially flat between years, had a $1.0 million unfavorable effect on the year-over-year net sales change. A decline in North American sales volume was offset by sales volume improvement in Europe and Asia. The foreign currency translation effect reflected a weaker U.S. dollar relative to the Polish zloty. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased three percent due to higher selling prices, partially offset by lower sales volumes. Selling prices increased five percent, which had a $15.4 million positive effect on the year-over-year change in net sales. The pass through of certain higher raw material costs to customers led to increased selling prices. Sales volume declined two percent which unfavorably impacted the net sales change by $5.5 million. Sales volume of polyols used in rigid foam applications declined two percent mainly due to lost share from one major customer. Phthalic anhydride sales volume declined seven percent. Sales volume of specialty polyols increased eight percent due to greater demand for product used in CASE applications and powdered resins. Net sales for European operations increased 22 percent due to higher selling prices, the favorable effect of foreign currency translation and a three percent increase in sales volumes, which accounted for $22.4 million, $7.9 million and $4.0 million, respectively, of the year-over-year net sales increase. Selling prices increased 14 percent primarily due to the pass through to customers of cost increases for certain raw materials. The sales volume improvement was primarily attributable to increased sales of specialty polyols, which reflected the Company’s successful efforts to utilize the production capacity of its new reactor in Poland. Sales volume also grew slightly due to increased demand for polyols used in rigid foam insulation and insulated metal panels. Net sales for Asia and Other operations increased 15 percent between years due to higher selling prices, a two percent increase in sales volume and the favorable effect of foreign currency, which accounted for $3.1 million, $0.5 million and $0.1 million, respectively, of the year-over-year net sales increase. Polymer operating income for 2017 declined $14.2 million, or 15 percent, compared to operating income for 2016. Gross profit decreased $15.0 million, or 12 percent, primarily due to reduced margins and lower sales volumes in North American operations. European operations reported a 14 percent gross profit improvement due to sales volume growth and lower manufacturing costs. Operating expenses declined $0.8 million, or three percent, versus prior year. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (a) In 2017, the Company changed its internal financial statement classification for certain transportation costs, transferring such costs from operating expenses to cost of sales. In this segment discussion, the 2016 North America gross profit and total operating expenses have been changed from the amounts presented before to make such amounts consistent with the current year classification. Polymer segment operating income remained unchanged. Gross profit for North American operations declined 18 percent year over year primarily due to reduced margins and a two percent decline in sales volume. The decline in margins reflected the effect of higher raw material costs that, due to competitive reasons, could not entirely be passed on to customers. Gross profit for European operations increased 14 percent primarily due to a three percent increase in sales volume and lower unit manufacturing costs. The 2016 results were negatively affected by higher plant expenses that resulted from the planned 30-day mandatory inspection shutdown of manufacturing operations in Germany during the third quarter of 2016. As a result of the shutdown, 2016 plant expenses included $2.4 million of inspection and storage expenses not incurred in 2017. The favorable effects of foreign currency translation positively impacted the year-over-year change in gross profit by $1.2 million. Gross profit for Asia and Other operations declined 93 percent despite a two percent increase in sales volume. Most of the decline was attributable to higher overhead costs incurred in 2017. Overhead costs were lower in 2016 as the Nanjing plant benefited from higher throughput to supply material to the Company’s European market to compensate for the mandatory shutdown at the German plant. The intercompany production reduced site overhead in 2016. Operating expenses for the Polymers segment decreased $0.8 million, or three percent, year over year largely due to lower U.S. incentive-based compensation expense. Specialty Products Net sales for 2017 declined $5.0 million, or six percent, compared to net sales for 2016. A seven percent decrease in sales volume accounted for most of the net sales decline. Most of the sales volume decrease was attributable to lower demand for food ingredient applications and nutritional supplemental products. Operating income decreased $0.8 million year over year primarily due to the lower sales volume partially offset by more favorable product mix. Corporate Expenses Corporate expenses, which are comprised of deferred compensation and other operating expenses that are not allocated to the reportable segments, declined $14.5 million year-over-year to $66.6 million in 2017 from $81.1 million in 2016. The decline in corporate expense was primarily attributable to lower deferred compensation expense ($11.9 million), U.S. incentive-based compensation ($2.4 million) and the previously discussed restructuring and impairment charges ($4.0 million). These decreases were partially offset by higher legal and consulting related expenses ($3.6 million) in 2017. Deferred compensation was $4.9 million of expense for 2017 compared to $16.8 million of expense for 2016. The lower expense primarily resulted from a $2.51 per share decrease in the value of Company common stock over the twelve months ended December 31, 2017, compared to a $31.79 per share increase for the same period of 2016. The following table presents the year-end Company common stock market prices used in the computation of deferred compensation expense: Liquidity and Capital Resources Overview Historically, the Company’s principal sources of liquidity have included cash flows from operating activities, available cash and cash equivalents and the use of available borrowing facilities. The Company’s principal uses of cash have included funding operating activities, capital investments and acquisitions. For the twelve months ended December 31, 2018, operating activities were a cash source of $171.1 million versus a source of $198.9 million for the comparable period in 2017. For the current year, investing cash outflows totaled $107.8 million, as compared to an outflow of $82.7 million in the prior year period, and financing activities were a use of $51.6 million, as compared to a use of $50.5 million in the prior year period. Cash and cash equivalents increased by $1.3 million compared to December 31, 2017, including an unfavorable exchange rate impact of $10.4 million. As of December 31, 2018, the Company’s cash and cash equivalents totaled $300.2 million. Cash in U.S. demand deposit accounts and money market funds totaled $61.0 million and $141.6 million, respectively. The Company’s non-U.S. subsidiaries held $97.6 million of cash outside the United States as of December 31, 2018. Operating Activity Net income in 2018 increased by $21.2 million versus the comparable period in 2017. Working capital was a cash use of $39.2 million in 2018 versus a source of $19.3 million in 2017. Accounts receivable were a source of $5.2 million in 2018 compared to a use of $16.4 million in 2017. Inventories were a use of $26.8 million in 2018 versus a source of $5.7 million in 2017. Accounts payable and accrued liabilities were a use of $19.0 million in 2018 compared to a source of $30.5 million for the same period in 2017. Working capital requirements were higher in 2018 compared to 2017 primarily due to the changes noted above. The change in inventories was primarily due to higher quantities, a portion which related to the Company’s first quarter acquisition in Ecatepec, Mexico. The change in accrued liabilities was primarily related to lower U.S. tax liabilities in 2018 versus 2017. It is management’s opinion that the Company’s liquidity is sufficient to provide for potential increases in working capital requirements during 2019. Investing Activity Cash used for investing activities increased $25.1 million year-over-year. Cash outflows from investing activities included capital expenditures of $86.6 million compared to $78.6 million in 2017. Other investing activities were a use of $21.2 million in 2018 versus a use of $4.1 million in 2017. The increase in other investing activities was primarily attributable to a use of $22.9 million cash related to the acquisition of a surfactant production facility in Ecatepec, Mexico and a portion of their related surfactant business during the first quarter of 2018. For 2019, the Company estimates that total capital expenditures will range from $120 million to $140 million including infrastructure and optimization spending in the United States, Mexico and Brazil. Financing Activity Cash flow from financing activities was a use of $51.6 million in 2018 versus a use of $50.5 million in 2017. The Company purchases shares of its common stock in the open market or from its benefit plans from time to time to fund its own benefit plans and also to mitigate the dilutive effect of new shares issued under its benefit plans. The Company may, from time to time, seek to retire or purchase additional amounts of its outstanding equity and/or debt securities through cash purchases and/or exchanges for other securities, in open market purchases, privately negotiated transactions or otherwise, including pursuant to plans meeting the requirements of Rule 10b5-1 promulgated by the SEC. Such repurchases or exchanges, if any, will depend on prevailing market conditions, the Company’s liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. For the twelve months ended December 31, 2018, the Company purchased 205,983 shares at a total cost of $15.5 million. At December 31, 2018, there were 494,287 shares remaining under the current share repurchase authorization. Debt and Credit Facilities Consolidated balance sheet debt decreased by $14.7 million for 2018, from $290.8 million to $276.1 million, primarily due to lower domestic debt. In 2018, net debt (which is defined as total debt minus cash - See the “Reconciliation of Non-GAAP Net Debt” section of this MD&A) decreased by $16.0 million, from a negative $8.1 million to a negative $24.1 million. As of December 31, 2018, the ratio of total debt to total debt plus shareholders’ equity was 26.0 percent compared to 28.2 percent at December 31, 2017. As of December 31, 2018, the ratio of net debt to net debt plus shareholders’ equity was negative 3.2 percent, compared to negative 1.1 percent at December 31, 2017. At December 31, 2018, the Company’s debt included $268.3 million of unsecured private placement loans with maturities ranging from 2019 through 2027 which were issued to insurance companies pursuant to note purchase agreements (the Note Purchase Agreements). These notes are the Company’s primary source of long-term debt financing and are supplemented by bank credit facilities to meet short and medium-term needs. On January 30, 2018, the Company entered into a five year committed $350 million multi-currency revolving credit facility that matures on January 30, 2023 with a syndicate of banks. This credit facility replaced the Company’s prior $125 million credit agreement. Loans under the credit agreement may be incurred, at the discretion of the Company, with terms to maturity of one to six months. The Company may choose from two interest rate options: (1) LIBOR applicable to each currency plus spreads ranging from 1.25 percent to 1.875 percent, depending on the Company’s net leverage ratio, or (2) the prime rate plus 0.25 percent to 0.875 percent, depending on the Company’s net leverage ratio. The credit agreement requires the Company to pay a commitment fee ranging from 0.15 percent to 0.325 percent per annum, which also depends on the Company’s net leverage ratio. The Company’s outstanding Note Purchase Agreements were amended effective January 30, 2018 to make certain covenants consistent with those included in the credit agreement. As of December 31, 2018, the Company had outstanding letters of credit totaling $4.7 million under the revolving credit agreement and no borrowings. There was $345.3 million remaining available under the revolving credit agreement as of December 31, 2018. The Company anticipates that cash from operations, committed credit facilities and cash on hand will be sufficient to fund anticipated capital expenditures, working capital, dividends and other planned financial commitments for the foreseeable future. Certain foreign subsidiaries of the Company maintain short-term bank lines of credit in their respective local currencies to meet working capital requirements as well as to fund capital expenditure programs and acquisitions. At December 31, 2018, the Company’s foreign subsidiaries had outstanding debt of $7.8 million. The Company has material debt agreements that require the maintenance of minimum interest coverage and minimum net worth. These agreements also limit the incurrence of additional debt as well as the payment of dividends and repurchase of treasury shares. As of December 31, 2018, testing for these agreements was based on the Company’s consolidated financial statements. Under the most restrictive of these debt covenants: 1. The Company is required to maintain a minimum interest coverage ratio, as defined within the agreements, not to exceed 3.50 to 1.00, for the preceding four calendar quarters. 2. The Company is required to maintain a maximum net leverage ratio, as defined within the agreements, not to exceed 3.50 to 1.00. 3. The Company is required to maintain net worth of at least $325.0 million. 4. The Company is permitted to pay dividends and purchase treasury shares after December 31, 2017, in amounts of up to $100.0 million plus 100 percent of net income and cash proceeds of stock option exercises, measured cumulatively December 31, 2017. The maximum amount of dividends that could have been paid within this limitation is disclosed as unrestricted retained earnings in Note 6 to the consolidated financial statements. The Company believes it was in compliance with all of its loan agreements as of December 31, 2018. Contractual Obligations At December 31, 2018, the Company’s contractual obligations, including estimated payments by period, were as follows: (a) Excludes unamortized debt issuance costs of $1.0 million. (b) Interest payments on debt obligations represent interest on all Company debt at December 31, 2018. The interest payment amounts related to the variable rate component of the Company’s debt assume that interest will be paid at the rates prevailing at December 31, 2018. Future interest rates may change, and, therefore, actual interest payments could differ from those disclosed in the above table. (c) Purchase obligations consist of raw material, utility and telecommunication service purchases made in the normal course of business. (d) The “Other” category comprises deferred revenues that represent commitments to deliver products, expected 2019 required contributions to the Company’s funded defined benefit pension plans, estimated payments related to the Company’s unfunded defined benefit supplemental executive and outside director pension plans, estimated payments (undiscounted) related to the Company’s asset retirement obligations, environmental remediation payments for which amounts and periods can be reasonably estimated and income tax liabilities for which payments and periods can be reasonably estimated. The above table does not include $86.9 million of other non-current liabilities recorded on the balance sheet at December 31, 2018, as summarized in Note 15 to the consolidated financial statements. The significant non-current liabilities excluded from the table are defined benefit pension, deferred compensation, environmental and legal liabilities and unrecognized tax benefits for which payment periods cannot be reasonably determined. In addition, deferred income tax liabilities are excluded from the table due to the uncertainty of their timing. Pension Plans The Company sponsors a number of defined benefit pension plans, the most significant of which cover employees in its U.S. and U.K. locations. The U.S. and U.K. plans are frozen, and service benefit accruals are no longer being made. The underfunded status (pretax) of the Company’s defined benefit pension plans was $23.8 million at December 31, 2018 versus $23.3 million at December 31, 2017. See Note 13, Postretirement Benefit Plans, to the consolidated financial statements for additional details. The Company contributed $5.8 million to its defined benefit plans in 2018. In 2019, the Company expects to contribute a total of $0.5 million to the U.K. defined benefit plan. As a result of pension funding relief included in the Highway and Transportation Funding Act of 2014, the Company has no 2019 contribution requirement to the U.S. pension plans. Payments to participants in the unfunded non-qualified plans should approximate $0.3 million in 2019, which is the same as payments made in 2018. Letters of Credit The Company maintains standby letters of credit under its workers’ compensation insurance agreements and for other purposes as needed. The insurance letters of credit are renewed annually and amended to the amounts required by the insurance agreements. As of December 31, 2018, the Company had a total of $4.7 million of outstanding standby letters of credit. Off-Balance Sheet Arrangements The Securities and Exchange Commission requires disclosure of off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. During the periods covered by this Form 10-K, the Company was not party to any such off-balance sheet arrangements. Environmental and Legal Matters The Company’s operations are subject to extensive federal, state and local environmental laws and regulations or similar laws in the other countries in which the Company does business. Although the Company’s environmental policies and practices are designed to ensure compliance with these regulations, future developments and increasingly stringent environmental regulation may require the Company to make additional unforeseen environmental expenditures. The Company will continue to invest in the equipment and facilities necessary to comply with existing and future regulations. During 2018, the Company’s expenditures for capital projects related to the environment were $5.4 million. Expenditures related to capital projects related to the environment projects are capitalized and depreciated over their estimated useful lives, which are typically 10 years. Recurring costs associated with the operation and maintenance of facilities for waste treatment and disposal and managing environmental compliance in ongoing operations at the Company’s manufacturing locations were approximately $28.3 million for 2018, $28.2 million for 2017 and $25.0 million for 2016. Over the years, the Company has received requests for information related to or has been named by government authorities as a potentially responsible party at a number of waste disposal sites where cleanup costs have been or may be incurred under CERCLA and similar state or foreign statutes. In addition, damages are being claimed against the Company in general liability actions for alleged personal injury or property damage in the case of some disposal and plant sites. The Company believes that it has made adequate provisions for the costs it is likely to incur with respect to the sites. See the Critical Accounting Policies section that follows for a discussion of the Company’s environmental liabilities accounting policy. After partial remediation payments at certain sites, the Company has estimated a range of possible environmental and legal losses from $23.4 million to $44.7 million at December 31, 2018, compared to $24.2 million to $45.4 million at December 31, 2017. Within the range of possible environmental losses, currently management has concluded that there are no amounts within the ranges that are more likely to occur than any other amounts in the ranges and, thus, has accrued at the lower end of the ranges; that accrual totaled $23.4 million at December 31, 2018 as compared to $24.2 million at December 31, 2017. Because the liabilities accrued are estimates, actual amounts could differ from the amounts reported. During 2018, cash outlays related to legal and environmental matters approximated $1.6 million compared to $2.0 million expended in 2017. For certain sites, the Company has responded to information requests made by federal, state or local government agencies but has received no response confirming or denying the Company’s stated positions. As such, estimates of the total costs, or range of possible costs, of remediation, if any, or the Company’s share of such costs, if any, cannot be determined with respect to these sites. Consequently, the Company is unable to predict the effect thereof on the Company’s financial position, cash flows and results of operations. Based upon the Company’s present knowledge with respect to its involvement at these sites, the possibility of other viable entities’ responsibilities for cleanup, and the extended period over which any costs would be incurred, management believes that the Company has no liability at these sites and that these matters, individually and in the aggregate, will not have a material effect on the Company’s financial position. See Item 3, Legal Proceedings, in this Form 10-K and Note 16, Contingencies, in the Notes to Consolidated Financial Statements for a summary of the significant environmental proceedings related to certain environmental sites. Outlook After record results in each of the past three years, management believes that its Surfactants segment will continue to benefit from diversification efforts into functional products, new technologies, improved internal efficiencies and expanded sales into its broad customer base globally. Management believes that its Polymer segment will benefit from the growing market for insulation materials and will deliver both full year volume growth and incremental margin improvement versus 2018. Management believes that its Specialty Products segment will improve year over year. Climate Change Legislation Based on currently available information, the Company does not believe that existing or pending climate change legislation or regulation is reasonably likely to have a material effect on the Company’s financial condition, results of operations or cash flows. Critical Accounting Policies The Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of America (generally accepted accounting principles or GAAP). Preparation of financial statements in accordance with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The following is a summary of the accounting policies the Company believes are the most important to aid in understanding its financial results: Deferred Compensation The Company sponsors deferred compensation plans that allow management employees to defer receipt of their annual bonuses and outside directors to defer receipt of their fees until retirement, departure from the Company or as elected by the participant. The plans allow for the deferred compensation to grow or decline based on the results of investment options chosen by the participants. The investment options include Company common stock and a limited selection of mutual funds. The Company funds the obligations associated with these plans by purchasing investment assets that match the investment choices made by the plan participants. A sufficient number of shares of treasury stock are maintained on hand to cover the equivalent number of shares that result from participants electing the Company common stock investment option. As a result, the Company must periodically purchase its common shares in the open market or in private transactions. Upon retirement or departure from the Company, participants receive cash amounts equivalent to the payment date value of the investment choices they have made or Company common stock shares equal to the number of share equivalents held in the accounts. Some plan distributions may be made in cash or Company common stock at the option of the participant. Other plan distributions can only be made in Company common stock. For deferred compensation obligations that may be settled in cash, the Company must record appreciation in the market value of the investment choices made by participants as additional compensation expense. Conversely, declines in the value of Company stock or the mutual funds result in a reduction of compensation expense since such declines reduce the cash obligation of the Company as of the date of the financial statements. These market price movements may result in significant period-to-period fluctuations in the Company’s income. The increases or decreases in compensation expenses attributable to market price movements are reported in the operating expenses section of the consolidated statements of income. Because the obligations that must be settled only in Company common stock are treated as equity instruments, fluctuations in the market price of the underlying Company stock do not affect earnings. At December 31, 2018 and December 31, 2017, the Company’s deferred compensation liability was $50.5 million and $58.9 million, respectively. In 2018 and 2017, approximately 53 percent and 55 percent, respectively, of deferred compensation liability represented deferred compensation tied to the performance of the Company’s common stock. The remainder of the deferred compensation liability was tied to the chosen mutual fund investment assets. A $1.00 increase in the market price of the Company’s common stock will result in approximately $0.4 million of additional compensation expense. A $1.00 reduction in the market price of the common stock will reduce compensation expense by a like amount. The expense or income associated with the mutual fund component will generally fluctuate in line with the overall percentage increase or decrease of the U.S. stock markets. The mutual fund assets related to the deferred compensation plans are recorded on the Company’s balance sheet at cost when acquired and adjusted to their market values at the end of each reporting period. As allowed by generally accepted accounting principles, the Company elected the fair value option for recording the mutual fund investment assets. Therefore, market value changes for the mutual fund investment assets are recorded in the income statement in the same periods that the offsetting changes in the deferred compensation liabilities are recorded. Dividends, capital gains distributed by the mutual funds and realized and unrealized gains and losses related to mutual fund shares are recognized as investment income or loss in the other, net line of the consolidated statements of income. Environmental Liabilities It is the Company’s accounting policy to record environmental liabilities when environmental assessments and/or remedial efforts are probable and the cost or range of possible costs can be reasonably estimated. When no amount within a range of possible costs is a better estimate than any other amount, the minimum amount in the range is accrued. Some of the factors on which the Company bases its estimates include information provided by feasibility studies, potentially responsible party negotiations and the development of remedial action plans. Estimates for environmental liabilities are subject to potentially significant fluctuations as new facts emerge related to the various sites where the Company is exposed to liability for the remediation of environmental contamination. See the Environmental and Legal Matters section of this MD&A for discussion of the Company’s recorded liabilities and range of cost estimates. Revenue Recognition On January 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). This ASU outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. The Company’s contracts typically have a single performance obligation that is satisfied at the time product is shipped and control passes to the customer as compared to the “risk and rewards” criteria used in prior years. For a small portion of the business, performance obligations are deemed satisfied when product is delivered to a customer location. For arrangements where the Company consigns product to a customer location, revenue is recognized when the customer uses the inventory. The Company accounts for shipping and handling as activities to fulfill a promise to transfer a good. As such, shipping and handling fees billed to customers in a sales transaction are recorded in Net Sales and shipping and handling costs incurred are recorded in Cost of Sales. Volume and cash discounts due customers are estimated and recorded in the same period as the sales to which the discounts relate and are reported as reductions of revenue in the consolidated statements of income. See Note 21 to the consolidated financial statements for more details. Recent Accounting Pronouncements See Note 1 to the consolidated financial statements, included in Part II, Item 8, for information on recent accounting pronouncements which affect the Company. Reconciliations of Non-GAAP Adjusted Net Income and Dilutive Earnings per Share The Company believes that certain non-GAAP measures, when presented in conjunction with comparable GAAP measures, are useful for evaluating the Company’s operating performance and provide better clarity on the impact of non-operational items. Internally, the Company uses this non-GAAP information as an indicator of business performance and evaluates management’s effectiveness with specific reference to these indicators. These measures should be considered in addition to, not a substitute for or superior to, measures of financial performance prepared in accordance with GAAP. The cumulative tax effect was calculated using the statutory tax rates for the jurisdictions in which the transactions occurred. Reconciliations of Non-GAAP Net Debt Management uses the non-GAAP net debt metric to show a more complete picture of the Company’s overall liquidity, financial flexibility and leverage level. This adjusted measure should be considered supplemental to and not a substitute for financial information prepared in accordance with GAAP. The Company's definition of this adjusted measure may differ from similarly titled measures used by other entities.

<s>[INST] Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: Surfactants Surfactants, which accounted for 70 percent of the Company’s consolidated net sales in 2018, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at five North American sites, two European sites (United Kingdom and France Germany ceased Surfactant production in the fourth quarter of 2018), five Latin American sites (Colombia and two sites in each of Mexico and Brazil) and two Asian sites (Philippines and Singapore). Recent significant Surfactants events include: o In March 2018, the Company, through a subsidiary in Mexico, acquired a production facility and a portion of its related surfactant business from BASF Mexicana, S.A. DE C.V. (BASF) (see Note 20, Acquisitions, for additional details). o During the third quarter of 2018, the Company approved a plan to shut down Surfactants operations at its plant site in Germany (see Note 22, Business Restructuring and Asset Impairments, for additional details). o During the fourth quarter of 2017, the Company approved a plan to restructure a portion of its Fieldsboro, New Jersey production facility (see Note 22, Business Restructuring and Asset Impairments, for additional details). o In 2016, the Company shut down its production facility in Canada, moving the production of goods previously manufactured in Canada to other Company North American production sites. Manufacturing operations at that facility ceased in the fourth quarter of 2016 but decommissioning activities continued throughout 2018 (see Note 22, Business Restructuring and Asset Impairments, for additional details). Polymers Polymers, which accounted for 26 percent of consolidated net sales in 2018, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively, CASE products). Powdered polyester resins are used in coating applications. CASE and polyester resins are collectively referred to as specialty polyols. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the United States, polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site, and specialty polyols are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyurethane polyols are manufactured by the Company’s subsidiary in Germany, and specialty polyols are manufactured by the Company’s Poland subsidiary. In China, polyurethane polyols and specialty polyols are manufactured at the Company’s Nanjing, China, manufacturing plant. Specialty Products Specialty Products, which accounted for four percent of consolidated net sales in 2018, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, at outside contractors. 2018 Acquisition On March 26, 2018, the Company, through a subsidiary in Mexico, acquired BASF production facility in Ecatepec, Mexico, and a portion of its related surfactants business. The facility, which is near Mexico [/INST] Positive. </s>

STEPAN CO

2020-02-27

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations The following is management’s discussion and analysis (MD&A) of certain significant factors that have affected the Company’s financial condition and results of operations during the annual periods included in the accompanying consolidated financial statements. Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: • Surfactants - Surfactants, which accounted for 68 percent of the Company’s consolidated net sales in 2019, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at five U.S. sites, two European sites (United Kingdom and France), five Latin American sites (Colombia and two sites in each of Mexico and Brazil) and two Asian sites (Philippines and Singapore). Recent significant Surfactants events include: o During January 2019, the Company’s plant in Ecatepec, Mexico experienced a sulfonation equipment failure that contributed to an operating loss at the site in 2019. The Ecatepec facility is now fully operational and, in December 2019, the Company received insurance recovery proceeds for damaged equipment, incremental supply chain expenses and business interruption. This plant, and a portion of its related surfactant business, was acquired from BASF in March 2018 (see Note 21, Acquisitions and Note 24, Insurance Recovery for additional details). o In December 2019 the Company acquired an oilfield demulsifier product line. The Company believes this acquisition will accelerate its strategy to diversify into additional application segments within the oilfield markets. The acquired business did not impact the Company’s 2019 financial results nor is it expected to be accretive to earnings in 2020 (see Note 21, Acquisitions, for additional details) o During the fourth quarter of 2018, the Company shut down Surfactant operations at its plant site in Germany. The Company ceased Surfactant production at this site to further reduce its fixed cost base, refocus Surfactant resources on higher margin end markets and allow for select assets to be repurposed to support future polyol growth. Decommissioning costs associated with the shutdown were incurred throughout 2019 (see Note 23, Business Restructuring, for additional details). o In 2016, the Company shut down its production facility in Canada, moving the production of goods previously manufactured in Canada to other Company North American production sites. Manufacturing operations at the facility ceased in the fourth quarter of 2016, but decommissioning activities have been ongoing since 2017 and will continue throughout 2020 (see Note 23, Business Restructuring, for additional details). • Polymers - Polymers, which accounted for 28 percent of consolidated net sales in 2019, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively, CASE products). Powdered polyester resins are used in coating applications. CASE and powdered polyester resins are collectively referred to as specialty polyols. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the United States, polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site, and specialty polyols are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyurethane polyols are manufactured by the Company’s subsidiary in Germany, and specialty polyols are manufactured by the Company’s Poland subsidiary. In China, polyurethane polyols and specialty polyols are manufactured at the Company’s Nanjing, China, manufacturing plant. • Specialty Products - Specialty Products, which accounted for four percent of consolidated net sales in 2019, include flavors, emulsifiers and solubilizers used in food, flavoring, nutritional supplement and pharmaceutical applications. Specialty products are primarily manufactured at the Company’s Maywood, New Jersey, site and, in some instances, by third-party contractors. o During 2019, the Company restructured its Specialty Products office in the Netherlands and eliminate positions from the site’s supply chain, quality control and research and development areas. This restructuring was designed to better align the number of personnel with current business requirements and reduce costs at the site (see Note 23, Business Restructuring, for additional details). Change in Accounting Principle During the first quarter of 2019 the Company elected to change its method of accounting for U.S. inventory valuation from the LIFO basis to the FIFO basis. Non-U.S. inventories have historically been maintained on the FIFO basis. The Company believes that this change to the FIFO method of inventory valuation is preferable as it provides a better matching of costs with the physical flow of goods, more accurately reflects the current market value of inventory presented on the Company’s consolidated balance sheet, standardizes the Company’s inventory valuation methodology and improves comparability with the Company’s industry peers. The Company has retrospectively applied this change to its prior year financial statement comparables. (See Note 2, Change in Method of Accounting for Inventory Valuation, for additional details). 2019 Acquisition On December 17, 2019, the Company acquired an oilfield demulsifier product line. The purchase price of the acquisition was $9,000,000 and was paid with cash on hand. This acquisition was accounted for as a business combination and the assets were measured and recorded at their estimated fair values. The primary assets acquired were intangibles, mostly comprised of goodwill ($3,497,000), product know-how ($1,500,000) and customer relationships ($3,200,000). A small amount of inventory was also acquired. All the acquired assets are included within the Company’s Surfactants segment. The fair value analysis remains in process and is expected to be finalized during the first half of 2020. The acquired business did not impact the Company’s 2019 financial results. Deferred Compensation Plans The accounting for the Company’s deferred compensation plans can cause period-to-period fluctuations in Company expenses and profits. Compensation expense results when the value of Company common stock and mutual fund investment assets held for the plans increase, and compensation income results when the value of Company common stock and mutual fund investment assets decline. The pretax effect of all deferred compensation-related activities (including realized and unrealized gains and losses on the mutual fund assets held to fund the deferred compensation obligations) and the income statement line items in which the effects of the activities were recorded are presented in the following table: (1) See the Segment Results - Corporate Expenses sections of this MD&A for details regarding the period-over-period changes in deferred compensation. Below are the year-end Company common stock market prices used in the computation of deferred compensation income and expense: Effects of Foreign Currency Translation The Company’s foreign subsidiaries transact business and report financial results in their respective local currencies. As a result, foreign subsidiary income statements are translated into U.S. dollars at average foreign exchange rates appropriate for the reporting period. Because foreign exchange rates fluctuate against the U.S. dollar over time, foreign currency translation affects year-over-year comparisons of financial statement items (i.e., because foreign exchange rates fluctuate, similar year-to-year local currency results for a foreign subsidiary may translate into different U.S. dollar results). The following tables present the effects that foreign currency translation had on the year-over-year changes in consolidated net sales and various income line items for 2019 compared to 2018 and 2018 compared to 2017: (1) The 2018 and 2017 gross profit, operating income and pretax income line items have been retrospectively changed from the amounts originally reported as a result of the Company’s first quarter 2019 change in method of accounting for U.S. inventory valuation from LIFO to FIFO. Results of Operations 2019 Compared with 2018 Summary Net income attributable to the Company for 2019 decreased seven percent from $111.1 million, or $4.76 per diluted share in 2018 to $103.1 million, or $4.42 per diluted share, in 2019. Adjusted net income increased seven percent to $119.4 million, or $5.12 per diluted share, from $111.7 million, or $4.79 per diluted share in 2018 (see the “Reconciliations of Non-GAAP Adjusted Net Income and Diluted Earnings per Share” section of this MD&A for reconciliations between reported net income attributable to the Company and reported earnings per diluted share and non-GAAP adjusted net income and adjusted earnings per diluted share). Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2019 compared to 2018 follows the summary. Consolidated net sales decreased $135.1 million, or seven percent, between years. Lower average selling prices negatively impacted the year-over-year change in net sales by $60.8 million. The decrease in average selling prices was primarily due to the pass through of lower raw material costs. Foreign currency translation negatively impacted the year-over-year change in net sales by $37.3 million due to a stronger U.S. dollar against the majority of currencies where the Company has foreign operations. Consolidated sales volume decreased two percent and negatively impacted the change in net sales by $37.0 million. Sales volume in the Surfactant segment decreased three percent while sales volume in the Polymer and Specialty Product segments increased four and one percent, respectively. Operating income declined $22.0 million, or 15 percent, between years. The majority of this decrease reflects higher deferred compensation expenses in 2019. Deferred compensation expenses increased $17.5 million year-over-year. Corporate expenses, excluding deferred compensation and business restructuring expenses, were up $1.6 million year-over-year. The majority of this increase reflects higher environmental remediation expense recognized in 2019. From a segment perspective, Specialty Product and Polymer operating income improved by $4.8 million and $3.2 million, respectively, whereas Surfactant operating income declined by $10.7 million. Foreign currency translation had an unfavorable $2.5 million effect on year-over-year consolidated operating income. Operating expenses (including deferred compensation expense and business restructuring expenses) increased $22.4 million, or 12 percent, between years. Changes in the individual income statement line items that comprise the Company’s operating expenses were as follows: • Selling expenses increased $0.6 million, or one percent, year-over-year. • Administrative expenses increased $3.3 million, or four percent, year over year. The increase was primarily due to higher environmental remediation and legal expenses. The majority of the environmental remediation costs relate to the Company’s Maywood, New Jersey site and the Company’s formerly-owned site in Wilmington, Massachusetts. Non-recurring employee separation costs incurred in 2018 partially offset the above. • Research, development and technical service (R&D) expenses increased $0.8 million, or one percent, year over year. • Deferred compensation expense increased $17.5 million year-over-year primarily due to a $28.44 per share increase in the market price of Company common stock during 2019 compared to a $4.97 per share decrease in 2018. See the Overview and Segment Results - Corporate Expenses sections of this MD&A for further details. • Business restructuring expenses were $2.7 million in 2019 versus $2.6 million in 2018. The 2019 restructuring expenses were primarily comprised of severance and office shutdown expenses related to the Specialty Products segment restructuring ($0.7 million), ongoing decommissioning costs associated with the Company’s manufacturing facility in Canada that ceased operations in the fourth quarter of 2016 ($1.4 million), and decommissioning expenses associated with the Company’s 2018 sulfonation shut down in Germany ($0.9 million). The 2018 restructuring expenses were comprised of asset and spare parts write-downs related to the Company’s decision to cease Surfactant operations in Germany ($1.4 million) and decommissioning costs associated with the Canadian plant closure ($1.2 million). See Note 23 to the consolidated financial statements for additional information. Net interest expense in 2019 declined $4.8 million, or 45 percent, versus prior year. This decrease was primarily attributable to the combination of higher interest earned on U.S. cash balances and lower interest expense resulting from scheduled debt repayments and the Company’s voluntary prepayment of its 5.88% Senior Notes in the second quarter of 2019. The higher interest on U.S. cash balances was principally due to foreign cash repatriation of $100.0 million to the United States in the fourth quarter of 2018. Other, net was $4.6 million of income in 2019 versus $0.7 million of expense in 2018. The Company recognized $4.9 million of investment gains (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets in 2019 compared to $1.4 million of losses in 2018. In addition, the Company reported foreign exchange gains of $0.1 million in 2019 versus $1.9 million of gains in 2018. The Company also reported $0.9 million of lower net periodic pension cost expense in 2019 versus the prior year. Other miscellaneous items resulted in $0.1 million of higher expense in 2019. The year-to-date effective tax rate was 18.1 percent in 2019 compared to 19.4 percent in 2018. This decrease was primarily attributable to incremental U.S. research and development tax credits, partially offset by other non-recurring favorable tax benefits recognized in 2018. See Note 10 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results (1) The 2018 segment and total operating income line items have been retrospectively changed from the amounts originally reported as a result of the Company’s first quarter 2019 change in method of accounting for U.S. inventory valuation from LIFO to FIFO. Surfactants Surfactants 2019 net sales decreased $113.2 million, or eight percent, versus 2018 net sales. The unfavorable impact of lower sales volume, lower average selling prices and foreign currency translation negatively impact the year-over-year change in net sales by $48.1 million, $40.8 million and $24.3 million, respectively. Sales volume decreased three percent year-over-year. Approximately 46 percent of the decline in sales volume was due to the Company’s exit from its sulfonation business in Germany during the fourth quarter of 2018. A year-over-year comparison of net sales by region follows: Net sales for North American operations decreased $65.3 million, or eight percent, between years. Lower average selling prices, a two percent decline in sales volume and the unfavorable impact of foreign currency translation negatively impacted the year-over-year change in net sales by $44.2 million, $20.4 million and $0.7 million, respectively. Selling prices decreased five percent mostly due to the pass through of lower raw material costs to customers. The decline in sales volume was mostly due to lower personal care commodity demand due to one customer losing an important share of business and lower sales volume to our distribution partners due to lower demand. The foreign currency impact reflected a stronger U.S. dollar relative to the Canadian dollar. Net sales for European operations declined $36.0 million, or 13 percent, primarily due to a nine percent decrease in sales volume and the unfavorable effects of foreign currency translation. These items negatively impacted the year-over-year change in net sales by $24.0 million and $12.8 million, respectively. The lower sales volume was principally due to the Company ceasing Surfactant production at its German site during the fourth quarter of 2018. A stronger U.S. dollar relative to the European euro and British pound sterling led to the foreign currency translation effect. Slightly higher selling prices favorably impacted the year-over-year change in net sales by $0.8 million. Net sales for Latin American operations were flat year-over-year. Higher average selling prices positively impacted the year-over-year change in net sales by $16.9 million. The unfavorable impact of foreign currency translation and a three percent decrease in sales volume negatively impacted the year-over-year change in net sales by $11.6 million and $5.7 million, respectively. The higher average selling prices were partially due to one-time benefits related to a VAT tax recovery in Brazil. The decline in sales volume is mostly attributable to lower sales volume to our distribution partners partially offset by higher demand in the agricultural end markets. The year-over-year strengthening of the U.S. dollar against the Colombian peso and Brazilian real generated most of the unfavorable foreign currency effect. Net sales for Asian operations declined $11.5 million, or 18 percent, primarily due to an 11 percent decline in sales volume and lower selling prices. These items negatively impacted the year-over-year change in net sales by $6.9 million and $5.3 million, respectively. The decline in sales volume was largely due to lower commodity demand in the laundry and cleaning end markets and lower sales volume to our distribution partners. The lower selling prices were mostly due to the pass through of lower raw material costs to customers. The favorable impact of foreign currency translation positively impacted the change in net sales by $0.7 million. Surfactant operating income for 2019 declined $10.7 million, or eight percent, versus operating income reported in 2018. Gross profit declined $8.6 million, or four percent, and operating expenses increased two percent year-over-year. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (1) The 2018 gross profit and operating income line items have been retrospectively changed from the amounts originally reported as a result of the Company’s first quarter 2019 change in method of accounting for U.S. inventory valuation from LIFO to FIFO. Gross profit for North American operations decreased $14.5 million, or nine percent, between years primarily due to lower unit margins and a two percent decline in sales volumes. These items negatively impacted the change in gross profit by $10.6 million and $3.8 million, respectively. The lower unit margins reflect a slightly less favorable customer and product mix and higher one-time inventory costs associated with the Company’s internal Asia-U.S. supply chain. The decline in sales volume was mostly due to lower personal care commodity demand due to one customer losing an important share of business and lower sales volume to our distribution partners due to lower demand. Gross profit for European operations increased $3.5 million, or 12 percent, primarily due to lower overhead costs and higher unit margins resulting from the Company ceasing Surfactant production at its German plant site during the fourth quarter of 2018. Unit margins also benefited from double digit volume growth in the agricultural and oilfield end markets. Higher unit margins favorably impacted the year-over-year change in gross profit by $8.0 million. A nine percent decline in sales volume and the unfavorable effect of foreign currency translation negatively impacted the current year by $2.7 million and $1.8 million, respectively. The lower sales volume is primarily attributable to the Company’s exit from the sulfonation in Germany during the fourth quarter of 2018, partially offset by volume growth in the agricultural and oilfield end markets. Gross profit for Latin American operations increased $5.7 million, or 22 percent, year-over-year primarily due to higher unit margins. Higher unit margins positively impacted the year-over-year change in gross profit by $7.8 million. The higher unit margins partially reflect one-time benefits related to a VAT tax recovery in Brazil and insurance recovery related to the Ecatepec, Mexico incident. Excluding the effect of the above items, average margins were flat between years. The unfavorable impact of foreign currency translation and three percent lower sales volume negatively impacted the year-over-year change in gross profit by $1.4 million and $0.7 million, respectively. Gross profit for Asian operations decreased $3.4 million, or 20 percent, largely due to an 11 percent decline in sales volume and lower unit margins. These items negatively impacted the year-over-year change in gross profit by $1.8 million and $1.7 million, respectively. The decline in sales volume was largely due to lower commodity demand in the laundry and cleaning end markets and lower sales to our distribution partners. The lower unit margins are primarily due to higher unit overhead costs in Singapore due to unfavorable production timing differences. Operating expenses for the Surfactants segment increased $2.1 million, or two percent, year-over-year. Most of this increase was attributable to higher salary and associated fringe benefit expenses. Polymers Polymers 2019 net sales decreased $15.1 million, or three percent, versus net sales for 2018. A four percent increase in sales volume positively impacted the year-over-year change in net sales by $19.6 million. Sales volume of polyols used in rigid foam applications increased nine percent during the year but was partially offset by lower phthalic anhydride sales volume. The unfavorable impact of lower average selling prices and foreign currency translation negatively impacted the year-over-year change in net sales by $22.4 million and $12.3 million, respectively. A year-over-year comparison of net sales by region follows: Net sales for North American operations declined $8.8 million, or three percent, primarily due to lower average selling prices partially offset by slightly favorable volume growth. The lower average selling prices negatively impacted the change in net sales by $11.6 million. Sales volume growth positively impacted the change in net sales by $2.8 million. Sales volume of polyols used in rigid foam applications increased 12 percent during the year but was largely offset by lower phthalic anhydride and specialty polyols sales volume. Net sales for European operations decreased $14.2 million, or eight percent, year-over-year. Sales volume growth of two percent positively impacted the year-over-year change in net sales by $4.1 million. The unfavorable impact of foreign currency translation and lower average selling prices negatively impacted the change in net sales by $10.5 million and $7.8 million, respectively. A stronger U.S. dollar relative to the Polish zloty led to the foreign currency translation effect. Net sales for Asia and Other operations increased $7.9 million, or 25 percent, primarily due to a 37 percent increase in sales volume. The increase in sales volume positively impacted the year-over-year change in net sales by $11.5 million. The unfavorable impact of foreign currency translation and lower average selling prices negatively impacted the change in net sales by $1.8 million each. Polymer operating income for 2019 increased $3.2 million, or five percent, versus operating income for 2018. Gross profit increased $3.9 million, or four percent, year-over-year. Operating expenses increased $0.7 million, or two percent, in 2019. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (1) The 2018 gross profit and operating income line items have been retrospectively changed from the amounts originally reported as a result of the Company’s first quarter 2019 change in method of accounting for U.S. inventory valuation from LIFO to FIFO. Gross profit for North American operations increased $0.5 million, or one percent, due to slightly higher sales volume. Sales volume of polyols used in rigid foam applications increased 12 percent during the year but was largely offset by lower phthalic anhydride and specialty polyols sales volume. Average unit margins were flat year-over-year. The flat margins largely reflect the consumption of higher priced 2018 year-end inventories carried to guard against winter supply disruptions and the non-recurrence of a $2.1 million class action settlement received in the first quarter of 2018. Gross profit for European operations declined $1.5 million, or six percent, year-over-year. Sales volume growth of two percent positively impacted the year-over-year change in gross profit by $0.6 million. The unfavorable impact of foreign currency translation and lower unit margins negatively impacted the year-over-year change in gross profit by $1.5 million and $0.6 million, respectively. Gross profit for Asia and Other operations improved $4.9 million primarily due to higher unit margins and 37 percent sales volume growth year-over-year. Operating expenses for the Polymers segment increased $0.7 million, or two percent, year-over-year. Specialty Products Specialty Products net sales decreased $6.8 million, or eight percent, versus net sales in 2018. A one percent increase in sales volume was more than offset by lower average selling prices. Gross profit increased $4.3 million and operating income increased $4.8 million year-over-year. These increases primarily reflect improved margins within the Company’s medium chain triglycerides (MCTs) product line and lower operating expenses as a result of the 2019 restructuring efforts. Corporate Expenses Corporate expenses, which include deferred compensation, business restructuring and other operating expenses that are not allocated to the reportable segments, increased $19.2 million between years. Corporate expenses were $81.5 million in 2019 versus $62.3 million in the prior year. This increase was primarily attributable to higher deferred compensation expense ($17.5 million). Higher environmental remediation expenses in 2019, partially offset by the non-recurrence of 2018 employee separation costs and costs associated with the Company’s 2018 first quarter acquisition in Mexico, also contributed to the year-over-year increase. Deferred compensation expense increased $17.5 million between years. This increase was primarily due to a $28.44 per share increase in the market price of the Company’s common stock in 2019 compared to a $4.97 per share decline in 2018. The following table presents the period-end Company common stock market prices used in the computation of deferred compensation expenses in 2019 and 2018: 2018 Compared with 2017 Summary Net income attributable to the Company for 2018 increased ten percent to $111.1 million, or $4.76 per diluted share, from $100.8 million, or $4.31 per diluted share, for 2017. Adjusted net income in 2018 decreased five percent to $111.7 million, or $4.79 per diluted share, from $117.5 million, or $5.03 per diluted share in 2017 (see the “Reconciliations of Non-GAAP Adjusted Net Income and Diluted Earnings per Share” section of this MD&A for reconciliations between reported net income attributable to the Company and reported earnings per diluted share and non-GAAP adjusted net income and adjusted earnings per diluted share). Below is a summary discussion of the major factors leading to the year-over-year changes in net sales, profits and expenses. A detailed discussion of segment operating performance for 2018 compared to 2017 follows the summary. Consolidated net sales increased $68.9 million, or four percent, between years. Higher sales volume, higher selling prices and the favorable impact of foreign currency translation positively impacted net sales by $64.7 million, $4.1 million and $0.1 million, respectively. Total Company sales volume increased three percent. Sales volume increased five percent and three percent for the Surfactants and Specialty Products segments, respectively. Sales volume declined three percent for the Polymers segment. Unit margins improved for Surfactants and Specialty Products and declined for Polymers. Operating income declined $5.6 million, or four percent, between years. Operating income declined for the Polymers segment and improved for Surfactants and Specialty Products segments. Corporate expenses were down $4.3 million between years. Business restructuring expenses were $0.5 million lower in 2018 versus 2017. In addition, 2018 deferred compensation expense declined by $7.1 million versus the 2017 balance. Foreign currency translation had an unfavorable $0.6 million effect on year-over-year consolidated operating income. Operating expenses (including deferred compensation expense and business restructuring expenses) decreased $1.2 million, or one percent, between years. Changes in the individual income statement line items that comprise the Company’s operating expenses were as follows: • Selling expenses increased $2.2 million, or four percent, year over year largely due to higher salaries and cloud-based application expense. A portion of the higher salaries is attributable to the 2018 acquisition in Mexico. • Administrative expenses increased $3.6 million, or five percent, year over year. The increase was primarily due to higher employee separation costs and salaries. • Research, development and technical service (R&D) expenses increased $0.6 million, or one percent, year over year. • Deferred compensation was income of $2.3 million in 2018 versus expense of $4.9 million in 2017. See the “Overview” and “Segment Results - Corporate Expenses” sections of this MD&A for further details. • Business restructuring expenses were $2.6 million in 2018 versus $3.1 million in 2017. 2018 restructuring charges were comprised of asset and spare part write-downs related to the Company’s decision to cease Surfactant operations in Germany ($1.4 million) and decommissioning costs associated with the Company’s manufacturing facility in Canada, which ceased operations in the fourth quarter of 2016 ($1.2 million). The 2017 restructuring charges related to decommissioning costs associated with the Canadian plant closure ($2.0 million), severance costs related to a partial restructuring of the Company’s production facility in Fieldsboro, New Jersey ($0.9 million) and workforce reduction expense at the Company’s Singapore plant. These business restructuring charges were excluded from the determination of segment operating income. See Note 23 to the consolidated financial statements for additional information. Net interest expense for 2018 declined $0.7 million, or six percent, from net interest expense for 2017. The decline in interest expense was principally attributable to higher interest income earned on excess cash and lower average debt levels due to scheduled repayments. Other, net was $0.7 million of expense in 2018 versus $3.5 million of income in 2017. The Company recognized $1.4 million of investment losses (including realized and unrealized gains and losses) for the Company’s deferred compensation and supplemental defined contribution mutual fund assets in 2018 compared to $5.1 million of gains in 2017. Partially offsetting this decrease was foreign exchange gains of $1.9 million in 2018 compared to foreign exchange losses of $0.6 million in 2017. In addition, the Company reported $1.2 million of net periodic pension cost in 2018 versus $1.0 million of net periodic pension cost in 2017. The year-to-date effective tax rate was 19.4 percent in 2018 compared to 31.4 percent in 2017. This decrease was primarily attributable to the following items: (a) a lower U.S. statutory tax rate of 21 percent in 2018 versus a rate of 35 percent in 2017; and (b) the enactment of U.S. tax reform, which resulted in a net tax cost of $10.3 million in 2017 that did not recur in 2018. The 2018 benefits were partially offset by certain unfavorable U.S. tax reform changes that became effective on January 1, 2018 (i.e., global intangible low-taxed income, non-deductible executive compensation, and the repeal of the domestic production activities deduction). In addition, during the third quarter of 2018, the Company filed applications to automatically change certain tax accounting methods related to the 2017 tax year. These method changes provided a favorable tax benefit that was partially offset by the negative tax impact recognized as a result of the Company’s decision to repatriate approximately $100.0 million of foreign cash in the fourth quarter of 2018. See Note 10 to the consolidated financial statements for a reconciliation of the statutory U.S. federal income tax rate to the effective tax rate. Segment Results (1) The 2018 and 2017 gross profit and operating income line items have been retrospectively changed from the amounts originally reported as a result of the Company’s first quarter 2019 change in method of accounting for U.S. inventory valuation from LIFO to FIFO. Surfactants Surfactants 2018 net sales increased $88.4 million, or seven percent, over net sales reported in 2017. Higher sales volume and selling prices accounted for $69.5 million and $26.2 million, respectively, of the year-over-year increase in net sales. Sales volume increased five percent year-over-year. The unfavorable effects of foreign currency translation negatively impacted the year-over-year change in net sales by $7.3 million. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased nine percent between years. Sales volume increased six percent, which favorably impacted the change in net sales by $42.0 million. The sales volume growth was largely driven by higher sales volume of products used in personal care and oilfield applications. Sales volume of general surfactants to our distribution partners also increased. Average selling prices increased three percent between years and positively impacted the year-over-year change in net sales by $26.4 million. The increase in selling prices was largely due to a more favorable mix of sales. Foreign currency translation positively impacted the change in net sales by $0.1 million. The foreign currency impact reflected a weaker U.S. dollar relative to the Canadian dollar. Net sales for European operations increased one percent versus prior year. The favorable effects of foreign currency translation positively impacted the year-over-year change in net sales by $11.8 million. A weaker U.S. dollar relative to the European euro and British pound sterling led to the foreign currency effect. Lower selling prices of four percent unfavorably impacted the year-over-year change in net sales by $10.5 million. Sales volume was flat versus the prior year. Net sales in 2017 were positively impacted by $4.7 million related to a favorable resolution of a prior year customer claim (see Note 25 to the consolidated financial statements for further information). Net sales for Latin American operations increased $22.0 million, or 12 percent, primarily due a 12 percent increase in sales volume and higher selling prices. These two items accounted for $22.5 million and $16.1 million, respectively, of the year-over-year change in net sales. The higher volume is mostly related to the Company’s first quarter 2018 acquisition in Ecatepec, Mexico and partially offset by lower demand and lost commodity business in Brazil. The higher selling prices primarily reflect the pass through to customers of increased raw material costs. Foreign currency translation negatively impacted the year-over-year change in net sales by $16.6 million. The foreign currency translation primarily reflects the year-over-year weakening of the Brazilian real and Mexican peso relative to the U.S. dollar. Net sales for Asian operations declined $3.8 million, or six percent, primarily due to the negative impact of foreign currency translation and lower average selling prices. These items negatively impacted the year-over-year change in net sales by $2.5 million and $2.0 million, respectively. The foreign currency impact primarily reflected a weaker Philippine peso relative to the U.S. dollar. Sales volume increased one percent, which positively impacted the year-over year change in net sales by $0.7 million. The sales volume increase was mostly due to higher sales of general surfactants to our distribution partners. Surfactant operating income for 2018 increased $7.8 million, or six percent, versus operating income reported in 2017. Gross profit increased $11.2 million due to improved results for North American operations. Operating expenses increased $3.4 million, or four percent. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (1) The 2018 and 2017 gross profit and operating income line items have been retrospectively changed from the amounts originally reported as a result of the Company’s first quarter 2019 change in method of accounting for U.S. inventory valuation from LIFO to FIFO. Gross profit for North American operations increased 13 percent, or $17.3 million, between years primarily due to higher unit margins and higher sales volumes. These items positively impacted the year-over-year change in gross profit by $9.5 million and $7.8 million, respectively. The higher unit margins were primarily due to a more favorable customer and product mix. Higher year-over-year sales of products used in personal care, agricultural and oilfield applications, along with products sold to our distribution partners contributed to the 2018 volume growth. Gross profit for European operations decreased four percent between years principally due to the aforementioned non-recurring $4.7 million favorable customer claim resolution in 2017. Lower unit margins, principally due to the non-recurrence of the prior year favorable customer claim resolution, negatively impacted the year-over-year change in gross profit by $2.5 million. Foreign currency translation positively affected the change in gross profit by $1.3 million. Sales volume was flat year-over-year. Gross profit for Latin American operations decreased $2.5 million, or nine percent, year-over-year primarily due to lower unit margins and the negative impact of foreign currency translation. These items unfavorably impacted the change in year-over-year gross profit by $3.1 million and $2.8 million, respectively. The lower unit margins principally related to higher integration and start-up costs associated with the Company’s first quarter 2018 acquisition in Ecatepec, Mexico. Sales volume growth of 12 percent positively impacted current year gross profit by $3.4 million. This growth primarily reflects the Company’s first quarter acquisition in Mexico partially offset by lower demand and lost commodity business in Brazil. The Ecatepec, Mexico acquisition was slightly accretive to Latin America gross profit in 2018. Asia gross profit decreased 13 percent largely due to lower unit margins and the unfavorable impact of foreign currency translation. These items unfavorably impacted the year-over-year change in gross profit by $2.3 million and $0.4 million, respectively. Sales volume growth of one percent positively impacted the year-over-year change in gross profit by $0.2 million. Operating expenses for the Surfactants segment increased $3.4 million, or four percent, year-over-year. Most of this increase was attributable to higher North American expenses. The higher North American expenses were primarily due to higher consulting fees, salaries, and cloud-based application expense. Polymers Polymer net sales for 2018 decreased $19.2 million, or four percent, over net sales for 2017. Lower sales volumes and selling prices negatively impacted the year-over-year change in net sales by $16.9 million and $9.0 million, respectively. The favorable effects of foreign currency translation positively impacted the year-over-year change in net sales by $6.7 million. The foreign currency effect reflected a weaker U.S. dollar relative to the Polish zloty. A year-over-year comparison of net sales by region follows: Net sales for North American operations increased three percent due to higher selling prices, partially offset by lower sales volumes. Selling prices increased five percent, which had a $15.4 million positive effect on the year-over-year change in net sales. The pass through of certain higher raw material costs to customers led to increased selling prices. Sales volume declined two percent which unfavorably impacted the net sales change by $5.5 million. Sales volume of polyols used in rigid foam applications declined two percent mainly due to lost share from one major customer. Phthalic anhydride sales volume declined seven percent. Sales volume of specialty polyols increased eight percent due to greater demand for product used in CASE applications and powdered resins. Net sales for European operations increased 22 percent due to higher selling prices, the favorable effect of foreign currency translation and a three percent increase in sales volumes, which accounted for $22.4 million, $7.9 million and $4.0 million, respectively, of the year-over-year net sales increase. Selling prices increased 14 percent primarily due to the pass through to customers of cost increases for certain raw materials. The sales volume improvement was primarily attributable to increased sales of specialty polyols, which reflected the Company’s successful efforts to utilize the production capacity of its new reactor in Poland. Sales volume also grew slightly due to increased demand for polyols used in rigid foam insulation and insulated metal panels. Net sales for Asia and Other operations increased 15 percent between years due to higher selling prices, a two percent increase in sales volume and the favorable effect of foreign currency, which accounted for $3.1 million, $0.5 million and $0.1 million, respectively, of the year-over-year net sales increase. Polymer operating income for 2018 declined $19.4 million, or 23 percent, compared to operating income in 2017. Gross profit decreased $19.4 million, or 17 percent, primarily due to a three percent decline in sales volumes and lower unit margins. Operating expenses were flat versus prior year. Year-over-year comparisons of gross profit by region and total segment operating expenses and operating income follow: (1) The 2018 and 2017 gross profit and operating income line items have been retrospectively changed from the amounts originally reported as a result of the Company’s first quarter 2019 change in method of accounting for U.S. inventory valuation from LIFO to FIFO. Gross profit for North American operations declined 16 percent primarily due to lower unit margins and a two percent decline in sales volume. These two items negatively impacted the year-over-year change in gross profit by $12.1 million and $1.4 million, respectively. The decline in margins primarily reflected competitive market pressures. Gross profit for European operations declined 21 percent primarily due to lower unit sales margins and a seven percent decline in sales volume. These items negatively impacted the year-over-year change in gross profit by $5.6 million and $2.1 million, respectively. The lower margins were primarily due to higher overhead resulting from lower production throughput in 2018 versus 2017. The favorable impact of foreign currency translation positively impacted the year-over-year change in gross profit by $1.0 million. Gross profit for Asia and Other operations improved $0.8 million primarily due to higher unit margins and the favorable impact of foreign currency translation. These items positively impacted the year-over-year change in gross profit by $0.7 million and $0.1 million, respectively. Operating expenses for the Polymers segment decreased $0.1 million year-over-year. Specialty Products Net sales for 2018 were flat with the prior year. Sales volume was up three percent versus the prior year. Operating income increased $1.7 million versus prior year primarily due to the higher sales volume and improved unit margins. Corporate Expenses Corporate expenses, which include deferred compensation and other operating expenses that are not allocated to the reportable segments, declined $4.3 million year-over-year to $62.3 million in 2018 from $66.6 million in 2017. The decline in corporate expenses was primarily attributable to lower deferred compensation expense ($7.2 million) and business restructuring expense ($0.5 million). These decreases were partially offset by higher 2018 employee separation costs and salaries. Deferred compensation was $2.3 million of income in 2018 compared to $4.9 million of expense in 2017. The favorable year-over-year change was primarily due to less mutual fund related expense incurred in the current year combined with a steeper drop in Stepan share price in 2018 versus 2017. Liquidity and Capital Resources Overview Historically, the Company’s principal sources of liquidity have included cash flows from operating activities, available cash and cash equivalents and the use of available borrowing facilities. The Company’s principal uses of cash have included funding operating activities, capital investments and acquisitions. For the twelve months ended December 31, 2019, operating activities were a cash source of $218.4 million versus a source of $171.1 million for the comparable period in 2018. For the current year, investing cash outflows totaled $112.7 million, as compared to an outflow of $107.8 million in the prior year period, and financing activities were a use of $90.5 million, as compared to a use of $51.6 million in the prior year period. Cash and cash equivalents increased by $15.2 million compared to December 31, 2018, including an unfavorable exchange rate impact of $0.1 million. As of December 31, 2019, the Company’s cash and cash equivalents totaled $315.4 million. Cash in U.S. demand deposit accounts, certificate of deposit accounts and money market funds totaled $64.7 million, $41.0 million and $110.7 million, respectively. The Company’s non-U.S. subsidiaries held $99.0 million of cash outside the United States as of December 31, 2019. Operating Activity Net cash provided by operating activities was $218.4 million in 2019, a 28 percent increase versus $171.1 million in 2018. Net income in 2019 decreased by $8.0 million versus the comparable period in 2018. Working capital was a cash source of $17.6 million in 2019 versus a use of $37.7 million in 2018. Accounts receivable were a source of $4.9 million in 2019 compared to a source of $5.2 million in 2018. Inventories were a source of $28.5 million in 2019 versus a use of $24.7 million in 2018. Accounts payable and accrued liabilities were a use of $15.1 million in 2019 compared to a use of $19.0 million for the same period in 2018. Working capital requirements were lower in 2019 compared to 2018 primarily due to the changes noted above. The current year inventory source of cash reflects lower quantities and prices. The current year accounts payable and accrued liabilities cash usage reflects lower quantities purchased and prices. It is management’s opinion that the Company’s liquidity is sufficient to provide for potential increases in working capital requirements during 2020. Investing Activity Cash used for investing activities increased $4.9 million year-over-year. Cash outflows from investing activities included capital expenditures of $105.6 million compared to $86.6 million in 2018. Other investing activities were a use of $7.1 million in 2019 versus a use of $21.2 million in 2018. The current year cash use in other investing activities was primarily attributable to the $9.0 million acquisition of an oilfield demulsifier product line during the fourth quarter of 2019. The cash use in other investing activities in 2018 was primarily attributable to the $22.9 million acquisition of a surfactant production facility, and a portion of the related surfactant business, in Ecatepec, Mexico. For 2020, the Company estimates that total capital expenditures will range from $110 million to $130 million including infrastructure and optimization spending in the United States, Germany and Mexico. Financing Activity Cash flow from financing activities was a use of $90.5 million in 2019 versus a use of $51.6 million in 2018. The Company purchases shares of its common stock in the open market or from its benefit plans from time to time to fund its own benefit plans and also to mitigate the dilutive effect of new shares issued under its benefit plans. The Company may, from time to time, seek to retire or purchase additional amounts of its outstanding equity and/or debt securities through cash purchases and/or exchanges for other securities, in open market purchases, privately negotiated transactions or otherwise, including pursuant to plans meeting the requirements of Rule 10b5-1 promulgated by the SEC. Such repurchases or exchanges, if any, will depend on prevailing market conditions, the Company’s liquidity requirements, contractual restrictions and other factors. The amounts involved may be material. For the twelve months ended December 31, 2019, the Company purchased 144,457 shares at a total cost of $13.2 million. At December 31, 2019, there were 349,830 shares remaining under the current share repurchase authorization. Debt and Credit Facilities Consolidated balance sheet debt decreased by $54.0 million for 2019, from $276.1 million to $222.1 million, primarily due to lower domestic debt. Cash balance as of December 31, 2019 was $315.4 million versus $300.2 million as of December 31, 2018. In 2019, net debt (which is defined as total debt minus cash - See the “Reconciliation of Non-GAAP Net Debt” section of this MD&A) decreased by $69.2 million, from a negative $24.1 million to a negative $93.3 million. As of December 31, 2019, the ratio of total debt to total debt plus shareholders’ equity was 19.9 percent compared to 26.0 percent at December 31, 2018. As of December 31, 2019, the ratio of net debt to net debt plus shareholders’ equity was negative 11.7 percent, compared to negative 3.2 percent at December 31, 2018. At December 31, 2019, the Company’s debt included $222.1 million of unsecured private placement loans with maturities ranging from 2020 through 2027 which were issued to insurance companies pursuant to note purchase agreements (the Note Purchase Agreements). These notes are the Company’s primary source of long-term debt financing and are supplemented by bank credit facilities to meet short and medium-term needs. On January 30, 2018, the Company entered into a five year committed $350 million multi-currency revolving credit facility with a syndicate of banks that matures on January 30, 2023. This revolving credit facility replaced the Company’s prior $125 million credit agreement. This credit agreement allows the Company to make unsecured borrowings, as requested from time to time, to finance working capital needs, permitted acquisitions, capital expenditures and for general corporate purposes. This unsecured facility is the Company’s primary source of short-term borrowings. As of December 31, 2019, the Company had outstanding letters of credit totaling $4.9 million under the revolving credit agreement and no borrowings, with $345.1 million remaining available. The Company anticipates that cash from operations, committed credit facilities and cash on hand will be sufficient to fund anticipated capital expenditures, working capital, dividends and other planned financial commitments for the foreseeable future. Certain foreign subsidiaries of the Company periodically maintain short-term bank lines of credit in their respective local currencies to meet working capital requirements as well as to fund capital expenditure programs and acquisitions. At December 31, 2019, the Company’s foreign subsidiaries had no outstanding debt. The Company has material debt agreements that require the maintenance of minimum interest coverage and minimum net worth. These agreements also limit the incurrence of additional debt as well as the payment of dividends and repurchase of treasury shares. As of December 31, 2019, testing for these agreements was based on the Company’s consolidated financial statements. Under the most restrictive of these debt covenants: 1. The Company is required to maintain a minimum interest coverage ratio, as defined within the agreements, not to exceed 3.50 to 1.00, for the preceding four calendar quarters. 2. The Company is required to maintain a maximum net leverage ratio, as defined within the agreements, not to exceed 3.50 to 1.00. 3. The Company is required to maintain net worth of at least $325.0 million. 4. The Company is permitted to pay dividends and purchase treasury shares after December 31, 2017, in amounts of up to $100.0 million plus 100 percent of net income and cash proceeds of stock option exercises, measured cumulatively beginning December 31, 2017. The maximum amount of dividends that could have been paid within this limitation is disclosed as unrestricted retained earnings in Note 7 to the consolidated financial statements. The Company believes it was in compliance with all of its loan agreements as of December 31, 2019. Contractual Obligations At December 31, 2019, the Company’s contractual obligations, including estimated payments by period, were as follows: (1) Excludes unamortized debt issuance costs of $0.8 million. (2) Interest payments on debt obligations represent interest on all Company debt at December 31, 2019. Future interest rates may change, and, therefore, actual interest payments could differ from those disclosed in the above table. (3) Purchase obligations consist of raw material, utility and telecommunication service purchases made in the normal course of business. (4) The “Other” category comprises deferred revenues that represent commitments to deliver products, expected 2020 required contributions to the Company’s funded defined benefit pension plans, estimated payments related to the Company’s unfunded defined benefit supplemental executive and outside director pension plans, estimated payments (undiscounted) related to the Company’s asset retirement obligations, environmental remediation payments for which amounts and periods can be reasonably estimated and income tax liabilities for which payments and periods can be reasonably estimated. The above table does not include $77.2 million of other non-current liabilities recorded on the balance sheet at December 31, 2019, as summarized in Note 16 to the consolidated financial statements. The significant non-current liabilities excluded from the table are defined benefit pension, deferred compensation, environmental and legal liabilities and unrecognized tax benefits for which payment periods cannot be reasonably determined. In addition, deferred income tax liabilities are excluded from the table due to the uncertainty of their timing. Pension Plans The Company sponsors a number of defined benefit pension plans, the most significant of which cover employees in the Company’s U.S. and U.K. locations. The U.S. and U.K. plans are frozen, and service benefit accruals are no longer being made. The underfunded status (pretax) of the Company’s defined benefit pension plans was $13.6 million at December 31, 2019 versus $23.8 million at December 31, 2018. See Note 14, Postretirement Benefit Plans, to the consolidated financial statements for additional details. The Company contributed $0.8 million to its defined benefit plans in 2019. In 2020, the Company expects to contribute a total of $0.5 million to the U.K. defined benefit plan. As a result of pension funding relief included in the Highway and Transportation Funding Act of 2014, the Company has no 2020 contribution requirement to the U.S. pension plans. Payments to participants in the unfunded non-qualified plans should approximate $0.3 million in 2020, which is the same as payments made in 2019. Letters of Credit The Company maintains standby letters of credit under its workers’ compensation insurance agreements and for other purposes as needed. The insurance letters of credit are renewed annually and amended to the amounts required by the insurance agreements. As of December 31, 2019, the Company had a total of $4.9 million of outstanding standby letters of credit. Off-Balance Sheet Arrangements The Securities and Exchange Commission requires disclosure of off-balance sheet arrangements that either have, or are reasonably likely to have, a current or future effect on the Company’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors. During the periods covered by this Form 10-K, the Company was not party to any such off-balance sheet arrangements. Environmental and Legal Matters The Company’s operations are subject to extensive federal, state and local environmental laws and regulations or similar laws in the other countries in which the Company does business. Although the Company’s environmental policies and practices are designed to ensure compliance with these regulations, future developments and increasingly stringent environmental regulations may require the Company to make additional unforeseen environmental expenditures. The Company will continue to invest in the equipment and facilities necessary to comply with existing and future regulations. During 2019, the Company’s expenditures for capital projects related to the environment were $3.7 million. Expenditures for capital projects related to the environment are capitalized and depreciated over their estimated useful lives, which are typically 10 years. Recurring costs associated with the operation and maintenance of facilities for waste treatment, waste disposal and managing environmental compliance in ongoing operations at the Company’s manufacturing locations were approximately $31.8 million for 2019, $28.3 million for 2018 and $28.2 million for 2017. Over the years, the Company has received requests for information related to or has been named by government authorities as a potentially responsible party at a number of waste disposal sites where cleanup costs have been or may be incurred under CERCLA and similar state or foreign statutes. In addition, damages are being claimed against the Company in general liability actions for alleged personal injury or property damage in the case of some disposal and plant sites. The Company believes that it has made adequate provisions for the costs it is likely to incur with respect to these sites. See the Critical Accounting Policies section that follows for a discussion of the Company’s environmental liabilities accounting policy. After partial remediation payments at certain sites, the Company has estimated a range of possible environmental and legal losses from $25.9 million to $43.7 million at December 31, 2019, compared to $23.4 million to $44.7 million at December 31, 2018. Within the range of possible environmental losses, management has currently concluded that there are no amounts within the ranges that are likely to occur than any other amounts in the ranges and, thus, has accrued at the lower end of the ranges. The Company’s environmental and legal accruals totaled $25.9 million at December 31, 2019 as compared to $23.4 million at December 31, 2018. Because the liabilities accrued are estimates, actual amounts could differ from the amounts reported. During 2019, cash outlays related to legal and environmental matters approximated $3.8 million compared to $1.6 million expended in 2018. For certain sites, the Company has responded to information requests made by federal, state or local government agencies but has received no response confirming or denying the Company’s stated positions. As such, estimates of the total costs, or range of possible costs, of remediation, if any, or the Company’s share of such costs, if any, cannot be determined with respect to these sites. Consequently, the Company is unable to predict the effect thereof on the Company’s financial position, cash flows and results of operations. Based upon the Company’s present knowledge with respect to its involvement at these sites and the possibility of other viable entities’ responsibilities for cleanup, management believes that the Company has no liability at these sites and that these matters, individually and in the aggregate, will not have a material effect on the Company’s financial position. See Item 3. Legal Proceedings, in this Form 10-K and Note 17, Contingencies, in the Notes to Consolidated Financial Statements for a summary of the significant environmental proceedings related to certain environmental sites. Outlook Management anticipates a very challenging first quarter of 2020 due to operational issues at its plant in Millsdale, Illinois (see Note 27, Subsequent Events, in the Notes to Consolidated Financial Statements for additional details). Despite the challenging start to 2020, management believes its Surfactant strategy, inclusive of its focus on end market diversification, Tier 2 and Tier 3 customers and cost out activities will continue to contribute to margin improvement. Management believes Polymers will continue to benefit from energy conservation efforts and the growing market for insulation materials around the globe. Management believes full year Specialty Products results will approximate 2019 results. Additional headwinds anticipated in 2020 include the negative impact of the Coronavirus in China as well as higher raw material sourcing costs due to the Illinois River lock closures scheduled during the second half of 2020. Climate Change Legislation Based on currently available information, the Company does not believe that existing or pending climate change legislation or regulation is reasonably likely to have a material effect on the Company’s financial condition, results of operations or cash flows. Critical Accounting Policies The Company prepares its financial statements in accordance with accounting principles generally accepted in the United States of America (generally accepted accounting principles or GAAP). Preparation of financial statements in accordance with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The following is a summary of the accounting policies the Company believes are the most important to aid in understanding its financial results: Deferred Compensation The Company sponsors deferred compensation plans that allow management employees to defer receipt of their annual bonuses and outside directors to defer receipt of their fees until retirement, departure from the Company or as elected by the participant. The plans allow for the deferred compensation to grow or decline based on the results of investment options chosen by the participants. The investment options include Company common stock and a limited selection of mutual funds. The Company funds the obligations associated with these plans by purchasing investment assets that match the investment choices made by the plan participants. A sufficient number of shares of treasury stock are maintained on hand to cover the equivalent number of shares that result from participants electing the Company common stock investment option. As a result, the Company must periodically purchase its common shares in the open market or in private transactions. Upon retirement or departure from the Company or at the elected time, participants receive cash amounts equivalent to the payment date value of the investment choices they have made or Company common stock shares equal to the number of share equivalents held in the accounts. Some plan distributions may be made in cash or Company common stock at the option of the participant. Other plan distributions can only be made in Company common stock. For deferred compensation obligations that may be settled in cash, the Company must record appreciation in the market value of the investment choices made by participants as additional compensation expense. Conversely, declines in the value of Company stock or the mutual funds result in a reduction of compensation expense since such declines reduce the cash obligation of the Company as of the date of the financial statements. These market price movements may result in significant period-to-period fluctuations in the Company’s income. The increases or decreases in compensation expenses attributable to market price movements are reported in the operating expenses section of the consolidated statements of income. Because the obligations that must be settled only in Company common stock are treated as equity instruments, fluctuations in the market price of the underlying Company stock do not affect earnings. At December 31, 2019 and December 31, 2018, the Company’s deferred compensation liability was $59.0 million and $50.5 million, respectively. In 2019 and 2018, approximately 55 percent and 53 percent, respectively, of deferred compensation liability represented deferred compensation tied to the performance of the Company’s common stock. The remainder of the deferred compensation liability was tied to the chosen mutual fund investment assets. A $1.00 increase in the market price of the Company’s common stock will result in approximately $0.3 million of additional compensation expense. A $1.00 reduction in the market price of the common stock will reduce compensation expense by a like amount. The expense or income associated with the mutual fund component will generally fluctuate in line with the overall percentage increase or decrease of the U.S. stock markets. The mutual fund assets related to the deferred compensation plans are recorded on the Company’s balance sheet at cost when acquired and adjusted to their market values at the end of each reporting period. As allowed by generally accepted accounting principles, the Company elected the fair value option for recording the mutual fund investment assets. Therefore, market value changes for the mutual fund investment assets are recorded in the income statement in the same periods that the offsetting changes in the deferred compensation liabilities are recorded. Dividends, capital gains distributed by the mutual funds and realized and unrealized gains and losses related to mutual fund shares are recognized as investment income or loss in the other, net line of the consolidated statements of income. Environmental Liabilities It is the Company’s accounting policy to record environmental liabilities when environmental assessments and/or remedial efforts are probable and the cost or range of possible costs can be reasonably estimated. When no amount within a range of possible costs is a better estimate than any other amount, the minimum amount in the range is accrued. Estimating the possible costs of remediation required making assumptions related to the nature and extent of contamination and the methods and resulting costs of remediation. Some of the factors on which the Company bases its estimates include information provided by decisions rendered by State and Federal environmental regulatory agencies, information provided by feasibility studies, and remedial action plans developed. Estimates for environmental liabilities are subject to potentially significant fluctuations as new facts emerge related to the various sites where the Company is exposed to liability for the remediation of environmental contamination. See the Environmental and Legal Matters section of this MD&A for discussion of the Company’s recorded liabilities and range of cost estimates. Revenue Recognition On January 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606). This ASU outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. The Company’s contracts typically have a single performance obligation that is satisfied at the time product is shipped and control passes to the customer as compared to the “risk and rewards” criteria used in prior years. For a small portion of the business, performance obligations are deemed satisfied when product is delivered to a customer location. For arrangements where the Company consigns product to a customer location, revenue is recognized when the customer uses the inventory. The Company accounts for shipping and handling as activities to fulfill a promise to transfer a good. As such, shipping and handling fees billed to customers in a sales transaction are recorded in Net Sales and shipping and handling costs incurred are recorded in Cost of Sales. Volume and cash discounts due to customers are estimated and recorded in the same period as the sales to which the discounts relate and are reported as reductions of revenue in the consolidated statements of income. See Note 22 to the consolidated financial statements for more details. Recent Accounting Pronouncements See Note 1 to the consolidated financial statements, included in Part II-Item 8, for information on recent accounting pronouncements which affect the Company. Reconciliations of Non-GAAP Adjusted Net Income and Dilutive Earnings per Share (1) The 2018 and 2017 amounts have been retrospectively changed from the amounts originally reported as a result of the Company’s first quarter 2019 change in method of accounting for U.S. inventory valuation from LIFO to FIFO. The Company believes that certain non-GAAP measures, when presented in conjunction with comparable GAAP measures, are useful for evaluating the Company’s operating performance and provide better clarity on the impact of non-operational items. Internally, the Company uses this non-GAAP information as an indicator of business performance and evaluates management’s effectiveness with specific reference to these indicators. These measures should be considered in addition to, not a substitute for or superior to, measures of financial performance prepared in accordance with GAAP. The cumulative tax effect was calculated using the statutory tax rates for the jurisdictions in which the transactions occurred. Reconciliations of Non-GAAP Net Debt Management uses the non-GAAP net debt metric to show a more complete picture of the Company’s overall liquidity, financial flexibility and leverage level. This adjusted measure should be considered supplemental to and not a substitute for financial information prepared in accordance with GAAP. The Company's definition of this measure may differ from similarly titled measures used by other entities.

<s>[INST] Overview The Company produces and sells intermediate chemicals that are used in a wide variety of applications worldwide. The overall business comprises three reportable segments: Surfactants Surfactants, which accounted for 68 percent of the Company’s consolidated net sales in 2019, are principal ingredients in consumer and industrial cleaning products such as detergents for washing clothes, dishes, carpets, floors and walls, as well as shampoos and body washes. Other applications include fabric softeners, germicidal quaternary compounds, lubricating ingredients, emulsifiers for spreading agricultural products and industrial applications such as latex systems, plastics and composites. Surfactants are manufactured at five U.S. sites, two European sites (United Kingdom and France), five Latin American sites (Colombia and two sites in each of Mexico and Brazil) and two Asian sites (Philippines and Singapore). Recent significant Surfactants events include: o During January 2019, the Company’s plant in Ecatepec, Mexico experienced a sulfonation equipment failure that contributed to an operating loss at the site in 2019. The Ecatepec facility is now fully operational and, in December 2019, the Company received insurance recovery proceeds for damaged equipment, incremental supply chain expenses and business interruption. This plant, and a portion of its related surfactant business, was acquired from BASF in March 2018 (see Note 21, Acquisitions and Note 24, Insurance Recovery for additional details). o In December 2019 the Company acquired an oilfield demulsifier product line. The Company believes this acquisition will accelerate its strategy to diversify into additional application segments within the oilfield markets. The acquired business did not impact the Company’s 2019 financial results nor is it expected to be accretive to earnings in 2020 (see Note 21, Acquisitions, for additional details) o During the fourth quarter of 2018, the Company shut down Surfactant operations at its plant site in Germany. The Company ceased Surfactant production at this site to further reduce its fixed cost base, refocus Surfactant resources on higher margin end markets and allow for select assets to be repurposed to support future polyol growth. Decommissioning costs associated with the shutdown were incurred throughout 2019 (see Note 23, Business Restructuring, for additional details). o In 2016, the Company shut down its production facility in Canada, moving the production of goods previously manufactured in Canada to other Company North American production sites. Manufacturing operations at the facility ceased in the fourth quarter of 2016, but decommissioning activities have been ongoing since 2017 and will continue throughout 2020 (see Note 23, Business Restructuring, for additional details). Polymers Polymers, which accounted for 28 percent of consolidated net sales in 2019, include polyurethane polyols, polyester resins and phthalic anhydride. Polyurethane polyols are used in the manufacture of rigid foam for thermal insulation in the construction industry and are also a base raw material for coatings, adhesives, sealants and elastomers (collectively, CASE products). Powdered polyester resins are used in coating applications. CASE and powdered polyester resins are collectively referred to as specialty polyols. Phthalic anhydride is used in unsaturated polyester resins, alkyd resins and plasticizers for applications in construction materials and components of automotive, boating and other consumer products. In addition, the Company uses phthalic anhydride internally in the production of polyols. In the United States, polyurethane polyols and phthalic anhydride are manufactured at the Company’s Millsdale, Illinois, site, and specialty polyols are manufactured at the Company’s Columbus, Georgia, site. In Europe, polyurethane polyols are manufactured by the Company’s subsidiary in Germany, and specialty polyols are manufactured by the Company’s Poland subsidiary. In China, polyurethane polyols and specialty polyols are manufactured at the Company’s Nan [/INST] Negative. </s>

INTERFACE INC

2015-02-25

2014-12-28

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Our revenues are derived from sales of floorcovering products, primarily modular carpet (we sold our broadloom carpet operations in August 2012). Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. During the past several years, we have successfully focused more of our marketing and sales efforts on non-corporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. Our mix of corporate office versus non-corporate office modular carpet sales in the Americas has shifted over the past several years to 44% and 56%, respectively, for 2014 compared with 64% and 36%, respectively, in 2001. Company-wide, our mix of corporate office versus non-corporate office sales was 58% and 42%, respectively, in 2014. We expect a further shift in the future as we continue to implement our market diversification strategy. During 2014, we had net sales of $1.0 billion, compared with $960.0 million in 2013. Operating income for 2014 was $70.3 million, compared with $95.6 million for 2013. Net income for 2014 was $24.8 million, or $0.37 per diluted share, compared with $48.3 million, or $0.73 per diluted share, in 2013. Included in our results for 2014 are $12.4 million of restructuring and asset impairment charges, as discussed below. Also included in our results for 2014 are $9.2 million of expenses for the premiums paid to redeem our 7.625% Senior Notes as well as $2.8 million of expenses related to the unamortized debt costs for the retired notes at redemption. Included in our results for 2013 is a $7.0 million gain related to the settlement of our insurance claim related to the fire at our Australian manufacturing facility, as discussed below. Also included in our 2013 results are a one-time tax dispute resolution benefit of $1.9 million related to the execution of bilateral pricing agreements, and $1.7 million of expenses for the retirement of debt. Included in our results for 2012 are $19.4 million of restructuring and asset impairment charges and $1.7 million of expenses related to the Australia fire, as discussed below. Also included in our 2012 results is a loss from discontinued operations, net of tax, of $17.0 million related to the now discontinued Bentley Prince Street business segment. Fire at Australia Facility In July 2012, a fire occurred at our manufacturing facility in Picton, Australia, which served customers throughout Australia and New Zealand. The fire caused extensive damage to the facility, as well as disruption to business activity in the region. After the fire, we utilized adequate production capacity at our manufacturing facilities in Thailand, China, the U.S. and Europe to meet customer demand formerly serviced from Picton. While this was executed with success, there were, as expected, business disruptions and delays in shipments that affected sales following the fire. While it is difficult to quantify the financial impacts of the fire, we believe it negatively affected net sales by approximately $13-18 million during the balance of 2012, and by approximately $18-23 million during 2013. We have completed the build-out of a new manufacturing facility in Minto, Australia, which commenced operations in January 2014. For additional information on the fire, please see the Note entitled “Fire at Australian Manufacturing Facility” in Item 8 of this Report. Discontinued Operations In 2012, we sold our Bentley Prince Street business segment. In accordance with applicable accounting standards, we have reported the results of operations for the former Bentley Prince Street business segment as “discontinued operations,” where applicable. Consequently, our discussion of sales and other results of operations (except for net income or loss amounts), including percentages derived from or based on such amounts, excludes these discontinued operations unless we indicate otherwise. Our discontinued operations had no net sales, income or loss during 2014 and 2013. Our discontinued operations had net sales of $57.0 million in 2012 (these results are included in our statements of operations as part of the “Income (loss) from discontinued operations, net of tax”). Loss from discontinued operations, inclusive of the loss on disposal as well as costs to sell the business, net of tax, was $17.0 million in 2012. The loss from discontinued operations, net of tax, for 2012 was comprised of the following after-tax amounts: (1) $8.6 million of loss on disposal; (2) $5.9 million of costs to sell the operations; and (3) $2.5 million of non-disposal loss from the discontinued operations. For additional information on discontinued operations, see the Notes entitled “Discontinued Operations” and “Taxes on Income” in Item 8 of this Report. Restructuring Charges 2014 Restructuring Plan In the third quarter of 2014, we committed to a new restructuring plan in our continuing efforts to reduce costs across our worldwide operations. In connection with this restructuring plan, we incurred a pre-tax restructuring and asset impairment charge in the third quarter of 2014 in an amount of $12.4 million. The charge was comprised of severance expenses of $9.7 million for a reduction of 100 employees, other related exit costs of $0.1 million, and a charge for impairment of assets of $2.6 million. Approximately $10 million of the charge will result in cash expenditures, primarily severance expense. 2012 Restructuring Plan In 2012, we committed to a restructuring plan in our continuing efforts to reduce costs across our worldwide operations and more closely align our operations with reduced demand levels in certain markets. The plan primarily consisted of ceasing manufacturing and warehousing operations at our facility in Shelf, England. In connection with this restructuring plan, we incurred a pre-tax restructuring and asset impairment charge in the first quarter of 2012 in an amount of $16.3 million, as well as additional related charges of $0.8 million in the third quarter of 2012 and $2.3 million in the fourth quarter of 2012. These charges are comprised of severance expenses of $8.5 million for a reduction of 145 employees, other related exit costs of $1.6 million, and impairment of assets of approximately $9.4 million. Approximately $10.1 million of the charge will result in cash expenditures, primarily severance expense. 7.625% Senior Notes In 2010, we completed a private offering of $275 million aggregate principal amount of 7.625% Senior Notes due 2018. Interest on the 7.625% Senior Notes was payable semi-annually on June 1 and December 1 (the first payment was on June 1, 2011). In November 2013, we redeemed $27.5 million aggregate principal amount of the 7.625% Senior Notes at a price equal to 103% of the principal amount of the notes redeemed, plus accrued interest to the redemption date. In November 2014, we redeemed $27.5 million aggregate principal amount of these notes at a price equal to 103% of the principal amount of notes redeemed, plus accrued interest to the redemption date. In December 2014, we redeemed the remaining $220 million of these notes at a price equal to 103.813% of their principal amount, plus accrued interest to the redemption date. 11.375% Senior Secured Notes In 2009, we completed a private offering of $150 million aggregate principal amount of 11.375% Senior Secured Notes due 2013 (the “11.375% Senior Secured Notes”). Interest on the 11.375% Senior Secured Notes was payable semi-annually on May 1 and November 1 (the first interest payment was on November 1, 2009). The 11.375% Senior Secured Notes were guaranteed, jointly and severally, on a senior secured basis by certain of our domestic subsidiaries. The 11.375% Senior Secured Notes were secured by a second-priority lien on substantially all of our and certain of our domestic subsidiaries’ assets that secure our Syndicated Credit Facility (discussed below) on a first-priority basis. Following the sale of our 7.625% Senior Notes and the repurchase of $141.9 million aggregate principal amount of our 11.375% Senior Secured Notes with the proceeds, $8.1 million aggregate principal amount of our 11.375% Senior Secured Notes remained outstanding. These remaining 11.375% Senior Secured Notes were repaid at maturity in November 2013. Analysis of Results of Operations The following discussion and analyses reflect the factors and trends discussed in the preceding sections. Our net sales that were denominated in currencies other than the U.S. dollar were approximately 51% in 2014, 52% in 2013, and 51% in 2012. Because we have such substantial international operations, we are impacted, from time to time, by international developments that affect foreign currency transactions. For example, the performance of the euro against the U.S. dollar, for purposes of the translation of European revenues into U.S. dollars, favorably affected our reported results during 2013, when the euro was strengthening relative to the U.S. dollar. During 2014, the euro remained relatively stable versus the U.S. dollar and, as such (and despite the significant decline of the euro versus the U.S. dollar in the fourth quarter of 2014), there was not a significant impact on net sales or operating income. During 2012, the dollar strengthened versus the euro, having a negative effect on our reported results. The following table presents the amount (in U.S. dollars) by which the exchange rates for converting euros into U.S. dollars have affected our net sales and operating income during the past three years: The following table presents, as a percentage of net sales, certain items included in our Consolidated Statements of Operations during the past three years: Net Sales Below we provide information regarding our net sales and analyze those results for each of the last three fiscal years. Fiscal years 2014, 2013 and 2012 were 52-week periods. (As a result of the sale of our Bentley Prince Street Segment in 2012, we currently have only one segment for segment reporting purposes.) Net Sales for 2014 Compared with 2013 For 2014, net sales increased $43.9 million (4.6%) versus 2013. This increase primarily occurred in our Americas and Europe businesses, due largely to the continued economic recoveries in those regions. On a geographic basis, we experienced sales increases in each of our major operating regions, with the Americas up 5%, Europe up 5% (6% in local currency) and Asia-Pacific up 1% (5% in local currency). On a consolidated basis, fluctuations in currency had a small (approximately 1%) negative impact on net sales, primarily in Australia, which is within our Asia-Pacific region. In the Americas, the increase was due largely to the continued strength and recovery of the corporate office market segment, where our sales grew 4%. We also had sales growth in all non-office market segments with the exception of healthcare, which was down less than 1%. The most significant of the non-office segment increases were in the hospitality (up 55%) and residential (up 15%) segments. The sales increase in the hospitality segment is due to our continued focus on penetrating this segment through large hotel chains, with most success occurring in the U.S. The increase in the residential segment primarily occurred in the multi-family residential channel, as our FLOR consumer business experienced essentially even sales compared with 2013. The weighted average selling price per square yard in the Americas was up approximately 1% in 2014 versus 2013. In Europe, the sales increase was due primarily to growth in the corporate office market (up 9% in U.S. Dollars, 11% in local currency), mostly in Western Europe and particularly in the United Kingdom and Germany. The government segment (down 10% in U.S. Dollars, 8% in local currency) experienced the most significant decrease in the region, mostly due to the continued austerity measures that were in place during the year. The weighted average selling price per square yard in Europe increased approximately 4% during 2014, a result of the continued economic recovery in the region as well as the premium positioning of our products. Notably, the euro experienced a significant decline versus the U.S. dollar during the fourth quarter of 2014, and as a result our sales in Europe for that quarterly period experienced an increase of 6% in local currency but a 2% decrease as reported in U.S. dollars. In Asia-Pacific, the sales increase occurred mostly in the corporate office (up 3%), healthcare (up over 100%) and education (up 15%) market segments. However, these increases were almost entirely offset by declines in the government (down 42%) and retail (down 20%) segments. On a consolidated basis, the translation of Australian dollars into U.S. dollars had a negative impact on this region’s 2014 sales performance - in local currency, Australia sales were up more than 9%, but up only 2% as reported in U.S. dollars. This currency impact was particularly acute in the fourth quarter of 2014, when the increase in Australia dollars was approximately 20% but was approximately 11% as reported in U.S. dollars. Outside of Australia, sales in the remainder of the Asia-Pacific region were essentially flat in 2014 versus 2013. The weighted average selling price per square yard in Asia-Pacific in 2014 decreased approximately 1%, largely due to the impact of the decline of the Australian dollar versus the U.S. dollar. Net Sales for 2013 Compared with 2012 For 2013, net sales increased $28.0 million (3.0%) versus 2012. This increase was due primarily to the strength of the economic recovery in the Americas, coupled with lower rates of decline in our international markets compared with 2012. On a geographic basis, we experienced a sales increase in the Americas (up 7.3%), which was partially offset by decreases in Europe (down 2.0% in U.S. dollars, 5.3% in local currency) and Asia-Pacific (down 2.5%). On a consolidated basis, fluctuations in currency exchange rates did not have a significant impact on the change in sales for 2013 compared with 2012. In the Americas, the increase primarily occurred in three of our market segments - corporate office, residential and hospitality. The corporate office segment experienced an increase of 9%, due primarily to the continued rebound of the commercial office market in the United States. The residential market segment saw an increase of 38%, due to the growth of our FLOR residential business. The increase in the hospitality market segment (up 37%) was a direct result of our continued sales and marketing efforts in this market over the prior two years. Only the retail segment (down 7%) experienced a significant decline. The weighted average selling price per square yard in the Americas saw an increase of approximately 3% versus 2012. In Europe, the sales decrease was a result of the continued macroeconomic uncertainty in the region. The decline occurred across virtually all market segments, with the corporate office (down 1% in U.S. dollars, 4% in local currency), retail (down 19% in U.S. dollars, 21% in local currency) and government (down 7% in U.S. dollars, 10% in local currency) being the most significant. The weighted average selling price per square yard in Europe was up slightly year over year in U.S. dollars and down less than 2% in local currency. In the fourth quarter of 2013, we saw a 4% sales increase in Europe in U.S. dollars (essentially flat in local currency) versus the fourth quarter of 2012, demonstrating some stabilization in the market at the close of the year In Asia-Pacific, the sales decline was largely a result of our performance in Australia, where we had lower sales as a result of the continued effect of the fire at our Australia manufacturing facility in 2012. The fire led to increased lead times for orders and other business disruptions that had a negative impact in the marketplace. The weakening of the Australian dollar in 2013 versus 2012 was another factor in the decline. The decrease in Australia was partially offset by sales increases in the rest of the Asia-Pacific region, particularly in China and Southeast Asia. The majority of the sales decline in Asia-Pacific occurred in the corporate office (down 10%), healthcare (down 51%) and education (down 14%) market segments. These decreases were mitigated somewhat by increases in the retail (up 67%), government (up 67%) and hospitality (up 55%) market segments. The weighted average selling price per square yard in the Asia-Pacific region declined approximately 4% in 2013 versus 2012. Cost and Expenses The following table presents our overall cost of sales and selling, general and administrative expenses during the past three years: For 2014, our cost of sales increased $45.0 million (7.3%) versus 2013. Fluctuations in currency exchange rates had a slight negative impact (1%) year over year. On a per-unit basis, we did not experience any significant difference in the cost of our raw materials in 2014 versus 2013. Most of the $45.0 million year over year increase in cost of sales was directly attributable to additional raw materials costs (approximately $30 million) and labor costs (approximately $4 million) associated with higher production volumes in 2014, particularly in the second half of the year. Of the remainder of the year over year increase, the majority is related to both the increased fixed costs as well as the inefficiencies associated with the start-up of our new and larger manufacturing facility in Australia which opened in January of 2014. These inefficiencies occurred primarily in the first six months of 2014. As a result of these items, as a percentage of sales, cost of sales increased to 66.1% in 2014, compared with 64.5% in 2013. For 2013, our cost of sales increased $4.0 million (1%) versus 2012. Fluctuations in currency exchange rates had a slight negative impact (less than 1%) year over year. The primary components of this increase in cost of sales were increases in raw material costs (approximately $3 million) and labor costs (approximately $0.4 million) associated with higher production volumes, particularly in the second and third quarters of 2013 versus the prior year periods. On a per unit basis, we did not experience any significant cost differences in raw materials in 2013 versus 2012. We saw gross margin expansion in our Europe and Asia-Pacific regions during 2013, especially in the fourth quarter, due to continued implementation of our lean manufacturing initiatives and streamlining of our supply chain in the Asia-Pacific region. As a result of these items, cost of sales decreased, as a percentage of sales, to 64.5% in 2013 versus 66.0% in 2012. For 2014, our selling, general and administrative expenses increased $4.9 million (1.9%) versus 2013. Fluctuations in currency exchange rates did not have a significant impact on the comparison. The largest driver of the increase was $5.6 million of higher selling expenses commensurate with the sales growth in each of our three operating regions. We also had increased marketing expenses of approximately $1.2 million, split evenly between our European modular carpet business and our FLOR consumer business. The increased marketing expense in Europe related to campaigns designed to further engage the architect and design community, while the increase in our FLOR business related to web-based marketing efforts. These increases were offset by a decline in administrative expenses of approximately $1.9 million, mostly due to lower incentive compensation in 2014 versus 2013, as well as the impacts of our restructuring actions in the third quarter of 2014. The benefits of the restructuring actions were particularly evident in the fourth quarter of 2014, when our selling, general and administrative expenses, as a percentage of sales, declined to 23.8% versus 26.6% for the fourth quarter of 2013. For the full year 2014, our selling, general and administrative expenses, as a percentage of sales, declined to 25.6%, versus 26.3% in 2013. For 2013, our selling, general and administrative expenses increased $21.1 million (9.1%) versus 2012. Fluctuations in currency exchange rates did not have a significant impact on the increase. The largest component of the change in selling, general and administrative expenses was an increase in selling costs of $9.2 million. The majority of this increase ($8.3 million) was in the Americas region, comprised of approximately $4.3 million of increased selling expenses for our FLOR store platform as it expanded to a total of 21 stores during 2013 and $3.9 million of increased selling costs at our core modular business in the Americas due to additions of sales people and other personnel in the sales group. We also experienced an increase in marketing costs of $3.0 million, primarily in the Americas ($2.0 million) and Europe ($1.0 million) divisions, related to targeted marketing programs designed to drive sales in non-corporate office market segments. The remainder of the increase was research and development and administrative costs, driven primarily by increased stock compensation expense ($4.6 million) related to new grants in 2013 as well as vesting of grants based on performance targets being met to a greater extent during 2013 versus 2012. Due to the above factors, as a percentage of net sales, selling, general and administrative expenses increased to 26.3% in 2013 versus 24.8% in 2012. Interest Expense For 2014, interest expense decreased $3.0 million to $20.8 million, versus $23.8 million in 2013. The primary reasons for the decrease were the redemption of $27.5 million of our 7.625% Senior Notes and the repayment at maturity of the remaining $8.1 million of our 11.375% Senior Subordinated Notes, each in the fourth quarter of 2013. In addition, as described above, we redeemed all of the remaining 7.625% Senior Notes in the fourth quarter of 2014, which also contributed to the interest expense decline. Although we incurred borrowings under our Syndicated Credit Facility to refinance the notes that were repaid and redeemed during 2013 and 2014, the borrowings under our Syndicated Credit Facility are at a significantly lower interest rate (currently less than 2.5% annually) than the interest rates on the notes that were refinanced. For 2013, interest expense decreased $1.2 million to $23.8 million versus $25.0 million in 2012. This decrease was primarily due to the repayment of the $8.1 million balance of our 11.375% Senior Secured Notes at maturity in November 2013 and the early redemption of $27.5 million of our 7.625% Senior Notes in November 2013. Although we subsequently borrowed under our Syndicated Credit Facility in December of 2013, the borrowing was at a significantly lower interest rate than the notes which were repaid in November 2013. Tax Our effective tax rate in 2014 was 30.6%, compared with an effective tax rate of 30.1% in 2013. This relative consistency in effective tax rate was primarily attributable to favorable tax effects related to foreign operations realized in both years. In addition, there was less of an increase due to valuation allowances related to state net operating loss carryforwards in 2014, which offset the decrease we realized in 2013 related to the favorable settlement of our Canada-U.S. bilateral advanced pricing agreement. For additional information on taxes and a reconciliation of effective tax rates to statutory tax rates, see the Note entitled “Taxes on Income” in Item 8 of this Report. Our effective tax rate in 2013 was 30.1%, compared with an effective rate of 39.9% in 2012. This decrease in effective rate was primarily attributable to (1) the settlement of our Canada-U.S. bilateral advanced pricing agreement, (2) a decrease in nondeductible business expenses, (3) a decrease in nondeductible reserves against capital assets, (4) an effective foreign tax rate that is lower than the federal statutory rate coupled with a significant increase of foreign earnings from 2012 to 2013, and (5) an effective state tax rate that is lower due to a larger proportion of foreign earnings in 2013. In addition, there was an increase in the effective rate attributable to valuation allowances related to state net operating loss carryforwards. For additional information on taxes and a reconciliation of effective tax rates to statutory tax rates, see the Note entitled “Taxes on Income” in Item 8 of this Report. Liquidity and Capital Resources General In our business, we require cash and other liquid assets primarily to purchase raw materials and to pay other manufacturing costs, in addition to funding normal course selling, general and administrative expenses, anticipated capital expenditures, interest expense and potential special projects. We generate our cash and other liquidity requirements primarily from our operations and from borrowings or letters of credit under our Syndicated Credit Facility discussed below. We believe that we will be able to continue to enhance the generation of free cash flow through the following initiatives: ● Improving our inventory turns by continuing to implement a made-to-order model throughout our organization; ● Reducing our average days sales outstanding through improved credit and collection practices; and ● Limiting the amount of our capital expenditures generally to those projects that have a short-term payback period. Historically, we use more cash in the first half of the fiscal year, as we fund insurance premiums, tax payments, incentive compensation and inventory build-up in preparation for the holiday/vacation season of our international operations. In addition, we have a high contribution margin business with low capital expenditure requirements. Contribution margin represents variable gross profit margin less the variable component of selling, general and administrative expenses, and for us is an indicator of profit on incremental sales after the fixed components of cost of sales and selling, general and administrative expenses have been recovered. While contribution margin should not be construed as a substitute for gross margin, which is determined in accordance with GAAP, it is included herein to provide additional information with respect to our potential for profitability. In addition, we believe that investors find contribution margin to be a useful tool for measuring our profitability on an operating basis. At December 28, 2014, we had $54.9 million in cash. Approximately $15.9 million of this cash was located in the United States, and the remaining $38.9 million was located at our international locations. Our position is that the cash located outside of the United States is permanently reinvested in the respective jurisdictions (except as identified below). We believe that our strategic plans and business needs support the status of our cash in foreign locations. Of the $38.9 million cash in foreign jurisdictions, approximately $2.4 million represents earnings which we have determined are not permanently reinvested, and as such we have provided for U.S. federal and state income taxes on these amounts in accordance with applicable accounting standards. As of December 28, 2014, we had $263.3 million of borrowings and $3.3 million in letters of credit outstanding under our Syndicated Credit Facility. Of those borrowings outstanding, $200 million were Term Loan A borrowings and $63.3 million were revolving loan borrowings. As of December 28, 2014, we could have incurred $183.4 million of additional revolving loan borrowings under our Syndicated Credit Facility. In addition, we could have incurred the equivalent of $19.0 million of borrowings under our other credit facilities in place at other non-U.S. subsidiaries. We have approximately $43.1 million in contractual cash obligations due by the end of fiscal year 2015, which includes, among other things, pension cash contributions, interest payments on our debt and lease commitments. Based on current interest rate and debt levels, we expect our aggregate interest expense for 2015 to be between $8 million and $10 million. We estimate aggregate capital expenditures in 2015 to be between $40 million and $50 million, although we are not committed to these amounts. In 2010, we completed a private offering of $275 million aggregate principal amount of 7.625% Senior Notes. Interest on the 7.625% Senior Notes was payable semi-annually on June 1 and December 1 (the first payment was made on June 1, 2011). In the fourth quarter of 2013, we redeemed $27.5 million aggregate principal amount of the 7.625% Senior Notes at a price equal to 103% of the principal amount of the notes redeemed, plus accrued interest to the redemption date. In the fourth quarter of 2014, we redeemed $27.5 million aggregate principal amount of the 7.625% Senior Notes at a price equal to 103% of their principal amount, plus accrued interest, and redeemed the remaining $220 million aggregate principal amount of these notes at a price equal to 103.813% of their principal amount, plus accrued interest. The redemption transactions in the fourth quarter of 2014 required an aggregate of $266.1 million (including principal payments, premiums and accrued interest), which was funded through a combination of term loan and revolving loan borrowings under the Syndicated Credit Facility and cash on hand. It is important for you to consider that we have a significant amount of indebtedness. Our Syndicated Credit Facility matures in October 2019. We cannot assure you that we will be able to renegotiate or refinance any of our debt on commercially reasonable terms, or at all. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, such as selling assets to meet our debt service obligations and other liquidity needs, or using cash, if available, that would have been used for other business purposes. Syndicated Credit Facility We have a syndicated credit facility (the “Facility”) pursuant to which the lenders provide to us and certain of our subsidiaries a multicurrency revolving credit facility and provide to us a term loan. The key features of the Facility are as follows: ● The Facility matures on October 3, 2019. ● The Facility includes (i) a multicurrency revolving loan facility made available to the Company and our principal subsidiaries in Europe and Australia not to exceed $240 million in the aggregate at any one time outstanding, and (ii) a revolving loan facility made available to our principal subsidiary in Thailand not to exceed the equivalent of $10 million in the aggregate at any one time outstanding. A sublimit of $40 million exists for the issuance of letters of credit under the Facility. ● The Facility includes $200 million of Term Loan A borrowing availability which could be used (and was in fact used) to refinance our 7.625% Senior Notes due 2018. ● The Facility provides for required amortization payments of the Term Loan A borrowing, as well as mandatory prepayments of the Term Loan A borrowing (and any term loans made available pursuant to any future multicurrency loan facility increase) from certain asset sales, casualty events and debt issuances, subject to certain qualifications and exceptions as provided for therein. ● Advances under the Facility are secured by a first-priority lien on substantially all of Interface, Inc.’s assets and the assets of each of our material domestic subsidiaries, which have guaranteed the Facility. ● The Facility contains financial covenants (specifically, a consolidated net leverage ratio and a consolidated interest coverage ratio) that must be met as of the end of each fiscal quarter. ● We have the option to increase the borrowing availability under the Facility, either for revolving loans or term loans, by up to $150 million, subject to the receipt of lender commitments for the increase and the satisfaction of certain other conditions. Interest Rates and Fees. Interest on base rate loans is charged at varying rates computed by applying a margin ranging from 0.25% to 1.50% over the applicable base interest rate (which is defined as the greatest of the prime rate, a specified federal funds rate plus 0.50%, or a specified LIBOR rate), depending on our consolidated net leverage ratio as of the most recently completed fiscal quarter. Interest on LIBOR-based loans and fees for letters of credit are charged at varying rates computed by applying a margin ranging from 1.25% to 2.50% over the applicable LIBOR rate, depending on our consolidated net leverage ratio as of the most recently completed fiscal quarter. In addition, we pay a commitment fee ranging from 0.20% to 0.35% per annum (depending on our consolidated net leverage ratio as of the most recently completed fiscal quarter) on the unused portion of the Facility. Amortization Prepayments. We are required to make amortization payments of the Term Loan A borrowing. The amortization payments are due on the last day of the calendar quarter, commencing with an initial amortization payment of $2.5 million on December 31, 2015. The quarterly amortization payment amount increases to $3.75 million on December 31, 2016. Covenants. The Facility contains standard and customary covenants for agreements of this type, including various reporting, affirmative and negative covenants. Among other things, these covenants limit our ability to: ● create or incur liens on assets; ● make acquisitions of or investments in businesses (in excess of certain specified amounts); ● incur indebtedness or contingent obligations; ● sell or dispose of assets (in excess of certain specified amounts); ● pay dividends or repurchase our stock (in excess of certain specified amounts); ● repay other indebtedness prior to maturity unless we meet certain conditions; and ● enter into sale and leaseback transactions. The Facility also requires us to remain in compliance with the following financial covenants as of the end of each fiscal quarter, based on our consolidated results for the year then ended: ● Consolidated Net Leverage Ratio: Must be no greater than (i) 4.50:1.00 through and including the fiscal quarter ending December 28, 2014, (ii) 4.00:1.00 from and including the fiscal quarter ending April 5, 2015 through and including the fiscal quarter ending January 3, 2016, and (iii) 3.75:1.00 for each fiscal quarter thereafter. ● Consolidated Interest Coverage Ratio: Must be no less than 2.25:1.00 as of the end of any fiscal quarter. Events of Default. If we breach or fail to perform any of the affirmative or negative covenants under the Facility, or if other specified events occur (such as a bankruptcy or similar event or a change of control of Interface, Inc. or certain subsidiaries, or if we breach or fail to perform any covenant or agreement contained in any instrument relating to any of our other indebtedness exceeding $20 million), after giving effect to any applicable notice and right to cure provisions, an event of default will exist. If an event of default exists and is continuing, the lenders’ Administrative Agent may, and upon the written request of a specified percentage of the lender group shall: ● declare all commitments of the lenders under the facility terminated; ● declare all amounts outstanding or accrued thereunder immediately due and payable; and ● exercise other rights and remedies available to them under the agreement and applicable law. Collateral. Pursuant to a Security and Pledge Agreement executed on the same date, the Facility is secured by substantially all of the assets of Interface, Inc. and our domestic subsidiaries (subject to exceptions for certain immaterial subsidiaries), including all of the stock of our domestic subsidiaries and up to 65% of the stock of our first-tier material foreign subsidiaries. If an event of default occurs under the Facility, the lenders’ Administrative Agent may, upon the request of a specified percentage of lenders, exercise remedies with respect to the collateral, including, in some instances, foreclosing mortgages on real estate assets, taking possession of or selling personal property assets, collecting accounts receivables, or exercising proxies to take control of the pledged stock of domestic and first-tier material foreign subsidiaries. As of December 28, 2014 we had $200 million of Term Loan A borrowings and $63.3 million of revolving loan borrowings outstanding under the Facility, and had $3.3 million in letters of credit outstanding under the Facility. We are presently in compliance with all covenants under the Syndicated Credit Facility and anticipate that we will remain in compliance with the covenants for the foreseeable future. Senior Notes As described above, all of our remaining 7.625% Senior Notes were redeemed in full in the fourth quarter of 2014. Analysis of Cash Flows Our primary sources of cash during 2014 were: (1) $200 million of Term Loan A borrowings and $48.9 million of revolving loan borrowings under our Syndicated Credit Facility; (2) $15.4 million due to an increase in accounts payable and accruals; and (3) $2.8 million due to a decrease in prepaid expenses and other current assets. Our primary uses of cash during 2014 were: (1) $256.8 million used to redeem our formerly outstanding 7.625% Senior Notes (comprised of $247.5 million for principal payments, and $9.3 million for premium payments); (2) $29.3 million due to an increase in accounts receivable; (3) $9.9 million used to repay a portion of our outstanding revolving loan borrowings under our Syndicated Credit Facility; (4) $9.3 million used to pay dividends on our common stock; and (5) $7.7 million used to repurchase 500,000 shares of our common stock. Our primary sources of cash during 2013 were: (1) $56.0 million of proceeds received from our insurance company on our claim related to the fire at our Australia manufacturing facility in 2012; (2) $26.3 million of borrowings under our Syndicated Credit Facility; and (3) $3.5 million due to a reduction in accounts receivable. Our primary uses of cash in 2013 were: (1) $91.9 million of capital expenditures, which included expenditures for the purchase and build-out of our new manufacturing facility in Minto, Australia; (2) $35.6 million of cash used to retire the remainder ($8.1 million aggregate principal amount) of our 11.375% Senior Secured Notes and a portion ($27.5 million aggregate principal amount) of our 7.625% Senior Notes; and (3) $17.3 million due to a decrease in accounts payable and accruals. Our primary sources of cash during 2012 were: (1) $32.2 million of net proceeds from the sale of our Bentley Prince Street business segment; (2) $20.0 million as a result of a reduction of accounts receivable; and (3) $20.7 million of proceeds from the insurance company with regard to the fire at our Australian facility. Our primary uses of cash during 2012 were: (1) $42.4 million of capital expenditures; (2) an increase of prepaid expenses and other current assets of $11.9 million, primarily related to the insurance receivable for our fire claim in Australia; and (3) $11.5 million for the redemption of the remainder of our former 9.5% Senior Subordinated Notes. We believe that our liquidity position will provide sufficient funds to meet our current commitments and other cash requirements for the foreseeable future. Funding Obligations We have various contractual obligations that we must fund as part of our normal operations. The following table discloses aggregate information about our contractual obligations (including the remaining contractual obligations related to our discontinued operations) and the periods in which payments are due. The amounts and time periods are measured from December 28, 2014. (1) Our capital lease obligations are insignificant. (2) Expected interest payments to be made in future periods reflect anticipated interest payments related to the $200 million of Term Loan A borrowings outstanding and the $63.3 million of revolving loan borrowings outstanding under our Syndicated Credit Facility as of December 28, 2014. We have also assumed in the presentation above that these notes and borrowings will remain outstanding until maturity. (3) Unconditional purchase obligations do not include unconditional purchase obligations that are included as liabilities in our Consolidated Balance Sheet. Our capital expenditure commitments are not significant. (4) We have two foreign defined benefit plans and a domestic salary continuation plan. We have presented above the estimated cash obligations that will be paid under these plans over the next ten years. Such amounts are based on several estimates and assumptions and could differ materially should the underlying estimates and assumptions change. Our domestic salary continuation plan is an unfunded plan, and we do not currently have any commitments to make contributions to this plan. However, we do use insurance instruments to hedge our exposure under the salary continuation plan. Contributions to our other employee benefit plans are at our discretion. (5) The above table does not reflect unrecognized tax benefits of $27.3 million, the timing of which payments are uncertain. See the Note entitled “Taxes on Income” in Item 8 of this Report for further information. Critical Accounting Policies The policies discussed below are considered by management to be critical to an understanding of our consolidated financial statements because their application places the most significant demands on management’s judgment, with financial reporting results relying on estimations about the effects of matters that are inherently uncertain. Specific risks for these critical accounting policies are described in the following paragraphs. For all of these policies, management cautions that future events may not develop as forecasted, and the best estimates routinely require adjustment. Revenue Recognition. The vast majority of our revenue is recognized at the date of shipment when the following criteria are met: persuasive evidence of an agreement exists, price to the buyer is fixed and determinable, and collectability is reasonably assured. Delivery is not considered to have occurred until the customer takes title and assumes the risks and rewards of ownership, which is generally on the date of shipment. Provisions for discounts, sales returns and allowances are estimated using historical experience, current economic trends, and the company’s quality performance. The related provision is recorded as a reduction of sales and cost of sales in the same period that the revenue is recognized. Accordingly, our estimates and assumptions regarding revenue recognition primarily relate to sales returns and allowances, which historically have been in the range of 2.5-3.0% of gross sales. Over the last several years, we have not experienced any significant fluctuation in sales returns and allowances, our estimates and assumptions related thereto have not changed significantly, and we believe our estimates and assumptions to be reasonably accurate. Management also believes this past experience can be relied upon for such estimates and assumptions in future periods, as our business model and customer mix have not changed significantly. A small percentage (approximately 5%) of our revenue relates to flooring installation projects, which generally involve short time periods (typically less than two weeks) and therefore present little risk of material difference due to changes in experience. Shipping and handling fees billed to customers are classified in net sales in the consolidated statements of operations. Shipping and handling costs incurred are classified in cost of sales in the consolidated statements of operations. Impairment of Long-Lived Assets. Long-lived assets are reviewed for impairment at the asset group level whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If the sum of the expected future undiscounted cash flow is less than the carrying amount of the asset, an impairment is indicated. A loss is then recognized for the difference, if any, between the fair value of the asset (as estimated by management using its best judgment) and the carrying value of the asset. If actual market value is less favorable than that estimated by management, additional write-downs may be required. Deferred Income Tax Assets and Liabilities. The carrying values of deferred income tax assets and liabilities reflect the application of our income tax accounting policies in accordance with applicable accounting standards, and are based on management’s assumptions and estimates regarding future operating results and levels of taxable income, as well as management’s judgment regarding the interpretation of the provisions of applicable accounting standards. The carrying values of liabilities for income taxes currently payable are based on management’s interpretations of applicable tax laws, and incorporate management’s assumptions and judgments regarding the use of tax planning strategies in various taxing jurisdictions. The use of different estimates, assumptions and judgments in connection with accounting for income taxes may result in materially different carrying values of income tax assets and liabilities and results of operations. We evaluate the recoverability of these deferred tax assets by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income inherently rely heavily on estimates. We use our historical experience and our short and long-term business forecasts to provide insight. Further, our global business portfolio gives us the opportunity to employ various prudent and feasible tax planning strategies to facilitate the recoverability of future deductions. To the extent we do not consider it more likely than not that a deferred tax asset will be recovered, a valuation allowance is established. As of December 28, 2014 and December 29, 2013, we had approximately $100.1 million and $113.7 million of U.S. federal net operating loss carryforwards, respectively. In addition, as of December 28, 2014 and December 29, 2013, we had state net operating loss carryforwards of $209.0 million and $193.0 million, respectively. As of December 28, 2014 and December 29, 2013, we had approximately $4.0 million and $2.0 million of foreign net operating loss carryforwards, respectively. Certain of these carryforwards are reserved with a valuation allowance because, based on the available evidence, we believe it is more likely than not that we would not be able to utilize those deferred tax assets in the future. The remaining year-end 2014 amounts are expected to be fully recoverable within the applicable statutory expiration periods. If the actual amounts of taxable income differ from our estimates, the amount of our valuation allowance could be materially impacted. Goodwill. Pursuant to applicable accounting standards, we test goodwill for impairment at least annually using a two step approach. In the first step of this approach, we prepare valuations of reporting units, using both a market comparable approach and an income approach, and those valuations are compared with the respective book values of the reporting units to determine whether any goodwill impairment exists. In preparing the valuations, past, present and expected future performance is considered. If impairment is indicated in this first step of the test, a step two valuation approach is performed. The step two valuation approach compares the implied fair value of goodwill to the book value of goodwill. The implied fair value of goodwill is determined by allocating the estimated fair value of the reporting unit to the assets and liabilities of the reporting unit, including both recognized and unrecognized intangible assets, in the same manner as goodwill is determined in a business combination under applicable accounting standards. After completion of this step two test, a loss is recognized for the difference, if any, between the fair value of the goodwill associated with the reporting unit and the book value of that goodwill. If the actual fair value of the goodwill is determined to be less than that estimated, an additional write-down may be required. During the fourth quarters of 2014, 2013 and 2012, we performed the annual goodwill impairment test. We perform this test at the reporting unit level. For our reporting units which carried a goodwill balance as of December 28, 2014, no impairment of goodwill was indicated. As of December 28, 2014, if our estimates of the fair value of our reporting units were 10% lower, we believe no additional goodwill impairment would have existed. Inventories. We determine the value of inventories using the lower of cost or market. We write down inventories for the difference between the carrying value of the inventories and their net realizable value. If actual market conditions are less favorable than those projected by management, additional write-downs may be required. We estimate our reserves for inventory obsolescence by continuously examining our inventories to determine if there are indicators that carrying values exceed net realizable values. Experience has shown that significant indicators that could require the need for additional inventory write-downs are the age of the inventory, the length of its product life cycles, anticipated demand for our products and current economic conditions. While we believe that adequate write-downs for inventory obsolescence have been made in the consolidated financial statements, consumer tastes and preferences will continue to change and we could experience additional inventory write-downs in the future. Our inventory reserve on December 28, 2014, and December 29, 2013, was $14.8 million and $13.4 million, respectively. To the extent that actual obsolescence of our inventory differs from our estimate by 10%, our 2014 net income would be higher or lower by approximately $1.0 million, on an after-tax basis. Pension Benefits. Net pension expense recorded is based on, among other things, assumptions about the discount rate, estimated return on plan assets and salary increases. While management believes these assumptions are reasonable, changes in these and other factors and differences between actual and assumed changes in the present value of liabilities or assets of our plans above certain thresholds could cause net annual expense to increase or decrease materially from year to year. The actuarial assumptions used in our salary continuation plan and our foreign defined benefit plans reporting are reviewed periodically and compared with external benchmarks to ensure that they appropriately account for our future pension benefit obligation. The expected long-term rate of return on plan assets assumption is based on weighted average expected returns for each asset class. Expected returns reflect a combination of historical performance analysis and the forward-looking views of the financial markets, and include input from actuaries, investment service firms and investment managers. The table below represents the changes to the projected benefit obligation as a result of changes in discount rate assumptions: Environmental Remediation. We provide for environmental remediation costs and penalties when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. Remediation liabilities are accrued based on estimates of known environmental exposures and are discounted in certain instances. We regularly monitor the progress of environmental remediation. Should studies indicate that the cost of remediation is to be more than previously estimated, an additional accrual would be recorded in the period in which such determination is made. As of December 28, 2014, no significant amounts were provided for remediation liabilities. Allowances for Doubtful Accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. Estimating this amount requires us to analyze the financial strengths of our customers. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. By its nature, such an estimate is highly subjective, and it is possible that the amount of accounts receivable that we are unable to collect may be different than the amount initially estimated. Our allowance for doubtful accounts on December 28, 2014, and December 29, 2013, was $7.9 million and $7.6 million, respectively. To the extent the actual collectability of our accounts receivable differs from our estimates by 10%, our 2014 net income would be higher or lower by approximately $0.6 million, on an after-tax basis, depending on whether the actual collectability was better or worse, respectively, than the estimated allowance. Product Warranties. We typically provide limited warranties with respect to certain attributes of our carpet products (for example, warranties regarding excessive surface wear, edge ravel and static electricity) for periods ranging from ten to twenty years, depending on the particular carpet product and the environment in which the product is to be installed. We typically warrant that any services performed will be free from defects in workmanship for a period of one year following completion. In the event of a breach of warranty, the remedy typically is limited to repair of the problem or replacement of the affected product. We record a provision related to warranty costs based on historical experience and periodically adjust these provisions to reflect changes in actual experience. Our warranty reserve on December 28, 2014, and December 29, 2013, was $1.8 million and $1.4 million, respectively. Actual warranty expense incurred could vary significantly from amounts that we estimate. To the extent the actual warranty expense differs from our estimates by 10%, our 2014 net income would be higher or lower by approximately $0.1 million, on an after-tax basis, depending on whether the actual expense is lower or higher, respectively, than the estimated provision. Off-Balance Sheet Arrangements We are not a party to any material off-balance sheet arrangements. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”) issued an accounting standard regarding recognition of revenue from contracts with customers. In summary, the core principle of this standard is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period, and early application is not permitted. While we are currently reviewing this new standard, it is not expected that the adoption of this guidance will have a material impact on our financial condition or results of operation. In July 2013, the FASB issued an accounting standard regarding the presentation of unrecognized tax benefits when a net operating loss carryforward, or similar tax credit carryforward, exists. This standard clarifies that an unrecognized tax benefit, or a portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, if such settlement is required or expected in the event the uncertain tax benefit is disallowed. In situations where a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, is not available at the reporting date under the tax law of the applicable jurisdiction or the tax law of the jurisdiction does not require, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability and should not be netted with the deferred tax asset. We implemented this standard in the first quarter of 2014, which resulted in reductions of deferred tax asset (long-term) and long-term other liabilities of approximately $21.8 million each. Pursuant to this standard, we also adjusted our December 29, 2013 consolidated balance sheet, resulting in decreases in our deferred tax asset (long-term) and long-term other liabilities of approximately $21.8 million each.

<s>[INST] General Our revenues are derived from sales of floorcovering products, primarily modular carpet (we sold our broadloom carpet operations in August 2012). Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. During the past several years, we have successfully focused more of our marketing and sales efforts on noncorporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. Our mix of corporate office versus noncorporate office modular carpet sales in the Americas has shifted over the past several years to 44% and 56%, respectively, for 2014 compared with 64% and 36%, respectively, in 2001. Companywide, our mix of corporate office versus noncorporate office sales was 58% and 42%, respectively, in 2014. We expect a further shift in the future as we continue to implement our market diversification strategy. During 2014, we had net sales of $1.0 billion, compared with $960.0 million in 2013. Operating income for 2014 was $70.3 million, compared with $95.6 million for 2013. Net income for 2014 was $24.8 million, or $0.37 per diluted share, compared with $48.3 million, or $0.73 per diluted share, in 2013. Included in our results for 2014 are $12.4 million of restructuring and asset impairment charges, as discussed below. Also included in our results for 2014 are $9.2 million of expenses for the premiums paid to redeem our 7.625% Senior Notes as well as $2.8 million of expenses related to the unamortized debt costs for the retired notes at redemption. Included in our results for 2013 is a $7.0 million gain related to the settlement of our insurance claim related to the fire at our Australian manufacturing facility, as discussed below. Also included in our 2013 results are a onetime tax dispute resolution benefit of $1.9 million related to the execution of bilateral pricing agreements, and $1.7 million of expenses for the retirement of debt. Included in our results for 2012 are $19.4 million of restructuring and asset impairment charges and $1.7 million of expenses related to the Australia fire, as discussed below. Also included in our 2012 results is a loss from discontinued operations, net of tax, of $17.0 million related to the now discontinued Bentley Prince Street business segment. Fire at Australia Facility In July 2012, a fire occurred at our manufacturing facility in Picton, Australia, which served customers throughout Australia and New Zealand. The fire caused extensive damage to the facility, as well as disruption to business activity in the region. After the fire, we utilized adequate production capacity at our manufacturing facilities in Thailand, China, the U.S. and Europe to meet customer demand formerly serviced from Picton. While this was executed with success, there were, as expected, business disruptions and delays in shipments that affected sales following the fire. While it is difficult to quantify the financial impacts of the fire, we believe it negatively affected net sales by approximately $1318 million during the balance of 2012, and by approximately $1823 million during 2013. We have completed the buildout of a new manufacturing facility in Minto, Australia, which commenced operations in January 2014. [/INST] Positive. </s>

INTERFACE INC

2016-03-02

2016-01-03

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Our revenues are derived from sales of floorcovering products, primarily modular carpet (we sold our broadloom carpet operations in August 2012). Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. During the past several years, we have successfully focused more of our marketing and sales efforts on non-corporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. Our mix of corporate office versus non-corporate office modular carpet sales in the Americas has shifted over the past several years to 44% and 56%, respectively, for 2015 compared with 64% and 36%, respectively, in 2001. Company-wide, our mix of corporate office versus non-corporate office sales was 59% and 41%, respectively, in 2015. We expect a further shift in the future as we continue to implement our market diversification strategy. During 2015, we had net sales of $1.0 billion, essentially flat as compared to $1.0 billion in 2014. Operating income for 2015 was $113.6 million as compared to $70.3 million for 2014. Net income for 2015 was $72.4 million, or $1.10 per diluted share, compared with $24.8 million, or $0.37 per diluted share, in 2014. Included in our results for 2014 are $12.4 million of restructuring and asset impairment charges, as discussed below. Also included in our results for 2014 are $9.2 million of expenses for the premiums paid to redeem our 7.625% Senior Notes as well as $2.8 million of expenses related to the unamortized debt costs for the retired notes at redemption. Included in our results for 2013 is a $7.0 million gain related to the settlement of our insurance claim related to the fire at our Australian manufacturing facility, as discussed below. Also included in our 2013 results are a one-time tax dispute resolution benefit of $1.9 million related to the execution of bilateral pricing agreements, and $1.7 million of expenses for the retirement of debt. Fire at Australia Facility In July 2012, a fire destroyed our manufacturing facility in Picton, Australia, which served customers throughout Australia and New Zealand. As a result, there were business disruptions and delays in shipments that affected sales in the region following the fire. While it is difficult to quantify the financial impacts of the fire, we believe it negatively affected net sales by approximately $13-18 million during the balance of 2012, and by approximately $18-23 million during 2013. We completed the build-out of a new manufacturing facility in Minto, Australia, which commenced operations in January 2014. For additional information on the fire, please see the Note entitled “Fire at Australian Manufacturing Facility” in Item 8 of this Report. 2014 Restructuring Plan In the third quarter of 2014, we committed to a new restructuring plan in our continuing efforts to reduce costs across our worldwide operations. In connection with this restructuring plan, we incurred a pre-tax restructuring and asset impairment charge in the third quarter of 2014 in an amount of $12.4 million. The charge was comprised of severance expenses of $9.7 million for a reduction of 100 employees, other related exit costs of $0.1 million, and a charge for impairment of assets of $2.6 million. Approximately $10 million of the charge has resulted in cash expenditures, primarily severance expense. 7.625% Senior Notes In 2010, we completed a private offering of $275 million aggregate principal amount of 7.625% Senior Notes due 2018. Interest on the 7.625% Senior Notes was payable semi-annually on June 1 and December 1 (the first payment was on June 1, 2011). In November 2013, we redeemed $27.5 million aggregate principal amount of the 7.625% Senior Notes at a price equal to 103% of the principal amount of the notes redeemed, plus accrued interest to the redemption date. In November 2014, we redeemed $27.5 million aggregate principal amount of these notes at a price equal to 103% of the principal amount of notes redeemed, plus accrued interest to the redemption date. In December 2014, we redeemed the remaining $220 million of these notes at a price equal to 103.813% of their principal amount, plus accrued interest to the redemption date. 11.375% Senior Secured Notes In 2009, we completed a private offering of $150 million aggregate principal amount of 11.375% Senior Secured Notes due 2013. Following the sale of our 7.625% Senior Notes and the repurchase of $141.9 million aggregate principal amount of our 11.375% Senior Secured Notes with the proceeds, $8.1 million aggregate principal amount of our 11.375% Senior Secured Notes remained outstanding. These remaining 11.375% Senior Secured Notes were repaid at maturity in November 2013. Analysis of Results of Operations The following discussion and analyses reflect the factors and trends discussed in the preceding sections. Our net sales that were denominated in currencies other than the U.S. dollar were approximately 48% in 2015, 51% in 2014, and 52% in 2013. Because we have such substantial international operations, we are impacted, from time to time, by international developments that affect foreign currency transactions. In 2015, the strengthening of the U.S. dollar led to a significant impact on our consolidated operations. In particular, the Euro, Australian dollar and Canadian dollar were translated at lower rates compared to prior years. The following table presents the amount (in U.S. dollars) by which the exchange rates for converting Euros, Australian dollars and Canadian dollars into U.S. dollars have affected our net sales and operating income during the past three years: The following table presents, as a percentage of net sales, certain items included in our Consolidated Statements of Operations during the past three years: Net Sales Below we provide information regarding our net sales and analyze those results for each of the last three fiscal years. Fiscal year 2015 was a 53 week period. Fiscal years 2014 and 2013 were 52-week periods. (As a result of the sale of our Bentley Prince Street Segment in 2012, we currently have only one segment for segment reporting purposes.) Net Sales for 2015 compared with 2014 For 2015, our net sales were essentially flat as compared to 2014. As discussed above, the largest global driver of this result was the significant devaluation of foreign currencies against the U.S. dollar. The approximate negative impact on sales from the decline of foreign currencies was $79.5 million, meaning that if currency levels had remained consistent year over year, our 2015 sales would have been higher by this amount. On a geographic basis, we experienced a sales increase in the Americas of 3.4%, and decreases in Europe of 5.1% and Asia-Pacific of 4.9%. The declines in Europe and Asia-Pacific are largely a result of the currency impacts discussed above. In the Americas, our weighted average selling price per square yard increased approximately 3.5% for the year, reflecting that the sales growth in the region was largely due to increased selling prices as overall sales volume remained relatively constant versus 2014. In the Americas, the sales increase in dollars occurred almost equally in the corporate office (up 4%) and hospitality (up 36%) market segments. The increase in hospitality is due to the continued sales efforts in this segment, as the Company has continued to invest resources in building our sales force in this market. The adoption rate for modular carpet in hospitality spaces has increased due to these efforts, and our sales continue to improve. The increase in the corporate office segment is due to the steady improvement in the U.S. economy as well as our conversion of customers from other flooring surfaces (such as broadloom carpet) to modular carpet. These increases were partially offset by small declines in the government (down 3%) and retail (down 1%) market segments, with sales in our other non-office market segments essentially flat. In Europe, the sales increase in local currency was 13.6%, but this was offset entirely by the impacts of a weaker Euro and, as translated into U.S. dollars, the decline was 5.1%. In local currency, the weighted average selling price per square yard for the region increased approximately 5%. In local currency, the corporate office segment was up 16%, which was largely due to the recovery in the European economy during the year which led to carpet purchases for new and refurbished office environments. In Europe, the majority of sales for the region occur in the corporate office market. In addition, we had sales increases in the retail (up 26%) and education (up 33%) market segments in Europe. The increase in education sales is due to a targeted focus on higher education customers across the region, particularly in the United Kingdom and France. The increase in the retail segment sales is due to the successes of our segmentation strategy in the region and was experienced across Europe. In Asia-Pacific, the sales decline of 4.9% as reported in U.S. dollars is reflective of the impact of the devaluation of the Australian dollar during the year. In local currency, the sales increase Asia-Pacific was approximately 5%. The weighted average selling price per square yard for the region declined approximately 7%. This percentage decline was also largely driven by the decline in the Australian dollar, as in local currency in Australia the weighted average selling price per square yard increased approximately 3% and the average selling price per square yard in Asia was down less than 1%. The sales increase in local currency in the region was driven by the corporate office segment, which is the bulk of the region’s sales. In U.S. dollars, the corporate office segment was up approximately 1%, and the hospitality segment was up nearly 12%, as the efforts to penetrate this growing market in the region continue. All other market segments in the region experienced declines for the year as compared to 2014. Net Sales for 2014 Compared with 2013 For 2014, net sales increased $43.9 million (4.6%) versus 2013. This increase primarily occurred in our Americas and Europe businesses, due largely to the continued economic recoveries in those regions. On a geographic basis, we experienced sales increases in each of our major operating regions, with the Americas up 5%, Europe up 5% (6% in local currency) and Asia-Pacific up 1% (5% in local currency). On a consolidated basis, fluctuations in currency had a small (approximately 1%) negative impact on net sales, primarily in Australia, which is within our Asia-Pacific region. In the Americas, the increase was due largely to the continued strength and recovery of the corporate office market segment, where our sales grew 4%. We also had sales growth in all non-office market segments with the exception of healthcare, which was down less than 1%. The most significant of the non-office segment increases were in the hospitality (up 55%) and residential (up 15%) segments. The sales increase in the hospitality segment is due to our continued focus on penetrating this segment through large hotel chains, with most success occurring in the U.S. The increase in the residential segment primarily occurred in the multi-family residential channel, as our FLOR consumer business experienced essentially even sales compared with 2013. The weighted average selling price per square yard in the Americas was up approximately 1% in 2014 versus 2013. In Europe, the sales increase was due primarily to growth in the corporate office market (up 9% in U.S. dollars, 11% in local currency), mostly in Western Europe and particularly in the United Kingdom and Germany. The government segment (down 10% in U.S. dollars, 8% in local currency) experienced the most significant decrease in the region, mostly due to the continued austerity measures that were in place during the year. The weighted average selling price per square yard in Europe increased approximately 4% during 2014, a result of the continued economic recovery in the region as well as the premium positioning of our products. Notably, the euro experienced a significant decline versus the U.S. dollar during the fourth quarter of 2014, and as a result our sales in Europe for that quarterly period experienced an increase of 6% in local currency but a 2% decrease as reported in U.S. dollars. In Asia-Pacific, the sales increase occurred mostly in the corporate office (up 3%), healthcare (up over 100%) and education (up 15%) market segments. However, these increases were almost entirely offset by declines in the government (down 42%) and retail (down 20%) segments. On a consolidated basis, the translation of Australian dollars into U.S. dollars had a negative impact on this region’s 2014 sales performance - in local currency, Australia sales were up more than 9%, but up only 2% as reported in U.S. dollars. This currency impact was particularly acute in the fourth quarter of 2014, when the increase in Australia dollars was approximately 20% but was approximately 11% as reported in U.S. dollars. Outside of Australia, sales in the remainder of the Asia-Pacific region were essentially flat in 2014 versus 2013. The weighted average selling price per square yard in Asia-Pacific in 2014 decreased approximately 1%, largely due to the impact of the decline of the Australian dollar versus the U.S. dollar. Cost and Expenses The following table presents our overall cost of sales and selling, general and administrative expenses during the past three years: For 2015, our cost of sales decreased $44.9 million (6.8%) compared with 2014. Fluctuations in currency exchange rates had an approximately $30 million favorable impact on our cost of sales - absent the foreign currency devaluations, our cost of sales would have declined approximately $15 million versus 2014. As a percentage of sales, our cost of sales declined to 61.8% in 2015, versus 66.1% in 2014. The primary reasons for this decline were (1) lower raw materials costs related to lower oil and related feedstock costs (raw material costs were down approximately 6-8% versus 2014), (2) higher absorption of fixed manufacturing costs associated with higher production volumes, particularly in the Americas (up 5%) and Europe (up nearly 10%), (3) continued stabilization of the supply chain and manufacturing footprint in the Asia-Pacific region with the normalization of the new carpet tile production facility in Australia during 2015 compared with 2014, (4) the resolution in 2015 of yarn supply issues that hampered the Company on a global basis in 2014, particularly during the second half of the year, and (5) a full year impact from our significant restructuring actions in the third quarter of 2014, particularly in Europe. For 2014, our cost of sales increased $45.0 million (7.3%) versus 2013. Fluctuations in currency exchange rates had a slight negative impact (1%) year over year. On a per-unit basis, we did not experience any significant difference in the cost of our raw materials in 2014 versus 2013. Most of the $45.0 million year over year increase in cost of sales was directly attributable to additional raw materials costs (approximately $30 million) and labor costs (approximately $4 million) associated with higher production volumes in 2014, particularly in the second half of the year. Of the remainder of the year over year increase, the majority is related to both the increased fixed costs as well as the inefficiencies associated with the start-up of our new and larger manufacturing facility in Australia which opened in January of 2014. These inefficiencies occurred primarily in the first six months of 2014. As a result of these items, as a percentage of sales, cost of sales increased to 66.1% in 2014, compared with 64.5% in 2013. For 2015, our selling, general and administrative (“SG&A”) expenses increased $12.0 million (4.6%) versus 2014. Currency exchange rates had a favorable impact on SG&A expenses; if currency rates had remained the same for 2015 versus that of 2014, our SG&A expenses would have been approximately $28 million higher than the 2014 levels. The largest factor driving the increase in SG&A expense increase year-over-year is additional administrative expense attributed to higher incentive-based compensation (approximately $12 million) and performance-based stock compensation (approximately $10 million), as performance targets were met in 2015 to a higher degree than in 2014. The majority of these expenses were at the corporate level and in the Americas region, and as a result they were not as impacted by foreign currency devaluations as other components of SG&A expense. These increases were offset by declines in marketing expense (down $4.1 million) and selling expense (down $2.8 million). While fluctuations in currency exchange rates were the driving factors in these declines, as a percentage of sales, selling and marketing expenses were lower in 2015, a direct result of our restructuring actions which took place in the third quarter of 2014. As a percentage of sales, our consolidated SG&A expenses increased to 26.9% in 2015 versus 25.6% in 2014. This percentage increase was entirely attributable to the performance-based stock compensation and incentive-based compensation discussed above, as absent these amounts SG&A expenses would have been lower as a percentage of sales in 2015 than in 2014. For 2014, our SG&A expenses increased $4.9 million (1.9%) versus 2013. Fluctuations in currency exchange rates did not have a significant impact on the comparison. The largest driver of the increase was $5.6 million of higher selling expenses commensurate with the sales growth in each of our three operating regions. We also had increased marketing expenses of approximately $1.2 million, split evenly between our European modular carpet business and our FLOR consumer business. The increased marketing expense in Europe related to campaigns designed to further engage the architect and design community, while the increase in our FLOR business related to web-based marketing efforts. These increases were offset by a decline in administrative expenses of approximately $1.9 million, mostly due to lower incentive compensation in 2014 versus 2013, as well as the impacts of our restructuring actions in the third quarter of 2014. The benefits of the restructuring actions were particularly evident in the fourth quarter of 2014, when our SG&A expenses, as a percentage of sales, declined to 23.8% versus 26.6% for the fourth quarter of 2013. For the full year 2014, our SG&A expenses, as a percentage of sales, declined to 25.6%, versus 26.3% in 2013. Interest Expense For 2015, our interest expense decreased $14.4 million to $6.4 million, versus $20.8 million in 2014. This substantial decrease in interest is due to the debt refinancing activities we undertook in the fourth quarter of 2014, in which we redeemed all of our $247.5 million of outstanding 7.625% Senior Notes and replaced them with borrowings under our Syndicated Credit Facility. This facility, which is comprised of a term loan as well as a multi-currency revolving debt facility, incurs interest at a significantly lower rate (currently approximately 2.0%) than the interest rate on the notes that were refinanced. In addition to the lower borrowing rates, we also reduced our borrowings under the facility by over $45 million during 2015, which contributed to our lower interest expense. For 2014, interest expense decreased $3.0 million to $20.8 million, versus $23.8 million in 2013. The primary reasons for the decrease were the redemption of $27.5 million of our 7.625% Senior Notes and the repayment at maturity of the remaining $8.1 million of our 11.375% Senior Secured Notes, each in the fourth quarter of 2013. In addition, as described above, we redeemed all of the remaining 7.625% Senior Notes in the fourth quarter of 2014, which also contributed to the interest expense decline. Although we incurred borrowings under our Syndicated Credit Facility to refinance the notes that were repaid and redeemed during 2013 and 2014, the borrowings under our Syndicated Credit Facility were at a significantly lower interest rate (less than 2.5% annually) than the interest rates on the notes that were refinanced. Tax Our effective tax rate in 2015 was 31.5%, compared with an effective tax rate of 30.6% in 2014. This increase in effective tax rate was primarily attributable to having a larger proportion of U.S. earnings in 2015, which are taxed at higher federal and state rates than our foreign earnings. The increase in effective rate was partially offset by a decrease in valuation allowances related to state net operating loss carryforwards utilized in 2015. For additional information on taxes and a reconciliation of effective tax rates to statutory tax rates, see the Note entitled “Taxes on Income” in Item 8 of this Report. Our effective tax rate in 2014 was 30.6%, compared with an effective tax rate of 30.1% in 2013. This relative consistency in effective tax rate was primarily attributable to favorable tax effects related to foreign operations realized in both years. In addition, there was less of an increase due to valuation allowances related to state net operating loss carryforwards in 2014, which offset the decrease we realized in 2013 related to the favorable settlement of our Canada-U.S. bilateral advanced pricing agreement. For additional information on taxes and a reconciliation of effective tax rates to statutory tax rates, see the Note entitled “Taxes on Income” in Item 8 of this Report. Liquidity and Capital Resources General In our business, we require cash and other liquid assets primarily to purchase raw materials and to pay other manufacturing costs, in addition to funding normal course SG&A expenses, anticipated capital expenditures, interest expense and potential special projects. We generate our cash and other liquidity requirements primarily from our operations and from borrowings or letters of credit under our Syndicated Credit Facility discussed below. We believe that we will be able to continue to enhance the generation of free cash flow through the following initiatives: ● Improving our inventory turns by continuing to implement a made-to-order model throughout our organization; ● Reducing our average days sales outstanding through improved credit and collection practices; and ● Limiting the amount of our capital expenditures generally to those projects that have a short-term payback period. Historically, we use more cash in the first half of the fiscal year, as we fund insurance premiums, tax payments, incentive compensation and inventory build-up in preparation for the holiday/vacation season of our international operations. In addition, we have a high contribution margin business with low capital expenditure requirements. Contribution margin represents variable gross profit margin less the variable component of SG&A expenses, and for us is an indicator of profit on incremental sales after the fixed components of cost of sales and SG&A expenses have been recovered. While contribution margin should not be construed as a substitute for gross margin, which is determined in accordance with GAAP, it is included herein to provide additional information with respect to our potential for profitability. In addition, we believe that investors find contribution margin to be a useful tool for measuring our profitability on an operating basis. At January 3, 2016, we had $75.7 million in cash. Approximately $14.3 million of this cash was located in the U.S., and the remaining $61.4 million was located outside of the U.S. The cash located outside of the U.S. is indefinitely reinvested in the respective jurisdictions (except as identified below). We believe that our strategic plans and business needs, particularly for working capital needs and capital expenditure requirements in Europe, Asia and Australia, support our assertion that our cash in foreign locations will be reinvested and remittance will be postponed indefinitely. Of the $61.4 million cash in foreign jurisdictions, approximately $3.6 million represents earnings which we have determined are not permanently reinvested, and as such we have provided for U.S. federal and state income taxes on these amounts in accordance with applicable accounting standards. As of January 3, 2016, we had $213.5 million of borrowings and $3.1 million in letters of credit outstanding under our Syndicated Credit Facility. Of those borrowings outstanding, $197.5 million were Term Loan A borrowings and $16.0 million were revolving loan borrowings. As of January 3, 2016, we could have incurred $230.9 million of additional revolving loan borrowings under our Syndicated Credit Facility. In addition, we could have incurred the equivalent of $14.6 million of borrowings under our other credit facilities in place at other non-U.S. subsidiaries. We have approximately $52.7 million in contractual cash obligations due by the end of fiscal year 2016, which includes, among other things, pension cash contributions, interest payments on our debt and lease commitments. Based on current interest rate and debt levels, we expect our aggregate interest expense for 2016 to be between $6 million and $8 million. We estimate aggregate capital expenditures in 2016 to be between $40 million and $50 million, although we are not committed to these amounts. In 2010, we completed a private offering of $275 million aggregate principal amount of 7.625% Senior Notes. Interest on the 7.625% Senior Notes was payable semi-annually on June 1 and December 1 (the first payment was made on June 1, 2011). In the fourth quarter of 2013, we redeemed $27.5 million aggregate principal amount of the 7.625% Senior Notes at a price equal to 103% of the principal amount of the notes redeemed, plus accrued interest to the redemption date. In the fourth quarter of 2014, we redeemed $27.5 million aggregate principal amount of the 7.625% Senior Notes at a price equal to 103% of their principal amount, plus accrued interest, and redeemed the remaining $220 million aggregate principal amount of these notes at a price equal to 103.813% of their principal amount, plus accrued interest. The redemption transactions in the fourth quarter of 2014 required an aggregate of $266.1 million (including principal payments, premiums and accrued interest), which was funded through a combination of term loan and revolving loan borrowings under the Syndicated Credit Facility and cash on hand. It is important for you to consider that we have a significant amount of indebtedness. Our Syndicated Credit Facility matures in October 2019. We cannot assure you that we will be able to renegotiate or refinance any of our debt on commercially reasonable terms, or at all. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, such as selling assets to meet our debt service obligations and other liquidity needs, or using cash, if available, that would have been used for other business purposes. Syndicated Credit Facility We have a syndicated credit facility (the “Facility”) pursuant to which the lenders provide to us and certain of our subsidiaries a multicurrency revolving credit facility and provide to us a term loan. The key features of the Facility are as follows: ● The Facility matures on October 3, 2019. ● The Facility includes (i) a multicurrency revolving loan facility made available to the Company and our principal subsidiaries in Europe and Australia not to exceed $240 million in the aggregate at any one time outstanding, and (ii) a revolving loan facility made available to our principal subsidiary in Thailand not to exceed the equivalent of $10 million in the aggregate at any one time outstanding. A sublimit of $40 million exists for the issuance of letters of credit under the Facility. ● The Facility includes $200 million of Term Loan A borrowing availability which could be used (and was in fact used) to refinance our 7.625% Senior Notes due 2018. ● The Facility provides for required amortization payments of the Term Loan A borrowing, as well as mandatory prepayments of the Term Loan A borrowing (and any term loans made available pursuant to any future multicurrency loan facility increase) from certain asset sales, casualty events and debt issuances, subject to certain qualifications and exceptions as provided for therein. ● Advances under the Facility are secured by a first-priority lien on substantially all of Interface, Inc.’s assets and the assets of each of our material domestic subsidiaries, which have guaranteed the Facility. ● The Facility contains financial covenants (specifically, a consolidated net leverage ratio and a consolidated interest coverage ratio) that must be met as of the end of each fiscal quarter. ● We have the option to increase the borrowing availability under the Facility, either for revolving loans or term loans, by up to $150 million, subject to the receipt of lender commitments for the increase and the satisfaction of certain other conditions. Interest Rates and Fees. Interest on base rate loans is charged at varying rates computed by applying a margin ranging from 0.25% to 1.50% over the applicable base interest rate (which is defined as the greatest of the prime rate, a specified federal funds rate plus 0.50%, or a specified LIBOR rate), depending on our consolidated net leverage ratio as of the most recently completed fiscal quarter. Interest on LIBOR-based loans and fees for letters of credit are charged at varying rates computed by applying a margin ranging from 1.25% to 2.50% over the applicable LIBOR rate, depending on our consolidated net leverage ratio as of the most recently completed fiscal quarter. In addition, we pay a commitment fee ranging from 0.20% to 0.35% per annum (depending on our consolidated net leverage ratio as of the most recently completed fiscal quarter) on the unused portion of the Facility. Amortization Prepayments. We are required to make amortization payments of the Term Loan A borrowing. The amortization payments are due on the last day of the calendar quarter, commencing with an initial amortization payment of $2.5 million that was made on December 31, 2015. The quarterly amortization payment amount increases to $3.75 million on December 31, 2016. Covenants. The Facility contains standard and customary covenants for agreements of this type, including various reporting, affirmative and negative covenants. Among other things, these covenants limit our ability to: ● create or incur liens on assets; ● make acquisitions of or investments in businesses (in excess of certain specified amounts); ● incur indebtedness or contingent obligations; ● sell or dispose of assets (in excess of certain specified amounts); ● pay dividends or repurchase our stock (in excess of certain specified amounts); ● repay other indebtedness prior to maturity unless we meet certain conditions; and ● enter into sale and leaseback transactions. The Facility also requires us to remain in compliance with the following financial covenants as of the end of each fiscal quarter, based on our consolidated results for the year then ended: ● Consolidated Net Leverage Ratio: Must be no greater than (i) 4.50:1.00 through and including the fiscal quarter ending December 28, 2014, (ii) 4.00:1.00 from and including the fiscal quarter ending April 5, 2015 through and including the fiscal quarter ending January 3, 2016, and (iii) 3.75:1.00 for each fiscal quarter thereafter. ● Consolidated Interest Coverage Ratio: Must be no less than 2.25:1.00 as of the end of any fiscal quarter. Events of Default. If we breach or fail to perform any of the affirmative or negative covenants under the Facility, or if other specified events occur (such as a bankruptcy or similar event or a change of control of Interface, Inc. or certain subsidiaries, or if we breach or fail to perform any covenant or agreement contained in any instrument relating to any of our other indebtedness exceeding $20 million), after giving effect to any applicable notice and right to cure provisions, an event of default will exist. If an event of default exists and is continuing, the lenders’ Administrative Agent may, and upon the written request of a specified percentage of the lender group shall: ● declare all commitments of the lenders under the facility terminated; ● declare all amounts outstanding or accrued thereunder immediately due and payable; and ● exercise other rights and remedies available to them under the agreement and applicable law. Collateral. Pursuant to a Security and Pledge Agreement executed on the same date, the Facility is secured by substantially all of the assets of Interface, Inc. and our domestic subsidiaries (subject to exceptions for certain immaterial subsidiaries), including all of the stock of our domestic subsidiaries and up to 65% of the stock of our first-tier material foreign subsidiaries. If an event of default occurs under the Facility, the lenders’ Administrative Agent may, upon the request of a specified percentage of lenders, exercise remedies with respect to the collateral, including, in some instances, foreclosing mortgages on real estate assets, taking possession of or selling personal property assets, collecting accounts receivables, or exercising proxies to take control of the pledged stock of domestic and first-tier material foreign subsidiaries. As of January 3, 2016, we had $197.5 million of Term Loan A borrowings and $16.0 million of revolving loan borrowings outstanding under the Facility, and had $3.1 million in letters of credit outstanding under the Facility. We are presently in compliance with all covenants under the Syndicated Credit Facility and anticipate that we will remain in compliance with the covenants for the foreseeable future. Senior Notes As described above, all of our remaining 7.625% Senior Notes were redeemed in full in the fourth quarter of 2014, and our remaining 11.375% Senior Secured Notes were repaid at maturity in the fourth quarter of 2013. Analysis of Cash Flows We exited 2015 with $75.7 million in cash, an increase of $20.8 million during the year. The increase in cash was primarily due to improved cash flow from operating activities of $125.4 million in 2015, compared with $46.4 million in 2014. The factors driving the increase in cash flow from operating activities were (1) higher net income in 2015 due to improved operational performance, (2) a $16.2 million reduction in cash paid for interest, as a result of our 2014 debt refinancing discussed above, (3) an $18.7 million reduction in accounts receivable, and (4) a $14.5 million increase in accounts payable and accrued expenses. The increase in cash from operating activities was partially offset by an increase in inventories of $26.5 million and an increase in prepaid expenses and other assets of $8.3 million. Our other primary uses of cash during 2015 were (1) $45.3 million of repayments of revolving loan borrowings under our Syndicated Credit Facility, (2) $27.2 million of capital expenditures, primary related to our manufacturing locations, (3) $13.3 million used to repurchase and retire 650,000 shares of our outstanding common stock, pursuant to our established share repurchase plan, (4) $11.9 million for the payment of dividends, and (5) $2.5 million for repayment of term loan borrowings under our Syndicated Credit Facility as required by the applicable amortization schedule. Our primary sources of cash during 2014 were: (1) $200 million of Term Loan A borrowings and $48.9 million of revolving loan borrowings under our Syndicated Credit Facility; (2) $15.4 million due to an increase in accounts payable and accruals; and (3) $2.8 million due to a decrease in prepaid expenses and other current assets. Our primary uses of cash during 2014 were: (1) $256.8 million used to redeem our formerly outstanding 7.625% Senior Notes (comprised of $247.5 million for principal payments, and $9.3 million for premium payments); (2) $29.3 million due to an increase in accounts receivable; (3) $9.9 million used to repay a portion of our outstanding revolving loan borrowings under our Syndicated Credit Facility; (4) $9.3 million used to pay dividends on our common stock; and (5) $7.7 million used to repurchase 500,000 shares of our common stock. Our primary sources of cash during 2013 were: (1) $56.0 million of proceeds received from our insurance company on our claim related to the fire at our Australia manufacturing facility in 2012; (2) $26.3 million of borrowings under our Syndicated Credit Facility; and (3) $3.5 million due to a reduction in accounts receivable. Our primary uses of cash in 2013 were: (1) $91.9 million of capital expenditures, which included expenditures for the purchase and build-out of our new manufacturing facility in Minto, Australia; (2) $35.6 million of cash used to retire the remainder ($8.1 million aggregate principal amount) of our 11.375% Senior Secured Notes and a portion ($27.5 million aggregate principal amount) of our 7.625% Senior Notes; and (3) $17.3 million due to a decrease in accounts payable and accruals. We believe that our liquidity position will provide sufficient funds to meet our current commitments and other cash requirements for the foreseeable future. Funding Obligations We have various contractual obligations that we must fund as part of our normal operations. The following table discloses aggregate information about our contractual obligations and the periods in which payments are due. The amounts and time periods are measured from January 3, 2016. ______________________ (1) Our capital lease obligations are insignificant. (2) Expected interest payments to be made in future periods reflect anticipated interest payments related to the $197.5 million of Term Loan A borrowings outstanding and the $16.0 million of revolving loan borrowings outstanding under our Syndicated Credit Facility as of January 3, 2016. We have also assumed in the presentation above that these borrowings will remain outstanding until maturity. (3) Unconditional purchase obligations do not include unconditional purchase obligations that are included as liabilities in our Consolidated Balance Sheet. Our capital expenditure commitments are not significant. (4) We have two foreign defined benefit plans and a domestic salary continuation plan. We have presented above the estimated cash obligations that will be paid under these plans over the next ten years. Such amounts are based on several estimates and assumptions and could differ materially should the underlying estimates and assumptions change. Our domestic salary continuation plan is an unfunded plan, and we do not currently have any commitments to make contributions to this plan. However, we do use insurance instruments to hedge our exposure under the salary continuation plan. Contributions to our other employee benefit plans are at our discretion. (5) The above table does not reflect unrecognized tax benefits of $28.3 million, the timing of which payments are uncertain. See the Note entitled “Taxes on Income” in Item 8 of this Report for further information. Critical Accounting Policies The policies discussed below are considered by management to be critical to an understanding of our consolidated financial statements because their application places the most significant demands on management’s judgment, with financial reporting results relying on estimations about the effects of matters that are inherently uncertain. Specific risks for these critical accounting policies are described in the following paragraphs. For all of these policies, management cautions that future events may not develop as forecasted, and the best estimates routinely require adjustment. Revenue Recognition. The vast majority of our revenue is recognized at the date of shipment when the following criteria are met: persuasive evidence of an agreement exists, price to the buyer is fixed and determinable, and collectability is reasonably assured. Delivery is not considered to have occurred until the customer takes title and assumes the risks and rewards of ownership, which is generally on the date of shipment. Provisions for discounts, sales returns and allowances are estimated using historical experience, current economic trends, and the Company’s quality performance. The related provision is recorded as a reduction of sales and cost of sales in the same period that the revenue is recognized. Accordingly, our estimates and assumptions regarding revenue recognition primarily relate to sales returns and allowances, which historically have been in the range of 2.5-3.0% of gross sales. Over the last several years, we have not experienced any significant fluctuation in sales returns and allowances, our estimates and assumptions related thereto have not changed significantly, and we believe our estimates and assumptions to be reasonably accurate. Management also believes this past experience can be relied upon for such estimates and assumptions in future periods, as our business model and customer mix have not changed significantly. A small percentage (approximately 5%) of our revenue relates to flooring installation projects, which generally involve short time periods (typically less than two weeks) and therefore present little risk of material difference due to changes in experience. Shipping and handling fees billed to customers are classified in net sales in the consolidated statements of operations. Shipping and handling costs incurred are classified in cost of sales in the consolidated statements of operations. Impairment of Long-Lived Assets. Long-lived assets are reviewed for impairment at the asset group level whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If the sum of the expected future undiscounted cash flow is less than the carrying amount of the asset, an impairment is indicated. A loss is then recognized for the difference, if any, between the fair value of the asset (as estimated by management using its best judgment) and the carrying value of the asset. If actual market value is less favorable than that estimated by management, additional write-downs may be required. Deferred Income Tax Assets and Liabilities. The carrying values of deferred income tax assets and liabilities reflect the application of our income tax accounting policies in accordance with applicable accounting standards, and are based on management’s assumptions and estimates regarding future operating results and levels of taxable income, as well as management’s judgment regarding the interpretation of the provisions of applicable accounting standards. The carrying values of liabilities for income taxes currently payable are based on management’s interpretations of applicable tax laws, and incorporate management’s assumptions and judgments regarding the use of tax planning strategies in various taxing jurisdictions. The use of different estimates, assumptions and judgments in connection with accounting for income taxes may result in materially different carrying values of income tax assets and liabilities and results of operations. We evaluate the recoverability of these deferred tax assets by assessing the adequacy of future expected taxable income from all sources, including reversal of taxable temporary differences, forecasted operating earnings and available tax planning strategies. These sources of income inherently rely heavily on estimates. We use our historical experience and our short and long-term business forecasts to provide insight. Further, our global business portfolio gives us the opportunity to employ various prudent and feasible tax planning strategies to facilitate the recoverability of future deductions. To the extent we do not consider it more likely than not that a deferred tax asset will be recovered, a valuation allowance is established. As of January 3, 2016 and December 28, 2014, we had approximately $26.2 million and $100.1 million of U.S. federal net operating loss carryforwards, respectively. In addition, as of January 3, 2016 and December 28, 2014, we had state net operating loss carryforwards of $139.3 million and $209.0 million, respectively. As of January 3, 2016 and December 28, 2014, we had approximately $3.7 million and $4.0 million of foreign net operating loss carryforwards, respectively. Certain of these carryforwards are reserved with a valuation allowance because, based on the available evidence, we believe it is more likely than not that we would not be able to utilize those deferred tax assets in the future. The remaining year-end 2015 amounts are expected to be fully recoverable within the applicable statutory expiration periods. If the actual amounts of taxable income differ from our estimates, the amount of our valuation allowance could be materially impacted. Goodwill. Pursuant to applicable accounting standards, we test goodwill for impairment at least annually using a two step approach. In the first step of this approach, we prepare valuations of reporting units, using both a market comparable approach and an income approach, and those valuations are compared with the respective book values of the reporting units to determine whether any goodwill impairment exists. In preparing the valuations, past, present and expected future performance is considered. If impairment is indicated in this first step of the test, a step two valuation approach is performed. The step two valuation approach compares the implied fair value of goodwill to the book value of goodwill. The implied fair value of goodwill is determined by allocating the estimated fair value of the reporting unit to the assets and liabilities of the reporting unit, including both recognized and unrecognized intangible assets, in the same manner as goodwill is determined in a business combination under applicable accounting standards. After completion of this step two test, a loss is recognized for the difference, if any, between the fair value of the goodwill associated with the reporting unit and the book value of that goodwill. If the actual fair value of the goodwill is determined to be less than that estimated, an additional write-down may be required. During the fourth quarters of 2015, 2014 and 2013, we performed the annual goodwill impairment test. We perform this test at the reporting unit level. For our reporting units which carried a goodwill balance as of January 3, 2016, no impairment of goodwill was indicated. As of January 3, 2016, if our estimates of the fair value of our reporting units were 10% lower, we believe no additional goodwill impairment would have existed. Inventories. We determine the value of inventories using the lower of cost or market. We write down inventories for the difference between the carrying value of the inventories and their net realizable value. If actual market conditions are less favorable than those projected by management, additional write-downs may be required. We estimate our reserves for inventory obsolescence by continuously examining our inventories to determine if there are indicators that carrying values exceed net realizable values. Experience has shown that significant indicators that could require the need for additional inventory write-downs are the age of the inventory, the length of its product life cycles, anticipated demand for our products and current economic conditions. While we believe that adequate write-downs for inventory obsolescence have been made in the consolidated financial statements, consumer tastes and preferences will continue to change and we could experience additional inventory write-downs in the future. Our inventory reserve on January 3, 2016 and December 28, 2014, was $15.5 million and $14.8 million, respectively. To the extent that actual obsolescence of our inventory differs from our estimate by 10%, our 2015 net income would be higher or lower by approximately $1.0 million, on an after-tax basis. Pension Benefits. Net pension expense recorded is based on, among other things, assumptions about the discount rate, estimated return on plan assets and salary increases. While management believes these assumptions are reasonable, changes in these and other factors and differences between actual and assumed changes in the present value of liabilities or assets of our plans above certain thresholds could cause net annual expense to increase or decrease materially from year to year. The actuarial assumptions used in our salary continuation plan and our foreign defined benefit plans reporting are reviewed periodically and compared with external benchmarks to ensure that they appropriately account for our future pension benefit obligation. The expected long-term rate of return on plan assets assumption is based on weighted average expected returns for each asset class. Expected returns reflect a combination of historical performance analysis and the forward-looking views of the financial markets, and include input from actuaries, investment service firms and investment managers. The table below represents the changes to the projected benefit obligation as a result of changes in discount rate assumptions: Environmental Remediation. We provide for environmental remediation costs and penalties when the responsibility to remediate is probable and the amount of associated costs is reasonably determinable. Remediation liabilities are accrued based on estimates of known environmental exposures and are discounted in certain instances. We regularly monitor the progress of environmental remediation. Should studies indicate that the cost of remediation is to be more than previously estimated, an additional accrual would be recorded in the period in which such determination is made. As of January 3, 2016, no significant amounts were provided for remediation liabilities. Allowances for Doubtful Accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of customers to make required payments. Estimating this amount requires us to analyze the financial strengths of our customers. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. By its nature, such an estimate is highly subjective, and it is possible that the amount of accounts receivable that we are unable to collect may be different than the amount initially estimated. Our allowance for doubtful accounts on January 3, 2016 and December 28, 2014, was $4.5 million and $5.9 million, respectively. To the extent the actual collectability of our accounts receivable differs from our estimates by 10%, our 2015 net income would be higher or lower by approximately $0.3 million, on an after-tax basis, depending on whether the actual collectability was better or worse, respectively, than the estimated allowance. Product Warranties. We typically provide limited warranties with respect to certain attributes of our carpet products (for example, warranties regarding excessive surface wear, edge ravel and static electricity) for periods ranging from ten to twenty years, depending on the particular carpet product and the environment in which the product is to be installed. We typically warrant that any services performed will be free from defects in workmanship for a period of one year following completion. In the event of a breach of warranty, the remedy typically is limited to repair of the problem or replacement of the affected product. We record a provision related to warranty costs based on historical experience and periodically adjust these provisions to reflect changes in actual experience. Our warranty and sales allowance reserve on January 3, 2016 and December 28, 2014, was $4.8 million and $4.0 million, respectively. Actual warranty expense incurred could vary significantly from amounts that we estimate. To the extent the actual warranty expense differs from our estimates by 10%, our 2015 net income would be higher or lower by approximately $0.3 million, on an after-tax basis, depending on whether the actual expense is lower or higher, respectively, than the estimated provision. Off-Balance Sheet Arrangements We are not a party to any material off-balance sheet arrangements. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”) issued an accounting standard regarding recognition of revenue from contracts with customers. In summary, the core principle of this standard is that an entity recognizes revenue from the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance for this standard was initially effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. However, in August of 2015, the FASB delayed the effective date of the standard for one full year. While we are currently reviewing this new standard, we do not believe that the adoption of this standard will have a material impact on our financial condition or results of operations. In January 2015, the FASB issued an accounting standard which eliminates the concept of extraordinary items from generally accepted accounting principles. The standard does not affect disclosure guidance for events or transactions that are unusual in nature or infrequent in their occurrence. The standard is effective for interim and annual periods in fiscal years beginning after December 15, 2015. The standard allows prospective or retrospective application. Early adoption is permitted if applied from the beginning of the fiscal year of adoption. We do not believe the adoption of this standard will have any significant effect on our ongoing financial reporting. In February 2015, the FASB issued an accounting standard which changes the way reporting enterprises evaluate whether (a) they should consolidate limited partnerships and similar entities, (b) fees paid to a decision maker or service provider are variable interests in a variable interest entity (“VIE”), and (c) variable interests in a VIE held by related parties of the reporting enterprise require the reporting enterprise to consolidate the VIE. The new accounting standard is effective for annual and interim periods in fiscal years beginning after December 15, 2015. We are currently evaluating the impact, if any, this standard will have on our ongoing financial reporting, but we do not believe the adoption of this standard will have any significant effect on our ongoing financial reporting. In April 2015, the FASB issued an accounting standard to simplify the presentation of debt issuance costs. This accounting standard requires debt issuance costs to be presented on the balance sheet as a direct reduction from the carrying amount of the related debt liability. In August 2015, the FASB issued an accounting standard update that allows the presentation of debt issuance costs related to line-of-credit arrangements as an asset on the balance sheet under the simplified guidance, regardless of whether there are any outstanding borrowings on the related arrangements. The guidance in these accounting standards is to be applied retrospectively and is effective for interim and annual reporting periods beginning after December 15, 2015. As these standards relate to presentation only, we do not believe the adoption of these accounting standards will have a material impact on our financial statements. In July 2015, the FASB issued an accounting standard to simplify the accounting for inventory. This standard requires all inventories to be measured at the lower of cost and net realizable value, except for inventory that is accounted for using the LIFO or the retail inventory method, which will be measured under existing accounting standards. The new guidance must be applied on a prospective basis and is effective for fiscal years beginning after December 15, 2016, with early adoption permitted. We are currently evaluating the impact of the adoption of this new standard and do not expect it to have a material impact on our consolidated financial statements. In November 2015, the FASB issued an accounting standard which requires deferred tax assets and liabilities, as well as any related valuation allowance, be classified as noncurrent on the balance sheet. As a result, each jurisdiction will only have one net noncurrent deferred tax asset or liability. This standard does not change the existing requirement that only permits offsetting within a jurisdiction. The amendments in the standard may be applied either prospectively or retrospectively to all prior periods presented. The new guidance is effective for annual periods beginning after December 15, 2016, and interim periods within those annual periods, with early adoption permitted. As this standard impacts only presentation, we do not expect it to have any significant effect on our consolidated financial statements. In February 2016, the FASB issued a new accounting standard regarding leases. The new standard establishes a right-of-use (ROU) model that requires a lessee to record a ROU asset and a lease liability on the balance sheet for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. The new standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. We are currently evaluating the impact of our pending adoption of the new standard on our consolidated financial statements.

<s>[INST] General Our revenues are derived from sales of floorcovering products, primarily modular carpet (we sold our broadloom carpet operations in August 2012). Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. During the past several years, we have successfully focused more of our marketing and sales efforts on noncorporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. Our mix of corporate office versus noncorporate office modular carpet sales in the Americas has shifted over the past several years to 44% and 56%, respectively, for 2015 compared with 64% and 36%, respectively, in 2001. Companywide, our mix of corporate office versus noncorporate office sales was 59% and 41%, respectively, in 2015. We expect a further shift in the future as we continue to implement our market diversification strategy. During 2015, we had net sales of $1.0 billion, essentially flat as compared to $1.0 billion in 2014. Operating income for 2015 was $113.6 million as compared to $70.3 million for 2014. Net income for 2015 was $72.4 million, or $1.10 per diluted share, compared with $24.8 million, or $0.37 per diluted share, in 2014. Included in our results for 2014 are $12.4 million of restructuring and asset impairment charges, as discussed below. Also included in our results for 2014 are $9.2 million of expenses for the premiums paid to redeem our 7.625% Senior Notes as well as $2.8 million of expenses related to the unamortized debt costs for the retired notes at redemption. Included in our results for 2013 is a $7.0 million gain related to the settlement of our insurance claim related to the fire at our Australian manufacturing facility, as discussed below. Also included in our 2013 results are a onetime tax dispute resolution benefit of $1.9 million related to the execution of bilateral pricing agreements, and $1.7 million of expenses for the retirement of debt. Fire at Australia Facility In July 2012, a fire destroyed our manufacturing facility in Picton, Australia, which served customers throughout Australia and New Zealand. As a result, there were business disruptions and delays in shipments that affected sales in the region following the fire. While it is difficult to quantify the financial impacts of the fire, we believe it negatively affected net sales by approximately $1318 million during the balance of 2012, and by approximately $1823 million during 2013. We completed the buildout of a new manufacturing facility in Minto, Australia, which commenced operations in January 2014. For additional information on the fire, please see the Note entitled “Fire at Australian Manufacturing Facility” in Item 8 of this Report. 2014 Restructuring Plan In the third quarter of 2014, we committed to a new restructuring plan in our continuing efforts to reduce costs across our worldwide operations. In connection with this restructuring plan, we incurred a pretax restructuring and asset impairment charge in the third quarter of 2014 in an amount of $12.4 million. The charge was comprised of severance expenses of $9.7 million for a reduction of 100 employees, other related exit costs of $0.1 million, and a [/INST] Positive. </s>

INTERFACE INC

2017-03-02

2017-01-01

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Our revenues are derived from sales of floorcovering products, primarily modular carpet. Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. During the past several years, we have successfully focused more of our marketing and sales efforts on non-corporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. Our mix of corporate office versus non-corporate office modular carpet sales in the Americas has shifted over the past several years to 44% and 56%, respectively, for 2016 compared with 64% and 36%, respectively, in 2001. Company-wide, our mix of corporate office versus non-corporate office sales was 59% and 41%, respectively, in 2016. We expect a further shift in the future as we continue to implement our market diversification strategy. During 2016, we had net sales of $958.6 million, down 4.3% compared to $1.0 billion in 2015. Operating income for 2016 was $84.9 million as compared to $113.6 million for 2015. Net income for 2016 was $ 54.2 million, or $0.83 per share, compared with $72.4 million, or $1.10 per diluted share in 2015. Included in our results for 2016 is a restructuring and asset impairment charge of $19.8 million, as discussed below. During 2015, we had net sales of $1.0 billion, essentially flat as compared to $1.0 billion in 2014. Operating income for 2015 was $113.6 million as compared to $70.3 million for 2014. Net income for 2015 was $72.4 million, or $1.10 per diluted share, compared with $24.8 million, or $0.37 per diluted share, in 2014. Included in our results for 2014 are $12.4 million of restructuring and asset impairment charges, as discussed below. Also included in our results for 2014 are $9.2 million of expenses for the premiums paid to redeem our 7.625% Senior Notes as well as $2.8 million of expenses related to the unamortized debt costs for the retired notes at redemption. Fire at Australia Facility In July 2012, a fire destroyed our manufacturing facility in Picton, Australia, which served customers throughout Australia and New Zealand. We completed the build-out of a new manufacturing facility in Minto, Australia, which commenced operations in January 2014. 2016 Restructuring Plan In the fourth quarter of 2016, we committed to a new restructuring plan in our continuing efforts to improve efficiencies and decrease costs across our worldwide operations, and more closely align our operating structure with our business strategy. The plan involves (i) a substantial restructuring of the FLOR business model that includes closure of its headquarters office and most retail FLOR stores, (ii) a reduction of approximately 70 FLOR employees and a number of employees in the commercial carpet tile business, primarily in the Americas and Europe regions, and (iii) the write-down of certain underutilized and impaired assets that include information technology assets, intellectual property assets, and obsolete manufacturing, office and retail store equipment. As a result of this plan, we incurred a pre-tax restructuring and asset impairment charge of $19.8 million in the fourth quarter of 2016, and we expect to record an additional charge in the first quarter of 2017 of approximately $7-9 million. (The charge in the first quarter of 2017 is primarily related to exit costs associated with the FLOR retail stores, a majority of which are expected to stay open for the first quarter of 2017.) The aggregate amount of the charges is expected to be approximately $27-29 million, estimated to be comprised of severance expenses ($10-11 million), lease exit costs ($6-8 million), impairment of assets ($9-10 million) and other items (approximately $1 million). Approximately $17 million of the anticipated charges is expected to result in future cash expenditures, primarily for severance payments (approximately $10 million) and lease exit costs (approximately $7 million). We expect the restructuring plan to be substantially completed in the first half of 2017. 2014 Restructuring Plan In the third quarter of 2014, we committed to a new restructuring plan in our continuing efforts to reduce costs across our worldwide operations. In connection with this restructuring plan, we incurred a pre-tax restructuring and asset impairment charge in the third quarter of 2014 in an amount of $12.4 million. The charge was comprised of severance expenses of $9.7 million for a reduction of 100 employees, other related exit costs of $0.1 million, and a charge for impairment of assets of $2.6 million. Approximately $10 million of the charge has resulted in cash expenditures, primarily severance expense. 7.625% Senior Notes In 2010, we completed a private offering of $275 million aggregate principal amount of 7.625% Senior Notes due 2018. In 2013, we redeemed $27.5 million aggregate principal amount of the 7.625% Senior Notes at a price equal to 103% of the principal amount of the notes redeemed, plus accrued interest to the redemption date. In November 2014, we redeemed $27.5 million aggregate principal amount of these notes at a price equal to 103% of the principal amount of notes redeemed, plus accrued interest to the redemption date. In December 2014, we redeemed the remaining $220 million of these notes at a price equal to 103.813% of their principal amount, plus accrued interest to the redemption date. Analysis of Results of Operations The following discussion and analyses reflect the factors and trends discussed in the preceding sections. Our net sales that were denominated in currencies other than the U.S. dollar were approximately 48% in 2016 and 2015, and 51% in 2014. Because we have such substantial international operations, we are impacted, from time to time, by international developments that affect foreign currency transactions. During 2016, our sales and operating income were negatively impacted by the strengthening of the U.S. dollar and euro against the British Pound Sterling, with smaller impacts due to weakening of the Australian dollar and Canadian dollar against the U.S. dollar. In 2015, the strengthening of the U.S. dollar led to a significant impact on our consolidated operations. In particular, the euro, Australian dollar and Canadian dollar were translated at lower rates compared to prior years. The following table presents the amount (in U.S. dollars) by which the exchange rates for converting euros, Australian dollars and Canadian dollars into U.S. dollars have affected our net sales and operating income during the past three years: The following table presents, as a percentage of net sales, certain items included in our Consolidated Statements of Operations during the past three years: Net Sales Below we provide information regarding our net sales and analyze those results for each of the last three fiscal years. Fiscal year 2015 was a 53-week period. Fiscal years 2016 and 2014 were 52-week periods. Net sales for 2016 compared with 2015 For 2016, our net sales declined $43.3 million (4.3%) as compared to 2015. Fluctuations in currency exchange rates had a negative impact on the comparison of approximately $10.9 million, meaning that if currency levels had remained constant year over year, our 2016 sales would have been higher by this amount. On a geographic basis, we experienced sales declines in the Americas (down 4.2%) and Europe (down 8.1%), partially offset by an increase of 2% in Asia-Pacific. In the Americas, our weighted average selling price per square yard increased approximately 1% in 2016 compared with 2015. The sales decline in the Americas was experienced across the majority of our customer segments, with the most significant decline occurring in the corporate office segment (down 5%), which is the largest single customer segment in the Americas. We saw lower levels of customer orders during the first three quarters of the year, although this trend somewhat reversed during the fourth quarter, as sales in the corporate segment were effectively flat for the quarter. We also experienced a decline in the residential market segment of 15%, due largely to the performance of our FLOR consumer business. Other declines were seen in the government (down 19%) and retail (down 5%) market segments. The decline in government segment sales in the region was primarily a result of reduced order activity in light of the election cycle. The hospitality market segment in the region increased 11% versus 2015, as we continue to convert customers to modular carpet. In Europe, our weighted average selling price per square meter declined approximately 3% in 2016 compared with 2015. The largest single factor impacting our performance in this region was the turmoil surrounding the decision of the United Kingdom to exit the European Union. This had a significant negative impact on our sales performance in the United Kingdom, which has historically been our third largest market. Not only were sales impacted by the uncertainty around the exit vote, the significant decline in the British Pound led to a translation effect on sales in the U.K. as reported in U.S. dollars. In local currency, the sales decline in the U.K. was 13%, but when translated into U.S. dollars the decline was over 25%. This decrease was partially offset by double digit increases in other countries, notably Germany, Spain and Italy. On a market segment basis, the decline was most significant in the corporate office market (down 6%), which represents the majority of sales within Europe. With the exception of the hospitality (up 19%) and healthcare (up 17%) market segments, all other non-office market segments in the region were down year over year, with the most significant declines occurring in the education (down 29%) and government (down 13%) market segments. In the Asia-Pacific region, our weighted average selling price per square meter declined approximately 1% in 2016 compared with 2015. The 2% sales increase in the region was evenly split between Australia and Asia, with both geographic markets seeing a 2% increase in revenue. In local currency, the increase in Australia was approximately 3%. The increase in sales in the Asia-Pacific region was experienced in the corporate office market segment (up 5%), which represents the majority of sales within the region. This increase was a result of large development projects that led to increases in the first half of the year, particularly in Australia. The only other market segment in the region that experienced an increase of significance was the hospitality segment (up 24%), due to investment in additional selling resources in the region which led to greater market share. Within the region, the sales increases in corporate and hospitality segments were offset by declines in the retail (down 31%) and education (down 11%) market segments. Net Sales for 2015 compared with 2014 For 2015, our net sales were essentially flat as compared to 2014. As discussed above, the largest global driver of this result was the significant devaluation of foreign currencies against the U.S. dollar. The approximate negative impact on sales from the decline of foreign currencies was $79.5 million, meaning that if currency levels had remained consistent year over year, our 2015 sales would have been higher by this amount. On a geographic basis, we experienced a sales increase in the Americas of 3.4%, and decreases in Europe of 5.1% and Asia-Pacific of 4.9%. The declines in Europe and Asia-Pacific are largely a result of the currency impacts discussed above. In the Americas, our weighted average selling price per square yard increased approximately 3.5% for the year, reflecting that the sales growth in the region was largely due to increased selling prices as overall sales volume remained relatively constant versus 2014. In the Americas, the sales increase in dollars occurred almost equally in the corporate office (up 4%) and hospitality (up 36%) market segments. The increase in hospitality is due to the continued sales efforts in this segment, as the Company has continued to invest resources in building our sales force in this market. The adoption rate for modular carpet in hospitality spaces has increased due to these efforts, and our sales continue to improve. The increase in the corporate office segment is due to the steady improvement in the U.S. economy as well as our conversion of customers from other flooring surfaces (such as broadloom carpet) to modular carpet. These increases were partially offset by small declines in the government (down 3%) and retail (down 1%) market segments, with sales in our other non-office market segments essentially flat. In Europe, the sales increase in local currency was 13.6%, but this was offset entirely by the impacts of a weaker Euro and, as translated into U.S. dollars, the decline was 5.1%. In local currency, the weighted average selling price per square yard for the region increased approximately 5%. In local currency, the corporate office segment was up 16%, which was largely due to the recovery in the European economy during the year which led to carpet purchases for new and refurbished office environments. In Europe, the majority of sales for the region occur in the corporate office market. In addition, we had sales increases in the retail (up 26%) and education (up 33%) market segments in Europe. The increase in education sales is due to a targeted focus on higher education customers across the region, particularly in the United Kingdom and France. The increase in the retail segment sales is due to the successes of our segmentation strategy in the region and was experienced across Europe. In Asia-Pacific, the sales decline of 4.9% as reported in U.S. dollars is reflective of the impact of the devaluation of the Australian dollar during the year. In local currency, the sales increase Asia-Pacific was approximately 5%. The weighted average selling price per square yard for the region declined approximately 7%. This percentage decline was also largely driven by the decline in the Australian dollar, as in local currency in Australia the weighted average selling price per square yard increased approximately 3% and the average selling price per square yard in Asia was down less than 1%. The sales increase in local currency in the region was driven by the corporate office segment, which is the bulk of the region’s sales. In U.S. dollars, the corporate office segment was up approximately 1%, and the hospitality segment was up nearly 12%, as the efforts to penetrate this growing market in the region continue. All other market segments in the region experienced declines for the year as compared to 2014. Cost and Expenses The following table presents our overall cost of sales and selling, general and administrative expenses during the past three years: For 2016, our cost of sales decreased $29.0 million (4.7%) compared with 2015. Fluctuations in currency exchange rates did not have a significant impact (less than 1%) on the comparison. In absolute dollars, the decrease in cost of sales was due to lower sales and production versus the prior year, as production for 2016 was down 11% in Americas, 3% in Europe and 3% in Asia-Pacific versus 2015. As a percentage of sales, our cost of sales declined to 61.5% in 2016 versus 61.8% in 2015. The most significant reason for this decline was lower raw materials costs during the year as a result of lower feedstock prices for our raw materials, primarily yarn. These lower prices produced a benefit in cost of sales of approximately $12 million, meaning that our raw materials costs for 2016 were lower by this amount. We also experienced more favorable production and utilization efficiencies in 2016 versus 2015. Our cost of sales was, however, negatively impacted by approximately $5 million in the second half of 2016, as there were additional costs within our Americas business as a result of the transition to a new centralized warehouse and distribution center operated by a third party for the region. We believe this situation has stabilized and will not continue to significantly impact our cost of sales in 2017. For 2015, our cost of sales decreased $44.9 million (6.8%) compared with 2014. Fluctuations in currency exchange rates had an approximately $30 million favorable impact on our cost of sales - absent the foreign currency devaluations, our cost of sales would have declined approximately $15 million versus 2014. As a percentage of sales, our cost of sales declined to 61.8% in 2015, versus 66.1% in 2014. The primary reasons for this decline were (1) lower raw materials costs related to lower oil and related feedstock costs (raw material costs were down approximately 6-8% versus 2014), (2) higher absorption of fixed manufacturing costs associated with higher production volumes, particularly in the Americas (up 5%) and Europe (up nearly 10%), (3) continued stabilization of the supply chain and manufacturing footprint in the Asia-Pacific region with the normalization of the new carpet tile production facility in Australia during 2015 compared with 2014, (4) the resolution in 2015 of yarn supply issues that hampered the Company on a global basis in 2014, particularly during the second half of the year, and (5) a full year impact from our significant restructuring actions in the third quarter of 2014, particularly in Europe. For 2016, our selling, general and administrative (“SG&A”) expenses decreased $5.4 million (2.0%) versus 2016. Currency fluctuations had only a slight (less than 1%) favorable impact on SG&A expenses. On an absolute dollar basis, the decrease was almost entirely related to lower administrative expenses of $9.4 million resulting from lower incentive-based compensation, including share-based compensation, due to performance targets not being met in 2016 to the same degree as in 2015. These declines were primarily at the corporate and Americas level. Other declines were lower selling expenses of $1.2 million due to reduced commissions on lower sales volumes. These decreases were partially offset by higher marketing expenses in 2016 of approximately $5.2 million, as we continued to expand our marketing efforts related to the early rollout of our modular resilient flooring (“MRF”) products as well as other initiatives to drive product adoption. These marketing increases were most significant in the Americas region (up $1.7 million) due to the MRF rollout and in the Asia-Pacific region (up $1.9 million), primarily in Asia related to additional customer events, product rollout support and increased marketing management. Despite the overall decline in SG&A expenses in absolute dollars, due to the lower sales in 2016 versus 2015 our SG&A expenses increased as a percentage of sales to 27.5% in 2016 versus 26.9% in 2015, as the decline in SG&A expenses was less than the decline in net sales. We expect SG&A expenses to decline as a percentage of sales in 2017 due to the restructuring activities discussed above. For 2015, our SG&A expenses increased $12.0 million (4.6%) versus 2014. Currency exchange rates had a favorable impact on SG&A expenses; if currency rates had remained the same for 2015 versus that of 2014, our SG&A expenses would have been approximately $28 million higher than the 2014 levels. The largest factor driving the increase in SG&A expense increase year-over-year is additional administrative expense attributed to higher incentive-based compensation (approximately $12 million) and performance-based stock compensation (approximately $10 million), as performance targets were met in 2015 to a higher degree than in 2014. The majority of these expenses were at the corporate level and in the Americas region, and as a result they were not as impacted by foreign currency devaluations as other components of SG&A expense. These increases were offset by declines in marketing expense (down $4.1 million) and selling expense (down $2.8 million). While fluctuations in currency exchange rates were the driving factors in these declines, as a percentage of sales, selling and marketing expenses were lower in 2015, a direct result of our restructuring actions which took place in the third quarter of 2014. As a percentage of sales, our consolidated SG&A expenses increased to 26.9% in 2015 versus 25.6% in 2014. This percentage increase was entirely attributable to the performance-based stock compensation and incentive-based compensation discussed above, as absent these amounts SG&A expenses would have been lower as a percentage of sales in 2015 than in 2014. Interest Expense For 2016, our interest expense decreased $0.3 million to $6.1 million, versus $6.4 million in 2015. This decrease was due to lower average outstanding debt balances in 2016 versus 2015. During 2016, we repaid a net amount of $6.2 million under our Syndicated Credit Facility, and this lower level of debt led to lower interest expense during 2016. We did incur additional Syndicated Credit Facility borrowings of approximately $63.5 million in December of 2016, but this debt was outstanding for only the final month of 2016 and did not have a significant impact on interest expense (less than $0.1 million). For 2015, our interest expense decreased $14.4 million to $6.4 million, versus $20.8 million in 2014. This substantial decrease in interest is due to the debt refinancing activities we undertook in the fourth quarter of 2014, in which we redeemed all of our $247.5 million of outstanding 7.625% Senior Notes and replaced them with borrowings under our Syndicated Credit Facility. This facility, which is comprised of a term loan as well as a multi-currency revolving debt facility, incurs interest at a significantly lower rate (currently approximately 2.0%) than the interest rate on the notes that were refinanced. In addition to the lower borrowing rates, we also reduced our borrowings under the facility by over $45 million during 2015, which contributed to our lower interest expense. Tax Our effective tax rate in 2016 was 31.6%, compared with an effective tax rate of 31.5% in 2015. The 2016 effective tax rate was favorably impacted by a higher portion of income earned in foreign jurisdictions which are taxed at lower tax rates than the U.S federal tax rate. The favorable impact to the 2016 effective tax rate was offset by a decrease in the release of valuation allowances related to state net operating loss carryforwards utilized in 2016 compared to 2015. For additional information on taxes and a reconciliation of effective tax rates to statutory tax rates, see the Note entitled “Taxes on Income” in Item 8 of this Report. Our effective tax rate in 2015 was 31.5%, compared with an effective tax rate of 30.6% in 2014. This increase in effective tax rate was primarily attributable to having a larger proportion of U.S. earnings in 2015, which are taxed at higher federal and state rates than our foreign earnings. The increase in effective rate was partially offset by a release in valuation allowances related to state net operating loss carryforwards utilized in 2015. For additional information on taxes and a reconciliation of effective tax rates to statutory tax rates, see the Note entitled “Taxes on Income” in Item 8 of this Report. Liquidity and Capital Resources General In our business, we require cash and other liquid assets primarily to purchase raw materials and to pay other manufacturing costs, in addition to funding normal course SG&A expenses, anticipated capital expenditures, interest expense and potential special projects. We generate our cash and other liquidity requirements primarily from our operations and from borrowings or letters of credit under our Syndicated Credit Facility discussed below. We believe that we will be able to continue to enhance the generation of free cash flow through the following initiatives: ● Improving our inventory turns by continuing to implement a made-to-order model throughout our organization; ● Reducing our average days sales outstanding through improved credit and collection practices; and ● Limiting the amount of our capital expenditures generally to those projects that have a short-term payback period. Historically, we use more cash in the first half of the fiscal year, as we fund insurance premiums, tax payments, incentive compensation and inventory build-up in preparation for the holiday/vacation season of our international operations. In addition, we have a high contribution margin business with low capital expenditure requirements. Contribution margin represents variable gross profit margin less the variable component of SG&A expenses, and for us is an indicator of profit on incremental sales after the fixed components of cost of sales and SG&A expenses have been recovered. While contribution margin should not be construed as a substitute for gross margin, which is determined in accordance with GAAP, it is included herein to provide additional information with respect to our potential for profitability. In addition, we believe that investors find contribution margin to be a useful tool for measuring our profitability on an operating basis. In December 2016, one of the Company’s foreign subsidiaries borrowed 61 million euros (approximately $63.5 million) under the Syndicated Credit Facility. The funds were distributed to its U.S. parent company to fund current and projected U.S. cash needs. A significant portion of these borrowings are expected to be repaid (but is not required to be repaid) in the first quarter of 2017. At January 1, 2017, we had $165.7 million in cash. Approximately $69.5 million of this cash was located in the U.S., and the remaining $96.2 million was located outside of the U.S. The cash located outside of the U.S. is indefinitely reinvested in the respective jurisdictions (except as identified below). We believe that our strategic plans and business needs, particularly for working capital needs and capital expenditure requirements in Europe, Asia and Australia, support our assertion that our cash in foreign locations will be reinvested and remittance will be postponed indefinitely. Of the $96.2 million of cash in foreign jurisdictions, approximately $4.8 million represents earnings which we have determined are not permanently reinvested, and as such we have provided for U.S. federal and state income taxes on these amounts in accordance with applicable accounting standards. As of January 1, 2017, we had $270.3 million of borrowings and $2.9 million in letters of credit outstanding under our Syndicated Credit Facility. Of those borrowings outstanding, $185.0 million were Term Loan A borrowings and $85.3 million were revolving loan borrowings. As of January 1, 2017, we could have incurred $161.7 million of additional revolving loan borrowings under our Syndicated Credit Facility. In addition, we could have incurred the equivalent of $14.8 million of borrowings under our other credit facilities in place at other non-U.S. subsidiaries. We have approximately $81.6 million in contractual cash obligations due by the end of fiscal year 2017, which includes, among other things, pension cash contributions, interest payments on our debt and lease commitments. Based on current interest rate and debt levels, we expect our aggregate interest expense for 2017 to be between $6 million and $9 million. We estimate aggregate capital expenditures in 2017 to be between $55 million and $65 million, although we are not committed to these amounts. In 2010, we completed a private offering of $275 million aggregate principal amount of 7.625% Senior Notes. In 2013, we redeemed $27.5 million aggregate principal amount of the 7.625% Senior Notes at a price equal to 103% of the principal amount of the notes redeemed, plus accrued interest to the redemption date. In 2014, we redeemed $27.5 million aggregate principal amount of the 7.625% Senior Notes at a price equal to 103% of their principal amount, plus accrued interest, and redeemed the remaining $220 million aggregate principal amount of these notes at a price equal to 103.813% of their principal amount, plus accrued interest. The redemption transactions in 2014 required an aggregate of $266.1 million (including principal payments, premiums and accrued interest), which was funded through a combination of term loan and revolving loan borrowings under the Syndicated Credit Facility and cash on hand. It is important for you to consider that we have a significant amount of indebtedness. Our Syndicated Credit Facility matures in October 2019. We cannot assure you that we will be able to renegotiate or refinance any of our debt on commercially reasonable terms, or at all. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, such as selling assets to meet our debt service obligations and other liquidity needs, or using cash, if available, that would have been used for other business purposes. It is also important for you to consider that borrowings under our Syndicated Credit Facility comprise the substantial majority of our indebtedness, and that these borrowings are based on variable interest rates (as described below) that expose the Company to the risk that short-term interest may increase. For information regarding the current variable interest rates of these borrowings and the potential impact on our interest expense from hypothetical increases in short term interest rates, please see the discussion under the heading 'Interest Rate Risk' in

<s>[INST] General Our revenues are derived from sales of floorcovering products, primarily modular carpet. Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. During the past several years, we have successfully focused more of our marketing and sales efforts on noncorporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. Our mix of corporate office versus noncorporate office modular carpet sales in the Americas has shifted over the past several years to 44% and 56%, respectively, for 2016 compared with 64% and 36%, respectively, in 2001. Companywide, our mix of corporate office versus noncorporate office sales was 59% and 41%, respectively, in 2016. We expect a further shift in the future as we continue to implement our market diversification strategy. During 2016, we had net sales of $958.6 million, down 4.3% compared to $1.0 billion in 2015. Operating income for 2016 was $84.9 million as compared to $113.6 million for 2015. Net income for 2016 was $ 54.2 million, or $0.83 per share, compared with $72.4 million, or $1.10 per diluted share in 2015. Included in our results for 2016 is a restructuring and asset impairment charge of $19.8 million, as discussed below. During 2015, we had net sales of $1.0 billion, essentially flat as compared to $1.0 billion in 2014. Operating income for 2015 was $113.6 million as compared to $70.3 million for 2014. Net income for 2015 was $72.4 million, or $1.10 per diluted share, compared with $24.8 million, or $0.37 per diluted share, in 2014. Included in our results for 2014 are $12.4 million of restructuring and asset impairment charges, as discussed below. Also included in our results for 2014 are $9.2 million of expenses for the premiums paid to redeem our 7.625% Senior Notes as well as $2.8 million of expenses related to the unamortized debt costs for the retired notes at redemption. Fire at Australia Facility In July 2012, a fire destroyed our manufacturing facility in Picton, Australia, which served customers throughout Australia and New Zealand. We completed the buildout of a new manufacturing facility in Minto, Australia, which commenced operations in January 2014. 2016 Restructuring Plan In the fourth quarter of 2016, we committed to a new restructuring plan in our continuing efforts to improve efficiencies and decrease costs across our worldwide operations, and more closely align our operating structure with our business strategy. The plan involves (i) a substantial restructuring of the FLOR business model that includes closure of its headquarters office and most retail FLOR stores, (ii) a reduction of approximately 70 FLOR employees and a number of employees in the commercial carpet tile business, primarily in the Americas and Europe regions, and (iii) the writedown of certain underutilized and impaired assets that include information technology assets, intellectual property assets, and obsolete manufacturing, office and retail store equipment. As a result of this plan, we incurred a pretax restructuring and asset impairment [/INST] Positive. </s>

INTERFACE INC

2018-03-01

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Our revenues are derived from sales of floorcovering products, primarily modular carpet and luxury vinyl tile (“LVT”). Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. Most of our sales are to customers in the corporate office market segment, but we also focus our marketing and sales efforts on non-corporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. Our mix of corporate office versus non-corporate office modular carpet sales in the Americas was 44% and 56%, respectively, for 2017. Company-wide, our mix of corporate office versus non-corporate office sales was 59% and 41%, respectively, in 2017. During 2017, we had net sales of $996.4 million, up 3.9% compared to $958.6 million in 2016. Operating income for 2017 was $109.8 million as compared to $84.9 million in 2016. Net income for 2017 was $53.2 million, or $0.86 per share, compared with $54.2 million, or $0.83 per share, in 2016. Included in our results for 2017 were $7.3 million of restructuring and asset impairment charges as well as $15.2 million of tax charges related to the recently enacted U.S. Tax Cuts and Jobs Act. Please see Item 8, Note 13 “Taxes on Income” for further discussion of these tax charges. During 2016, we had net sales of $958.6 million, down 4.3% compared to $1.0 billion in 2015. Operating income for 2016 was $84.9 million as compared to $113.6 million for 2015. Net income for 2016 was $54.2 million, or $0.83 per share, compared with $72.4 million, or $1.10 per share, in 2015. Included in our results for 2016 was a restructuring and asset impairment charge of $19.8 million, as discussed below. 2016 Restructuring Plan In the fourth quarter of 2016, we committed to a new restructuring plan in our continuing efforts to improve efficiencies and decrease costs across our worldwide operations, and more closely align our operating structure with our business strategy. The plan involved (i) a substantial restructuring of the FLOR business model that included closure of its headquarters office and most retail FLOR stores, (ii) a reduction of approximately 70 FLOR employees and a number of employees in the commercial carpet tile business, primarily in the Americas and Europe regions, and (iii) the write-down of certain underutilized and impaired assets that included information technology assets, intellectual property assets, and obsolete manufacturing, office and retail store equipment. As a result of this plan, we incurred a pre-tax restructuring and asset impairment charge in the fourth quarter of 2016 of $19.8 million. In connection with this plan, in the first quarter of 2017, the Company recorded an additional charge of $7.3 million, primarily related to exit costs associated with the closure of most FLOR retail stores in the first quarter of 2017. The charge in the fourth quarter of 2016 was comprised of $10.1 million of severance charges, $8.0 million of asset impairment charges and lease exit costs of $1.7 million. The charge in the first quarter of 2017 was comprised of lease exit costs of $3.4 million, asset impairment charges of $3.3 million and severance charges of $0.6 million. Approximately $16 million of the charges were expected to result in cash expenditures, primarily for severance payments (approximately $11 million) and lease exit costs (approximately $5 million). This restructuring plan was substantially completed in 2017. Analysis of Results of Operations The following discussion and analyses reflect the factors and trends discussed in the preceding sections. Our net sales that were denominated in currencies other than the U.S. dollar were approximately 46% in 2017, and 48% in 2016 and 2015. Because we have such substantial international operations, we are impacted, from time to time, by international developments that affect foreign currency transactions. In 2017, the strengthening of the euro, Australian dollar and Canadian dollar had a small positive impact on our net sales and operating income. During 2016, our sales and operating income were negatively impacted by the strengthening of the U.S. dollar and euro against the British Pound Sterling, with smaller impacts due to weakening of the Australian dollar and Canadian dollar against the U.S. dollar. In 2015, the strengthening of the U.S. dollar led to a significant impact on our consolidated operations. In particular, the euro, Australian dollar and Canadian dollar were translated at lower rates compared to prior years. The following table presents the amounts (in U.S. dollars) by which the exchange rates for converting euros, Australian dollars and Canadian dollars into U.S. dollars have affected our net sales and operating income during the past three years: The following table presents, as a percentage of net sales, certain items included in our Consolidated Statements of Operations during the past three years: Net Sales Below we provide information regarding our net sales and analyze those results for each of the last three fiscal years. Fiscal year 2015 was a 53-week period. Fiscal years 2017 and 2016 were 52-week periods. Net sales for 2017 compared with 2016 For 2017, our net sales increased $37.8 million (3.9%) as compared to 2016. Fluctuations in currency exchange rates had a positive impact on the comparison of approximately $5.5 million, meaning that if currency levels had remained constant year over year our 2017 sales would have been lower by this amount. On a geographic basis, we experienced sales growth across all our regions. Sales in the Americas were up 3.5%, sales in Europe were up 2.0% in U.S. dollars (1.5% increase in local currencies), and sales in Asia-Pacific were up 8.7%. In the Americas, our weighted average selling price per square yard for our modular carpet decreased 1% in 2017 as compared to 2016. The sales increase in the Americas was due primarily to the introduction of our LVT products in early 2017, as our modular carpet sales in the Americas declined versus 2016. This decline in modular carpet sales was due entirely to the closure of our FLOR specialty retail stores in the first quarter of 2017, as our commercial modular business was up approximately 1% in 2017 as compared to 2016. The corporate office market segment increased 2% for the year. Other market segments showing growth were the government (up 19%), retail (up 5%) and education (up 4%) market segments. The increase in the government market segment was seen across most government customers, with sales to state and municipal governments representing the most significant increase. The increase in retail was due to the performance of our Interface SERVICES™ business, which has a larger percentage of its sales to the retail segment. These increases were offset by declines in the hospitality (down 7%) and healthcare (down 6%) market segments. In Europe, our weighted average selling price per square meter increased 3% in 2017 compared with 2016. Sales in the region were up in both U.S. dollars (2%) and local currency (1.5%). Within the region, the weakening of the British Pound versus the euro had a negative impact on sales, however this was offset by the strengthening of the euro versus the U.S. dollar during 2017 as compared to 2016. The United Kingdom, which has historically been our third largest market, experienced a sales increase in local currency of 3% for the year, but a decline of 2% when translated into U.S. dollars. We also experienced growth in Germany in 2017, but this was partially offset by other declines in central Europe. The increase in sales was entirely within the corporate office market segment (up 3%) as no other market segment had a significant increase in sales. The corporate office market comprises the majority of sales in the Europe region. This increase was partially offset by declines in the retail (down 17%), education (down 12%), and residential (down 52%) market segments. In Asia-Pacific, our weighted average selling price increased 5.6% for the year, with the appreciation of the Australian dollar having a positive impact on this increase. Within the region, Asia sales increased 5% while Australia sales increased 12% as translated into U.S. dollars. As noted, the appreciation of the Australian dollar had a positive impact on the sales increase, as in local currency sales in Australia increased 9%. The increase in sales for the region was primarily due to the strength of the corporate office market (which comprises the bulk of the region’s sales and was up 8%). Other non-office market segments showing growth for the year were education (up 16%) and healthcare (up 36%). The increase in the education segment was due to our success in the Australian education market, a result of increased government education spending in the market, as well as growth of student accommodation projects at the university level. These increases were only slightly offset by declines in the retail, government and residential market segments. Net sales for 2016 compared with 2015 For 2016, our net sales declined $43.3 million (4.3%) as compared to 2015. Fluctuations in currency exchange rates had a negative impact on the comparison of approximately $10.9 million, meaning that if currency levels had remained constant year over year, our 2016 sales would have been higher by this amount. On a geographic basis, we experienced sales declines in the Americas (down 4.2%) and Europe (down 8.1%), partially offset by an increase of 2% in Asia-Pacific. In the Americas, our weighted average selling price per square yard increased approximately 1% in 2016 compared with 2015. The sales decline in the Americas was experienced across the majority of our customer segments, with the most significant decline occurring in the corporate office segment (down 5%), which is the largest single customer segment in the Americas. We saw lower levels of customer orders during the first three quarters of the year, although this trend somewhat reversed during the fourth quarter, as sales in the corporate segment were effectively flat for the quarter. We also experienced a decline in the residential market segment of 15%, due largely to the performance of our FLOR consumer business. Other declines were seen in the government (down 19%) and retail (down 5%) market segments. The decline in government segment sales in the region was primarily a result of reduced order activity in light of the election cycle. The hospitality market segment in the region increased 11% versus 2015, as we continued to convert customers to modular carpet. In Europe, our weighted average selling price per square meter declined approximately 3% in 2016 compared with 2015. The largest single factor impacting our performance in this region was the turmoil surrounding the decision of the United Kingdom to exit the European Union. This had a significant negative impact on our sales performance in the United Kingdom, which has historically been our third largest market. Not only were sales impacted by the uncertainty around the exit vote, the significant decline in the British Pound led to a translation effect on sales in the U.K. as reported in U.S. dollars. In local currency, the sales decline in the U.K. was 13%, but when translated into U.S. dollars the decline was over 25%. This decrease was partially offset by double digit increases in other countries, notably Germany, Spain and Italy. On a market segment basis, the decline was most significant in the corporate office market (down 6%), which represents the majority of sales within Europe. With the exception of the hospitality (up 19%) and healthcare (up 17%) market segments, all other non-office market segments in the region were down year over year, with the most significant declines occurring in the education (down 29%) and government (down 13%) market segments. In the Asia-Pacific region, our weighted average selling price per square meter declined approximately 1% in 2016 compared with 2015. The 2% sales increase in the region was evenly split between Australia and Asia, with both geographic markets seeing a 2% increase in revenue. In local currency, the increase in Australia was approximately 3%. The increase in sales in the Asia-Pacific region was experienced in the corporate office market segment (up 5%), which represents the majority of sales within the region. This increase was a result of large development projects that led to increases in the first half of the year, particularly in Australia. The only other market segment in the region that experienced an increase of significance was the hospitality segment (up 24%), due to investment in additional selling resources in the region which led to greater market share. Within the region, the sales increases in corporate and hospitality segments were offset by declines in the retail (down 31%) and education (down 11%) market segments. Cost and Expenses The following table presents our overall cost of sales and selling, general and administrative expenses during the past three years: For 2017, our costs of sales increased $20.4 million (3.5%) compared with 2016. Fluctuations in currency exchange rates did not have a significant impact (less than 1%) on the comparison. In absolute dollars, the increase in costs of sales was a result of the higher sales for 2017 as compared to 2016. As noted above, sales increased 3.9% in 2017. As a percentage of sales, our costs of sales improved to 61.3% in 2017 versus 61.5% in 2016. This improvement was a result of (1) productivity initiatives, including our investment in our manufacturing facilities in LaGrange Georgia, (2) lower cost of sales as a percentage of sales due to the introduction of our LVT product offerings, which commanded margins in 2017 that were accretive to our modular carpet products, and (3) non-recurring charges in 2016 related to the transition to a centralized warehouse and distribution center in our Americas business. These benefits were partially offset by (1) higher raw materials costs due to input cost inflation, particularly in our European business, and (2) negative gross margin impacts due to the exit of our FLOR specialty retail business. Our FLOR business delivers higher gross margins than our commercial business, and with the closure of the specialty retail stores the decline in sales had a negative impact on our cost of sales as a percentage of sales. For 2016, our cost of sales decreased $29.0 million (4.7%) compared with 2015. Fluctuations in currency exchange rates did not have a significant impact (less than 1%) on the comparison. In absolute dollars, the decrease in cost of sales was due to lower sales and production versus the prior year, as production for 2016 was down 11% in Americas, 3% in Europe and 3% in Asia-Pacific versus 2015. As a percentage of sales, our cost of sales declined to 61.5% in 2016 versus 61.8% in 2015. The most significant reason for this decline was lower raw materials costs during the year as a result of lower feedstock prices for our raw materials, primarily yarn. These lower prices produced a benefit in cost of sales of approximately $12 million, meaning that our raw materials costs for 2016 were lower by this amount. We also experienced more favorable production and utilization efficiencies in 2016 versus 2015. Our cost of sales was, however, negatively impacted by approximately $5 million in the second half of 2016, as there were additional costs within our Americas business as a result of the transition to a new centralized warehouse and distribution center operated by a third party for the region. For 2017, our SG&A expenses increased $5.0 million (1.9%) versus 2016. Currency fluctuations had only a slight (less than 1%) unfavorable impact on SG&A expenses. The increase in SG&A expenses during the year was due to (1) higher incentive-based compensation (approximately $6 million) and performance-based stock compensation (approximately $1.5 million) as performance targets were met to a higher degree in 2017 as comparted to 2016, and (2) higher administrative expenses of $5 million as we centralize certain support functions. These increases were partially offset by (1) lower marketing expenses of $3.9 million, a result of our restructuring efforts as well as global consolidation of costs for marketing expenditures leading to lower levels of total spend, and (2) lower selling costs of $4.2 million due primarily to exiting our FLOR specialty retail business in 2017. Despite the higher SG&A expense in absolute dollars, due to the increase in sales noted above, SG&A expenses declined as a percentage of sales in 2017 to 27.0% versus 27.5% in 2016. For 2016, our SG&A expenses decreased $5.4 million (2.0%) versus 2015. Currency fluctuations had only a slight (less than 1%) favorable impact on SG&A expenses. On an absolute dollar basis, the decrease was almost entirely related to lower administrative expenses of $9.4 million resulting from lower incentive-based compensation, including share-based compensation, due to performance targets not being met in 2016 to the same degree as in 2015. These declines were primarily at the corporate and Americas level. Other declines were lower selling expenses of $1.2 million due to reduced commissions on lower sales volumes. These decreases were partially offset by higher marketing expenses in 2016 of approximately $5.2 million, as we continued to expand our marketing efforts related to the early rollout of our modular resilient flooring (“MRF”) products as well as other initiatives to drive product adoption. These marketing increases were most significant in the Americas region (up $1.7 million) due to the MRF rollout and in the Asia-Pacific region (up $1.9 million), primarily in Asia related to additional customer events, product rollout support and increased marketing management. Despite the overall decline in SG&A expenses in absolute dollars, due to the lower sales in 2016 versus 2015 our SG&A expenses increased as a percentage of sales to 27.5% in 2016 versus 26.9% in 2015, as the decline in SG&A expenses was less than the decline in net sales. Interest Expense For 2017, our interest expense increased $1.0 million to $7.1 million, versus $6.1 million in 2016. This increase was a result of (1) higher average interest rates under our Syndicated Credit Facility during 2017 (the average interest rate for 2016 was 2.5% as compared to 2.9% for 2017), and (2) in 2017 we fixed the variable interest rate on $100 million of our term loan borrowings under the Syndicated Credit Facility by entering into an interest rate swap transaction. The effect of this interest rate swap was to increase the interest rate on the $100 million notional amount of the swap above the variable rate in effect for our other term loan borrowings under the Syndicated Credit Facility. For 2016, our interest expense decreased $0.3 million to $6.1 million, versus $6.4 million in 2015. This decrease was due to lower average outstanding debt balances in 2016 versus 2015. During 2016, we repaid a net amount of $6.2 million under our Syndicated Credit Facility, and this lower level of debt led to lower interest expense during 2016. We did incur additional Syndicated Credit Facility borrowings of approximately $63.5 million in December of 2016, but this debt was outstanding for only the final month of 2016 and did not have a significant impact on interest expense (less than $0.1 million). Tax On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the “Tax Act”) was enacted into law. Among the significant changes resulting from the law, the Tax Act reduces the U.S. federal income tax rate from 35% to 21% effective January 1, 2018 and creates a modified territorial tax system with a one-time mandatory “transition tax” on previously unrepatriated foreign earnings. Due to the tax legislation, the Company has recorded a provisional tax expense of $3.5 million related to the remeasurement of its net deferred tax assets. The Company also recorded a provisional tax expense of $11.7 million related to the one-time transition toll tax. These amounts are considered provisional because they use reasonable estimates of which tax returns have not been filed and because estimated amounts may be impacted by future regulatory and accounting guidance if and when issued. The Company will adjust these provisional amounts as further information becomes available and as we refine our calculations. Please see Item 8, Note 13 entitled “Taxes on Income” for further information on the financial statement impact of the Tax Act. Our effective tax rate in 2017 was 47.0%, compared with an effective tax rate of 31.6% in 2016. The increase in our effective tax rate in 2017 compared to 2016 was primarily due to a $15.2 million tax charge for the impacts of the Tax Act as discussed above and an increase in U.S. earnings resulting in more U.S. state tax expense. Our effective tax rate in 2016 was 31.6%, compared with an effective tax rate of 31.5% in 2015. The 2016 effective tax rate was favorably impacted by a higher portion of income earned in foreign jurisdictions which are taxed at lower tax rates than the U.S federal tax rate. The favorable impact to the 2016 effective tax rate was offset by a decrease in the release of valuation allowances related to state net operating loss carryforwards utilized in 2016 compared to 2015. For additional information on taxes and a reconciliation of effective tax rates to statutory tax rates, see the Note 13 entitled “Taxes on Income” in Item 8 of this Report. Liquidity and Capital Resources General In our business, we require cash and other liquid assets primarily to purchase raw materials and to pay other manufacturing costs, in addition to funding normal course SG&A expenses, anticipated capital expenditures, interest expense and potential special projects. We generate our cash and other liquidity requirements primarily from our operations and from borrowings or letters of credit under our Syndicated Credit Facility discussed below. Historically, we use more cash in the first half of the fiscal year, as we pay insurance premiums, taxes and incentive compensation and build up inventory in preparation for the holiday/vacation season of our international operations. In December 2016, one of the Company’s foreign subsidiaries borrowed 61 million euros (approximately $63.5 million) under the Syndicated Credit Facility. The funds were distributed to its U.S. parent company to fund then-current and projected U.S. cash needs. A significant portion of these borrowings were repaid in the first quarter of 2017. At December 31, 2017, we had $87.0 million in cash. Approximately $14.1 million of this cash was located in the U.S., and the remaining $72.9 million was located outside of the U.S. The cash located outside of the U.S. is indefinitely reinvested in the respective jurisdictions (except as identified below). We believe that our strategic plans and business needs, particularly for working capital needs and capital expenditure requirements in Europe, Asia, Canada, and Australia, support our assertion that a portion of our cash in foreign locations will be reinvested and remittance will be postponed indefinitely. Of the $72.9 million of cash in foreign jurisdictions, approximately $43.0 million represents earnings which we have determined are not permanently reinvested, and as such we have provided for foreign withholding and U.S. state income taxes on these amounts in accordance with applicable accounting standards. As of December 31, 2017, we had $229.9 million of borrowings and $6.0 million in letters of credit outstanding under our Syndicated Credit Facility. Of those borrowings outstanding, $170.0 million were Term Loan A borrowings and $59.9 million were revolving loan borrowings. As of December 31, 2017, we could have incurred $184.1 million of additional revolving loan borrowings under our Syndicated Credit Facility. In addition, we could have incurred the equivalent of $9.8 million of borrowings under our other credit facilities in place at other non-U.S. subsidiaries. We have approximately $95.0 million in contractual cash obligations due by the end of fiscal year 2018, which includes, among other things, pension cash contributions, interest payments on our debt and lease commitments. Based on current interest rate and debt levels, we expect our aggregate interest expense for 2018 to be between $8 million and $11 million. We estimate aggregate capital expenditures in 2018 to be between $50 million and $60 million, although we are not committed to these amounts. It is important for you to consider that we have a significant amount of indebtedness. Our Syndicated Credit Facility matures in August of 2022. We cannot assure you that we will be able to renegotiate or refinance any of our debt on commercially reasonable terms, or at all. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, such as selling assets to meet our debt service obligations and other liquidity needs, or using cash, if available, that would have been used for other business purposes. It is also important for you to consider that borrowings under our Syndicated Credit Facility comprise the substantial majority of our indebtedness, and that these borrowings are based on variable interest rates (as described below) that expose the Company to the risk that short-term interest may increase. We have, however, entered into an interest rate swap transaction to fix the variable interest rate with respect to $100 million of the term loan borrowings under the Syndicated Credit Facility. For information regarding the current variable interest rates of these borrowings, the potential impact on our interest expense from hypothetical increases in short term interest rates, and the interest rate swap transaction, please see the discussion in

<s>[INST] General Our revenues are derived from sales of floorcovering products, primarily modular carpet and luxury vinyl tile (“LVT”). Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. Most of our sales are to customers in the corporate office market segment, but we also focus our marketing and sales efforts on noncorporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. Our mix of corporate office versus noncorporate office modular carpet sales in the Americas was 44% and 56%, respectively, for 2017. Companywide, our mix of corporate office versus noncorporate office sales was 59% and 41%, respectively, in 2017. During 2017, we had net sales of $996.4 million, up 3.9% compared to $958.6 million in 2016. Operating income for 2017 was $109.8 million as compared to $84.9 million in 2016. Net income for 2017 was $53.2 million, or $0.86 per share, compared with $54.2 million, or $0.83 per share, in 2016. Included in our results for 2017 were $7.3 million of restructuring and asset impairment charges as well as $15.2 million of tax charges related to the recently enacted U.S. Tax Cuts and Jobs Act. Please see Item 8, Note 13 “Taxes on Income” for further discussion of these tax charges. During 2016, we had net sales of $958.6 million, down 4.3% compared to $1.0 billion in 2015. Operating income for 2016 was $84.9 million as compared to $113.6 million for 2015. Net income for 2016 was $54.2 million, or $0.83 per share, compared with $72.4 million, or $1.10 per share, in 2015. Included in our results for 2016 was a restructuring and asset impairment charge of $19.8 million, as discussed below. 2016 Restructuring Plan In the fourth quarter of 2016, we committed to a new restructuring plan in our continuing efforts to improve efficiencies and decrease costs across our worldwide operations, and more closely align our operating structure with our business strategy. The plan involved (i) a substantial restructuring of the FLOR business model that included closure of its headquarters office and most retail FLOR stores, (ii) a reduction of approximately 70 FLOR employees and a number of employees in the commercial carpet tile business, primarily in the Americas and Europe regions, and (iii) the writedown of certain underutilized and impaired assets that included information technology assets, intellectual property assets, and obsolete manufacturing, office and retail store equipment. As a result of this plan, we incurred a pretax restructuring and asset impairment charge in the fourth quarter of 2016 of $19.8 million. In connection with this plan, in the first quarter of 2017, the Company recorded an additional charge of $7.3 million, primarily related to exit costs associated with the closure of most FLOR retail stores in the first quarter of 2017. The charge in the fourth quarter of 2016 was comprised of $10.1 million of severance charges, $8.0 million of [/INST] Positive. </s>

INTERFACE INC

2019-02-28

2018-12-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Our revenues are derived from sales of floorcovering products, primarily modular carpet, luxury vinyl tile (“LVT”) and starting in August 2018, rubber flooring products. Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. Most of our sales are to customers in the corporate office market segment, but we also focus our marketing and sales efforts on non-corporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. Our mix of corporate office versus non-corporate office modular carpet and LVT sales in the Americas was 45% and 55%, respectively, for 2018. Company-wide, our mix of corporate office versus non-corporate office modular carpet and LVT sales was 60% and 40%, respectively, in 2018. On August 7, 2018, the Company completed the acquisition of nora for a purchase price of €385.1 million, or $447.2 million at the exchange rate as of the transaction date, including acquired cash of €40.0 million ($46.5 million) for a net purchase price of €345.1 million ($400.7 million). Nora is an industry leader in the rubber flooring market, and this acquisition is expected to advance the Company’s growth strategy in expanding market segments, particularly in the healthcare, life sciences and education market segments. Similar to Interface, nora operates on an international footprint and the Company expects the acquisition will also allow for geographic sales synergies as well. During 2018, we had net sales of $1,179.6 million, up 18.4% compared to $996.4 million in 2017. Operating income for 2018 was $76.4 million as compared to $111.6 million in 2017. Net income for 2018 was $50.3 million, or $0.84 per share, compared with $53.2 million, or $0.86 per share, in 2017. The 2018 period includes the results of the acquired nora business from August 7 through the end of the year, including nora net sales of $112.6 million during that stub period. These results included amortization related to the fair value of inventory acquired of $26.7 million, and amortization of acquired intangible assets of $5.4 million. 2018 also includes $9.5 million related to nora transaction expenses. Also included in our results for 2018 were $20.5 million of restructuring and asset impairment charges as well as $6.7 million of tax benefits related to the finalization of our analysis of the U.S. Tax Cuts and Jobs Act enacted in 2017. Please see Item 8, Note 15 “Taxes on Income” for further discussion of these tax benefits. During 2017, we had net sales of $996.4 million, up 3.9% compared to $958.6 million in 2016. Operating income for 2017 was $109.8 million as compared to $84.9 million in 2016. Net income for 2017 was $53.2 million, or $0.86 per share, compared with $54.2 million, or $0.83 per share, in 2016. Included in our results for 2017 were $7.3 million of restructuring and asset impairment charges as well as $15.2 million of tax charges related to the U.S. Tax Cuts and Jobs Act enacted in 2017. Please see Item 8, Note 15 “Taxes on Income” for further discussion of these tax charges. Restructuring Plans On December 29, 2018, the Company committed to a new restructuring plan in its continuing efforts to improve efficiencies and decrease costs across its worldwide operations, and more closely align its operating structure with its business strategy. The plan involves (i) a restructuring of its sales and administrative operations in the United Kingdom, (ii) a reduction of approximately 200 employees, primarily in the Europe and Asia-Pacific geographic regions, and (iii) the write-down of certain underutilized and impaired assets that include information technology assets and obsolete manufacturing equipment. As a result of this plan, the Company recorded a pre-tax restructuring and asset impairment charge in the fourth quarter of 2018 of approximately $20.5 million. The charge is comprised of severance expenses (approximately $10.8 million), impairment of assets (approximately $8.6 million) and other items (approximately $1.1 million). The charge is expected to result in future cash expenditures of $12 million, primarily for severance payments (approximately $10.8 million). The restructuring plan is expected to be substantially completed in the first half of 2019, and is expected to yield gross annual savings of approximately $12 million beginning in fiscal 2019. The Company expects to redeploy in 2019 essentially all of the anticipated savings toward the funding of sales and strategic growth initiatives, yielding negligible net savings on the Company’s income statement. In the fourth quarter of 2016, we committed to a separate restructuring plan. The plan involved (i) a substantial restructuring of the FLOR business model that included closure of its headquarters office and most retail FLOR stores, (ii) a reduction of approximately 70 FLOR employees and a number of employees in the commercial carpet tile business, primarily in the Americas and Europe regions, and (iii) the write-down of certain underutilized and impaired assets that included information technology assets, intellectual property assets, and obsolete manufacturing, office and retail store equipment. As a result of the 2016 restructuring plan, we incurred a pre-tax restructuring and asset impairment charge in the fourth quarter of 2016 of $19.8 million. In connection with this plan, in the first quarter of 2017, the Company recorded an additional charge of $7.3 million, primarily related to exit costs associated with the closure of most FLOR retail stores in the first quarter of 2017. The charge in the fourth quarter of 2016 was comprised of $10.1 million of severance charges, $8.0 million of asset impairment charges and lease exit costs of $1.7 million. The charge in the first quarter of 2017 was comprised of lease exit costs of $3.4 million, asset impairment charges of $3.3 million and severance charges of $0.6 million. This 2016 restructuring plan was substantially completed in 2017. Analysis of Results of Operations The following discussion and analyses reflect the factors and trends discussed in the preceding sections. Our net sales that were denominated in currencies other than the U.S. dollar were approximately 49% in 2018, 46% in 2017, and 48% in 2016. Because we have such substantial international operations, we are impacted, from time to time, by international developments that affect foreign currency transactions. In 2018, the strengthening of the Euro and British pound against the U.S. dollar had a positive impact on our net sales and operating income. In 2017, the strengthening of the Euro, Australian dollar and Canadian dollar had a small positive impact on our net sales and operating income. During 2016, our sales and operating income were negatively impacted by the strengthening of the U.S. dollar and Euro against the British pound sterling, with smaller impacts due to weakening of the Australian dollar and Canadian dollar against the U.S. dollar. The following table presents the amounts (in U.S. dollars) by which the exchange rates for converting Euros, British pounds, Australian dollars and Canadian dollars into U.S. dollars have affected our net sales and operating income during the past three years: The following table presents, as a percentage of net sales, certain items included in our Consolidated Statements of Operations during the past three years: Net Sales Below we provide information regarding our net sales and analyze those results for each of the last three fiscal years. Fiscal years 2018, 2017, and 2016 were 52-week periods. Net sales for 2018 compared with 2017 For 2018, our net sales increased $183.1 million (18.4%) as compared to 2017. As discussed above, the 2018 period included revenue of $112.6 million from the nora acquisition that was not present in 2017. This nora revenue was broken down by region as follows: the Americas $47.6 million, Europe $51.2 million, and Asia-Pacific $13.7 million. Fluctuations in currency exchange rates had a positive impact on our year-over-year sales comparison of approximately $8.4 million, meaning that if currency levels had remained constant year over year our 2018 sales would have been lower by this amount. On a geographic basis, including the impact of nora, we experienced sales growth across all our regions. Sales in the Americas were up 16.0%, sales in Europe were up 29.7% as reported in U.S. dollars, and sales in Asia-Pacific were up 9.7%. The sales increase of 16.0% in the Americas in 2018 was due primarily to the impact of the nora acquisition, growth from our luxury vinyl tile (“LVT”) products, which were introduced in early 2017, but offset by a slight decrease of 2% in our weighted average selling price per square yard for our modular carpet and a decrease of 5% in our weighted average selling price per square feet for LVT compared to 2017. The legacy Interface Americas carpet and LVT business grew approximately 8% for the year. This increase in the legacy business was due to an increase in the corporate office market segment (up 9%) as well as increases in the retail (up 18%) and hospitality (up 7%) market segments. The increase in retail was due to the performance of our Interface SERVICES™ business, which has a larger percentage of its sales in the retail segment. These legacy sales increases were partially offset by a decline in the government (down 10%) market segment. The acquired nora business generated approximately 42% of its revenue in the Americas region, which was primarily in the healthcare, education, and transportation market segments. In Europe, sales in the region were up in both U.S. dollars (29.7%) and local currency (25.0%). This sales increase was due primarily to the impact of the nora acquisition, growth in our LVT products and the strengthening of the Euro and British pound against the U.S. dollar. In Europe, our weighted average selling price per square yard for modular carpet tile increased 3% and our weighted average selling price per square feet for LVT decreased 6% in 2018 compared with 2017. The legacy Interface European carpet and LVT business grew 9% on a U.S. dollar basis, and 5% in local currency. Our legacy business in the United Kingdom, which has historically been our third largest market, experienced a sales decrease in local currency of 7% for the year, but a decline of 4% when translated into U.S. dollars. The sales growth in the legacy Interface European business was most pronounced in the corporate office (up 9%), retail (up 11%), healthcare (up 15%), and hospitality (up 34%) market segments. The acquired nora business generated approximately 46% of its revenue in the Europe region, which was primarily in the healthcare, education, and transportation market segments. In Asia-Pacific, sales increased 9.7% primarily due to the impact of the nora acquisition and growth in our LVT products. This sales increase was partially offset by the weakening of the Australian dollar and lower sales in Australia. Our weighted average selling price per square yard for modular carpet and our weighted average selling price per square feet for LVT decreased 5% in 2018 compared to 2017. The legacy Interface Asia-Pacific carpet and LVT business grew 1% on a U.S. dollar basis and 2% in local currency. Within the region on a legacy Interface basis, Asia sales increased 8% while Australia sales decreased 5% as translated into U.S. dollars. The sales growth in the legacy Asia-Pacific business was primarily in the hospitality (up 5%) and healthcare (up 6%) market segments, partially offset by decreases in government (down 32%) and retail (down 3%) market segments. The acquired nora business generated approximately 12% of its revenue in the Asia-Pacific region, which was primarily in the healthcare and education market segments. Net sales for 2017 compared with 2016 For 2017, our net sales increased $37.8 million (3.9%) as compared to 2016. Fluctuations in currency exchange rates had a positive impact on the comparison of approximately $5.5 million, meaning that if currency levels had remained constant year over year our 2017 sales would have been lower by this amount. On a geographic basis, we experienced sales growth across all our regions. Sales in the Americas were up 3.5%, sales in Europe were up 2.0% in U.S. dollars (1.5% increase in local currencies), and sales in Asia-Pacific were up 8.7%. In the Americas, our weighted average selling price per square yard for our modular carpet decreased 1% in 2017 as compared to 2016. The sales increase in the Americas was due primarily to the introduction of our LVT products in early 2017, as our modular carpet sales in the Americas declined versus 2016. This decline in modular carpet sales was due entirely to the closure of our FLOR specialty retail stores in the first quarter of 2017, as our commercial modular business was up approximately 1% in 2017 as compared to 2016. The corporate office market segment increased 2% for the year. Other market segments showing growth were the government (up 19%), retail (up 5%) and education (up 4%) market segments. The increase in the government market segment was seen across most government customers, with sales to state and municipal governments representing the most significant increase. The increase in retail was due to the performance of our Interface SERVICES™ business, which has a larger percentage of its sales to the retail segment. These increases were offset by declines in the hospitality (down 7%) and healthcare (down 6%) market segments. In Europe, our weighted average selling price per square meter increased 3% in 2017 compared with 2016. Sales in the region were up in both U.S. dollars (2%) and local currency (1.5%). Within the region, the weakening of the British pound versus the Euro had a negative impact on sales, however this was offset by the strengthening of the Euro versus the U.S. dollar during 2017 as compared to 2016. The United Kingdom, which has historically been our third largest market, experienced a sales increase in local currency of 3% for the year, but a decline of 2% when translated into U.S. dollars. We also experienced growth in Germany in 2017, but this was partially offset by other declines in central Europe. The increase in sales was entirely within the corporate office market segment (up 3%) as no other market segment had a significant increase in sales. The corporate office market comprises the majority of sales in the Europe region. This increase was partially offset by declines in the retail (down 17%), education (down 12%), and residential (down 52%) market segments. In Asia-Pacific, our weighted average selling price increased 5.6% for the year, with the appreciation of the Australian dollar having a positive impact on this increase. Within the region, Asia sales increased 5% while Australia sales increased 12% as translated into U.S. dollars. As noted, the appreciation of the Australian dollar had a positive impact on the sales increase, as in local currency sales in Australia increased 9%. The increase in sales for the region was primarily due to the strength of the corporate office market (which comprises the bulk of the region’s sales and was up 8%). Other non-office market segments showing growth for the year were education (up 16%) and healthcare (up 36%). The increase in the education segment was due to our success in the Australian education market, a result of increased government education spending in the market, as well as growth of student accommodation projects at the university level. These increases were only slightly offset by declines in the retail, government and residential market segments. Cost and Expenses The following table presents our overall cost of sales and selling, general and administrative expenses during the past three years: For 2018, our costs of sales increased $144.8 million (23.7%) compared with 2017. Included in the 2018 period are cost of sales of $96.6 million for the acquired business nora, which includes amortization related to acquired inventory and intangible assets of $32.1 million. Fluctuations in currency exchange rates did not have a significant impact (less than 1%) on the year-over-year comparison. In absolute dollars, the increase in costs of sales was a result of higher sales for 2018 as compared to 2017. As a percentage of sales, our costs of sales increased to 64.0% in 2018 versus 61.3% in 2017. This increase was a result of (1) higher costs of sales related to the acquired nora business, including purchase accounting amortization of $32.1 million for acquired inventory and intangible assets, (2) delayed productivity initiatives due to increased sales and production volumes, as well as (3) a change in the sales mix weighted more heavily toward the InterfaceServices business. These service sales typically generate a lower gross margin compared to the rest of our operations. For 2017, our costs of sales increased $20.4 million (3.5%) compared with 2016. Fluctuations in currency exchange rates did not have a significant impact (less than 1%) on the comparison. In absolute dollars, the increase in costs of sales was a result of the higher sales for 2017 as compared to 2016. As noted above, sales increased 3.9% in 2017. As a percentage of sales, our costs of sales improved to 61.3% in 2017 versus 61.5% in 2016. This improvement was a result of (1) productivity initiatives, including our investment in our manufacturing facilities in LaGrange, Georgia, (2) lower cost of sales as a percentage of sales due to the introduction of our LVT product offerings, which commanded margins in 2017 that were accretive to our modular carpet products, and (3) non-recurring charges in 2016 related to the transition to a centralized warehouse and distribution center in our Americas business. These benefits were partially offset by (1) higher raw materials costs due to input cost inflation, particularly in our European business, and (2) negative gross margin impacts due to the exit of our FLOR specialty retail business. Our FLOR business delivers higher gross margins than our commercial business, and with the closure of the specialty retail stores the decline in sales had a negative impact on our cost of sales as a percentage of sales. For 2018, our SG&A expenses increased $60.3 million (22.6%) versus 2017. SG&A expenses for the acquired nora business were $34.9 million from August 7 through the end of the 2018 year. Currency fluctuations had only a slight (less than 1%) unfavorable impact on SG&A expenses. The increase in SG&A expenses during the year was due to (1) transaction costs in connection with the nora acquisition of $5.3 million, (2) higher performance-based stock compensation of approximately $7.0 million as performance targets were met to a higher degree in 2018 as compared to 2017, (3) higher selling expenses of $24.0 million related to the acquired nora business, (4) higher selling expense of $7.5 million due to higher sales volumes in the legacy Interface business, and (5) higher administrative expenses of $15.8 million primarily due to the acquired nora business as noted above. As a percentage of sales, SG&A expenses increased to 27.8% in 2018 versus 26.8% in 2017. For 2017, our SG&A expenses increased $5.4 million (2.1%) versus 2016. Currency fluctuations had only a slight (less than 1%) unfavorable impact on SG&A expenses. The increase in SG&A expenses during the year was due to (1) higher incentive-based compensation (approximately $6 million) and performance-based stock compensation (approximately $1.5 million) as performance targets were met to a higher degree in 2017 as compared to 2016, and (2) higher administrative expenses of $5 million as we centralize certain support functions. These increases were partially offset by (1) lower marketing expenses of $3.9 million, a result of our restructuring efforts as well as global consolidation of costs for marketing expenditures leading to lower levels of total spend, and (2) lower selling costs of $4.2 million due primarily to exiting our FLOR specialty retail business in 2017. Despite the higher SG&A expense in absolute dollars, due to the increase in sales noted above, SG&A expenses declined as a percentage of sales in 2017 to 26.8% versus 27.3% in 2016. Interest Expense For 2018, our interest expense increased $8.3 million to $15.4 million, versus $7.1 million in 2017. This increase was a result of (1) additional debt incurred to complete the nora acquisition and (2) higher average interest rates on our borrowings (our average borrowing rate for 2018 was 3.5% as compared to 2.9% for 2017). Our interest rate swap entered into in 2017 did not have any significant impact on interest expense for 2018. For 2017, our interest expense increased $1.0 million to $7.1 million, versus $6.1 million in 2016. This increase was a result of (1) higher average interest rates under our Syndicated Credit Facility during 2017 (the average interest rate for 2016 was 2.5% as compared to 2.9% for 2017), and (2) in 2017 we fixed the variable interest rate on $100 million of our term loan borrowings under the Syndicated Credit Facility by entering into an interest rate swap transaction. The effect of this interest rate swap was to increase the interest rate on the $100 million notional amount of the swap above the variable rate in effect for our other term loan borrowings under the Syndicated Credit Facility. Tax On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the “Tax Act”) was enacted into law. Among the significant changes resulting from the law, the Tax Act reduced the U.S. federal income tax rate from 35% to 21% effective January 1, 2018 and created a modified territorial tax system with a one-time mandatory “transition toll tax” on previously unrepatriated foreign earnings. As of December 31, 2017, the Company recorded a provisional tax expense of $3.5 million related to the remeasurement of its net deferred tax asset and a provisional tax expense of $11.7 million related to the one-time transition toll tax. As of December 30, 2018, the Company completed the accounting of remeasuring its net deferred tax asset which resulted in a $1.7 million decrease to the previously recorded provisional amount and completed its assessment of the one-time transition toll tax which resulted in a $5.0 million decrease to the previously recorded provisional amount. See “Note 15 - Taxes on Income” to the consolidated financial statements for further information on the financial statement impact of the Tax Act. Our effective tax rate in 2018 was 8.6%, compared with an effective tax rate of 47.0% in 2017. The decrease in our effective tax rate in 2018 compared to 2017 was primarily due to a $6.7 million tax benefit related to the impacts of the Tax Act as discussed above, the reduction in the U.S. federal income tax rate from 35% to 21%, and an increase in U.S. federal and foreign tax credits. Our effective tax rate in 2017 was 47.0%, compared with an effective tax rate of 31.6% in 2016. The increase in our effective tax rate in 2017 compared to 2016 was primarily due to the $15.2 million provisional tax charge for the impacts of the Tax Act as discussed above and an increase in U.S. earnings resulting in more U.S. state tax expense. For additional information on taxes and a reconciliation of effective tax rates to statutory tax rates, see the Note 15 entitled “Taxes on Income” in Item 8 of this Report. Liquidity and Capital Resources General In our business, we require cash and other liquid assets primarily to purchase raw materials and to pay other manufacturing costs, in addition to funding normal course SG&A expenses, anticipated capital expenditures, interest expense and potential special projects. We generate our cash and other liquidity requirements primarily from our operations and from borrowings or letters of credit under our Syndicated Credit Facility discussed below. Historically, we use more cash in the first half of the fiscal year, as we pay insurance premiums, taxes and incentive compensation and build up inventory in preparation for the holiday/vacation season of our international operations. On August 7, 2018, our Syndicated Credit Facility was amended and restated in connection with our acquisition of nora. Please see Note 9 and Note 18 in Item 8 for additional information. At December 30, 2018, we had $81.0 million in cash. Approximately $11.6 million of this cash was located in the U.S., and the remaining $69.4 million was located outside of the U.S. The cash located outside of the U.S. is indefinitely reinvested in the respective jurisdictions (except as identified below). We believe that our strategic plans and business needs, particularly for working capital needs and capital expenditure requirements in Europe, Asia, Canada, and Australia, support our assertion that a portion of our cash in foreign locations will be reinvested and remittance will be postponed indefinitely. Of the $69.4 million of cash in foreign jurisdictions, approximately $7.5 million represents earnings which we have determined are not permanently reinvested, and as such we have provided for foreign withholding and U.S. state income taxes on these amounts in accordance with applicable accounting standards. As of December 30, 2018, we had $626.7 million of borrowings and $3.6 million in letters of credit outstanding under our amended and restated Syndicated Credit Facility. Of those borrowings outstanding, $616.1 million were term loan borrowings and $10.6 million were revolving loan borrowings. As of December 30, 2018, we could have incurred $285.9 million of additional revolving loan borrowings under our amended and restated Syndicated Credit Facility. In addition, we could have incurred the equivalent of $9.5 million of borrowings under our other credit facilities in place at other non-U.S. subsidiaries. We have approximately $105.4 million in contractual cash obligations due by the end of fiscal year 2019, which includes, among other things, pension cash contributions, interest payments on our debt and lease commitments. Based on current interest rates and debt levels, we expect our aggregate interest expense for 2019 to be between $24 million and $26 million. We estimate aggregate capital expenditures in 2019 to be between $65 million and $75 million, although we are not committed to these amounts. It is important for you to consider that we have a significant amount of indebtedness. Our amended and restated Syndicated Credit Facility matures in August of 2023. We cannot assure you that we will be able to renegotiate or refinance any of our debt on commercially reasonable terms, or at all. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, such as selling assets to meet our debt service obligations and other liquidity needs, or using cash, if available, that would have been used for other business purposes. It is also important for you to consider that borrowings under our Syndicated Credit Facility comprise the substantial majority of our indebtedness, and that these borrowings are based on variable interest rates (as described below) that expose the Company to the risk that short-term interest may increase. We have, however, entered into an interest rate swap transaction to fix the variable interest rate with respect to $100 million of the term loan borrowings under the Syndicated Credit Facility. For information regarding the current variable interest rates of these borrowings, the potential impact on our interest expense from hypothetical increases in short term interest rates, and the interest rate swap transaction, please see the discussion in

<s>[INST] General Our revenues are derived from sales of floorcovering products, primarily modular carpet, luxury vinyl tile (“LVT”) and starting in August 2018, rubber flooring products. Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. Most of our sales are to customers in the corporate office market segment, but we also focus our marketing and sales efforts on noncorporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. Our mix of corporate office versus noncorporate office modular carpet and LVT sales in the Americas was 45% and 55%, respectively, for 2018. Companywide, our mix of corporate office versus noncorporate office modular carpet and LVT sales was 60% and 40%, respectively, in 2018. On August 7, 2018, the Company completed the acquisition of nora for a purchase price of €385.1 million, or $447.2 million at the exchange rate as of the transaction date, including acquired cash of €40.0 million ($46.5 million) for a net purchase price of €345.1 million ($400.7 million). Nora is an industry leader in the rubber flooring market, and this acquisition is expected to advance the Company’s growth strategy in expanding market segments, particularly in the healthcare, life sciences and education market segments. Similar to Interface, nora operates on an international footprint and the Company expects the acquisition will also allow for geographic sales synergies as well. During 2018, we had net sales of $1,179.6 million, up 18.4% compared to $996.4 million in 2017. Operating income for 2018 was $76.4 million as compared to $111.6 million in 2017. Net income for 2018 was $50.3 million, or $0.84 per share, compared with $53.2 million, or $0.86 per share, in 2017. The 2018 period includes the results of the acquired nora business from August 7 through the end of the year, including nora net sales of $112.6 million during that stub period. These results included amortization related to the fair value of inventory acquired of $26.7 million, and amortization of acquired intangible assets of $5.4 million. 2018 also includes $9.5 million related to nora transaction expenses. Also included in our results for 2018 were $20.5 million of restructuring and asset impairment charges as well as $6.7 million of tax benefits related to the finalization of our analysis of the U.S. Tax Cuts and Jobs Act enacted in 2017. Please see Item 8, Note 15 “Taxes on Income” for further discussion of these tax benefits. During 2017, we had net sales of $996.4 million, up 3.9% compared to $958.6 million in 2016. Operating income for 2017 was $109.8 million as compared to $84.9 million in 2016. Net income for 2017 was $53.2 million, or $0.86 per share, compared with $54.2 million, or $0.83 per share, in 2016. Included in our results for 2017 were $7.3 million of rest [/INST] Negative. </s>

INTERFACE INC

2020-02-26

2019-12-29

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General Our revenues are derived from sales of floorcovering products, primarily modular carpet, luxury vinyl tile (“LVT”) and starting in August 2018, rubber flooring products. Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. Most of our sales are to customers in the corporate office market segment, but we also focus our marketing and sales efforts on non-corporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. In the Americas, our mix of corporate office versus non-corporate office modular carpet and LVT sales was 47% and 53%, respectively, for 2019. Company-wide, our mix of corporate office versus non-corporate office modular carpet and LVT sales was 61% and 39%, respectively, in 2019. On August 7, 2018, the Company completed the acquisition of nora for a purchase price of €385.1 million, or $447.2 million at the exchange rate as of the transaction date, including acquired cash of €40.0 million ($46.5 million) for a net purchase price of €345.1 million ($400.7 million). Nora is an industry leader in the rubber flooring market, and this acquisition is expected to advance the Company’s growth strategy in expanding market segments, particularly in the healthcare, life sciences and education market segments. Similar to Interface, nora operates on an international footprint and the Company expects the acquisition will also allow for geographic sales synergies as well. During fiscal 2019, the Company continued to expand into these market segments as the sales of rubber flooring products were primarily in the healthcare, education and transportation market segments. During 2019, we had net sales of $1,343.0 million, up 13.9% compared to $1,179.6 million in 2018. Operating income for 2019 was $130.9 million compared to $76.4 million in 2018. Net income for 2019 was $79.2 million, or $1.34 per share, compared to $50.3 million, or $0.84 per share, in 2018. The 2019 period included the results of the acquired nora business for the full fiscal year, $5.9 million of purchase accounting amortization in connection with the nora acquisition, and $12.9 million of restructuring and other charges. The 2018 period included the results on the nora acquisition from August 7, 2018 to the end of the 2018 fiscal year. During 2018, we had net sales of $1,179.6 million, up 18.4% compared to $996.4 million in 2017. Operating income for 2018 was $76.4 million as compared to $111.6 million in 2017. Net income for 2018 was $50.3 million, or $0.84 per share, compared with $53.2 million, or $0.86 per share, in 2017. The 2018 period included the results of the acquired nora business from August 7 through the end of the year, including nora net sales of $112.6 million during that stub period. These results included amortization related to the fair value of inventory acquired of $26.7 million, and amortization of acquired intangible assets of $5.4 million. 2018 also includes $9.5 million related to nora transaction expenses. Also included in our results for 2018 were $20.5 million of restructuring and asset impairment charges as well as $6.7 million of tax benefits related to the finalization of our analysis of the U.S. Tax Cuts and Jobs Act enacted in 2017. Please see Item 8, Note 16 “Income Taxes” for further discussion of these tax benefits. Restructuring Plans On December 23, 2019, the Company committed to a new restructuring plan that continues to focus on efforts to improve efficiencies and decrease costs across its worldwide operations, and more closely align its operating structure with its business strategy. The plan involves a reduction of approximately 105 employees and early termination of two office leases. As a result of this plan, the Company recorded a pre-tax restructuring charge in the fourth quarter of 2019 of approximately $9.0 million. The charge is comprised of severance expenses ($8.8 million) and lease exit costs ($0.2 million). The restructuring plan is expected to result in future cash expenditures of approximately $9.0 million for payment of the employee severance and lease exit costs, as described above. The Company expects to complete the restructuring plan in fiscal year 2020, and expects the plan to yield annualized savings of approximately $6.0 million. A portion of the annualized savings is expected to be realized on the income statement in fiscal year 2020, with the remaining portion of the annualized savings expected to be realized in fiscal year 2021. On December 29, 2018, the Company committed to a new restructuring plan in its continuing efforts to improve efficiencies and decrease costs across its worldwide operations, and more closely align its operating structure with its business strategy. The plan involved (i) a restructuring of its sales and administrative operations in the United Kingdom, (ii) a reduction of approximately 200 employees, primarily in the Europe and Asia-Pacific geographic regions, and (iii) the write-down of certain underutilized and impaired assets that included information technology assets and obsolete manufacturing equipment. As a result of this plan, the Company recorded a pre-tax restructuring and asset impairment charge in the fourth quarter of 2018 of approximately $20.5 million. The charge was comprised of severance expenses (approximately $10.8 million), impairment of assets (approximately $8.6 million) and other items (approximately $1.1 million). The charge was expected to result in future cash expenditures of $12 million, primarily for severance payments (approximately $10.8 million). The restructuring plan was substantially complete at the end of fiscal 2019. The Company redeployed the savings toward the funding of sales and strategic growth initiatives in 2019, yielding negligible net savings on the Company’s income statement. In connection with the 2018 restructuring plan, the Company recorded $0.7 million of additional lease exit costs in the third quarter of 2019, and in the fourth quarter of 2019 the Company adjusted its expected severance expenses and recognized a decrease in restructuring costs of $1.7 million. In the first quarter of 2017, the Company recorded a restructuring charge of $7.3 million, which was related to a previous restructuring plan announced in 2016, primarily related to exit costs associated with the closure of various FLOR retail stores. The 2017 charge was comprised of lease exit costs of $3.4 million, asset impairment charges of $3.3 million and severance charges of $0.6 million. The restructuring plan was substantially completed in 2017. Analysis of Results of Operations The following discussion and analyses reflect the factors and trends discussed in the preceding sections. Net sales denominated in currencies other than the U.S. dollar were approximately 49% in 2019, 49% in 2018, and 46% in 2017. Because we have such substantial international operations, we are impacted, from time to time, by international developments that affect foreign currency transactions. In 2019, the weakening of the Euro, British pound, Australian dollar, Canadian dollar and Chinese renminbi against the U.S. dollar had a negative impact on our net sales and operating income. In 2018, the strengthening of the Euro and British pound against the U.S. dollar had a positive impact on our net sales and operating income. In 2017, the strengthening of the Euro, Australian dollar and Canadian dollar had a positive impact on our net sales and operating income. The following table presents the amounts (in U.S. dollars) by which the exchange rates for translating Euros, British pounds, Australian dollars and Canadian dollars into U.S. dollars have affected our net sales and operating income during the past three years: The following table presents, as a percentage of net sales, certain items included in our Consolidated Statements of Operations during the past three years: Net Sales Below we provide information regarding our net sales and analyze those results for each of the last three fiscal years. Fiscal years 2019, 2018, and 2017 were 52-week periods. Net sales for 2019 compared with 2018 For 2019, our net sales increased $163.5 million (13.9%) as compared to 2018. As discussed above, the 2019 period included revenue from the nora acquisition for the full fiscal year. The 2018 period included nora revenue only from the acquisition date on August 7, 2018 to the end of the 2018 fiscal year of $112.6 million during that stub period. The increase in net sales was primarily volume related and not materially impacted by changing prices. Fluctuations in currency exchange rates had a negative impact on our year-over-year sales comparison of approximately $26.2 million, meaning that if currency levels had remained constant year over year our 2019 sales would have been higher by this amount. On a geographic basis, including the impact of the nora acquisition, we experienced sales growth across all our regions. Sales in the Americas were up 11.0%, sales in Europe were up 23.0% as reported in U.S. dollars, and sales in Asia-Pacific were up 8.5%. The sales increase of 11.0% in the Americas in 2019 was due primarily to the impact of the nora acquisition and growth from our luxury vinyl tile (“LVT”) products. The legacy Americas carpet and LVT business grew approximately 3.6% for the year. This increase in the legacy business was due to increased sales in the corporate office market segment (up 8.6%) as well as increases in the healthcare (up 18.2%) and education (up 7.6%) market segments. These legacy sales increases were partially offset by a decline in the retail market segment (down 24.6%). In Europe, sales in the region were up in both U.S. dollars (23.0%) and local currency (29.1%). This increase was due primarily to the impact of the nora acquisition and growth from our LVT products offset by weakening of the Euro and British pound against the U.S. dollar. The legacy European carpet and LVT business declined 2.7% on a U.S. dollar basis, but grew 2.6% in local currency. The sales growth in local currency in the legacy European business was most pronounced in the corporate office segment (up 6.9%). The decline in legacy sales on a U.S. dollars basis was primarily due to the weakening of the Euro and British pound against the U.S. dollar. In Asia-Pacific, sales increased 8.5% primarily due to the impact of the nora acquisition and growth in our LVT products. This sales increase was partially offset by the weakening of the Australian dollar and lower sales in Australia. The legacy Asia-Pacific carpet and LVT business declined 3.9% on a U.S. dollar basis, but increased 0.1% in local currency. The sales decline in the legacy Asia-Pacific business was primarily in the corporate (down 5.7%) and government (down 17.9%) market segments, partially offset by increases in the retail market segment (up 12.0%). Net sales for 2018 compared with 2017 For 2018, our net sales increased $183.1 million (18.4%) compared to 2017. As discussed above, the 2018 period included revenue of $112.6 million from the nora acquisition that was not present in 2017. Fluctuations in currency exchange rates had a positive impact on our year-over-year sales comparison of approximately $8.4 million, meaning that if currency levels had remained constant year over year our 2018 sales would have been lower by this amount. On a geographic basis, including the impact of nora, we experienced sales growth across all of our regions. Sales in the Americas were up 16.0%, sales in Europe were up 29.7% as reported in U.S. dollars, and sales in Asia-Pacific were up 9.7%. The sales increase of 16.0% in the Americas in 2018 was due primarily to the impact of the nora acquisition. The legacy Interface Americas carpet and LVT business grew approximately 8% for the year. This increase in the legacy business was due to an increase in the corporate office market segment (up 9%) as well as increases in the retail (up 18%) and hospitality (up 7%) market segments. The increase in retail was due to the performance of our Interface SERVICES™ business, which had a larger percentage of its sales in the retail segment. These legacy sales increases were partially offset by a decline in the government (down 10%) market segment. In Europe, sales in the region were up in both U.S. dollars (29.7%) and local currency (25.0%). This sales increase was due primarily to the impact of the nora acquisition, growth in our LVT products and the strengthening of the Euro and British pound against the U.S. dollar. The legacy Interface European carpet and LVT business grew 9% on a U.S. dollar basis, and 5% in local currency. The sales growth in the legacy Interface European business was most pronounced in the corporate office (up 9%), retail (up 11%), healthcare (up 15%), and hospitality (up 34%) market segments. In Asia-Pacific, sales increased 9.7% primarily due to the impact of the nora acquisition and growth in our LVT products. This sales increase was partially offset by the weakening of the Australian dollar and lower sales in Australia. The legacy Interface Asia-Pacific carpet and LVT business grew 1% on a U.S. dollar basis and 2% in local currency. Within the region on a legacy Interface basis, Asia sales increased 8% while Australia sales decreased 5% as translated into U.S. dollars. The sales growth in the legacy Asia-Pacific business was primarily in the hospitality (up 5%) and healthcare (up 6%) market segments, partially offset by decreases in government (down 32%) and retail (down 3%) market segments. Cost and Expenses The following table presents our overall cost of sales and selling, general and administrative (“SG&A”) expenses during the past three years: For 2019, our costs of sales increased $62.4 million (8.3%) compared to 2018. Included in 2019 are costs of sales for the acquired nora business for the full year, which includes purchase accounting amortization of $5.9 million related to acquired intangible assets. Fluctuations in currency exchange rates had a 1.8% positive impact on the year-over-year comparison. In absolute dollars, the increase in costs of sales was a result of higher sales for 2019 as compared to 2018, as well as the full year impact of the acquired nora business. As a percentage of sales, our costs of sales decreased to 60.9% in 2019 versus 64.0% in 2018. This decrease was primarily due to productivity initiatives and the nora non-recurring inventory step-up amortization which occurred in 2018, but did not recur in 2019. For 2018, our costs of sales increased $144.8 million (23.7%) compared with 2017. Included in the 2018 period are cost of sales of $96.6 million for the acquired nora business, which includes amortization related to acquired inventory and intangible assets of $32.1 million. Fluctuations in currency exchange rates did not have a significant impact (less than 1%) on the year-over-year comparison. In absolute dollars, the increase in costs of sales was a result of higher sales for 2018 as compared to 2017. As a percentage of sales, our costs of sales increased to 64.0% in 2018 versus 61.3% in 2017. This increase was a result of (1) higher costs of sales related to the acquired nora business, including purchase accounting amortization of $32.1 million for acquired inventory and intangible assets, (2) delayed productivity initiatives due to increased sales and production volumes, as well as (3) a change in the sales mix weighted more heavily toward the Interface Services business, which typically generates a lower gross margin compared to the rest of our operations. For 2019, our SG&A expenses increased $54.2 million (16.5%) versus 2018. Included in the 2019 period were a full year of SG&A expenses for the acquired nora business versus only a stub period of approximately five months in 2018. Fluctuations in currency rates had a 1.5% favorable impact on SG&A expenses. The increase in SG&A expenses during the year was primarily due to (1) higher selling expenses for the full year impact in 2019 of the acquired nora business, (2) higher year-over-year legal expenses of $3.5 million related to the SEC matter discussed in Note 17 - “Commitments and Contingencies”, and (3) higher selling expenses related to bringing the Company’s global sales organization together for a meeting to accelerate the nora integration, advance our selling system transformation, and engage the sales force in the Company’s sustainability mission. These increases were partially offset by lower stock compensation expense of $5.8 million compared to prior year. As a percentage of sales, SG&A expenses increased to 28.4% in 2019 versus 27.8% in 2018. For 2018, our SG&A expenses increased $60.3 million (22.6%) versus 2017. SG&A expenses for the acquired nora business were $34.9 million from August 7 through the end of the 2018 year. Currency fluctuations had only a slight (less than 1%) unfavorable impact on SG&A expenses. The increase in SG&A expenses during the year was due to (1) transaction costs in connection with the nora acquisition of $5.3 million, (2) higher performance-based stock compensation of approximately $7.0 million as performance targets were met to a higher degree in 2018 as compared to 2017, (3) higher selling expenses of $24.0 million related to the acquired nora business, (4) higher selling expense of $7.5 million due to higher sales volumes in the legacy Interface business, and (5) higher administrative expenses of $15.8 million primarily due to the acquired nora business as noted above. As a percentage of sales, SG&A expenses increased to 27.8% in 2018 versus 26.8% in 2017. Interest Expense For 2019, our interest expense increased $10.2 million to $25.6 million, versus $15.4 million in 2018. This increase was a result of higher outstanding borrowings incurred in August 2018 to complete the nora acquisition offset slightly by lower average interest rates on our borrowings (our average borrowing rate for 2019 was 3.27% as compared to 3.50% for 2018). Our interest rate swaps, entered into in 2017 and 2019, had approximately $0.2 million impact on interest expense for 2019. For 2018, our interest expense increased $8.3 million to $15.4 million, versus $7.1 million in 2017. This increase was a result of (1) additional debt incurred to complete the nora acquisition and (2) higher average interest rates on our borrowings (our average borrowing rate for 2018 was 3.5% as compared to 2.9% for 2017). Our interest rate swap entered into in 2017 did not have any significant impact on interest expense for 2018. Tax On December 22, 2017, the U.S. Tax Cuts and Jobs Act (the “Tax Act”) was enacted into law. Among the significant changes resulting from the law, the Tax Act reduced the U.S. federal income tax rate from 35% to 21% effective January 1, 2018 and created a modified territorial tax system with a one-time mandatory “transition toll tax” on previously unrepatriated foreign earnings. As of December 31, 2017, the Company recorded a provisional tax expense of $3.5 million related to the remeasurement of its net deferred tax asset and a provisional tax expense of $11.7 million related to the one-time transition toll tax. As of December 30, 2018, the Company completed the accounting of remeasuring its net deferred tax asset which resulted in a $1.7 million decrease to the previously recorded provisional amount and completed its assessment of the one-time transition toll tax which resulted in a $5.0 million decrease to the previously recorded provisional amount. See Note 16 - “Income Taxes” to the consolidated financial statements in Item 8 for further information on the financial statement impact of the Tax Act. Our effective tax rate in 2019 was 22.2%, compared with an effective tax rate of 8.6% in 2018. The increase in our effective tax rate in 2019 compared to 2018 was primarily due to the nonrecurring $6.7 million tax benefit realized in 2018 related to the impacts of the Tax Act as discussed above. In addition, there was a net increase in our effective tax rate in 2019 due to less U.S. federal and foreign tax credits which was partially offset by a reduction in non-deductible expenses, favorable change in unrecognized tax benefits and a higher portion of income earned in foreign jurisdictions not subject to U.S. state income taxes. Our effective tax rate in 2018 was 8.6%, compared with an effective tax rate of 47.0% in 2017. The decrease in our effective tax rate in 2018 compared to 2017 was primarily due to a $6.7 million tax benefit related to the impacts of the Tax Act as discussed above, the reduction in the U.S. federal income tax rate from 35% to 21%, and an increase in U.S. federal and foreign tax credits. Liquidity and Capital Resources General In our business, we require cash and other liquid assets primarily to purchase raw materials and to pay other manufacturing costs, in addition to funding normal course SG&A expenses, anticipated capital expenditures, interest expense and potential special projects. We generate our cash and other liquidity requirements primarily from our operations and from borrowings or letters of credit under our Syndicated Credit Facility discussed below. Historically, we use more cash in the first half of the fiscal year, as we pay insurance premiums, taxes and incentive compensation and build up inventory in preparation for the holiday/vacation season of our international operations. On August 7, 2018, our Syndicated Credit Facility was amended and restated in connection with our acquisition of nora. Please see Note 9 - “Long-Term Debt” and Note 19 - “Acquisition of Nora” in Item 8 for additional information. At December 29, 2019, we had $81.3 million in cash. Approximately $2.9 million of this cash was located in the U.S., and the remaining $78.4 million was located outside of the U.S. The cash located outside of the U.S. is indefinitely reinvested in the respective jurisdictions (except as identified below). We believe that our strategic plans and business needs, particularly for working capital needs and capital expenditure requirements in Europe, Asia, and Australia, support our assertion that a portion of our cash in foreign locations will be reinvested and remittance will be postponed indefinitely. Of the $78.4 million of cash in foreign jurisdictions, approximately $3.6 million represents earnings which we have determined are not permanently reinvested, and as such we have provided for foreign withholding and U.S. state income taxes on these amounts in accordance with applicable accounting standards. As of December 29, 2019, we had $602.5 million of borrowings and $2.2 million in letters of credit outstanding under our amended and restated Syndicated Credit Facility. Of those borrowings outstanding, $581.6 million were term loan borrowings and $20.9 million were revolving loan borrowings. As of December 29, 2019, we had additional borrowing capacity of $276.9 million under our amended and restated Syndicated Credit Facility and $9.5 million of borrowings under our other credit facilities in place at other non-U.S. subsidiaries. We have approximately $162.8 million in contractual cash obligations due by the end of fiscal year 2020, which includes, among other things, pension cash contributions, interest payments on our debt and lease commitments. Based on current interest rates and debt levels, we expect our aggregate interest expense for 2020 to be between $24 million and $25 million. We estimate aggregate capital expenditures in 2020 to be between $50 million and $60 million, although we are not committed to these amounts. It is important for you to consider that we have a significant amount of indebtedness. Our amended and restated Syndicated Credit Facility matures in August of 2023. We cannot assure you that we will be able to renegotiate or refinance any of our debt on commercially reasonable terms, or at all. If we are unable to refinance our debt or obtain new financing, we would have to consider other options, such as selling assets to meet our debt service obligations and other liquidity needs, or using cash, if available, that would have been used for other business purposes. It is also important for you to consider that borrowings under our Syndicated Credit Facility comprise the substantial majority of our indebtedness, and that these borrowings are based on variable interest rates (as described below) that expose the Company to the risk that short-term interest may increase. We have, however, entered into interest rate swap transactions to fix the variable interest rate with respect to $250 million of the term loan borrowings under the Syndicated Credit Facility. For information regarding the current variable interest rates of these borrowings, the potential impact on our interest expense from hypothetical increases in short term interest rates, and the interest rate swap transaction, please see the discussion in

<s>[INST] Our revenues are derived from sales of floorcovering products, primarily modular carpet, luxury vinyl tile (“LVT”) and starting in August 2018, rubber flooring products. Our business, as well as the commercial interiors industry in general, is cyclical in nature and is impacted by economic conditions and trends that affect the markets for commercial and institutional business space. The commercial interiors industry, including the market for floorcovering products, is largely driven by reinvestment by corporations into their existing businesses in the form of new fixtures and furnishings for their workplaces. In significant part, the timing and amount of such reinvestments are impacted by the profitability of those corporations. As a result, macroeconomic factors such as employment rates, office vacancy rates, capital spending, productivity and efficiency gains that impact corporate profitability in general, also affect our business. Most of our sales are to customers in the corporate office market segment, but we also focus our marketing and sales efforts on noncorporate office segments to reduce somewhat our exposure to economic cycles that affect the corporate office market segment more adversely, as well as to capture additional market share. In the Americas, our mix of corporate office versus noncorporate office modular carpet and LVT sales was 47% and 53%, respectively, for 2019. Companywide, our mix of corporate office versus noncorporate office modular carpet and LVT sales was 61% and 39%, respectively, in 2019. On August 7, 2018, the Company completed the acquisition of nora for a purchase price of €385.1 million, or $447.2 million at the exchange rate as of the transaction date, including acquired cash of €40.0 million ($46.5 million) for a net purchase price of €345.1 million ($400.7 million). Nora is an industry leader in the rubber flooring market, and this acquisition is expected to advance the Company’s growth strategy in expanding market segments, particularly in the healthcare, life sciences and education market segments. Similar to Interface, nora operates on an international footprint and the Company expects the acquisition will also allow for geographic sales synergies as well. During fiscal 2019, the Company continued to expand into these market segments as the sales of rubber flooring products were primarily in the healthcare, education and transportation market segments. During 2019, we had net sales of $1,343.0 million, up 13.9% compared to $1,179.6 million in 2018. Operating income for 2019 was $130.9 million compared to $76.4 million in 2018. Net income for 2019 was $79.2 million, or $1.34 per share, compared to $50.3 million, or $0.84 per share, in 2018. The 2019 period included the results of the acquired nora business for the full fiscal year, $5.9 million of purchase accounting amortization in connection with the nora acquisition, and $12.9 million of restructuring and other charges. The 2018 period included the results on the nora acquisition from August 7, 2018 to the end of the 2018 fiscal year. During 2018, we had net sales of $1,179.6 million, up 18.4% compared to $996.4 million in 2017. Operating income for 2018 was $76.4 million as compared to $111.6 million in 2017. Net income for 2018 was $50.3 million, or $0.84 per share, compared with $53.2 million, or $0.86 per share, in 2017. The 2018 period included the results of the acquired nora business from August 7 through the end of the year, including nora net sales of $112.6 million during that stub period. These results included amortization related to the fair value of inventory acquired of $26.7 million, and amortization of acquired intangible assets [/INST] Positive. </s>

GANNETT CO INC /DE/

2015-02-25

2014-12-28

ITEM 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain factors affecting forward-looking statements Certain statements in this Annual Report on Form 10-K contain certain forward-looking statements regarding business strategies, market potential, future financial performance and other matters. The words “believe,” “expect,” “estimate,” “could,” “should,” “intend,” “may,” “plan,” “seek,” “anticipate,” “project” and similar expressions, among others, generally identify “forward-looking statements,” which speak only as of the date the statements were made. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results and events to differ materially from those anticipated in the forward-looking statements. We are not responsible for updating or revising any forward-looking statements, whether the result of new information, future events or otherwise, except as required by law. Potential risks and uncertainties which could adversely affect our results include, without limitation, the following factors: (a) competitive pressures in the markets in which we operate; (b) increased consolidation among major retailers or other events which may adversely affect business operations of major customers and depress the level of local and national advertising; (c) a decline in viewership of major networks and local news programming resulting from alternative forms of media, or other factors; (d) macroeconomic trends and conditions; (e) economic downturns leading to a continuing or accelerated decrease in circulation or local, national or classified advertising; (f) potential disruption or interruption of our operations due to accidents, extraordinary weather events, civil unrest, political events, terrorism or cyber security attacks; (g) an accelerated decline in general print readership and/or advertiser patterns as a result of competitive alternative media or other factors; (h) an inability to adapt to technological changes or grow our online business; (i) an increase in newsprint, syndication programming costs or reverse retransmission payments over the levels anticipated; (j) labor relations, including, but not limited to, labor disputes which may cause revenue declines or increased labor costs; (k) an inability to realize benefits or synergies from acquisitions of new businesses or dispositions of existing businesses or to operate businesses effectively following acquisitions or divestitures; (l) our ability to attract and retain employees; (m) rapid technological changes and frequent new product introductions prevalent in electronic publishing and digital businesses; (n) an increase in interest rates; (o) a weakening in the British pound to U.S. dollar exchange rate; (p) volatility in financial and credit markets which could affect the value of retirement plan assets and our ability to raise funds through debt or equity issuances and otherwise affect our ability to access the credit and capital markets at the times and in the amounts needed and on acceptable terms; (q) changes in the regulatory environment which could encumber or impede our efforts to improve operating results or the value of assets; (r) credit rating downgrades, which could affect the availability and cost of future financing; (s) adverse outcomes in proceedings with governmental authorities or administrative agencies; (t) the proposed separation of our Publishing business from our Broadcasting and Digital businesses may be distracting to management and may not be completed on the terms or timeline currently contemplated, if at all; and (u) an other than temporary decline in operating results and enterprise value that could lead to non-cash goodwill, other intangible asset, investment or property, plant and equipment impairment charges. We continue to monitor the uneven economic recovery in the U.S. and U.K., as well as new and developing competition and technological change, to evaluate whether any indicators of impairment exist, particularly for those reporting units where fair value is closer to carrying value. Executive Summary We are a leading international media and marketing solutions company operating primarily in the United States and the United Kingdom (U.K.). Approximately 91% of 2014 consolidated revenues are generated by our domestic operations and approximately 9% by our foreign operations, primarily in the U.K. We implement our strategy and manage our operations through three business segments: Broadcasting (television), Publishing, and Digital. Through our Broadcasting Segment, we own or service (through shared service agreements or similar arrangements) 46 television stations with affiliated digital platforms sites. These stations serve almost one-third of the U.S. population in markets with more than 35 million households. The Publishing Segment’s operations comprise 100 daily publications and digital platforms in the U.S. and the U.K., more than 400 non-daily publications in the U.S., and more than 125 such titles in the U.K. The Publishing Segment’s 82 U.S. daily publications include USA TODAY, which is currently the nation’s number one newspaper in consolidated print and digital circulation. Together with 18 daily paid-for publications our Newsquest division operates in the U.K., the total average daily print and digital circulation of our 100 domestic and U.K. daily publications was approximately 5.4 million for 2014. In the markets we serve, we also operate desktop, smartphone and tablet products which are tightly integrated with publishing operations. Our broadcasting and publishing operations have strategic business relationships with online affiliates including CareerBuilder, Cars.com, and Shoplocal.com. The Publishing Segment also includes commercial printing, newswire, marketing and data services operations. Our Digital Segment consists of Cars.com, CareerBuilder, PointRoll and Shoplocal. Cars.com, of which we recently acquired full ownership, is the leading destination for online car shoppers. CareerBuilder is the global leader in human capital solutions, helping companies to target, attract and retain talent. Its online job site, CareerBuilder.com, is the largest in North America with the highest revenue. CareerBuilder is rapidly expanding its international operations. On August 5, 2014, following a strategic review of our growth strategies and structure, we announced a plan to separate our Publishing business into an independent publicly traded company. We expect to complete the transaction as a tax-free spin-off in mid-2015, subject to market, regulatory, and certain other conditions. We also announced that Robert J. Dickey has been appointed as CEO-designee of the standalone Publishing company following separation. The separation is subject to risks, uncertainties and conditions and there can be no assurance that the separation will be completed on the terms or on the timing currently contemplated, or at all. Please see the information in Item 1A Risk Factors of this Form 10-K, which describes some of the risks and uncertainties associated with the proposed separation. Fiscal year: Our fiscal year ends on the last Sunday of the calendar year. Our 2014 fiscal year ended on Dec. 28, 2014, and encompassed a 52-week period. Our 2013 fiscal year encompassed a 52-week period and the 2012 fiscal year encompassed a 53-week period. Operating results summary: Company-wide operating revenues were $6.01 billion in 2014, an increase of 16% from $5.16 billion in 2013. Broadcasting revenues for 2014 increased 103% to $1.69 billion, a record-high, driven primarily by the acquisitions of Belo and London Broadcasting Company television stations as well as substantially higher retransmission revenue, political and Winter Olympics advertising. Publishing revenues were $3.42 billion for 2014 or 4% below 2013 levels, reflecting a 6% decline in advertising revenues, and a 1% decline in circulation revenues. Digital Segment revenues totaled $919 million for 2014, a record high and an increase of 23%. The increase reflects strong results at CareerBuilder driven by the strength of human capital software solutions and the recent acquisition of Cars.com (formerly known as Classified Ventures, LLC). Digital revenues company-wide, including the Digital Segment and all digital revenues generated by other business segments, were approximately $1.72 billion in 2014, nearly 30% of total operating revenues, a record-high, and an increase of 15% compared to 2013. The increase was driven primarily by higher revenue associated with digital advertising and marketing solutions across all segments, strong growth at CareerBuilder and the Cars.com acquisition. Total operating expenses increased by 12% to $4.95 billion for 2014, primarily due to the Belo and Cars.com acquisitions. This increase was partially offset by lower volume-related expenses in our Publishing Segment and continued cost efficiency efforts company-wide. Newsprint expense for publishing was 9% lower than in 2013 due to a decline in consumption and prices. We reported operating income for 2014 of $1.06 billion compared to $739 million in 2013, a 43% increase. Company-wide operating margins improved significantly to 18% in 2014 compared to 14% in 2013 driven by strong growth in Broadcasting Segment results. Our net equity income in unconsolidated investees for 2014 was $167 million, an increase of $123 million over 2013, reflecting primarily the gain in the second quarter from the sale of Apartments.com by Classified Ventures, of which we owned 27%. Interest expense was $273 million in 2014, an increase of $97 million compared to 2013, largely due to new debt associated with the Belo and Cars.com acquisitions. Other non-operating items totaled $404 million in 2014, an increase of $452 million over 2013, primarily reflecting the write up of our prior investment in Cars.com to fair value once we completed the acquisition. We reported net income attributable to Gannett of $1.06 billion or $4.58 per diluted share for 2014 compared to $389 million or $1.66 per diluted share for 2013. Net income attributable to noncontrolling interests was $68 million in 2014, an increase of 19% or $11 million over 2013, reflecting significantly improved operating results at CareerBuilder. During 2014, we paid out $181 million in dividends and repurchased 2.7 million shares at a cost of $76 million for an average price of $28.13 per share. Outlook for 2015: For 2015, we expect revenue in our Broadcasting Segment to be impacted by challenging year-over-year comparisons due to the cyclical absence of record political advertising and significant Olympics revenues, which totaled $200 million in 2014. We anticipate Broadcasting Segment revenues in 2015 will benefit from higher retransmission revenues, television digital revenue growth and Super Bowl revenue across our NBC stations. Within our Publishing Segment, we intend to drive growth opportunities by capitalizing on our national brand equity to increase the integration of local and national content, enhance our position as a trusted provider of local news through expanded digital offerings and leverage our expertise to provide integrated solutions to advertisers. While we expect traditional advertising and circulation revenues to remain challenging, some of that decline will be offset by growth in digital marketing services and other digital revenues. As discussed above on page 25, we plan to separate our Publishing business into an independent publicly traded company. Digital Segment revenues are expected to increase significantly primarily due to the addition of Cars.com and continued growth at CareerBuilder. Total operating expenses are also expected to increase in comparison to 2014. Broadcasting Segment expenses are anticipated to increase, commensurate with growth in revenue and reflecting increased reverse retransmission fees as a part of programming expenses. Publishing expenses will reflect lower spending due to cost reductions and efficiency gains on initiatives as well as lower newsprint expense, as consumption continues to decline. The following 2015 outlook does not reflect the proposed separation of our Publishing business from our Broadcasting and Digital businesses: • Depreciation expense is expected to be in the range of $210 million to $215 million in 2015. Capital expenditures are expected to be approximately $135 million to $140 million. • Amortization expense is expected to be in the range of $125 million to $140 million in 2015, a significant increase over 2014 primarily due to the Cars.com acquisition. • We project our interest expense will increase slightly in 2015, reflecting the full year impact of debt issued in the second half of 2014 in connection with the Cars.com acquisition. Basis of reporting Following is a discussion of the key factors that have affected our accounting for or reporting on the business over the last three fiscal years. This commentary should be read in conjunction with our financial statements, selected financial data and the remainder of this Form 10-K. Critical accounting policies and the use of estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe the following discussion addresses our most critical accounting policies, which are those that are important to the presentation of our financial condition and results of operations and require management’s most subjective and complex judgments. Business Combinations: We allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed and intangible assets acquired, based on their estimated fair values. The excess of the fair value of purchase consideration over the values of these identifiable assets and liabilities is recorded as goodwill. When determining the fair value of assets acquired and liabilities assumed, management makes significant estimates and assumptions, especially with respect to intangible assets. Critical estimates in valuing certain identifiable assets include but are not limited to expected long-term market growth; station revenue shares within a market; future expected operating expenses; cost of capital; and appropriate discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Goodwill: As of Dec. 28, 2014, goodwill represented approximately 40% of our total assets. Goodwill represents the excess of acquisition cost over the fair value of assets acquired, including identifiable intangible assets, net of liabilities assumed. Goodwill is tested for impairment on an annual basis (first day of fourth quarter) or between annual tests if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Before performing the annual two-step goodwill impairment test, we are first permitted to perform a qualitative assessment to determine if the two-step quantitative test must be completed. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance, as well as company and specific reporting unit specifications. If after performing this assessment, we conclude it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then we are required to perform a two-step quantitative test. Otherwise, the two-step test is not required. In the first step of the quantitative test, we are required to determine the fair value of each reporting unit and compare it to the carrying amount of the reporting unit. Fair value of the reporting unit is determined using various techniques, including multiple of earnings and discounted cash flow valuation. Determining the fair value of the reporting units is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include changes in revenue and operating margins used to project future cash flows, discount rates, valuation multiples of entities engaged in the same or similar lines of business and future economic and market conditions. If the carrying amount of the reporting unit exceeds the fair value of the reporting unit, we perform the second step of the impairment test, as this is an indication that the reporting unit goodwill may be impaired. In the second step of the impairment test, we determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then an impairment of goodwill has occurred and we must recognize an impairment loss for the difference between the carrying amount and the implied fair value of goodwill. In 2014, following this testing, we recognized impairment charges in our Publishing Segment of $22 million and in our Digital Segment of $24 million. The charges were to bring the recorded goodwill equal to implied fair value based on future projections for each reporting unit. The impairment charges coincide with updated financial projections for each of these reporting units. We used both the qualitative and quantitative assessments for our goodwill impairment testing during 2014. We have 6 major reporting units (defined as reporting units with goodwill in excess of $50 million) which accounted for 99% of our goodwill balance at Dec. 28, 2014. The following table shows the aggregate goodwill for these units summarized at the segment level: For the Broadcasting Segment, which is considered a single reporting unit, the estimated value would need to decline by over 40% to fail step one of the quantitative goodwill impairment test. In the case of the Publishing Segment, there are three major reporting units that comprise the goodwill balance shown above. These consist of U.S. Community Publishing (including Gannett Publishing Services), Newsquest and USA TODAY group (which includes USA TODAY brand properties). For U.S. Community Publishing, USA TODAY group and Newsquest, the estimated fair value of each of these reporting units exceeded the carrying value at the most recent test. In order for the reporting unit with the least amount of headroom to fail step one of the quantitative goodwill impairment test, the estimated value of the reporting unit would have to decline by over 30%. The Digital Segment balance represents primarily Cars.com and CareerBuilder. For CareerBuilder, we performed a qualitative assessment and concluded that it was more likely than not that the fair value was greater than the carrying value. After the impairment testing date, we completed our acquisition of Cars.com which is part of the Digital Segment. The carrying value of Cars.com on the day of acquisition was equal to its fair value. Fair value of the reporting units depends on several factors, including the future strength of the economy in our principal broadcast, publishing and digital markets. Generally uneven recoveries in the U.S. and U.K. markets have had an adverse effect on most of our reporting units in recent years. The differences between fair value and carrying value have narrowed particularly for certain less significant reporting units in the Publishing Segment. New and developing competition as well as technological change could also adversely affect future fair value estimates. Any one or a combination of these factors could lead to declines in reporting unit fair values and result in goodwill impairment charges. Indefinite Lived Intangibles: This asset grouping consists of FCC licenses for television stations and mastheads and trade names for publishing and digital businesses. Indefinite lived assets are not subject to amortization and as a result they are tested for impairment annually (on the first day of the fourth quarter), or more frequently if events or changes in circumstances suggest that the asset might be impaired. We are permitted to perform a qualitative assessment to determine if it is more likely than not that the fair value of the indefinite lived asset is more than its carrying amount. If that is the case, then we would not have to perform the quantitative analysis. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance of the indefinite lived asset. Television FCC licenses are not subject to amortization and are tested for impairment annually (first day of fourth quarter), or more frequently if events or changes in circumstances indicate that the asset might be impaired. If the licenses are not tested qualitatively, then the quantitative impairment test consists of a comparison of the fair value of the license with its carrying amount. Fair value is estimated using an income approach referred to as the “Greenfield Approach.” This method requires multiple assumptions relating to the future prospects of each individual television station including, but not limited to: (i) expected long-term market growth characteristics, (ii) station revenue shares within a market for a new entrant, (iii) future expected operating expenses, (iv) costs of capital and (v) appropriate discount rates. We performed a qualitative analysis on all of our FCC licenses on the impairment testing date and concluded that it was more likely than not that the fair value was more than the carrying value for each license. We completed our acquisition of Belo in late 2013 and London Broadcasting in mid-2014 and as a result recorded FCC licenses for all stations acquired. As these FCC licenses were recorded at fair value on the date of acquisition, any future declines in the fair value of the FCC license would result in an impairment charge. Factors that could cause the fair value to decline would be negative changes in any of the assumptions described in the above Greenfield Approach. The discount rate used generally has a significant impact to the Greenfield Approach valuation. For our 2014 impairment testing date the discount rate had declined from when we completed our acquisition of Belo. Future increases in the discount rate assumptions could cause a decline in the fair value of our FCC licenses which may result in an impairment charge. Local mastheads (publishing periodical titles and web site domain names) and other trade names are not subject to amortization and as a result they are tested for impairment annually (first day of the fourth quarter), or more frequently if events or changes in circumstances suggest that the asset might be impaired. The quantitative impairment test consists of a comparison of the fair value of each masthead/domain name or trade name with its carrying amount. We use a “relief from royalty” approach which utilizes a discounted cash flow model to determine the fair value of each masthead/domain name or trade name. Management’s judgments and estimates of future operating results in determining the reporting unit fair values are consistently applied to each underlying business in determining the fair value of each intangible asset. We do not believe that any of our larger trade names or mastheads (those with book values over $10 million) are at risk of requiring an impairment charge in the foreseeable future. After the impairment testing date, we completed our acquisition of Cars.com and as a result recorded an indefinite-lived trade name valued at $872 million. As this trade name was recorded at fair value on the date of acquisition, any future declines in the fair value of the trade name would result in an impairment charge. Other Long-Lived Assets (Property, Plant and Equipment and Amortizable Intangible Assets): Property, plant and equipment are recorded at cost and depreciated on a straight-line method over the estimated useful lives of such assets. Changes in circumstances, such as technological advances or changes to our business model or capital strategy, could result in actual useful lives differing from our estimates. In cases where we determine the useful life of buildings and equipment should be shortened, we would, after evaluating for impairment, depreciate the asset over its revised remaining useful life thereby increasing depreciation expense. Accelerated depreciation was recorded in the years 2012-2014 for certain property, plant and equipment, reflecting specific decisions to consolidate production and other business services, primarily affecting the Publishing Segment. If an indicator is present, we review our property, plant and equipment assets for potential impairment at the asset group level (generally at the local business level) by comparing the carrying value of such assets with the expected undiscounted cash flows to be generated by those asset groups/local business units. Due to expected continued cash flow in excess of carrying value from its businesses, no property, plant or equipment assets were considered impaired. Our amortizable intangible assets consist mainly of customer relationships, internally valued technology and retransmission agreements. These asset values are amortized systematically over their estimated useful lives. An impairment test of these assets would be triggered if the undiscounted cash flows from the related asset group (business unit) were to be less than the asset carrying value. We do not believe that any of our larger amortizable intangible assets (those with book values over $10 million) are at risk of requiring an impairment in the foreseeable future. Pension Accounting: We, along with our subsidiaries, have various defined benefit retirement plans, under which substantially all of the benefits have been frozen in previous years. We account for our pension plans in accordance with the applicable accounting guidance, which requires us to include the funded status of our pension plans in our balance sheets, and to recognize, as a component of other comprehensive income (loss), the gains or losses that arise during the period, but are not recognized in pension expense. Pension expense is reported on the Consolidated Statements of Income as “Cost of sales and operating expenses,” or “Selling, general and administrative expenses”. The determination of pension plan obligations and expense is dependent upon a number of assumptions regarding future events, the most important of which are the discount rate applied to pension plan obligations and the expected long-term rate of return on plan assets. The discount rate assumption is based on investment yields available at year-end on corporate bonds rated AA and above with a maturity to match the expected benefit payment stream. A decrease in discount rates would increase pension obligations. We establish the expected long-term rate of return by developing a forward-looking, long-term return assumption for each pension fund asset class, taking into account factors such as the expected real return for the specific asset class and inflation. A single, long-term rate of return is then calculated as the weighted average of the target asset allocation percentages and the long-term return assumption for each asset class. We apply the expected long-term rate of return to the fair value of its pension assets in determining the dollar amount of its expected return. Changes in the expected long-term return on plan assets would increase or decrease pension plan expense. The effects of actual results differing from these assumptions are accumulated as unamortized gains and losses. A corridor approach is used in the amortization of these gains and losses, by amortizing the balance exceeding the greater of 10% of the beginning balances of the projected benefit obligation or the fair value of the plan assets. The amortization period is based on the average life expectancy of plan participants, which is currently estimated to be approximately 22 years for our principal retirement plan. For 2014, the assumption used for the discount rate was 4.05% for our principal retirement plan obligations. As an indication of the sensitivity of pension liabilities to the discount rate assumption, a 50 basis point reduction in the discount rate at the end of 2014 would have increased plan obligations by approximately $125 million. A 50 basis point change in the discount rate used to calculate 2014 expense would have changed total pension plan expense for 2014 by approximately $1.8 million. We assumed a rate of 8.00% for our long-term expected return on pension assets used for our principal retirement plan. As an indication of the sensitivity of pension expense to the long-term rate of return assumption, a 50 basis point decrease in the expected rate of return on pension assets would have increased estimated pension plan expense for 2014 by approximately $9.8 million. Income Taxes: Our annual tax rate is based on our income, statutory tax regulations and rates, and tax planning opportunities available in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax expense and in evaluating our tax positions. Tax law requires certain items to be included in our tax returns at different times than when the items are reflected in the financial statements. The annual tax expense reflected in the Consolidated Statements of Income is different than that reported in our tax returns. Some of these differences are permanent, for example expenses recorded for accounting purposes that are not deductible in the returns such as non-deductible goodwill, and some differences are temporary and reverse over time, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax liabilities generally represent tax expense recognized in the financial statements for which payment has been deferred, or expense for which a deduction has been taken already in the tax return but the expense has not yet been recognized in the financial statements. Deferred tax assets generally represent items that can be used as a tax deduction or credit in tax returns in future years for which a benefit has already been recorded in the financial statements. Valuation allowances are established when necessary to reduce deferred income tax assets to the amounts we believe are more likely than not to be recovered. In evaluating the amount of any such valuation allowance, we consider the existence of cumulative income or losses in recent years, the reversal of existing temporary differences, the existence of taxable income in prior carry back years, available tax planning strategies and estimates of future taxable income for each of our taxable jurisdictions. The latter two factors involve the exercise of significant judgment. As of Dec. 28, 2014, deferred tax asset valuation allowances totaled $200 million, primarily related to federal and state capital losses, foreign tax credits, foreign losses and state net operating losses available for carry forward to future years. Although realization is not assured, we believe it is more likely than not that all other deferred tax assets for which no valuation allowances have been established will be realized. This conclusion is based on our history of cumulative income in recent years and review of historical and projected future taxable income. We determine whether it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit is recorded in our financial statements. A tax position is measured as the portion of the tax benefit that is greater than 50% likely to be realized upon settlement with a taxing authority (that has full knowledge of all relevant information). We may be required to change our provision for income taxes when the ultimate treatment of certain items is challenged or agreed to by taxing authorities, when estimates used in determining valuation allowances on deferred tax assets significantly change, or when receipt of new information indicates the need for adjustment in valuation allowances. Future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported in the Consolidated Financial Statements in the year these changes occur. The effect of a one percentage point change in the effective tax rate for 2014 would have resulted in a change of $13 million in the provision for income taxes and net income attributable to Gannett Co., Inc. RESULTS OF OPERATIONS Consolidated summary A consolidated summary of our results is presented below. A discussion of operating results of our Broadcasting, Publishing, and Digital Segments, along with other factors affecting net income attributable to Gannett, is as follows: Broadcasting Segment 2014 was a record year for our Broadcasting Segment. The largest contributor was the significant expansion of our television station portfolio. At the end of 2014, our broadcasting operations included 46 television stations either owned or serviced through shared service agreements or other similar agreements. Stations in our broadcasting division cover almost one-third of the U.S. population in markets with more than 35 million households. Broadcasting Segment revenues accounted for approximately 28% of our reported operating revenues in 2014. Broadcasting Segment revenues accounted for approximately 16% of our reported operating revenues in 2013 and 17% in 2012. Over the last three years, Broadcasting Segment revenues, expenses and operating income were as follows: Broadcasting Segment revenues are grouped into five categories: Core (Local and National), Political, Retransmission, Digital and Other. The following table summarizes the year-over-year changes in these select revenue categories. Reported Broadcasting Segment revenues increased $857 million to $1.69 billion or 103% for 2014, a record high, primarily driven by the acquisition of Belo and London Broadcasting television stations, as well as substantially higher retransmission revenue and record non-presidential year political advertising. Core advertising revenues, which consist of Local and National non-political advertising, increased 74% to $1.05 billion in 2014 mainly due to television station acquisitions and $41 million in advertising associated with the Winter Olympics that was partially offset by political advertising displacement. Political advertising reached $159 million compared to $13 million in 2013, driven by a strong political footprint. Retransmission revenues increased 145% in 2014 resulting from the expansion of our Broadcasting Segment portfolio and rate increases. Within the Broadcasting Segment, digital revenue increased 156% compared to 2013 reflecting continued growth from digital marketing services products. Broadcasting Segment costs doubled to $947 million in 2014. The increase is driven primarily by the acquisitions as well as higher investment in digital initiatives and reverse network compensation. As a result of all of these factors, Broadcasting Segment operating income more than doubled to $745 million in 2014. Broadcasting Segment results 2013-2012: Reported broadcasting revenues decreased $71 million to $835 million or 8% for 2013. The 2013 year-over-year comparison is impacted by the absence of a record level of political spending and advertising revenues associated with the 2012 Summer Olympics as well as an extra week in 2012’s results. Core advertising revenues, while impacted by the displacement of record political revenues, were up 3% in 2013, reflecting strong growth in the media, medical, and services categories. Retransmission revenues increased 52% in 2013 and digital television revenues increased 21% compared to 2012. Broadcasting Segment costs increased 2% to $473 million in 2013. The increase reflects higher digital sales and marketing costs in 2013 associated with online revenue growth and workforce restructuring costs associated with the Belo transaction. As a result of all of these factors, Broadcasting Segment operating income decreased 18% to $362 million in 2013. Publishing Segment Our publishing operations include USCP, Gannett Publishing Services, USA TODAY group (which includes USA TODAY brand properties), Newsquest, which produces daily and non-daily publications in the U.K., Clipper Magazine, Gannett Government Media and other advertising and marketing services businesses. The Publishing Segment in 2014 contributed 57% of our revenues. Publishing operating results were as follows: Foreign currency translation impacts: The average exchange rate used to translate U.K. publishing results was 1.65 for 2014, 1.56 for 2013 and 1.58 for 2012. Translation fluctuations impact U.K. publishing revenue, expense and operating income results. Publishing Segment operating revenues: Publishing operating revenues are derived principally from advertising sales which accounted for 61% of total publishing revenues in 2014, and circulation sales which accounted for 33% of total publishing revenues in 2014. Advertising revenues include those derived from advertising placed with print products as well as publishing related Internet desktop, smartphone and tablet applications. These include revenue in the classified, retail and national advertising categories. Circulation revenues are derived principally from distributing our publications on our digital platforms, from home delivery and from single copy sales of our publications. Other publishing revenues are mainly from commercial printing. The table below presents the principal components of Publishing Segment revenues for the last three years. Publishing Segment digital revenues were up for the year in the U.S. as well as at Newsquest in the U.K. Revenues benefited from our continued focus on digital marketing services. Domestic U.S. digital revenues were up 4%, while digital revenues at Newsquest increased 21% in local currency. The table below presents the principal components of Publishing Segment advertising revenues for the last three years. These amounts include advertising revenue from printed publications as well as online advertising revenue from desktop, smartphone and tablets affiliated with the publications. Publishing Segment revenue comparisons 2014-2013: Advertising Revenue: Advertising revenues for 2014 decreased $129 million or 6%. The decrease reflects lower advertising demand due to ongoing secular pressures. The tables below present the percentage change in 2014 compared to 2013 for each of the major advertising and classified revenue categories, presented as if the Apartments.com sale, which affected classified real estate revenue comparisons, occurred at the beginning of 2013. Revenue recorded to classified real estate advertising related to Apartments.com sales totaled approximately $4 million in 2014 and $15 million in 2013. The table below presents the percentage change for the retail, national, and classified categories for 2014 compared to 2013. Retail advertising revenues were down $62 million or 5% in 2014. In the U.S., revenues were down in all major categories. Retail advertising revenues, in local currency, were down 2% in the U.K. National advertising revenues were down $44 million or 12% in 2014, primarily due to lower advertising sales for USCP, Newsquest, and USA TODAY. The table below presents the percentage change in classified categories for 2014 compared to 2013 as if the Apartments.com sale occurred at the beginning of 2013. Classified advertising revenues declined 4% in the U.S. and 3% in the U.K in 2014. Domestically, automotive advertising was down 2% for the year while employment and real estate both declined 4% for the year. In the U.K., while most classified advertising categories were lower, employment advertising improved 7% in local currency, reflecting the recovery in the U.K. economy. Circulation Revenue: Publishing Segment circulation revenues decreased by $10 million or 1%. Circulation revenues decreased 1% in 2014 at USCP, reflecting an increase in home delivery revenue offset by a decrease in single copy revenue. Home delivery revenue was boosted by the pricing impact of placing USA TODAY local editions in 35 of our USCP units and the strength of our All Access Content Subscription Model, adding engaging content which allowed us to deploy strategic pricing initiatives. Circulation revenues were 4% lower at USA TODAY and 1% lower in local currency in the U.K., due to declines in print circulation volume, partially offset by cover price increases, implemented in 2013. Daily average print and digital, replica and non-replica circulation, excluding USA TODAY, declined 9%, while Sunday net paid circulation declined 3%. For local publishing operations in the U.S. and U.K., morning circulation accounted for approximately 95% of total daily volume, while evening circulation accounted for 5%. Local publishing circulation volume is summarized in the table below. Other Revenue: Commercial printing and other publishing revenues were down 7% in 2014 and totaled $233 million, reflecting the sale of a print business and a decrease in U.K. commercial print revenues. Commercial printing revenues in the U.S. and U.K. combined accounted for nearly 60% of total other revenues. Publishing Segment revenue comparisons 2013-2012: Advertising Revenue: Advertising revenues for 2013 declined $157 million or 7%. The decrease reflecting lower advertising demand due to secular pressures, a slow pace of the economic recovery, and the extra week in 2012. Ad revenues were lower in both the U.S. and the U.K. In the U.K., in local currency, advertising revenues comparisons lagged comparisons in the U.S. Newsquest advertising revenues were down 8% compared with 6% decline for U.S. publishing. Retail advertising revenues were down $73 million or 6% in 2013. In the U.S., revenues were down in all major categories. Retail advertising revenues were down 4% in the U.K. on a constant currency basis. National advertising revenues were down $31 million or 8% in 2013, primarily due to lower advertising sales for U.S. Community Publishing, Newsquest, and as well as for USA TODAY and its associated businesses. Classified advertising revenues declined $53 million or 7% in 2013 with a decline of 7% in the U.S. and 8% in the U.K. Domestically, automotive advertising was down 2% for the year while employment declined 10%. Real estate continued to reflect the housing issues nationwide and was down 5% for the year. Most classified advertising results in the U.K. lagged results in the U.S. as automotive, employment and real estate declined in local currency 10%, 4% and 9%, respectively. Circulation Revenue: Publishing Segment circulation revenues increased by $12 million or 1% over 2012, reflecting the second consecutive annual company-wide circulation revenue increase. Circulation revenues were up as a result of the implementation of the All Access Content Subscription Model in 2012. Circulation revenues increased 3% in 2013 at USCP. Circulation revenue in the U.K. was up 3% compared to last year in local currency reflecting increases in cover prices. Revenue comparisons reflect generally lower circulation volumes more than offset by price increases. Daily average print and digital, replica and non-replica circulation, excluding USA TODAY, declined 8%, while Sunday net paid circulation declined 5%. Circulation revenues were lower at USA TODAY, reflecting lower average print daily circulation volume, partially offset by price increases. For local publishing operations in the U.S. and U.K., morning circulation accounted for approximately 95% of total daily volume, while evening circulation accounted for 5%. Other Revenue: Commercial printing and other publishing revenues were down 2% in 2013 and totaled $250 million. Declines in other publishing revenues were partially offset by an increase in commercial print revenues. Commercial printing revenues in the U.S. and U.K. combined, accounted for approximately 60% of total other revenues. Publishing Segment digital revenues in 2013 were up for the year in the U.S. as well as at Newsquest in the U.K. Revenues benefited from our continued focus on digital marketing services and the All Access Content Subscription Model. Domestic U.S. digital revenues were up 34%, while digital revenues at Newsquest increased 13% in local currency. Publishing Segment expense comparisons 2014-2013: Publishing operating expense decreased to $3.19 billion in 2014 primarily due to continued cost reductions and efficiency efforts as well as lower print volumes, partially offset by special charges for transformation costs, asset impairments and workforce restructuring. Publishing payroll costs were down 4% compared to 2013, reflecting the impact of workforce restructuring. Newsprint expense was down 9% in 2014 due to a decline in consumption and prices. Publishing Segment expense comparisons 2013-2012: Publishing operating expense decreased to $3.26 billion in 2013 as continued cost efficiency efforts were partially offset by strategic initiative spending of $36 million. A majority of the strategic spending in 2013 was in conjunction with digital relaunches and the investments made in our digital marketing services business. Publishing payroll costs were down 3% compared to 2012, reflecting the impact of workforce restructuring across certain divisions. Newsprint expense was down 14% in 2013 due to a decline in consumption and prices. Publishing Segment operating results 2014-2013: Publishing operating income decreased to $228 million in 2014 from $314 million in 2013. The principal factors affecting reported operating results comparisons for the full year were the following: • Lower operating results in the U.S. as advertising revenue categories were affected by the impact of the secular pressure on print advertising demand; • Significant increase in digital revenue; • Special charges for transformation costs and asset impairments as well as workforce restructuring costs totaled $123 million in 2014 and $89 million in 2013; • A decrease in newsprint expense. Publishing Segment operating results 2013-2012: Publishing operating income decreased to $314 million in 2013 from $369 million in 2012. The principal factors affecting reported operating results comparisons for the full year were the following: • Lower operating results in the U.S. and U.K. as advertising revenue categories were affected by the impact of the soft economy on advertising demand, partially offset by an increase in circulation revenue at our USCP and U.K. operations; • Strategic initiative spending in 2013 of $36 million; • Special charges for transformation costs and asset impairments as well as workforce restructuring totaled $89 million in 2013 and $74 million in 2012; • Significant increase in digital revenue; • Negative impact of the extra week in 2012; and • A decrease in newsprint expense. Digital Segment The Digital Segment includes results for stand-alone digital subsidiaries including Cars.com, CareerBuilder, PointRoll, and Shoplocal. On October 1, 2014, we completed the acquisition of the remaining 73% interest that we did not already own in Cars.com. Full year results for 2014 include Cars.com results following the acquisition on October 1. On April 1, 2014, CareerBuilder acquired Broadbean, a leader in online recruitment software that enables job distribution, candidate sourcing and big data analytics for employers. The Broadbean acquisition, when combined with the addition of Economic Modeling Specialists Intl. in 2012, represents the next step in CareerBuilder’s transformation, positioning it as a leading company in the rapidly growing software-as-a-service market for talent management solutions. Digital Segment revenues, expenses and operating income were as follows: Digital Segment revenues increased $171 million or 23% over 2013 to a record high of $919 million, primarily reflecting the impact of the Cars.com acquisition, and continued growth in revenues at CareerBuilder. Digital Segment expenses in 2014 increased 23% to $764 million, primarily due to the Cars.com acquisition and an increase in expenses at CareerBuilder associated with its revenue growth. As a result of these factors, Digital Segment operating income increased to $155 million in 2014. CareerBuilder, a global leader in human capital solutions majority-owned by Gannett, provides services ranging from labor market intelligence to talent management software and other recruitment tools. It is the largest online job site in the U.S., measured both by traffic and revenue, has a presence in more than 60 markets worldwide and focuses on technology solutions and niche sites. Its North American network revenue is driven mainly from its own sales force but it also derives revenues from its owner affiliated businesses, including our local media organizations, which sell various CareerBuilder employment products including upsells of print employment ads. North American revenue increased 3%, compared to last year. CareerBuilder revenues in the Digital Segment exclude amounts recorded at Gannett-owned local media organizations. Digital Segment results 2013-2012: Digital Segment revenues increased $29 million or 4% over 2012, primarily reflecting a strong increase in revenues at CareerBuilder. Digital Segment expenses in 2013 decreased 8% to $620 million, primarily due to a $78 million decrease in impairment charges in 2013 partly offset by an increase in expenses at CareerBuilder associated with its revenue growth. As a result of these factors, Digital Segment operating income increased to $128 million in 2013. Consolidated operating expenses Over the last three years, our consolidated operating expenses were as follows: Total reported operating expenses increased 12% to $4.95 billion in 2014, primarily due to the impact of the acquisitions of Belo and the London Broadcasting Company television stations, as well as the acquisition of Cars.com partly offset by continued cost efficiency efforts company-wide as well as lower newsprint expense. Depreciation expense was 21% higher in 2014, reflecting the acquisitions of television stations as well as Cars.com. The non-cash facility consolidation and asset impairment charges for all years are more fully discussed beginning on page 34 and in Notes 3 and 4 to the Consolidated Financial Statements. Payroll and benefits and newsprint costs (along with certain other production material costs), the largest elements of our normal operating expenses, are presented below, expressed as a percentage of total pre-tax operating expenses. Operating expense comparisons 2013-2012: Total reported operating expense decreased 3% to $4.42 billion in 2013, due to continued cost efficiency efforts company-wide, lower facility consolidation and asset impairment charges as well as lower newsprint expense. These were partially offset by $58 million in workforce restructuring charges and $41 million of strategic initiative investments made throughout the year. Depreciation expense was 5% lower in 2013, reflecting certain assets reaching the end of their depreciable life. Non-operating income and expense Equity earnings: This income statement category reflects results from unconsolidated minority interest investments, including our equity share of operating results from our publishing partnerships, including the California Newspapers Partnership, Texas-New Mexico Newspapers Partnership, Tucson newspaper partnership and other online/digital businesses including Cars.com before we acquired it on October 1. Our net equity income in unconsolidated investees for 2014 was $167 million, an increase of $123 million over 2013. This increase reflects primarily the gain on the sale of Apartments.com, partly offset by the lower equity income from Classified Ventures as well as softer results for newspaper partnerships. Our net equity income in unconsolidated investees for 2013 was $44 million, an increase of $21 million over 2012. This increase reflects better results at Classified Ventures, the California Newspapers Partnership, as well as reduced impairment charges recognized in 2013. Interest expense: 2014 interest expense increased by 55% to $273 million compared to 2013 due to a higher average debt level of $3.85 billion. The higher average debt level is related to additional borrowings, partly offset by a lower average interest rate. Interest expense in 2013 was higher compared to 2012, due to a higher average debt level related to the issuance of $1.85 billion in senior notes in the second half of 2013 primarily related to the Belo acquisition which closed on Dec. 23, 2013. We increased our long-term debt by $781 million or 21% in 2014. At the end of 2014, our leverage ratio was 2.96x, within the financial covenants under its revolving credit agreements. A further discussion of our borrowing and related interest cost is presented in the “Liquidity and capital resources” section of this report beginning on page 40 and in Note 6 to the Consolidated Financial Statements. Other non-operating items: We reported a net gain of $404 million for other non-operating items in 2014. The majority reflects the write-up of our prior 27% investment in Cars.com to fair value post acquisition and a gain related to required accounting for the pre-existing affiliate agreement between us and Cars.com. The net gain was partially offset by acquisition costs and expenses incurred for our previously announced separation in to two public companies. Other non-operating items totaled a net loss of $48 million in 2013 with the majority related to costs associated with the Belo transaction and a non-cash charge associated with the change in control and sale of interests related to Captivate. These costs were partly offset by interest income earned in 2013. We reported a net gain of $9 million in 2012 with the majority related to a gain on distribution from a cost method investment and interest income earned during 2012. Provision for income taxes We reported pre-tax income attributable to Gannett of $1.29 billion for 2014. The provision for income taxes reflects a special net tax benefit from the sale of a non-strategic subsidiary at a loss, for which a partial tax benefit was recognized. The effective tax rate on pre-tax income is 17.5%. We reported pre-tax income attributable to Gannett of $502 million for 2013. The provision for income taxes reflects certain state audit settlements and a special net tax benefit from the release of certain tax reserves due to a multi-year federal audit settlement in 2013. The effective tax rate on pre-tax income is 22.6%. The lower tax rate for 2014 compared to 2013 is due to special items contributing a net tax benefit that related primarily to the 2014 sale of a non-strategic subsidiary at a loss, for which a partial tax benefit was recognized, partially offset by a reduction in audit resolutions. We reported pre-tax income attributable to Gannett of $620 million for 2012. The provision for income taxes reflects an impairment of non-deductible goodwill, certain state audit settlements and a special net tax benefit from the release of certain tax reserves due to a federal audit settlement in 2012. The effective tax rate on pre-tax income is 31.5%. The lower effective tax rate for 2013 compared to 2012 is due to special items contributing a net tax benefit that related primarily to a multi-year federal audit settlement recognized in 2013 as well as a non-deductible goodwill impairment charge incurred in 2012. Further information concerning income tax matters is contained in Note 9 of the Consolidated Financial Statements. Net income attributable to Gannett Co., Inc. Net income attributable to Gannett Co., Inc. and related per share amounts are presented in the table below. Net income attributable to Gannett Co., Inc. consists of net income reduced by net income attributable to noncontrolling interests, primarily from CareerBuilder. Net income attributable to noncontrolling interests was $68 million in 2014, $57 million in 2013 and $51 million in 2012. Operating results non-GAAP information Presentation of non-GAAP information: We use non-GAAP financial performance and liquidity measures to supplement the financial information presented on a GAAP basis. These non-GAAP financial measures should not be considered in isolation from or as a substitute for the related GAAP measures, and should be read in conjunction with financial information presented on a GAAP basis. We discuss in this report non-GAAP financial performance measures that exclude from its reported GAAP results the impact of special items consisting of: • Workforce restructuring charges; • Transformation costs; • Non-cash asset impairment charges; • A non-cash charge related to a change in control and sale of interests in a business; • Non-cash charges related to certain investments accounted for under the equity method; • Equity income gain on the sale of Apartments.com by Classified Ventures; • Non-operating income from the write-up of our prior equity investment in Cars.com to fair value post acquisition; • Other non-operating expenses related to acquisition costs, donations to our foundation and expenses incurred for our previously announced spin-off of our publishing operation; and • Special tax gains and charges, as well as the tax effect of the above special items. We believe that such expenses, charges and credits are not indicative of normal, ongoing operations and their inclusion in results makes for more difficult comparisons between years and with peer group companies. Workforce restructuring and transformation expenses primarily relate to incremental expenses we have incurred to consolidate or outsource production processes and centralize other functions. Workforce restructuring expenses include payroll and related benefit costs as well as charges related to our partial withdrawal from certain multi-employer pension plans. Transformation costs include incremental expenses incurred by us to execute on our transformation and growth plan and incremental expenses associated with optimizing our real estate portfolio. Asset impairment charges reflect non-cash charges to reduce the book value of certain intangible assets to their respective fair value, as our projections for the business underlying the related asset had declined. In 2014, we recorded a pre-tax gain of $148 million related to the Classified Ventures sale of its Apartments.com business. This gain is reflected in the line equity income in unconsolidated investees, net. Other non-operating items for 2014 included special gains and charges primarily related to (1) income related to the write-up of our prior investment in Cars.com to fair value post acquisition and the required accounting for the pre-existing affiliate agreement between us and Cars.com, (2) costs for acquiring six London Broadcasting Company television stations and the remaining outstanding shares of Cars.com, (3) expenses related to the planned spin-off of our publishing operation, (4) the early retirement of our 9.375% notes due in 2017, and (5) non-cash donations to our charitable foundation. Other non-operating items in 2013 included Belo acquisition related expenses, a non-cash charge related to a sale of interests in a business and a currency loss related to the weakening of the British pound associated with the downgrade of the U.K. sovereign credit rating. The income tax provision for 2014 reflects a tax benefit related to our portfolio restructuring, the sale of a non-strategic investment, and a charge related to the sale of our interest in television station KMOV-TV in St. Louis, MO, in February 2014. The income tax provision for 2013 included special credits related to reserve releases as a result of federal exam resolution and lapse of certain statutes of limitations. Results for 2012 included a credit related primarily to tax settlements covering multiple years. We discuss Adjusted EBITDA, a non-GAAP financial performance measure that we believe offers a useful view of our overall business operations. Adjusted EBITDA is defined as net income attributable to Gannett before (1) net income attributable to noncontrolling interests, (2) income taxes, (3) interest expense, (4) equity income, (5) other non-operating items, (6) workforce restructuring, (7) transformation costs, (8) asset impairment charges, (9) depreciation and (10) amortization. When Adjusted EBITDA is discussed in reference to performance on a consolidated basis, the most directly comparable GAAP financial measure is Net income attributable to Gannett. We use non-GAAP financial performance measures for purposes of evaluating business unit and consolidated company performance. Therefore, we believe that each of the non-GAAP measures presented provides useful information to investors by allowing them to view our businesses through the eyes of our management and Board of Directors, facilitating comparison of results across historical periods, and providing a focus on the underlying ongoing operating performance of our businesses. Many of our peer group companies present similar non-GAAP measures to better facilitate industry comparisons. Discussion of special charges and credits affecting reported results: We recorded workforce restructuring related costs totaling $40 million ($26 million after-tax or $.11 per share) in 2014, $58 million ($37 million after-tax or $.16 per share) in 2013, and $49 million ($29 million after-tax or $.12 per share) in 2012. These charges were taken in connection with workforce reductions related to facility consolidation and outsourcing efforts and as part of a general program to fundamentally change our cost structure. Company-wide transformation plans led us to recognize charges in 2012-2014 associated with revising the useful lives of certain assets over a shortened period, as well as shutdown costs and charges to reduce the carrying value of assets held for sale to fair value less costs to sell. Total charges for these matters were $79 million ($44 million after-tax or $.19 per share) in 2014, $25 million ($15 million after-tax or $.06 per share) in 2013, and $32 million ($20 million after-tax or $.08 per share) in 2012. We performed impairment tests on certain assets including goodwill and other intangible assets that resulted in the recognition of impairment charges in 2012-2014. During 2014, we recorded non-cash asset impairment charges of $51 million ($46 million after-tax or $.20 per share). In 2013, non-cash asset impairment charges totaled $33 million ($20 million after-tax or $.08 per share). In 2012, non-cash asset impairment totaled $90 million ($87 million after-tax or $.37 per share). These facility consolidation and non-cash impairment charges are detailed in Notes 3 and 4 to the Consolidated Financial Statements. Other non-operating items totaled a gain of $542 million ($325 million after-tax or $1.40 per share) in 2014. The gain is primarily from the $477 million write-up of our prior 27% investment in Cars.com to fair value post acquisition and gain on the settlement of the pre-existing affiliate agreement between us and Cars.com, as well as our equity share of Classified Ventures’ gain on the sale of Apartments.com in April of 2014 that totaled $148 million. Non-operating charges in 2014 were primarily for acquisition costs for the Cars.com and London Broadcasting Company acquisitions, expenses incurred for our previously announced spin-off of our publishing operations, non-cash donations to our charitable foundation and the early retirement of our 9.375% notes due in 2017. In 2013, non-operating items charges totaled $55 million ($41 million after-tax or $.17 per share) and primarily related to a loss recognized on the Captivate transaction and Belo acquisition costs. In 2012, non-operating items charges totaled $7 million ($4 million after-tax or $.02 per share) related to asset impairments of a cost and equity method investment. In 2014, we recorded special net tax benefits that totaled $218 million or $.94 per share that were primarily driven by a restructuring of our portfolio which included the sale of a non-strategic equity investment. We also recorded a tax benefit of $28 million or $.12 per share related to resolution of several federal tax claims in 2013. In 2012, we recorded $13 million or $.06 per share related primarily to tax settlements covering multiple years. Consolidated results The following is a discussion of our as adjusted non-GAAP financial results. All as adjusted (non-GAAP basis) measures are labeled as such or “adjusted”. Adjustments to remove special items from GAAP operating expense follow: Adjusted operating expenses increased 11% in 2014 over 2013 to $4.78 billion primarily due to the acquisitions of the Belo and London Broadcasting Company television stations and Cars.com, partly offset by continued efficiency efforts company-wide. Adjusted operating expenses decreased 2% in 2013 over 2012 to $4.31 billion, due to continued efficiency efforts company-wide and the extra week in 2012, partly offset by an increase in Digital Segment expenses related to the increase in revenue. Adjustments to remove special items from GAAP operating income follow: Adjusted operating income increased 44% in 2014 over 2013 to $1.23 billion. The increase reflects substantially higher revenue growth in the Broadcasting and Digital Segments to record levels, partially offset by a decline in the Publishing Segment. Broadcasting Segment revenues and operating results were higher due to the Belo and London Broadcasting Company television station acquisitions and significant increases in Olympic and political spending as well as retransmission revenue, partly offset by higher expense related to revenue growth as well as higher reverse network compensation fees. Publishing Segment results reflected lower advertising demand and circulation revenue, partially offset by lower operating expenses due primarily to continuing cost efficiency efforts. Digital Segment revenues and operating results were higher primarily due to the impact of the Cars.com acquisition and strong results at Cars.com and CareerBuilder. Digital revenues company-wide including the Digital Segment and all digital revenues generated by other business segments were approximately $1.72 billion in 2014, nearly 30% of operating revenues, and an increase of 15% compared to 2013. Adjusted operating income decreased 11% in 2013 over 2012 to $855 million. Broadcasting Segment revenues and operating results were lower, reflecting the absence of significant political and Olympic revenues generated in 2012. Publishing Segment revenues reflected lower advertising demand, partially offset by a 1% increase in circulation revenue. Digital Segment revenues increased, reflecting solid revenue growth at CareerBuilder. Digital revenues company-wide including the Digital Segment and all digital revenues generated by other business segments were approximately $1.47 billion in 2013, nearly 30% of operating revenues and an increase of 16% compared to 2012. Adjustments to remove special items from GAAP non-operating expense which consist of equity income or loss, interest expense and other non-operating items follow: Adjusted non-operating expense increased 95% in 2014 over 2013 to $244 million. This increase reflects higher interest expense due to higher average debt levels from additional borrowings. Adjusted non-operating expense increased 11% in 2013 over 2012 to $125 million reflecting higher interest expense due to higher average debt levels principally related to the issuance of senior notes related to the Belo transaction. A summary of the impact of special items on our effective tax rate follows: The adjusted effective tax rate in 2014 was 30.9% compared to 29.7% in 2013. The slightly higher rate for 2014 reflects a higher proportion of income derived in the U.S., which is taxed at a higher rate, mainly due to the income related to the acquisitions of Belo and Cars.com, as well as fewer tax reserve releases due to expiring statutes of limitations. The adjusted effective tax rate in 2013 was 29.7% compared to 30.9% in 2012. The lower rate for 2013 reflects higher reserve releases due to audit settlements and the lapse of certain statutes of limitations. Adjustments to remove special items from GAAP net income attributable to Gannett Co., Inc. and diluted earnings per share follow: Adjusted net income attributable to Gannett Co., Inc. increased 34% in 2014 (35% on a diluted per share basis) as a result of higher as adjusted (non-GAAP basis) operating income in the Broadcasting and Digital Segments, partially offset by lower operating income in the Publishing Segment. Adjusted net income attributable to Gannett Co., Inc. decreased 14% in 2013 over 2012 (13% on a diluted per share basis) as a result of lower as adjusted (non-GAAP basis) operating income in the Broadcasting and Publishing Segments, partially offset by higher operating income in the Digital Segment. Adjustments to reconcile GAAP net income attributable to Gannett Co., Inc. to Adjusted EBITDA follow: Adjusted EBITDA increased 43% to $1.49 billion in 2014 from $1.04 billion in 2013. Adjusted EBITDA margins increased significantly to 24.8% in 2014. Both increases reflect the acquisitions of Belo and Cars.com as well record results in our Broadcasting and Digital Segments. Adjusted EBITDA decreased 9% to $1.04 billion in 2013 from $1.15 billion in 2012, driven by the absence of record political spending achieved in 2012 and revenue associated with the Summer Olympics along with a decrease in Publishing Segment results. Segment results The following is a discussion of our as adjusted non-GAAP financial results. All as adjusted (non-GAAP basis) measures are labeled as such or “adjusted”. A summary of the impact of workforce restructuring charges and transformation costs on our Broadcasting Segment is presented below: Adjusted Broadcasting Segment operating expenses increased 102% in 2014 compared to 2013, driven primarily by acquisitions as well as higher investment in digital initiatives and reverse network compensation. Adjusted Broadcasting Segment operating income increased 103% to $767 million in 2014, driven by record non-presidential political revenues, the expansion of the television station portfolio, Winter Olympics advertising, and a significant increase in retransmission and digital revenue. Adjusted Broadcasting Segment operating expenses decreased 1% in 2013 compared to 2012 due to lower expenses associated with the record level of political spending achieved in 2012 and the Summer Olympics. Adjusted Broadcasting Segment operating income decreased 15% to $377 million in 2013, reflecting the absence of record political spending and Summer Olympic revenue achieved in 2012. A summary of the impact of workforce restructuring charges, transformation costs and asset impairment charges on our Publishing Segment is presented below: Adjusted Publishing Segment operating expenses decreased 3% in 2014 compared to 2013 due to continued cost efficiency efforts and lower newsprint expense. On the same basis, adjusted Publishing Segment operating income declined 13% in 2014 compared to 2013 due to lower advertising revenue, partially offset by the positive impact of the All Access Content Subscription Model and the addition of USA TODAY local editions at 35 of our USCP operations. Adjusted Publishing Segment operating expenses decreased 3% in 2013 compared to 2012 as continued cost efficiency efforts were partially offset by strategic initiative spending of $36 million. Adjusted Publishing Segment operating income declined 9% in 2013 compared to 2012 due to lower advertising revenue in the U.S. and U.K., $36 million of strategic initiative spending, the negative impact of the extra week in 2012, partially offset by a 1% increase in circulation revenue, and a decrease in newsprint expense. A summary of the impact of workforce restructuring charges and asset impairment charges on our Digital Segment is presented below: Year-over-year adjusted operating expense comparisons for 2014 and 2013 reflect primarily the impact of the Cars.com acquisition and higher expense related to strong revenue growth at CareerBuilder. On the same basis, adjusted operating income increased 30%, reflecting record revenues in our Digital Segment. Year-over-year adjusted operating expense comparisons for 2013 and 2012 reflect increases in expenses at CareerBuilder associated with its revenue growth. The CareerBuilder revenue growth also drove the year-over-year improvements in adjusted Digital Segment operating income. A summary of the impact of special charges on our Corporate Segment is presented below: Presentation of Pro Forma Information Pro forma information is presented on the basis as if the acquisitions of Cars.com as well as the Belo and London Broadcasting Company televisions stations, the Captivate disposition, the sale of a print business and the Apartments.com sale had occurred at the beginning of 2013. This pro forma financial information is based on historical results of operations, adjusted for the allocation of the purchase price and other acquisition accounting adjustments, and is not necessarily indicative of what our results would have been had we operated the businesses since the beginning of 2013. Pro forma adjustments include revenues and expenses for the former Belo stations acquired on December 23, 2013. The pro forma adjustments exclude revenues and expenses for the former Belo stations in Phoenix, AZ and St. Louis, MO. Certain of our subsidiaries and Sander Media, a holding company that has a station-operation agreement with us, agreed to sell these stations upon receiving government approval. KMOV-TV, the television station in St. Louis, was sold in February 2014 and the two television stations in Phoenix were sold in June 2014. Pro forma adjustments include the six television stations acquired from London Broadcasting Company on July 8, 2014. Pro forma adjustments include revenues and expenses for the acquisition of Cars.com on October 1, 2014. The pro forma adjustments reflect depreciation expense and amortization of intangibles related to the fair value adjustments of the assets acquired and the alignment of accounting policies for all acquisitions. Pro forma adjustments include reductions to revenues and expenses for Captivate since we sold our controlling interest in Captivate in the third quarter of 2013. Adjustments also include revenue and expense reductions related to the second quarter 2014 sale of a print business and the impact from the second quarter 2014 Classified Ventures sale of Apartments.com. Reconciliations of our Broadcasting Segment, Digital Segment and company-wide revenues and expenses on an as reported basis to a pro forma basis for 2014 and 2013 are below: Pro forma Broadcasting Segment revenue increased 19% in 2014 due to record non-presidential political spending as well as $41 million in Winter Olympic revenue. Retransmission revenue increased 62% and digital revenue was up 19% due to continued growth from digital marketing services products. Core advertising was impacted by the displacement resulting from record political advertising revenue and declined 2% on a pro forma basis. Broadcasting Segment expenses were up 4% on a pro forma basis, driven by the expenses associated with revenue growth initiatives at our new and existing stations, as well as reverse compensation and investments in sales and marketing tools in support of our sales transformation initiative. Digital Segment revenue on a pro forma basis increased 8% in 2014 primarily due to growth in Cars.com and CareerBuilder revenues. Cars.com revenues on a pro forma basis reflect organic growth in the markets in which they sell direct as well as price increases for affiliates implemented October 1, 2014. Digital Segment expenses were up 4% on a pro forma basis reflecting increases in Cars.com and CareerBuilder expenses in support of higher revenues. Pro forma company-wide revenues were $6.36 billion in 2014, a 4% increase compared to 2013. The increase reflects a significant increase in Broadcasting and Digital Segment revenues, partially offset by a decrease in Publishing Segment revenues. Pro forma company-wide expenses declined slightly to $5.10 billion in 2014 as a result of higher Broadcasting and Digital Segment expenses, offset by lower Publishing Segment expenses. As a result, company-wide pro forma operating income increased 23% to $1.26 billion in 2014, driven by a 46% increase in Broadcasting Segment operating income and a 32% increase in Digital Segment operating income. FINANCIAL POSITION Liquidity and capital resources Our cash flow from operating activities was $821 million in 2014, versus $511 million in 2013, primarily reflecting the strength of our Broadcasting and Digital Segments propelled by strategic acquisitions, successful growth initiatives and operating efficiencies. Net cash tax payments were $83 million higher compared to 2013 due to higher earnings. Interest payments were up $116 million reflecting the issuance of debt to fund the Belo and Cars.com acquisitions. Net cash used for investing activities totaled $1.66 billion for 2014. We received a $154.6 million cash distribution from Classified Ventures related to its sale of Apartments.com as a return of investment in 2014. Payments for acquisitions reflect the cash spent to acquire Cars.com; six London Broadcasting television stations in Texas, and CareerBuilder’s acquisition of Broadbean. Payments for acquisitions also reflect the cash spent by us to acquire KMOV-TV, KASW-TV and KTVK-TV television assets that were previously owned by other parties. We purchased those assets pursuant to an option agreement we had with the former owner. These assets and other KMOV-TV, KASW-TV and KTVK-TV assets we already owned were immediately sold to Meredith Corporation. Meredith purchased the assets for $407.5 million plus working capital. We used a portion of the proceeds in a tax efficient exchange to acquire six London Broadcasting Company television stations from SunTX Capital Partners, which closed early in our third quarter. Cash provided by financing activities totaled $490 million in 2014. Proceeds from long term debt and term loans were $1.31 billion. These proceeds were used to partially finance the acquisition of Cars.com, repay the unsecured notes that matured in November 2014 and for other general corporate purposes. We repurchased approximately 2.7 million shares of our stock for $76 million, paid dividends totaling $181 million and made dividend payments and distributions to noncontrolling membership shareholders of $22 million. Certain key measurements of the elements of working capital for the last three years are presented in the following chart: Our operations have historically generated strong positive cash flow which, along with our program of maintaining bank revolving credit availability, has provided adequate liquidity to meet our requirements, including those for acquisitions. Long-term debt Our long-term debt is summarized below: Our debt balance at year end 2014 increased by $781 million primarily reflecting additional borrowings to fund the acquisition of the remaining 73% of Cars.com we did not previously own. This was partially offset by the early repayment of the 9.375% notes due November 2017 and the repayment of the 8.75% notes due November 2014 for $250 million each. We redeemed the 9.375% notes by paying 104.688% of the outstanding principal amount in accordance with the original terms. The early redemption of these notes saved us approximately $19 million in interest expense for 2014. In September 2014, and in support of the Cars.com acquisition, we completed the private placement of $350 million in aggregate principal amount of 4.875% senior unsecured notes due 2021 (the 2021 Notes). The 2021 Notes were priced at 98.531% of face value, resulting in a yield to maturity of 5.125%. Subject to certain exceptions, we are unable to redeem the 2021 Notes before Sept. 15, 2017. On the same day, we completed the private placement of $325 million in aggregate principal amount of 5.500% senior unsecured notes due 2024 (the 2024 Notes). The 2024 Notes were priced at 99.038% of face value, resulting in a yield to maturity of 5.625%. Subject to certain exceptions, we are unable to redeem the 2024 Notes before Sept. 15, 2019. The 2021 and 2024 Notes were issued in a private offering that is exempt from the registration requirements of the Securities Act of 1933. The 2021 and 2024 Notes are guaranteed on a senior basis by our subsidiaries that guarantee our revolving credit facility, term loan and our other outstanding notes. In August 2013, we entered into an agreement to replace, amend and restate our existing revolving credit facilities with a credit facility expiring on Aug. 5, 2018, which was further amended on Sept. 24, 2013 (the Credit Agreement). Total commitments under the Credit Agreement are $1.3 billion. Subject to total leverage ratio limits, the Credit Agreement eliminates our restriction on incurring additional indebtedness. The Credit Agreement was amended as of February 13, 2015. The maximum total leverage ratio permitted by the Credit Agreement as amended, is 4.0x through September 30, 2016, reducing to 3.75x thereafter. Commitment fees on the revolving credit agreement are equal to 0.375% - 0.50% of the undrawn commitments, depending upon our leverage ratio, and are computed on the average daily undrawn balance under the revolving credit agreement and paid each quarter. Under the Credit Agreement, we may borrow at an applicable margin above the Eurodollar base rate (LIBOR loan) or the higher of the Prime Rate, the Federal Funds Effective Rate plus 0.50%, or the one month LIBOR rate plus 1.00% (ABR loan). The applicable margin is determined based on our leverage ratio but differs between LIBOR loans and ABR loans. For LIBOR based borrowing, the margin varies from 1.75% to 2.5%. For ABR based borrowing, the margin will vary from 0.75% to 1.50%. Based on our leverage ratio as of Dec. 28, 2014, our applicable margins were 2.25% and 1.25%, respectively. On Dec. 28, 2014, we had unused borrowing capacity of $625 million under our revolving credit agreement. We have an effective universal shelf registration statement under which an unspecified amount of securities may be issued, subject to a $7.0 billion limit established by the Board of Directors. Proceeds from the sale of such securities may be used for general corporate purposes, including capital expenditures, working capital, securities repurchase programs, repayment of debt and financing of acquisitions. We may also invest borrowed funds that are not required for other purposes in short-term marketable securities. The following schedule of annual maturities of the principal amount of total debt assumes we use available capacity under our revolving credit agreement to refinance unsecured floating rate term loans and notes due in 2015. Based on this refinancing assumption, all of the obligations other than VIE unsecured floating rate term loans due in 2015 are reflected as maturities for 2016 and beyond. (1) Maturities of principal amounts of debt due in 2015 (primarily the 10% fixed rate notes due in June 2015 and 6.375% fixed rate notes due in September 2015) are assumed to be repaid with funds from the revolving credit agreement, which matures in 2018. Our debt maturities may be repaid with cash flow from operating activities, by accessing capital markets or a combination of both. As previously noted, in August 2014, we announced our plan to separate our Publishing business into an independent publicly traded company. We expect to complete the separation in mid-2015. In connection with this action, we are undertaking capital structure planning for each company. We are working to ensure that each separate business is well capitalized with financial flexibility to pursue its strategic priorities. Contractual obligations and commitments The following table summarizes the expected cash outflows resulting from financial contracts and commitments as of the end of 2014. (1) See Note 6 to the Consolidated Financial Statements. The amounts included above include periodic interest payments. Interest payments are based on interest rates in effect at year-end. (2) See Note 11 to the Consolidated Financial Statements. (3) Includes purchase obligations related to printing contracts, capital projects, interactive marketing agreements, wire services and other legally binding commitments. Amounts which we are liable for under purchase orders outstanding at Dec. 28, 2014, are reflected in the Consolidated Balance Sheets as accounts payable and accrued liabilities and are excluded from the table above. (4) Programming contracts include television station commitments to purchase programming to be produced in future years. This also includes amounts fixed or currently accrued under network affiliation agreements. (5) Other long-term liabilities consist of both unfunded and under-funded postretirement benefit plans. Unfunded plans include the Gannett Supplemental Executive Retirement Plan and the Gannett Retiree Welfare Plan. Employer contributions, which equal the expected benefit payments, are reflected in the table above over the next ten-year period. Our under-funded plans include the Gannett Retirement Plan, the G.B. Dealey Retirement Plan, the Newsquest Pension Scheme, and the Detroit Free Press, Inc. Newspaper Guild of Detroit Pension Plan. Expected employer contributions for these plans are included for the following fiscal year. Contributions beyond the next fiscal year are excluded due to uncertainties regarding significant assumptions involved in estimating these contributions, such as interest rate levels as well as the amount and timing of invested asset returns. Due to uncertainty with respect to the timing of future cash flows associated with unrecognized tax benefits at Dec. 28, 2014, we are unable to make reasonably reliable estimates of the period of cash settlement. Therefore, $59 million of unrecognized tax benefits have been excluded from the contractual obligations table above. See Note 9 to the Consolidated Financial Statements for a further discussion of income taxes. In 2014, we shut down one of our publishing businesses and incurred $21.0 million of shutdown costs associated with future contractual promotional payments. These costs are accrued on our balance sheet at the end of 2014 and will be primarily paid in 2015. They have been excluded from the contractual obligations above. For 2015, we expect to contribute $12 million to the Gannett Retirement Plan reflective of pension relief legislation enacted in 2014. We also expect to contribute $13 million to the Newsquest Plan. Due to uncertainties regarding significant assumptions involved in estimating future contributions, such as interest rate levels and the amount and timing of asset returns, we are unable to reasonably estimate future contributions beyond 2015, and therefore no plan contributions thereafter are reflected in the above table. In December 1990, we adopted a Transitional Compensation Plan (the TCP). The TCP provides termination benefits to key executives whose employment is terminated under certain circumstances within two years following a change in control of our company. Benefits under the TCP include a severance payment of up to three years’ compensation and continued life and medical insurance coverage. We amended the TCP in April 2010 to provide that new participants will not be entitled to the benefit of the TCP’s excise tax gross-up or modified single trigger provisions. In August 2014, we adopted the Gannett Leadership Team Transition Severance Plan (GLT Plan) to promote retention and minimize disruption for certain senior executives in connection with the potential spin-off of our publishing segment into a new, independent publicly traded company. No amounts have been included in the above contractual obligation table for either the TCP or GLT plans. Capital stock In June 2013, we announced that our Board of Directors approved a new program to repurchase up to $300 million of our common stock. As of Dec. 28, 2014, the value of shares that may be repurchased under the existing program is $149 million. The share repurchase program was temporarily suspended upon the announcement of the Cars.com acquisition, but was re-initiated in February 2015, well ahead of the timeline we had previously anticipated, as a result of our strong operating performance and the strength of our balance sheet. The shares may be repurchased at management’s discretion, either in the open market or in privately negotiated block transactions. Management’s decision to repurchase shares will depend on price and other corporate developments. Purchases may occur from time to time and no maximum purchase price has been set. There is no expiration date for the $300 million stock repurchase program. Certain of the shares we previously acquired have been reissued in settlement of employee stock awards. The Gannett Co., Inc. 401(k) Savings Plan, our principal defined contribution plan which was established in 1990, includes a company matching contribution in the form of our stock. We fund the match by buying our stock in the open market and depositing it in the participant’s account. Our common stock outstanding at Dec. 28, 2014, totaled 226,739,091 shares, compared with 227,568,888 shares at Dec. 29, 2013. Dividends Dividends declared on common stock amounted to $181 million in 2014, compared with $183 million in 2013. On Feb. 24, 2015, the Board of Directors declared a dividend of $.20 per share, payable on April 1, 2015, to shareholders of record as of the close of business March 6, 2015. Accumulated other comprehensive income (loss) Our foreign currency translation adjustment, included in accumulated other comprehensive income (loss) and reported as part of shareholders’ equity, totaled $391 million at the end of 2014 and $427 million at the end of 2013. The decrease reflected a weakening of the British pound against the U.S. dollar. Newsquest’s assets and liabilities at Dec. 28, 2014, were translated from British pounds to U.S. dollars at an exchange rate of 1.56 versus 1.65 at the end of 2013. Newsquest’s financial results were translated at an average rate of 1.65 for 2014, 1.56 for 2013 and 1.58 for 2012. We recognized the funded status of our pension and retiree medical benefit plans in the Consolidated Balance Sheets. At Dec. 28, 2014, accumulated other comprehensive loss includes a reduction of equity of $1.17 billion and at Dec. 29, 2013, the reduction of equity was $921 million, for losses that will be amortized to pension and other postretirement costs in future years. The increased reduction was driven by lower rates used to discount our pension obligations as well as updates to assumed life expectancies of the plan’s participants. Effects of inflation and changing prices and other matters Our results of operations and financial condition have not been significantly affected by inflation. The effects of inflation and changing prices on our property, plant and equipment and related depreciation expense have been reduced as a result of an ongoing capital expenditure program and the availability of replacement assets with improved technology and efficiency. We are exposed to foreign exchange rate risk primarily due to our ownership of Newsquest, which uses the British pound as its functional currency, which is then translated into U.S. dollars. Our foreign currency translation adjustment, related principally to Newsquest and reported as part of shareholders’ equity, totaled $391 million at Dec. 28, 2014. Newsquest’s assets and liabilities were translated from British pounds to U.S. dollars at the Dec. 28, 2014, exchange rate of 1.56. Refer to

<s>[INST] Certain statements in this Annual Report on Form 10K contain certain forwardlooking statements regarding business strategies, market potential, future financial performance and other matters. The words “believe,” “expect,” “estimate,” “could,” “should,” “intend,” “may,” “plan,” “seek,” “anticipate,” “project” and similar expressions, among others, generally identify “forwardlooking statements,” which speak only as of the date the statements were made. These forwardlooking statements are subject to certain risks and uncertainties that could cause actual results and events to differ materially from those anticipated in the forwardlooking statements. We are not responsible for updating or revising any forwardlooking statements, whether the result of new information, future events or otherwise, except as required by law. Potential risks and uncertainties which could adversely affect our results include, without limitation, the following factors: (a) competitive pressures in the markets in which we operate; (b) increased consolidation among major retailers or other events which may adversely affect business operations of major customers and depress the level of local and national advertising; (c) a decline in viewership of major networks and local news programming resulting from alternative forms of media, or other factors; (d) macroeconomic trends and conditions; (e) economic downturns leading to a continuing or accelerated decrease in circulation or local, national or classified advertising; (f) potential disruption or interruption of our operations due to accidents, extraordinary weather events, civil unrest, political events, terrorism or cyber security attacks; (g) an accelerated decline in general print readership and/or advertiser patterns as a result of competitive alternative media or other factors; (h) an inability to adapt to technological changes or grow our online business; (i) an increase in newsprint, syndication programming costs or reverse retransmission payments over the levels anticipated; (j) labor relations, including, but not limited to, labor disputes which may cause revenue declines or increased labor costs; (k) an inability to realize benefits or synergies from acquisitions of new businesses or dispositions of existing businesses or to operate businesses effectively following acquisitions or divestitures; (l) our ability to attract and retain employees; (m) rapid technological changes and frequent new product introductions prevalent in electronic publishing and digital businesses; (n) an increase in interest rates; (o) a weakening in the British pound to U.S. dollar exchange rate; (p) volatility in financial and credit markets which could affect the value of retirement plan assets and our ability to raise funds through debt or equity issuances and otherwise affect our ability to access the credit and capital markets at the times and in the amounts needed and on acceptable terms; (q) changes in the regulatory environment which could encumber or impede our efforts to improve operating results or the value of assets; (r) credit rating downgrades, which could affect the availability and cost of future financing; (s) adverse outcomes in proceedings with governmental authorities or administrative agencies; (t) the proposed separation of our Publishing business from our Broadcasting and Digital businesses may be distracting to management and may not be completed on the terms or timeline currently contemplated, if at all; and (u) an other than temporary decline in operating results and enterprise value that could lead to noncash goodwill, other intangible asset, investment or property, plant and equipment impairment charges. We continue to monitor the uneven economic recovery in the U.S. and U.K., as well as new and developing competition and technological change, to evaluate whether any indicators of impairment exist, particularly for those reporting units where fair value is closer to carrying value. Executive Summary We are a leading international media and marketing solutions company operating primarily in the United States and the United Kingdom (U.K.). Approximately 91% of 2014 consolidated revenues are generated by our domestic operations and approximately 9% by our foreign operations, primarily in the U.K. We implement our strategy and manage our operations through three business segments: Broadcasting (television), Publishing, and Digital. Through our Broadcasting Segment, we own or service (through shared service agreements or similar arrangements) 46 television stations with affiliated digital platforms sites. These stations serve almost onethird of the U.S. population in markets with more than 35 million households. [/INST] Positive. </s>

TEGNA INC

2016-02-29

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Executive Summary Our company is comprised of a dynamic portfolio of media and digital businesses that provide content that matters and brands that deliver. Our media business includes 46 television stations operating in 38 markets, offering high-quality television programming and digital content. Our digital business primarily consists of our Cars.com and CareerBuilder business units that operate in the automotive and human capital solutions industries. The Cars.com website provides credible and easy-to-understand information from consumers and experts to provide car buyers with greater control over the car buying and servicing process. CareerBuilder helps companies target, attract and retain workforce talent through an array product offerings including talent management software and other advertising and recruitment solutions. On the first day of our fiscal third quarter, June 29, 2015, we completed the spin-off of our publishing businesses. Our company was renamed TEGNA Inc., and our stock trades on the New York Stock Exchange under the symbol TGNA. In addition, during the fourth quarter of 2015, we sold substantially all of the businesses within our Other Segment. We have presented the financial condition and results of operations of the former publishing businesses and Other Segment as discontinued operations in the accompanying consolidated financial statements for all periods presented. For a summary of discontinued operations, see Note 13. Fiscal year: Beginning in fiscal year 2015, we changed our financial reporting cycle to a calendar year-end. Accordingly, our 2015 fiscal year began on December 29, 2014 (the day after the end of the 2014 fiscal year) and ended on December 31, 2015. Historically, our fiscal year was a 52-53 week fiscal year that ended on the last Sunday of the calendar year. As a result, our 2015 fiscal year had four more days than the 2014 and 2013 fiscal years. The impact of the four extra days did not have a material impact on our financial statements, and therefore, we have not restated the historical results. RESULTS OF OPERATIONS: Consolidated summary A consolidated summary of our results is presented below. Consolidated Operating Revenue and Expense 2015 compared to 2014: Operating revenues were $3.05 billion in 2015, an increase of 16% from $2.63 billion in 2014. Media Segment revenues for 2015 decreased 1% to $1.68 billion, as double-digit growth in retransmission revenue and online revenue and higher core revenue was offset by the record level of political advertising revenue of $159 million achieved in 2014. Digital Segment revenues totaled $1.37 billion for 2015, a record high and an increase of 47%. The increase reflects the acquisition and strong organic growth of Cars.com revenue. Total reported operating expenses increased 11% to $2.14 billion in 2015, primarily due to the acquisition of Cars.com. Depreciation expense was 6% higher in 2015, reflecting the impact from the 2014 acquisitions of London Broadcasting television stations and Cars.com. Facility consolidation and non-cash asset impairment charges for all years are discussed in Notes 3 and 11 to the Consolidated Financial Statements. We reported operating income for 2015 of $913 million compared to $707 million in 2014, a 29% increase primarily driven by the acquisition of Cars.com. Our consolidated operating margins improved to 30% in 2015 compared to 27% in 2014 driven by improvement in margins from our Digital Segment, partially offset by the impact from the absence of Olympic and political spending in 2014. 2014 compared to 2013: Operating revenues for 2014 increased 64% to $2.62 billion, primarily due to increases from Media Segment as a result of the acquisitions of Belo and London Broadcasting Company television stations as well as substantially higher retransmission revenue, political and Olympic advertising. Digital Segment also increased as a result of increases at CareerBuilder driven by the strength of human capital software solutions and acquisition of Cars.com in October 2014. Operating expenses increased by 48% to $1.92 billion for 2014, primarily due to the acquisitions of Belo, London Broadcasting Company and Cars.com. Payroll expense trends: Payroll expense is the largest element of our normal operating expenses, and is summarized below, expressed as a percentage of total pre-tax operating expenses. Payroll expense as a percentage of total pre-tax operating expenses has remained consistent during 2013 through 2015. Non-operating income and expense Equity earnings: This income statement category reflects our share of earnings or losses from equity method investees. Our net equity income in unconsolidated investees for 2015 decreased from a gain of $151 million in 2014 to an equity loss of $5 million, reflecting primarily the absence of a $148 million gain on the sale of Apartments.com by Classified Ventures in 2014. Net equity income from unconsolidated investees for 2014 increased by $130 million compared to 2013 driven by the Apartments.com gain. Interest expense: Interest expense in 2015 was $274 million and increased by $1 million primarily due to a higher average debt level of $4.37 billion compared to $3.85 billion in 2014. The higher average debt level is related to additional borrowings related to the October 2014 Cars.com acquisition. This increase was substantially offset by a lower average interest rate. Interest expense in 2014 was higher compared to 2013, due to a higher average debt level of $3.85 billion in 2014 compared to $2.01 billion in 2013. The higher average debt level is related to additional borrowing related to both the Belo and Cars.com acquisitions in 2013 and 2014, respectively, partly offset by a lower average interest rate. A further discussion of our borrowing and related interest cost is presented in the “Liquidity and capital resources” section of this report beginning on page 25 and in Note 6 to the Consolidated Financial Statements. Other non-operating items: We reported a net loss of $12 million for other non-operating items in 2015. This loss is comprised of costs related to the spin-off of our publishing businesses partially offset by a gain of $44 million on the sale of a business. Other non-operating items totaled a net gain of $404 million in 2014 with the majority related to the write-up of our prior 27% investment in Cars.com to fair value post acquisition and a gain related to required accounting for the pre-existing affiliate agreement between us and Cars.com. The net gain was partially offset by acquisition costs and expenses incurred for the spin-off of our publishing businesses. We reported a net loss from non-operating items of $45 million in 2013 with the majority related to costs associated with the Belo transaction and a non-cash charge associated with the change in control and sale of interests related to our Captivate business. These costs were partially offset by interest income earned in 2013. Provision for income taxes We reported pre-tax income from continuing operations attributable to TEGNA of $560 million for 2015. The effective tax rate on pre-tax income was 36.1%. We reported pre-tax income from continuing operations attributable to TEGNA of $922 million for 2014. The provision for income taxes reflects a special net tax benefit from the sale of a non-strategic subsidiary at a loss, for which a partial tax benefit was recognized. The effective tax rate in 2014 was 25.4%. The higher tax rate for 2015 compared to 2014 is due to special items contributing a net tax benefit that related primarily to the 2014 sale of a non-strategic subsidiary at a loss, for which a partial tax benefit was recognized, partially offset by a reduction in audit resolutions. We reported pre-tax income from continuing operations attributable to TEGNA of $55 million for 2013. The provision for income taxes reflects certain state audit settlements and a special net tax benefit from the release of certain tax reserves due to a multi-year federal audit settlement in 2013. The effective tax rate on pre-tax income was 24.5% which was comparable to the effective tax rate of 25.4% in 2014. Further information concerning income tax matters is contained in Note 5 of the Consolidated Financial Statements. Net income from continuing operations attributable to TEGNA Inc. Net income from continuing operations attributable to TEGNA Inc. and related per share amounts are presented in the table below. Net income from continuing operations attributable to TEGNA Inc. consists of net income reduced by net income attributable to noncontrolling interests, primarily from CareerBuilder. We reported net income from continuing operations attributable to TEGNA of $357 million or $1.56 per diluted share for 2015 compared to $688 million or $2.97 per diluted share for 2014. Net income attributable to noncontrolling interests was $63 million in 2015, $68 million in 2014 and $57 million in 2013. Outlook for 2016: For 2016, we expect a record year for Media Segment revenues. Although we are still in the early stages of the campaign cycle, we are projecting Media segment revenues to increase in the high-teens to low 20% range with record political revenues in 2016 enhanced by our strong geographical footprint. We also anticipate significant summer Olympic revenue as television viewership of the Rio games has been projected to reach record highs. Digital Segment revenues are expected to continue to increase driven by anticipated growth of 10%+ at Cars.com and mid-single digit revenue growth at CareerBuilder. These strong Media and Digital revenue drivers across the segments will all meaningfully contribute to total company revenue increases in the low to mid-teen range over 2015. Total operating expenses are also expected to increase in the range of 8% to 10% in comparison to 2015 driven by higher revenues as we expand into richer content and broader product suites across all of our businesses. We also expect an increase in programming costs from the newly-negotiated affiliation agreements during the second half of 2015, as well as increases from digital sales growth initiatives within the Media Segment. In addition, we anticipate the following expenses and cash flow items in 2016: • Depreciation expense is expected to be in the range of $90 million to $95 million in 2016. • Amortization expense is expected to be approximately $110 million in 2016. • We project interest expense of nearly $235 million. • Capital expenditures are expected to be approximately $85 million to $95 million. A discussion of operating results of our Media, and Digital Segments is as follows: Media Segment At the end of 2015, our Media operations included 46 television stations either owned or serviced through shared service agreements or other similar agreements. Media Segment revenues accounted for approximately 55% of our reported operating revenues for 2015. Over the last three years, Media Segment revenues, expenses and operating income were as follows: Media Segment revenues are grouped into five categories: Core (Local and National), Political, Retransmission, Digital and Other. The following table summarizes the year-over-year changes in these select revenue categories. Media Segment results 2015-2014: Media Segment revenues decreased $10 million to $1.68 billion or by 1% year-over-year for 2015, primarily due to record level of political advertising revenue of $159 million and $41 million in Olympic advertising revenue achieved during 2014. The change to a calendar year-end reporting cycle extended our fiscal year 2015 by four extra days which increased Media Segment revenues by $11 million. Core advertising revenues, which consist of Local and National non-political advertising, increased 3% to $1.07 billion in 2015. Political advertising revenue declined $138 million to $21 million in 2015. Political revenues are cyclical and higher in even years (e.g. 2014, 2016). Retransmission revenues increased 24% in 2015 resulting from newly negotiated agreements and annual rate increases. Within the Media Segment, digital revenue increased 16% compared to 2014 reflecting continued growth from digital marketing services products. Media Segment operating expenses increased 2% to $968 million in 2015. The increase is driven primarily by higher reverse network compensation fees, increased costs from investment in digital initiatives, and incremental costs driven by the July 2014 acquisition of London Broadcasting Company. As a result of all of these factors, Media Segment operating income decreased to $714 million in 2015 from $747 million in 2014. Media Segment results 2014-2013: Revenues increased $857 million to $1.69 billion or 103% for 2014, a record high. The increase was primarily driven by the acquisition of Belo and London Broadcasting television stations, as well as substantially higher retransmission revenue and record non-presidential year political advertising. Core advertising revenues increased 74% to $1.05 billion in 2014 mainly due to television station acquisitions and $41 million in advertising associated with the Winter Olympics that was partially offset by political advertising displacement. Political advertising reached $159 million compared to $13 million in 2013, driven by our strong political footprint. Retransmission revenues increased 145% in 2014 resulting from the expansion of our Media Segment portfolio and rate increases. Within the Media Segment, digital revenue increased 156% compared to 2013 reflecting continued growth from digital marketing services products. Media Segment operating expenses doubled to $945 million in 2014. The increase is driven primarily by the impact from acquisitions, higher reverse network compensation fees, and higher investment in digital initiatives. As a result of all of these factors, Media Segment operating income more than doubled to $747 million in 2014. Digital Segment The Digital Segment is comprised of our stand-alone digital business units including Cars.com, CareerBuilder, G/O Digital, and Cofactor (also operating as ShopLocal). On Nov. 12, 2015, we sold PointRoll which was part of Cofactor. Digital Segment revenues accounted for 45% of our total reported operating revenues for 2015. Digital Segment revenues, expenses and operating income were as follows: Digital Segment results 2015-2014: Digital Segment revenues increased $435 million or 47% over 2014 to a record high of $1.37 billion, primarily driven by the acquisition and strong organic growth of Cars.com and partially offset by slightly lower CareerBuilder revenues. CareerBuilder revenues decreased 2% in 2015 driven by year-over-year declines in foreign exchange rates as well as the strategic shift in focus in its product offerings. During 2015 CareerBuilder continued its transition toward higher-margin software-as-a-service solutions, including its new pre-hire platform and new recruitment software products. Software-as-a-service revenues increased 30% in 2015 and represented approximately 21% of total revenues within CareerBuilder. Revenues under these arrangements are generally longer term and recognized over 2-3 year contracts. These revenue increases were offset by declines from lower-margin, transactional source and screen arrangements and other transactional offerings, as CareerBuilder moves away from these product offerings to focus on the platform solutions. Digital Segment expenses in 2015 increased 40% to $1.14 billion, primarily due to the Cars.com acquisition partly offset by lower expenses reflecting lower revenue at CareerBuilder. As a result of these factors, Digital Segment operating income increased to $229 million in 2015. Digital Segment results 2014-2013: Digital Segment revenues increased $166 million or 22% over 2013 to $934 million, primarily reflecting the impact of the Cars.com acquisition, and growth in revenues at CareerBuilder. Digital Segment expenses in 2014 increased 23% to $814 million primarily due to the Cars.com acquisition and an increase in expenses at CareerBuilder associated with its revenue growth. As a result of these factors, Digital Segment operating income increased to $120 million in 2014. Operating results non-GAAP information Presentation of non-GAAP information: We use non-GAAP financial performance and liquidity measures to supplement the financial information presented on a GAAP basis. These non-GAAP financial measures should not be considered in isolation from or as a substitute for the related GAAP measures, and should be read in conjunction with financial information presented on a GAAP basis. We discuss in this report non-GAAP financial performance measures that exclude from our reported GAAP results the impact of special items consisting of: • Workforce restructuring charges; • Transformation items; • Non-cash asset impairment charges; • Special gains and losses recorded in operating and non-operating; and • Special tax gains and charges, as well as the tax effect of the above special items. We believe that such expenses, charges and credits are not indicative of normal, ongoing operations and their inclusion in results makes for more difficult comparisons between years and with peer group companies. Workforce restructuring expenses primarily relate to incremental expenses we have incurred to centralize functions. Workforce restructuring expenses include payroll and related benefit costs. Transformation items include incremental expenses incurred by us to execute on our transformation and growth plan and incremental expenses and gains associated with optimizing our real estate portfolio. Asset impairment charges reflect non-cash charges to reduce the book value of certain intangible assets to their respective fair value. Non-operating items for 2015 included special gains and charges primarily related to the gain from the sale of a business offset by expenses related to the spin-off of our publishing businesses. In 2014, non-operating items included income related to the write-up of our investment in Classified Ventures to fair value, costs for acquiring six London Broadcasting Company television stations, costs related to acquire the remaining outstanding shares of Cars.com, expenses related to the planned spin-off of our publishing operation and non-cash donations to our charitable foundation. Both 2015 and 2014 included call premiums to early retire certain senior notes. The gain of $137 million recognized in equity income in unconsolidated investees, net in 2014 is principally related to a gain on the sale of Apartments.com by Classified Ventures. The income tax provision for 2015 reflects a net tax benefit primarily due to the impact of a deferred tax rate adjustment related to the spin-off of our publishing businesses. The income tax provision for 2014 reflects a tax benefit related to our portfolio restructuring, the sale of a non-strategic investment, and a charge related to the sale of our interest in television station KMOV in St. Louis, MO, in February 2014. We discuss Adjusted EBITDA, a non-GAAP financial performance measure that we believe offers a useful view of our overall business operations. Adjusted EBITDA is defined as net income from continuing operations attributable to TEGNA before (1) net income attributable to noncontrolling interests, (2) income taxes, (3) interest expense, (4) equity income, (5) other non-operating items, (6) workforce restructuring, (7) transformation costs, (8) asset impairment charges, (9) depreciation and (10) amortization. When Adjusted EBITDA is discussed in reference to performance on a consolidated basis, the most directly comparable GAAP financial measure is Net income from continuing operations attributable to TEGNA. We use non-GAAP financial performance measures for purposes of evaluating business unit and consolidated company performance. Therefore, we believe that each of the non-GAAP measures presented provides useful information to investors by allowing them to view our businesses through the eyes of our management and Board of Directors, facilitating comparison of results across historical periods, and providing a focus on the underlying ongoing operating performance of our businesses. Many of our peer group companies present similar non-GAAP measures to better facilitate industry comparisons. Reconciliations of certain line items impacted by special items to the most directly comparable financial measure calculated and presented in accordance with GAAP on our consolidated statements of income follow: Non-GAAP consolidated results The following is a discussion of our as adjusted non-GAAP financial results. Adjusted operating expenses increased 18% in 2015 over 2014 to $2.20 billion primarily due to the acquisitions of Cars.com. Adjusted operating income increased 11% in 2015 over 2014 to $849 million. The increase reflects higher Digital Segment operating results primarily due to the impact of the Cars.com acquisition and strong results at Cars.com. Adjusted non-operating item charges increased 8% in 2015 over 2014 to $280 million. This increase reflects higher interest expense due to higher average debt levels from additional borrowings related to the Cars.com acquisition in October 2014. The adjusted effective tax rate for 2015 was 34.7% compared to 35.0% in 2014. Adjusted net income attributable to TEGNA Inc. increased 16% in 2015 (18% on a diluted per share basis) as a result of higher as adjusted (non-GAAP basis) operating income in the Digital Segment. Adjustments to reconcile Adjusted net income from continuing operations attributable to TEGNA Inc. to Adjusted EBITDA follow: Adjusted EBITDA increased 16% to $1.06 billion in 2015 from $911 million in 2014. Adjusted EBITDA margins were relatively unchanged at 34.6% in 2015 reflecting the lower operating results in the Media Segment due to the anticipated absence of record non-presidential year political advertising revenues in 2014. Segment results The following is a discussion of our as adjusted non-GAAP financial results. All as adjusted (non-GAAP basis) measures are labeled as such or “adjusted”. A summary of the impact of workforce restructuring charges and transformation costs on our Media Segment is presented below: Adjusted Media Segment operating expenses increased 5% in 2015 compared to 2014, driven primarily by higher investment in digital initiatives and reverse network compensation. Adjusted Media Segment operating income decreased 7% to $714 million in 2015, driven by the absence of a record level of political advertising revenues and Olympic advertising that benefited 2014 results. A summary of the impact of workforce restructuring charges and asset impairment charges on our Digital Segment is presented below: Year-over-year adjusted operating expense comparisons for 2015 and 2014 reflect primarily the impact of the Cars.com acquisition. Adjusted operating income increased 65%, reflecting record revenues in our Digital Segment. Presentation of Pro Forma Information Pro forma information is presented as if the acquisition of Cars.com and the sale of PointRoll had occurred on the first day of 2014. The pro forma financial information is based on historical results of operations, adjusted for the allocation of the purchase price and other acquisition accounting adjustments, and is not necessarily indicative of what our results would have been had we operated the business since the beginning of 2014. Pro forma adjustments for Cars.com reflect depreciation expense and amortization of intangibles related to the fair value adjustments of the assets acquired and the alignment of accounting policies. Reconciliations of Digital Segment revenues and expenses on a reported basis to a pro forma basis for 2015 and 2014 are below: Digital Segment revenue on a pro forma basis increased 6% in 2015 primarily due to growth in Cars.com revenues. Cars.com revenues on a pro forma basis reflect organic growth in the markets in which they sell direct as well as price increases for affiliates implemented October 1, 2014. Digital Segment expenses were relatively flat on a pro forma basis. FINANCIAL POSITION Liquidity and capital resources Operating Activities: Our cash flow from operating activities was $613 million in 2015, versus $821 million in 2014. The decrease in net cash flow from operating activities was due to the relative absence of $200 million of political and Olympic revenue achieved last year, the absence of our publishing businesses in the third and fourth quarters of 2015, a $22.5 million increase in pension payments in 2015, the timing of certain reverse network compensation payments, payments related to previously accrued expenses for the shutdown of USA Weekend and routine changes in working capital. The increase in pension payments in 2015 was primarily due to a voluntary contribution we made of $100.0 million to our principal retirement plan prior to the spin-off. There were no required contributions to any of our principal pension plans for the remainder of 2015. Cash paid for income taxes were lower in 2015 by $101 million compared to 2014, primarily due to the tax benefit received on the voluntary pension payment and the decrease in net income compared to the prior year. Investing Activities: Net cash provided by investing activities was $217.3 million for 2015 compared to cash used by investing activities of $1.66 billion in 2014. The difference between periods was primarily attributable to proceeds of $411 million related to sales of assets (primarily sales of corporate headquarters and Seattle broadcast buildings) and sale of businesses (primarily Gannett Healthcare, Clipper and PointRoll) in 2015. This compares to payments for acquisitions of approximately $1.99 billion (primarily Cars.com, London Broadcasting and Broadbean) in 2014. Capital expenditures amounted to $118.7 million in 2015 and $150 million in 2014. Financing Activities: Net cash used for financing activities was $819.7 million in 2015 compared to net cash provided by financing activities of $490.5 million in 2014. The difference between periods is primarily due to receiving less proceeds from the issuance of debt, increased repurchases of our common stock, increased debt repayments, and a one-time cash transfer of $63 million to our former publishing businesses in connection with the spin-off. In 2015, our debt balance decreased as a result of $587 million of debt repayments, partially offset by additional borrowings of $200 million under a new five-year term loan as discussed below within "Long-term Debt" section. In 2014, proceeds from long-term debt and term loans were $1.31 billion which was used to partially finance the acquisition of Cars.com and repay the unsecured notes that matured in November 2014. In 2015, we repurchased approximately 9.6 million shares of our stock for $271 million, paid dividends (excluding the special spin-off distribution of our publishing businesses) totaling $167.5 million ($0.74 per share) and made dividend payments and distributions to noncontrolling membership shareholders of $25 million. Our operations have historically generated strong positive cash flow which, along with our program of maintaining bank revolving credit availability, has provided adequate liquidity to meet our requirements, including those for acquisitions. Long-term debt As of Dec. 31, 2015, our outstanding debt, net of unamortized discounts amounted to $4.2 billion and mainly is in the form of private placement fixed rate notes and borrowings under a revolving credit facility. See "Note 6 Long-term debt" to our consolidated financial statements for a table summarizing the components of our long-term debt. As of Dec. 31, 2015, we were in compliance with all covenants contained in our debt and credit agreements. Our debt balance as of Dec. 31, 2015 decreased by $287 million from Dec. 28, 2014, primarily reflecting debt payments of $587 million partially offset by additional borrowings, including the new $200 million term loan mentioned below. On June 29, 2015, we entered into an agreement to amend and extend our existing revolving credit facility with one expiring on June 29, 2020 (the Amended and Restated Competitive Advance and Revolving Credit Agreement). As a result, the maximum total leverage ratio permitted by the new agreement is 5.0x through June 30, 2017, after which, as amended, it is reduced to 4.75x through June 30, 2018 and then to 4.50x thereafter. Commitment fees on the revolving credit agreement are equal to 0.25% - 0.40% of the undrawn commitments, depending upon our leverage ratio, and are computed on the average daily undrawn balance under the revolving credit agreement and paid each quarter. Under the Amended and Restated Competitive Advance and Revolving Credit Agreement, we may borrow at an applicable margin above the Eurodollar base rate (LIBOR loan) or the higher of the Prime Rate, the Federal Funds Effective Rate plus 0.50%, or the one month LIBOR rate plus 1.00% (ABR loan). The applicable margin is determined based on our leverage ratio but differs between LIBOR loans and ABR loans. For LIBOR-based borrowing, the margin varies from 1.75% to 2.50%. For ABR-based borrowing, the margin will vary from 0.75% to 1.50%. On September 23, 2015, we amended the Amended and Restated Competitive Advance and Revolving Credit Agreement to add an additional lender. Total commitments under the Amended and Restated Competitive Advance and Revolving Credit Agreement are $1.4 billion. As of Dec. 31, 2015, we had unused borrowing capacity of $658 million under our revolving credit agreement. In June 2015, we also borrowed $200 million under a new five-year term loan due in 2020 which has a year-end 2015 principal balance of $180 million. The interest rate on the term loan is equal to the same interest rates as borrowings under the Amended and Restated Competitive Advance and Revolving Credit Agreement. Both the revolving credit agreement and the term loan are guaranteed by a majority of our wholly-owned material domestic subsidiaries. We have an effective shelf registration statement under which an unspecified amount of securities may be issued, subject to a $7.0 billion limit established by the Board of Directors. Proceeds from the sale of such securities may be used for general corporate purposes, including capital expenditures, working capital, securities repurchase programs, repayment of debt and financing of acquisitions. We may also invest borrowed funds that are not required for other purposes in short-term marketable securities. Our debt maturities may be repaid with cash flow from operating activities, by accessing capital markets or a combination of both. The following schedule of annual maturities of the principal amount of total debt assumes we use available capacity under our revolving credit agreement to refinance unsecured floating rate term loans and fixed rate notes due in 2016 through 2018. Based on this refinancing assumption, all of the obligations other than the VIE unsecured floating rate term loan due prior to 2019 are reflected as maturities for 2019 and beyond. (1) Maturities of principal amount of debt due in 2016 through 2018 (primarily the 10% fixed rate notes due in April 2016 and the 7.125% fixed rate notes due in September 2018) are assumed to be repaid with funds from the revolving credit agreement, which matures in 2020. Excluding our ability to repay funds with the revolving credit agreement, contractual debt maturities are $266 million, $72 million and $131 million in 2016, 2017 and 2018, respectively. (2) Assumes current revolving credit agreement borrowings comes due in 2020 and credit facility is not extended. Contractual obligations and commitments The following table summarizes the expected cash outflows resulting from financial contracts and commitments as of the end of 2015. (1) Long-term debt includes scheduled principal payments only. See Note 6 to the Consolidated Financial Statements for further information. (2) We have $720 million of outstanding borrowings under our revolving credit facility as of Dec. 31, 2015. We have not included estimated interest payments since payments into and out of the credit facility change daily. Interest on the senior notes is based on the stated cash coupon rate and excludes the amortization of debt issuance discount. The term loan interest rates are based on the actual rates as of Dec. 31, 2015. (3) See Note 12 to the Consolidated Financial Statements. (4) Includes purchase obligations related to capital projects, interactive marketing agreements and other legally binding commitments. Amounts which we are liable for under purchase orders outstanding at Dec. 31, 2015, are reflected in the Consolidated Balance Sheets as accounts payable and accrued liabilities and are excluded from the table above. (5) Programming contracts include television station commitments to purchase programming to be produced in future years. This also includes amounts related to our network affiliation agreements. (6) Other noncurrent liabilities consist of both unfunded and under-funded postretirement benefit plans. Unfunded plans include the TEGNA Supplemental Executive Retirement Plan and the TEGNA Retiree Welfare Plan. Employer contributions, which equal the expected benefit payments, are reflected in the table above over the next ten-year period. Our under-funded plans include the TEGNA Retirement Plan and the G.B. Dealey Retirement Plan (merged into the TEGNA Retirement Plan effective Dec. 31, 2015). We do not anticipate any contributions to the TEGNA Retirement Plan in 2016. Contributions beyond the next fiscal year are excluded due to uncertainties regarding significant assumptions involved in estimating these contributions, such as interest rate levels as well as the amount and timing of invested asset returns. Due to uncertainty with respect to the timing of future cash flows associated with unrecognized tax benefits at Dec. 31, 2015, we are unable to make reasonably reliable estimates of the period of cash settlement. Therefore, approximately $20 million of unrecognized tax benefits have been excluded from the contractual obligations table above. See Note 5 to the Consolidated Financial Statements for a further discussion of income taxes. Capital stock In June 2015, our Board of Directors approved a $750 million share repurchase program to be completed over a three-year period beginning June 29, 2015. On Oct. 20, 2015, our Board of Directors approved a $75 million increase to the share repurchase program, bringing the total authorized amount to $825 million. The shares may be repurchased at management’s discretion, either in the open market or in privately negotiated block transactions. Management’s decision to repurchase shares will depend on price and other corporate developments. Purchases may occur from time to time and no maximum purchase price has been set. Certain of the shares we previously acquired have been reissued in settlement of employee stock awards. Our common stock outstanding at Dec. 31, 2015, totaled 219,754,180 shares, compared with 226,739,091 shares at Dec. 28, 2014. Effects of inflation and changing prices and other matters Our results of operations and financial condition have not been significantly affected by inflation. The effects of inflation and changing prices on our property and equipment and related depreciation expense have been reduced as a result of an ongoing capital expenditure program and the availability of replacement assets with improved technology and efficiency. We are minimally exposed to foreign exchange rate risk primarily due to our majority ownership of CareerBuilder which uses several currencies but primarily the British pound and Euro as its functional currencies, which are then translated into U.S. dollars. Our foreign currency translation adjustment, related principally to CareerBuilder and reported as part of shareholders’ equity, totaled $20 million at Dec. 31, 2015. Critical accounting policies and the use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe the following discussion addresses our most critical accounting policies, which are those that are important to the presentation of our financial condition and results of operations and require management’s most subjective and complex judgments. This commentary should be read in conjunction with our financial statements, selected financial data and the remainder of this Form 10-K. Revenue Recognition: We generate revenue from a diverse set of product and service offerings which include advertising, retransmission consent fees, and software and recruitment services. Revenue is recognized when persuasive evidence of an arrangement exists, performance under the contract has begun, the contract price is fixed or determinable and collectability of the related fee is reasonably assured. Revenue from sales agreements that contain multiple deliverable elements is allocated to each element based on the relative best estimate of selling price. Elements are treated as separate units of accounting if there is standalone value upon delivery. Amounts received from customers in advance of revenue recognition are deferred as liabilities. Below is a detail discussion of revenue by our two reportable segments. Media Segment: The primary source of revenue for our Media Segment is through the sale of advertising time on its television stations. Advertising revenues are recognized, net of agency commissions, in the period when the advertisements are aired. Our Media Segment also earns revenue from retransmission consent arrangements. Under these agreements, we receive cash consideration from multichannel video programming distributors (e.g., cable and satellite providers) in return for our consent to permit the cable/satellite operator to retransmit our television signal. Retransmission consent fees are recognized over the contract period based on a negotiated fee per subscriber. Retransmission consent fees revenues have increased as a percentage of overall Media Segment revenue in recent years. In 2015, such revenues accounted for approximately 27% of overall Media Segment revenue compared to 18% in 2013. In addition, our Media Segment also generates online advertising revenue through the display of digital advertisements across its various digital platforms. Online advertising agreements typically take the form of an impression-based contract, fixed fee time-based contract or transaction based contract. The customers are billed for impressions delivered or click-throughs on their advertisements. An impression is the display of an advertisement to an end-user on the website and is a measure of volume. A click-through occurs when an end-user clicks on an impression. Revenue is recognized evenly over the contract term for fixed fee contracts where a minimum number of impressions or click-throughs is not guaranteed. Revenue is recognized as the service is delivered for transaction based contracts. Digital Segment: The primary source of revenue for our Digital Segment is through the sale of online subscription advertising products. Cars.com sells subscription advertising products targeting car dealerships and national advertisers, and CareerBuilder earns revenue through placement of job postings on its network of websites. Revenue is recognized for our Digital Segment’s online advertising arrangements in the same manner as described above for Media Segments online advertising revenue. CareerBuilder service offerings include human capital Software-as-a-Service (SaaS) and various other recruitment solutions (employment branding services and access to online resume databases). Generally, the human capital SaaS offering and access related to resume databases are subscription-based contracts for which revenue is recognized ratably over the subscription period. SaaS contracts are generally two to three year contracts. Recruitment solutions (which include sourcing and screening services) are more transactional based contracts, and therefore, revenue is recognized as delivery occurs. In addition, through our G/O Digital business unit, we also provide digital marketing services and revenue is recognized for these offerings as advertising and services are delivered. Goodwill: As of Dec. 31, 2015, our goodwill balance was $3.9 billion and represented approximately 46% of our total assets. Goodwill represents the excess of acquisition cost over the fair value of assets acquired, including identifiable intangible assets, net of liabilities assumed. Goodwill is tested for impairment on an annual basis (first day of our fourth quarter) or between annual tests if events or changes in circumstances occurred that indicate the fair value of a reporting unit below its carrying amount. Our goodwill has been allocated to and is tested for impairment at a level referred to as the reporting unit. The level at which we test goodwill for impairment requires us to determine whether the operations below the business segment level constitute a business for which discrete financial information is available and segment management regularly reviews the operating results. For Media, goodwill is accounted for at the segment level. For Digital, the reporting units are the stand-alone digital businesses such as Cars.com, CareerBuilder, ShopLocal and PointRoll. The following table shows the aggregate goodwill for these units summarized at the segment level: Before performing the annual two-step goodwill impairment test, we first have the option to perform a qualitative assessment to determine if the two-step quantitative test must be completed. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance, as well as company and specific reporting unit specifications. If after performing this assessment, we conclude it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then we are required to perform a two-step quantitative test. Otherwise, the two-step test is not required. In 2015, we elected to not perform the optional qualitative assessment of goodwill; and instead, we performed the quantitative impairment test. When performing the first step of the quantitative test, we determine the fair value of each reporting unit and compare it to the carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds the fair value of the reporting unit, we perform the second step of the impairment test, as this is an indication that the reporting unit goodwill may be impaired. In the second step of the impairment test, we determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then an impairment of goodwill has occurred and we must recognize an impairment loss for the difference between the carrying amount and the implied fair value of goodwill. We estimate the fair value of each reporting unit using a combination of a market-based valuation methodology using comparable public company trading values, and income approach using the discounted cash flow (DCF) analysis. Determining fair value requires the exercise of significant judgments, including the amount and timing of expected future cash flows, long-term growth rates, discount rates and relevant comparable public company earnings multiples. The cash flows employed in the DCF analysis are based on our best estimate of future sales, earnings and cash flows after considering factors such as general market conditions and recent operating performance. The discount rates utilized in the DCF analysis are based on the respective reporting unit’s weighted average cost of capital, which takes into account the relative weights of each component of capital structure (equity and debt) and represents the expected cost of new capital, adjusted as appropriate to consider the risk inherent in future cash flows of the respective reporting unit. In the fourth quarter of 2015, we completed our annual goodwill impairment test for each of our reporting units. The results of these tests indicated that the estimated fair values of our reporting units exceed their carrying values, with the exception of our PointRoll reporting unit within our Digital Segment. After performing step 2 of the impairment test, we recorded a non-cash impairment charge of $8 million. For the Media Segment, which is considered a single reporting unit, the estimated value would need to decline by over 50% to fail step one of the quantitative goodwill impairment test. The Digital Segment balance represents primarily Cars.com and CareerBuilder. For both of these reporting units, the estimated value would need to decline by more than 20% to fail step one of the quantitative goodwill impairment test. Impairment assessment inherently involves management judgments regarding a number of assumptions described above. Fair value of the reporting units also depends on the future strength of the economy in our principal media and digital markets. New and developing competition as well as technological change could also adversely affect future fair value estimates. Due to the many variables inherent in the estimation of a reporting unit's fair value and the relative size of our recorded goodwill, differences in assumptions could have a material effect on the estimated fair value of one or more of our reporting units and could result in a goodwill impairment charge in a future period. Indefinite Lived Intangibles: This asset grouping consists of FCC broadcast licenses related to our acquisitions of television stations, and trade names from the Cars.com and CareerBuilder acquisitions. As of Dec. 31, 2015 indefinite lived intangible assets were $2.1 billion and represented approximately 25% of our total assets. Indefinite lived assets are not subject to amortization and, as a result, they are tested for impairment annually (on the first day of our fourth quarter), or more frequently if events or changes in circumstances suggest that the asset might be impaired. We have the option to first perform a qualitative assessment to determine if it is more likely than not that the fair value of the indefinite lived asset is more than its carrying amount. If that is the case, then we would not have to perform the quantitative analysis. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance of the indefinite lived asset. In 2015, we elected to not perform the optional qualitative assessment; and instead, we performed the quantitative impairment test. The fair value for the FCC broadcast licenses were determined using an income approach referred to as the Greenfield method. This method requires multiple assumptions relating to the future prospects of each individual television station including, but not limited to: (i) expected long-term market growth characteristics, (ii) station revenue shares within a market for a new entrant, (iii) future expected operating expenses, (iv) costs of capital and (v) appropriate discount rates. We performed a quantitative analysis on all of our FCC licenses on the impairment testing date and concluded that no impairment existed. We completed our acquisition of Belo in late 2013 and London Broadcasting in mid-2014 and as a result recorded FCC licenses for all stations acquired. As these FCC licenses were recorded at fair value on the date of acquisition, any future declines in the fair value of the FCC license could result in an impairment charge. Factors that could cause the fair value to decline would be negative changes in any of the assumptions described in the above Greenfield method. The discount rate used generally has a significant impact to the valuation. For our 2015 impairment testing date the discount rate had declined from when we completed our acquisition of Belo and London Broadcasting. Future increases in the discount rate assumptions could cause a decline in the fair value of our FCC licenses which may result in an impairment charge. The estimates of fair value for the trade names are determined using the "relief from royalty" methodology, which is a variation of the income approach. Discount rate assumptions are based on an assessment of the risk inherent in the projected future cash flows generated by the intangible asset. Also subject to judgment are assumptions about royalty rates, which are based on the estimated rates at which similar trade names are being licensed in the marketplace. We completed our annual impairment testing of trade names and determined that no impairments existed based on the results of the impairment test. Although trade name assets are not currently impaired, changes in future market rates or decreases in future cash flows and growth rates could result in an impairment charge in a future period. Other Long-Lived Assets (Property and Equipment and Amortizable Intangible Assets): Property and equipment are recorded at cost and depreciated on a straight-line method over the estimated useful lives of such assets. Changes in circumstances, such as technological advances or changes to our business model or capital strategy, could result in actual useful lives differing from our estimates. In cases where we determine the useful life of buildings and equipment should be shortened, we would, after evaluating for impairment, depreciate the asset over its revised remaining useful life thereby increasing depreciation expense. If an indicator is present, we review our property and equipment assets for potential impairment at the asset group level (generally at the local business level) by comparing the carrying value of such assets with the expected undiscounted cash flows to be generated by those asset groups/local business units. Due to expected continued cash flow in excess of carrying value from its businesses, no property, plant or equipment assets were considered impaired. Our amortizable intangible assets consist mainly of customer relationships, acquired technology and retransmission agreements. These asset values are amortized systematically over their estimated useful lives. An impairment test of these assets would be triggered if the undiscounted cash flows from the related asset group (business unit) were to be less than the asset carrying value. We do not believe that any of our larger amortizable intangible assets (those with book values over $10 million) are at risk of requiring an impairment in the foreseeable future. Income Taxes: Our annual tax rate is based on our income, statutory tax regulations and rates, and tax planning opportunities available in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax expense and in evaluating our tax positions. Tax law requires certain items to be included in our tax returns at different times than when the items are reflected in the financial statements. The annual tax expense reflected in the Consolidated Statements of Income is different than that reported in our tax returns. Some of these differences are permanent, for example expenses recorded for accounting purposes that are not deductible in the returns such as non-deductible goodwill, and some differences are temporary and reverse over time, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax liabilities generally represent tax expense recognized in the financial statements for which payment has been deferred, or expense for which a deduction has been taken already in the tax return but the expense has not yet been recognized in the financial statements. Deferred tax assets generally represent items that can be used as a tax deduction or credit in tax returns in future years for which a benefit has already been recorded in the financial statements. Valuation allowances are established when necessary to reduce deferred income tax assets to the amounts we believe are more likely than not to be recovered. In evaluating the amount of any such valuation allowance, we consider the existence of cumulative income or losses in recent years, the reversal of existing temporary differences, the existence of taxable income in prior carry back years, available tax planning strategies and estimates of future taxable income for each of our taxable jurisdictions. The latter two factors involve the exercise of significant judgment. As of Dec. 31, 2015, deferred tax asset valuation allowances totaled $184 million, primarily related to federal and state capital losses, and state net operating losses available for carry forward to future years. Although realization is not assured, we believe it is more likely than not that all other deferred tax assets for which no valuation allowances have been established will be realized. This conclusion is based on our history of cumulative income in recent years and review of historical and projected future taxable income. We determine whether it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit is recorded in our financial statements. A tax position is measured as the portion of the tax benefit that is greater than 50% likely to be realized upon settlement with a taxing authority (that has full knowledge of all relevant information). We may be required to change our provision for income taxes when the ultimate treatment of certain items is challenged or agreed to by taxing authorities, when estimates used in determining valuation allowances on deferred tax assets significantly change, or when receipt of new information indicates the need for adjustment in valuation allowances. Future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported in the Consolidated Financial Statements in the year these changes occur. The effect of a one percentage point change in the effective tax rate for 2015 would have resulted in a change of $6 million in the provision for income taxes and net income from continuing operations attributable to TEGNA Inc.

<s>[INST] Our company is comprised of a dynamic portfolio of media and digital businesses that provide content that matters and brands that deliver. Our media business includes 46 television stations operating in 38 markets, offering highquality television programming and digital content. Our digital business primarily consists of our Cars.com and CareerBuilder business units that operate in the automotive and human capital solutions industries. The Cars.com website provides credible and easytounderstand information from consumers and experts to provide car buyers with greater control over the car buying and servicing process. CareerBuilder helps companies target, attract and retain workforce talent through an array product offerings including talent management software and other advertising and recruitment solutions. On the first day of our fiscal third quarter, June 29, 2015, we completed the spinoff of our publishing businesses. Our company was renamed TEGNA Inc., and our stock trades on the New York Stock Exchange under the symbol TGNA. In addition, during the fourth quarter of 2015, we sold substantially all of the businesses within our Other Segment. We have presented the financial condition and results of operations of the former publishing businesses and Other Segment as discontinued operations in the accompanying consolidated financial statements for all periods presented. For a summary of discontinued operations, see Note 13. Fiscal year: Beginning in fiscal year 2015, we changed our financial reporting cycle to a calendar yearend. Accordingly, our 2015 fiscal year began on December 29, 2014 (the day after the end of the 2014 fiscal year) and ended on December 31, 2015. Historically, our fiscal year was a 5253 week fiscal year that ended on the last Sunday of the calendar year. As a result, our 2015 fiscal year had four more days than the 2014 and 2013 fiscal years. The impact of the four extra days did not have a material impact on our financial statements, and therefore, we have not restated the historical results. RESULTS OF OPERATIONS: Consolidated summary A consolidated summary of our results is presented below. Consolidated Operating Revenue and Expense 2015 compared to 2014: Operating revenues were $3.05 billion in 2015, an increase of 16% from $2.63 billion in 2014. Media Segment revenues for 2015 decreased 1% to $1.68 billion, as doubledigit growth in retransmission revenue and online revenue and higher core revenue was offset by the record level of political advertising revenue of $159 million achieved in 2014. Digital Segment revenues totaled $1.37 billion for 2015, a record high and an increase of 47%. The increase reflects the acquisition and strong organic growth of Cars.com revenue. Total reported operating expenses increased 11% to $2.14 billion in 2015, primarily due to the acquisition of Cars.com. Depreciation expense was 6% higher in 2015, reflecting the impact from the 2014 acquisitions of London Broadcasting television stations and Cars.com. Facility consolidation and noncash asset impairment charges for all years are discussed in Notes 3 and 11 to the Consolidated Financial Statements. We reported operating income for 2015 of $913 million compared to $707 million in 2014, a 29% increase primarily driven by the acquisition of Cars.com. Our consolidated operating margins improved to 30% in 2015 compared to 27% in 2014 driven by improvement in margins from our Digital Segment, partially offset by the impact from the absence of Olympic and political spending in 2014. 2014 compared to 2013: Operating revenues for 2014 increased 64% to $2.62 billion, primarily due to increases from Media Segment as a result of the acquisitions of Belo and London Broadcasting Company television stations as well as substantially higher retransmission revenue, political and Olympic advertising. Digital Seg [/INST] Positive. </s>

TEGNA INC

2017-02-28

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Executive Summary Our company is comprised of a dynamic portfolio of media and digital businesses that provide content that matters and brands that deliver. Our media business includes 46 television stations operating in 38 markets, offering high-quality television programming and digital content. Our digital business primarily consists of our Cars.com and CareerBuilder business units that operate in the automotive and human capital solutions industries. Cars.com is a leading online destination for automotive consumers offering credible, objective information about car shopping, selling and servicing. CareerBuilder helps companies target, attract and retain workforce talent through an array of product offerings including talent management software and other advertising and recruitment solutions. On September 7, 2016, we announced our intention to spin-off the Cars.com business unit into a separate stand-alone public company and we also announced our plans to conduct a strategic review of our 53% ownership interest in CareerBuilder. While we perform the necessary steps to complete the spin and strategic review, we will maintain the current operating and reporting structure and will continue to report the financial results of both entities in continuing operations within our Digital Segment. Fiscal year: Beginning in fiscal year 2015, we changed our financial reporting cycle to a calendar year-end. Accordingly, our 2015 fiscal year began on December 29, 2014 (the day after the end of the 2014 fiscal year) and ended on December 31, 2015. Historically, our fiscal year was a 52-53 week fiscal year that ended on the last Sunday of the calendar year. As a result, our 2015 fiscal year had two more days than fiscal year 2016. The impact of the extra days in 2015 did not have a material impact on our financial statements; and therefore, we have not restated the historical results. Consolidated Results from Operations A consolidated summary of our results is presented below. Consolidated Operating Revenue Operating revenues increased $290 million, or 10%, in 2016 as compared to 2015. This increase is comprised of a $252 million increase from our Media Segment and a $39 million increase at our Digital Segment. Record Media Segment revenues of $1.93 billion were driven by political advertising revenue of $155 million, record Summer Olympics revenue of $56 million in the third quarter of 2016, and a substantial increase of retransmission revenue of $133 million and online revenue of $13 million. These increases were partially offset by a $20 million decrease in core advertising due in part to election year political displacement. Increases in the Digital Segment were driven by continued revenue growth at Cars.com of $37 million, G/O Digital of $28 million and CareerBuilder of $16 million. These increases at the Digital Segment were partially offset by the absence of $32 million of revenue contributed in 2015 by our PointRoll business, which was sold in November 2015. Operating revenues increased $425 million, or 16%, in 2015 as compared to 2014. This increase comprised a $435 million increase from our Digital Segment, partially offset by a $10 million decline at our Media Segment. Media Segment revenues for 2015 decreased 1% to $1.68 billion, as growth in retransmission revenue of $87 million, online revenue of $15 million, and higher core revenue of $26 million were offset by a decline of political advertising revenue of $138 million (from the record level of political advertising revenue of $159 million achieved in 2014). Digital Segment revenues totaled $1.37 billion for 2015, an increase of 47%. The increase reflects the impact of the Cars.com acquisition (acquired on October 1, 2014) as well as the strong organic growth of Cars.com revenue, as well as price increases for affiliates implemented October 1, 2014, resulting in an increase in revenue of $451 million in 2015. Partially offsetting the revenue increase at Cars.com, was a decrease of $20 million as a result of a decline in revenue and sale of our PointRoll business in November 2015. Costs of Revenue Cost of revenue increased $116 million, or 13%, in 2016 as compared to 2015. This increase was primarily due to an $89 million increase in programming costs incurred by the Media Segment. In addition, our 2016 business acquisitions contributed $17 million to the increase, and cost increases at Cars.com added $11 million to our cost of revenue (primarily due to higher traffic acquisition costs and increased compensation costs). Cost of revenue decreased $32 million, or 3%, in 2015 as compared to 2014. This decrease was due to a $25 million decrease at CareerBuilder primarily due to the expiration and non-renewal of certain revenue-share arrangements. Selling, General and Administrative Expenses Selling, general, and administrative expenses increased $26 million, or 2%, in 2016 as compared to 2015. The increase was primarily driven by the 2016 business acquisitions of Aurico, DealerRater, and Workterra, which increased selling, general, and administrative expenses by $18 million. In addition, severance expense increased $9 million year-over-year driven by a voluntary retirement program in our Media Segment completed in 2016. Our 2016 expenses also increased due to the absence of rental income at our corporate headquarters, which was $5 million in 2015, resulting from our sale of the building in the fourth quarter of 2015. Selling, general, and administrative expenses increased $301 million, or 39%, in 2015 as compared to 2014. The majority of the increase was due to the October 2014 acquisition of the remaining ownership of Cars.com which resulted in a year over year increase in selling, general and administrative expenses of $217 million. Depreciation Expense Depreciation expense decreased $1 million, or 1%, in 2016 as compared to 2015. This decrease is primarily due to a $5 million decline in depreciation at Corporate, primarily driven by the October 2015 sale of our corporate headquarters building that resulted in a year-over-year decrease in depreciation expense of $4 million. The decrease was also driven by the sale of our PointRoll business in November 2015, which led to a year-over-year decline in depreciation expense of $3 million. These decreases were partially offset by a $5 million increase in CareerBuilder’s depreciation, which was due to the acquisition of new computer equipment, an increase in internally developed software and new leasehold improvements. Depreciation expense increased $5 million, or 6%, in 2015 as compared to 2014. The increase was due to the acquisition of Cars.com in October 2014 which resulted in a year over year increase in depreciation expense of $6 million. Intangible Asset Amortization Expense Intangible asset amortization expense increased by less than $1 million, or less than 1%, in 2016 as compared to 2015. The increase was primarily driven by the 2016 acquisitions, which was substantially offset by a decline in amortization expense associated with previous acquisitions as a result of reaching the end of their useful lives. Intangible asset amortization expense increased $48 million, or 73%, in 2015 as compared to 2014. The October 2014 acquisition of Cars.com resulted in amortization expense in 2015 and 2014 of $73 million and $18 million, respectively. This increase was partially offset by a $7 million reduction in amortization expense related to certain intangible assets in 2015 as a result of reaching the end of their useful lives. Asset impairment and Facility Consolidation Charges (Gains) Asset impairment and facility consolidation charges (gains) fluctuated $91 million from a gain of ($59) million in 2015 to a charge of $32 million in 2016. The fluctuation was mainly due to the absence of the $90 million net gain from the sale of our corporate headquarters building in 2015. The 2016 charges were comprised of a goodwill impairment charge of $15 million incurred in the third quarter of 2016, a $6 million impairment related to a programming asset, a $5 million impairment charge related to a long-lived-asset, and a $5 million lease related charge. Asset impairment and facility consolidation charges (gains) fluctuated $104 million from charges of $45 million in 2014 to a gain of ($59) million in 2015. The year-over-year fluctuation was driven by the $90 million net gain from the sale of our corporate headquarters building in 2015, and by non-cash impairment charges of $31 million in 2014 related to certain reporting units within our Digital Segment (primarily PointRoll, ShopLocal and BLiNQ). Operating Income Operating income increased $59 million, or 6%, in 2016 as compared to 2015. The increase was driven by the changes in revenue and operating expenses described above. Further, the increase in 2016 was partially offset by the absence of the $90 million gain on the sale of our corporate headquarters building in 2015. Our consolidated operating margins were lower at 29% in 2016 compared to 30% in 2015, primarily driven by the absence in 2016 of the net gain on the sale of our corporate headquarters building reported in 2015. Operating income increased $206 million, or 29%, in 2015 as compared to 2014, primarily driven by the acquisition of Cars.com which contributed $180 million of the increase. Our consolidated operating margins improved to 30% in 2015 compared to 27% in 2014 driven by improvement in margins from our Digital Segment as well as the net gain on the sale of our corporate headquarters building, partially offset by the impact from the absence of Winter Olympics and political spending in 2014. Payroll expense trends: Payroll expense is the largest element of our normal operating expenses, and is summarized below, expressed as a percentage of total pre-tax operating expenses. Payroll expense as a percentage of total pre-tax operating expenses decreased in 2016, reflecting that total operating expenses grew at a faster rate than payroll expense. Non-operating income and expense Equity earnings (losses): This income statement category reflects earnings or losses from our equity method investments. Equity losses increased $2 million, or 42% in 2016 as compared to 2015. The increased losses were primarily due to ($4 million) of impairment charges related to two equity method investments recorded in 2016. These impairment losses were partially offset by a year over year improvement in results for other equity method investments. Equity earnings (losses) fluctuated $156 million from a $151 million gain in 2014 to a ($5 million) loss in 2015. This fluctuation was primarily due to the absence of a $148 million gain on the sale of Apartments.com by Classified Ventures in 2014. Interest expense: Interest expense decreased $42 million, or 15%, in 2016 as compared to 2015, primarily due to lower average outstanding total debt balance and a lower average interest rate, reflecting the extinguishment of higher cost debt in 2015 and 2016, including the 10% senior notes and 7.125% notes that we repaid in April and November of 2016, respectively. The total average outstanding debt was $4.25 billion in 2016 compared to $4.37 billion in 2015. The weighted average interest rate on total outstanding debt was 5.29% in 2016, compared to 5.98% in 2015. Interest expense increased $1 million, or less than 1%, in 2015 as compared to 2014, due to a higher average debt level of $4.37 billion in 2015 compared to $3.85 billion in 2014. The higher average debt level was related to additional borrowing related to both the Belo and Cars.com acquisitions in 2013 and 2014, respectively, partly offset by a lower average interest rate. The weighted average interest rate on total outstanding debt was 5.98% in 2015, compared to 6.65% in 2014. A further discussion of our borrowing and related interest cost is presented in the “Liquidity and capital resources” section of this report beginning on page 26 and in Note 7 to the consolidated financial statements. Other non-operating items: Other non-operating items fluctuated $9 million from a loss of $12 million in 2015 to a loss of $20 million in 2016. The 2016 non-operating loss primarily consisted of $24 million in costs associated with the spin-off of our Cars.com business unit, the strategic review of CareerBuilder, and acquisition related costs. Our 2015 non-operating loss consisted of $45 million in costs related to the spin-off of our former publishing business and $9 million in costs incurred in connection with the early extinguishment of debt. These costs in 2015 were offset by a gain of $44 million on the sale of a business. Other non-operating items in 2014 represented a net gain of $404 million, with the majority related to the write-up of our prior 27% investment in Cars.com to fair value post-acquisition and a gain related to required accounting for the pre-existing affiliate agreement between Cars.com and us. This gain was partially offset by acquisition costs and expenses incurred for the spin-off of our publishing businesses completed in 2015. Provision for income taxes We reported pre-tax income from continuing operations attributable to TEGNA of $661 million for 2016. The effective tax rate on pre-tax income was 32.8%. We reported pre-tax income from continuing operations attributable to TEGNA of $560 million for 2015. The effective tax rate on pre-tax income was 36.1%. The 2016 effective tax rate decreased as compared to 2015 primarily due to a decrease in TEGNA’s state effective tax rate applied to our deferred tax items. This reduction of our state effective tax rate was driven by various tax planning initiatives, in particular a state income tax project that was concluded in the fourth quarter of 2016. When these tax items are reported on our future state tax returns, they will be subject to a lower tax rate than had been recorded previously, which created a deferred tax benefit in 2016 that reduced our effective tax rate. In addition, in the first quarter of 2016 we early adopted the Financial Accounting Standards Board (FASB) guidance on employee share-based payments that requires all excess tax benefits and tax deduction shortfalls to be recognized as an income tax benefit or expense in the income statement. As a result in 2016, we realized an excess tax benefit with respect to our employee share-based payments, which reduced our effective tax rate by 1% as compared to 2015. This FASB guidance will continue to apply in the future; however, among other factors, the amount of the income tax benefit or expense will be dependent on our future stock price, which cannot be accurately predicted. We reported pre-tax income from continuing operations attributable to TEGNA of $922 million for 2014. The provision for income taxes reflects a special net tax benefit from the sale of a non-strategic subsidiary at a loss, for which a partial tax benefit was recognized. The effective tax rate in 2014 was 25.4%. Further information concerning income tax matters is contained in Note 6 of the consolidated financial statements. Net income from continuing operations attributable to TEGNA Inc. Net income from continuing operations attributable to TEGNA Inc. and related per share amounts are presented in the table below. Net income from continuing operations attributable to TEGNA Inc. consists of net income from continuing operations reduced by net income attributable to noncontrolling interests, from CareerBuilder and its subsidiaries. We reported net income from continuing operations attributable to TEGNA of $444 million or $2.02 per diluted share for 2016 compared to $357 million or $1.56 per diluted share for 2015. Net income attributable to noncontrolling interests was $51 million in 2016, $63 million in 2015 and $68 million in 2014. Earnings per share benefited from a net decrease of approximately ten million diluted shares from December 31, 2015 to December 31, 2016, and approximately two million dilutive shares from December 31, 2014, to December 31, 2015, as a result of share repurchases, which were partially offset by share issuances under our stock-based award programs. Outlook for 2017: Based on current trends, we expect Media Segment revenue in the first quarter of 2017 to be flat to slightly above the first quarter of 2016. The year-over-year comparison will be unfavorably impacted by substantially lower political advertising revenue ($16 million in the first quarter of 2016) and the move of the Super Bowl to our 3 small FOX stations in 2017 from our 11 CBS stations in 2016. Excluding the unfavorable impact of the Super Bowl shift (approximately $9 million) and lower politically-related advertising, the percentage increase in Media Segment revenues is expected to be in the mid-single digits in the first quarter of 2017 compared to the first quarter of 2016. In addition, beginning in January 2017, 11 of our NBC stations will be making reverse compensation payments for the first time. As such, 2017 will be a unique year as there will be an unfavorable gap between the increase in retransmission revenue we earn from multichannel video programming distributors (MVPD), compared to the increase in reverse compensation we will pay our affiliates. At the end of 2016, we renegotiated several new retransmission agreements with major MVPD carriers, and as a result, we have reduced our net retransmission gap in 2017 to approximately $25 million to $30 million. Further, we expect our strategic initiatives launched in 2016 (as discussed in our Media Segment section within Item 1 Business) will more than offset the remaining net retransmission gap in 2017. For Cars.com, we are expecting modest single-digit revenue growth in the first quarter of 2017. We expect to see revenue growth in Cars.com national and major accounts businesses, but at a lower rate than during the same quarter last year primarily related to reduction in spending at two national accounts due to a transition to an advertising agency and a change in placement strategy during the first quarter. Once these transitions are completed, we expect these two national accounts to increase their spending as we progress throughout the year. Excluding the impact of these two accounts, we expect Cars.com national and major accounts to be up in the range of 12% to 15% in the first quarter of 2017. While Cars.com is taking steps to improve, and in some cases restructure, the relationships with our affiliates, we expect a mid single-digit revenue decline in the first quarter of 2017 for affiliate revenues. The following is a discussion of operating results of our Media and Digital Segments: Media Segment At the end of 2016, our Media operations included 46 television stations either owned or serviced through shared service agreements or other similar agreements. Media Segment revenues accounted for approximately 58% of our consolidated operating revenues for 2016. A summary of our Media Segment results is presented below: Media Segment revenues are grouped into five categories: Core (Local and National), Political, Retransmission, Digital and Other. The following table summarizes the year-over-year changes in these select revenue categories. Media Segment results 2016-2015: Media Segment revenues increased $251 million, or 15%, to a record high in 2016 as compared to 2015. The increase was driven by political advertising, a record level of Summer Olympics advertising, and a substantial increase in retransmission revenues. Core advertising revenues, which consist of local and national non-political advertising (and includes Olympics advertising), decreased $20 million or 2%, mostly due to: political advertising displacement; softer markets in the insurance and retail categories; and an $8 million impact related to two fewer days in 2016 as compared to 2015 as a result of the fiscal year-end change. These decreases were partially offset by a record $56 million Summer Olympics advertising revenue in the third quarter of 2016 which was up over 20% compared to the last Summer Olympics in 2012. Political advertising revenue increased $133 million due to the presidential election year political spending. Political revenues are cyclical and higher in even years (e.g. 2014, 2016). Retransmission revenues increased $133 million or 30% in 2016, reflecting retransmission agreements renewed at the end of last year, as well as annual rate increases for existing agreements. Digital revenues within our Media Segment increased $13 million or 12% primarily due to continued growth of digital marketing services products. Media Segment operating expenses increased $159 million or 16% in 2016 as compared to 2015. The increase was mainly due to an increase of $89 million in programming costs (primarily associated with reverse compensation to network affiliates related to retransmission revenue) as well as investments in growth initiatives, $19 million primarily related to severance charges incurred with the voluntary early retirement program and the absence of a $13 million building sale gain in the first quarter of 2015. Asset impairment charges recognized in 2016 primarily relate to a $6 million charge associated with an internally produced program and a $2 million impairment of a long-lived asset that is now classified as held for sale and was written down to its fair value in 2016. Excluding the impacts of the voluntary early retirement program expense and asset impairment charges in 2016 and the building sale gain in 2015, Media Segment operating expenses increased 14% in 2016. As a result of all of these factors, Media Segment operating income increased to $806 million in 2016 from $714 million in 2015. Media Segment results 2015-2014: Media Segment revenues decreased $10 million to $1.68 billion or 1% in 2015 as compared to 2014. The decrease was primarily due to the absence of record level of political advertising revenue of $159 million and $41 million in Winter Olympics advertising revenue achieved during 2014. The change to a calendar year-end reporting cycle extended our fiscal 2015 by four extra days which increased Media Segment revenue by $11 million. Core advertising revenues increased $26 million or 3% in 2015. Political advertising revenue declined $138 million to $21 million in 2015. Retransmission revenues increased $87 million or 24% in 2015 resulting from newly negotiated agreements and annual rate increases. Within the Media Segment, digital revenue increased $15 million or 15% compared to 2014, reflecting continued growth from digital marketing services products. Media Segment operating expenses increased $23 million or 2% in 2015. The increase was primarily due to an increase of $22 million in programming costs as well as a $16 million increase in cost of digital initiatives, partially offset by a $13 million building sale gain in the first quarter of 2015. As a result of all of these factors, Media Segment operating income decreased to $714 million in 2015 from $747 million in 2014. Digital Segment Our Digital Segment includes results for our stand-alone digital subsidiaries including Cars.com, CareerBuilder, G/O Digital and Cofactor (also operating as ShopLocal) business units. In December 2016, we sold our Cofactor business unit. In November 2015, we sold our PointRoll business unit which was previously part of Cofactor. Many of our other digital offerings are highly integrated within our Media Segment offerings; therefore, the results of these integrated digital offerings are reported within the operating results of our Media Segment. A summary of our Digital Segment results is presented below: Note: Numbers may not sum due to rounding. Digital Segment results 2016-2015: Our 2016 Digital Segment revenue was $1.41 billion, a record high. Digital Segment revenues increased $39 million, or 3%, in 2016 as compared to 2015. The increase was driven by continued revenue growth at Cars.com of $37 million, or 6%, G/O Digital of $28 million or 94% (due to combination of a new commercial agreement which started in mid 2015 and organic growth) and CareerBuilder of $16 million, or 2%. These increases were partially offset by the sale of our former PointRoll business which contributed $32 million of revenue in 2015. The increase in Cars.com revenues was due to an increase in retail revenue (driven by increased subscription package volume and upsells and the acquisition of DealerRater) and higher national advertising purchased by auto manufacturers. The increase in CareerBuilder revenue was driven by $40 million of increases from employer services (driven by the acquisition of Aurico and higher revenue across sales channels due), $12 million of increased resume database revenues (due to sales and renewals of its new Recruitment Edge product) and $12 million from continued growth in software as a service (SaaS) revenues. These increases at CareerBuilder were partially offset by lower job site revenue of $48 million (due to lower job postings and competitive pricing pressure). Digital Segment expenses increased $38 million or 3% in 2016 as compared to 2015. This increase was driven by higher expenses at CareerBuilder of $47 million, primarily due to the acquisition of Aurico and Workterra. Also impacting the increase in 2016 was an increase in G/O Digital operating expenses of $24 million (due to a new commercial agreement which started in mid 2015) and an increase at Cars.com of $14 million (consistent with revenue growth). These increases are partially offset by the sale of our PointRoll business which resulted in a decline in operating expenses of $36 million, and the absence of $8 million of costs associated with our former BLiNQ business which was shut down in the second quarter of 2015. As a result of these factors, Digital Segment operating income increased to $230 million in 2016. Digital Segment results 2015-2014: Digital Segment revenues increased $435 million, or 47%, in 2015 as compared to 2014. The increase was driven by the $451 million incremental full year impact of the Cars.com acquisition on October 1, 2014, partially offset by a decrease of revenues at CareerBuilder of $15 million, or 2%. The decrease in CareerBuilder revenues in 2015 was driven by the strategic shift in focus in its product offerings. During 2015, CareerBuilder continued its transition toward higher-margin software-as-a-service solutions, including its pre-hire platform and new recruitment software products. As a result, SaaS revenues increased $35 million, or 30%. These revenue increases were offset by declines from lower-margin, transactional source and screen arrangements and other transactional offerings totaling approximately $56 million, as CareerBuilder moved away from these product offerings to focus on the SaaS platform solutions. In addition, 2015 revenue increased $26 million due to G/O Digital (due to combination of a new commercial agreement which started in mid 2015 and organic growth), which was offset by 2015 declines in revenue of $24 million from various other digital business units (primarily PointRoll). Digital Segment expenses in 2015 increased $325 million, or 40%, primarily due to the $271 million incremental full year impact of the Cars.com acquisition and G/O Digital increase of $21 million (due to combination of a new commercial agreement in mid 2015 and organic growth). These increases were offset by a decrease in CareerBuilder expenses of $14 million, or 2%, (reflecting lower revenue and strategic shift in focus on its product offerings), and a $13 million reduction in expenses in the BLiNQ business, which was shut down in the second quarter of 2015. As a result of these factors, Digital Segment operating income increased by $109 million or 91% in 2015. Operating results non-GAAP information Presentation of non-GAAP information: We use non-GAAP financial performance and liquidity measures to supplement the financial information presented on a GAAP basis. These non-GAAP financial measures should not be considered in isolation from, or as a substitute for, the related GAAP measures, nor should they be considered superior to the related GAAP measures, and should be read together with financial information presented on a GAAP basis. Also, our non-GAAP measures may not be comparable to similarly titled measures of other companies. Management and our Board of Directors use the non-GAAP financial measures for purposes of evaluating business unit and consolidated company performance. Furthermore, the Executive Compensation Committee of our Board of Directors uses non-GAAP measures such as Adjusted EBITDA, non-GAAP net income, non-GAAP EPS and free cash flow to evaluate management’s performance. Therefore, we believe that each of the non-GAAP measures presented provides useful information to investors and other stakeholders by allowing them to view our business through the eyes of management and our Board of Directors, facilitating comparisons of results across historical periods and focus on the underlying ongoing operating performance of our business. We discuss in this Form 10-K non-GAAP financial performance measures that exclude from our reported GAAP results the impact of “special items” consisting of severance expense, impairment charges on operating assets and equity investments, facility consolidation charges, gains related to building sales, gains/losses related to business disposals, expenses related to business acquisitions, costs associated with the company’s spin-off transactions, and benefits to our income tax provision. We also adjust net income attributed to noncontrolling interests to the extent any of the above items are related to our CareerBuilder business unit. We believe that such expenses, charges and gains are not indicative of normal, ongoing operations. Such items vary from period to period and are significantly impacted by the timing and nature of these events. Therefore, while we may incur or recognize these types of expenses, charges and gains in the future, we believe that removing these items for purposes of calculating the non-GAAP financial measures provides investors with a more focused presentation of our ongoing operating performance. We discuss Adjusted EBITDA, a non-GAAP financial performance measure that we believe offers a useful view of the overall operation of its businesses. The Company defines Adjusted EBITDA as net income from continuing operations attributable to TEGNA before (1) net income attributable to noncontrolling interests, (2) interest expense, (3) income taxes, (4) equity income (losses) in unconsolidated investees, net, (5) other non-operating items such as spin-off transaction expense, investment income and currency gains and losses, (6) severance expense, (7) facility consolidation charges, (8) impairment charges, (9) depreciation and (10) amortization. When Adjusted EBITDA is discussed in reference to performance on a consolidated basis, the most directly comparable GAAP financial measure is Net income from continuing operations attributable to TEGNA. We do not analyze non-operating items such as interest expense and income taxes on a segment level; therefore, the most directly comparable GAAP financial measure to Adjusted EBITDA when performance is discussed on a segment level is Operating income. Users should consider the limitations of using Adjusted EBITDA, including the fact that this measure does not provide a complete measure of our operating performance. Adjusted EBITDA is not intended to purport to be an alternative to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity. In particular, Adjusted EBITDA is not intended to be a measure of free cash flow available for management’s discretionary expenditures, as this measure does not consider certain cash requirements, such as working capital needs, capital expenditures, contractual commitments, interest payments, tax payments and other debt service requirements. We also discuss free cash flow, a non-GAAP liquidity measure (see Selected Financial Data on page 67). Free cash flow is defined as “net cash flow from operating activities” as reported on the statement of cash flows reduced by “purchase of property and equipment”. We believe that free cash flow is a useful measure for management and investors to evaluate the level of cash generated by operations and the ability of its operations to fund investments in new and existing businesses, return cash to shareholders under the company’s capital program, repay indebtedness, add to our cash balance, or use in other discretionary activities. We use free cash flow to monitor cash available for repayment of indebtedness and in discussions with the investment community. Like Adjusted EBITDA, free cash flow is not intended to be a measure of cash flow available for management’s discretionary use. Discussion of special charges and credits affecting reported results: Our results for the fiscal year ended December 31, 2016, included the following items we consider “special items” and are not indicative of our normal ongoing operations: • Severance charges primarily related to a voluntary retirement program at our Media Segment (which includes payroll and related benefit costs); • Non-cash asset impairment and facility consolidation charges primarily associated with goodwill, operating assets, and an operating lease; • Non-operating costs primarily associated with the anticipated spin-off of our Cars.com business unit, strategic review of CareerBuilder, acquisition related costs and equity method investment impairments; • Impact of special items on our net income attributable to noncontrolling interests; and • Special tax benefit related to the release of a portion of our capital loss valuation allowance due to the sale of certain deferred compensation plan investments. Results for the fiscal year ended December 31, 2015, included the following special items: • Costs associated with workforce restructuring; • Non-cash asset impairment and facility consolidation charges primarily related to reducing the carrying value of certain assets to fair value, a goodwill impairment charge, and shut down costs associated with our former BLiNQ business; • Gains on building sales, primarily from the sale of our corporate headquarters building; • Non-operating items related to the spin-off of our former publishing businesses, a gain related to the sale of Gannett Healthcare Group, and other miscellaneous non-operating expenses; and • Special tax benefit primarily related to the restructuring of our legal entities in advance of the spin-off of our publishing businesses. Below are reconciliations of certain line items impacted by special items to the most directly comparable financial measure calculated and presented in accordance with GAAP on our Consolidated Statements of Income: Non-GAAP consolidated results The following is a comparison of our as adjusted non-GAAP financial results between 2016 and 2015. Changes between the periods are driven by the same factors summarized above in the “Results of Operations” section within Management’s Discussion and Analysis of Financial Condition and Results of Operations. Adjusted EBITDA - Non-GAAP Reconciliations of Adjusted EBITDA to net income from continuing operations attributable to TEGNA Inc. presented in accordance with GAAP on our Consolidated Statements of Income is presented below: Adjusted EBITDA increased $180 million or 17% to $1.23 billion in 2016 from $1.05 billion in 2015. The increase was driven by in an increase of $121 million or 15% in the Media Segment and the absence of $52 million in publishing-related unallocated costs that occurred in 2015. As a result, Adjusted EBITDA margins increased to 36.9% in 2016 from 34.6% in 2015. FINANCIAL POSITION Liquidity and capital resources Our strong cash generation capability and financial condition, together with our significant borrowing capacity under our revolving credit agreement, are sufficient to fund our capital expenditures, interest, dividends, share repurchases, investments in strategic initiatives and other operating requirements. Over the longer term, we expect to continue to fund debt maturities, acquisitions and investments through a combination of cash flows from operations, borrowings under our revolving credit agreement and funds raised in the capital markets. Our strong operating cash flows enabled our Board of Directors to approve two key capital allocation initiatives following the spin-off of our publishing businesses in 2015. First, we began paying a regular quarterly cash dividend of $0.14 per share. We paid dividends totaling $122 million in 2016 and $168 million in 2015 (excluding the special spin-off distribution of our publishing businesses). Second, in 2015, our Board of Directors also approved an $825 million share repurchase program to be completed over a three-year period ending June 2018. See the “Capital stock” section below for more information on the share repurchase program. As of December 31, 2016, our total long-term debt was $4.04 billion. Cash and cash equivalents as of December 31, 2016 totaled $77 million. Our operations have historically generated strong positive cash flow which, along with bank revolving credit availability, has provided adequate liquidity to meet our internal investment requirements, as well as acquisitions. Our financial and operating performance, as well as our ability to generate sufficient cash flow to maintain compliance with credit facility covenants, are subject to certain risk factors; see Item 1A - Risk Factors for further discussion. The following table provides a summary of our cash flow information followed by a discussion of the key elements of our cash flows: Note: Numbers may not sum due to rounding. Operating Activities 2016 compared to 2015: Our net cash flow from operating activities was $683 million in 2016, compared to $651 million in 2015. Operating cash flow in 2016 increased due to the absence of any pension contributions to our principal retirement plan (we made a $100 million contribution in 2015). In addition, operating cash flow increased due to higher revenue in 2016. Partially offsetting these increases in cash flow from operating activities was a $101 million increase in income tax payments (due to higher taxable income), and the absence of our former publishing businesses which generated approximately $27 million of operating cash flow in the first half of 2015 (through the spin-off date of June 29, 2015). 2015 compared to 2014: Our net cash flow from operating activities was $651 million in 2015 compared to $848 million in 2014. The decrease was due to the relative absence of $200 million of political and Olympic revenue achieved in 2014, the absence of our publishing businesses in the third and fourth quarters of 2015, a $23 million increase in pension payments in 2015, the timing of certain reverse network compensation payments, payments related to previously accrued expenses for the shutdown of USA Weekend and routine changes in working capital. The increase in pension payments in 2015 was primarily due to a $100 million voluntary contribution we made in 2015 to our principal retirement plan prior to the spin-off of our publishing businesses. Cash paid for income taxes were lower in 2015 by $101 million compared to 2014, primarily due to the tax benefit received on the voluntary pension payment and the decrease in net income compared to the prior year. Investing Activities 2016 compared to 2015: Net cash used by investing activities was $273 million in 2016 compared to cash provided by investing activities of $217 million in 2015. The difference between periods was primarily attributable to proceeds received in 2015 of $411 million related to sales of assets (primarily the sales of our corporate headquarters and Seattle broadcast buildings) and the sale of businesses (primarily Gannett Healthcare, Clipper and PointRoll). The year over year change was also attributable to the increase in cash paid for acquisitions from $54 million in 2015 to $206 million in 2016 (which includes DealerRater, Aurico, and Workterra - see Note 3 to the consolidated financial statements). 2015 compared to 2014: Net cash provided by investing activities was $217 million for 2015 compared to cash used by investing activities of $1.66 billion in 2014. In 2015, we received proceeds of $411 million related to sales of assets and the sale of businesses. This compares to payments for acquisitions of approximately $1.99 billion (primarily Cars.com, London Broadcasting and Broadbean) in 2014. Capital expenditures amounted to $119 million in 2015 and $150 million in 2014. Financing Activities 2016 compared to 2015: Net cash used for financing activities was $462 million in 2016 compared to $858 million in 2015. The difference between periods is primarily due to 2016 decreases in: debt repayments of $170 million; repurchases of our common stock of $109 million; and a one-time cash transfer in 2015 of $63 million to our former publishing businesses in connection with the spin-off. 2015 compared to 2014: Net cash used for financing activities was $858 million in 2015 compared to net cash provided by financing activities of $464 million in 2014. The difference between periods is primarily due to receiving less proceeds from the issuance of debt, increased repurchases of our common stock in 2015, increased debt repayments in 2015, and a one-time cash transfer in 2015 of $63 million to our former publishing businesses in connection with the Gannett spin-off. Long-term debt As of December 31, 2016, our outstanding debt, net of unamortized discounts and deferred financing costs, amounted to $4.04 billion and mainly is in the form of fixed rate notes and borrowings under a revolving credit facility. See “Note 7 Long-term debt” to our consolidated financial statements for a table summarizing the components of our long-term debt. As of December 31, 2016, we were in compliance with all covenants contained in our debt and credit agreements. Below is a summary of our 2016 debt activity: • On April 1, 2016 our unsecured notes bearing a fixed rate of 10% became due, and therefore, we made a debt maturity payment of approximately $203 million (comprised of principal and accrued interest). The payment was made using borrowings from our revolving credit facility. • On September 30, 2016, we borrowed $300 million under a new four-year term loan due in 2020. The interest rate on the term loan is equal to the same interest rates as borrowings under the Amended and Restated Competitive Advance and Revolving Credit Agreement discussed below. Both the revolving credit agreement and the term loan are guaranteed by a majority of our wholly-owned material domestic subsidiaries. We used substantially all of the proceeds from the new term loan to repay a portion of the outstanding obligation under our revolving credit facility. • On November 1, 2016, we redeemed the remaining $70 million of 7.125% unsecured notes due in September 2018 at par, using available cash on hand. This redemption will result in a total net reduction of interest expense of approximately $5 million over the next two years. • As of December 31, 2016, we had unused borrowing capacity of $844 million under our revolving credit facility. In 2015, we entered into an agreement to amend and extend our existing revolving credit facility with one expiring on June 29, 2020 (the Amended and Restated Competitive Advance and Revolving Credit Agreement). As a result, the maximum total leverage ratio permitted by the new agreement is 5.0x through June 30, 2017, after which, as amended, it is reduced to 4.75x through June 30, 2018, and then to 4.50x thereafter. Commitment fees on the revolving credit agreement are equal to 0.25% - 0.40% of the undrawn commitments, depending upon our leverage ratio, and are computed on the average daily undrawn balance under the revolving credit agreement and paid each quarter. Under the Amended and Restated Competitive Advance and Revolving Credit Agreement, we may borrow at an applicable margin above the Eurodollar base rate (LIBOR loan) or the higher of the Prime Rate, the Federal Funds Effective Rate plus 0.50%, or the one month LIBOR rate plus 1.00% (ABR loan). The applicable margin is determined based on our leverage ratio but differs between LIBOR loans and ABR loans. For LIBOR-based borrowing, the margin varies from 1.75% to 2.50%. For ABR-based borrowing, the margin will vary from 0.75% to 1.50%. On September 26, 2016, we amended the Amended and Restated Competitive Advance and Revolving Credit Agreement to increase the capacity of the facility by $103 million. Total commitments under the Amended and Restated Competitive Advance and Revolving Credit Agreement are $1.5 billion. We also have an effective shelf registration statement under which an unspecified amount of securities may be issued, subject to a $7.0 billion limit established by the Board of Directors. Proceeds from the sale of such securities may be used for general corporate purposes, including capital expenditures, working capital, securities repurchase programs, repayment of debt and financing of acquisitions. We may also invest borrowed funds that are not required for other purposes in short-term marketable securities. Our debt maturities may be repaid with cash flow from operating activities, by accessing capital markets or a combination of both. The following schedule of annual maturities of the principal amount of total debt assumes we use available capacity under our revolving credit agreement to refinance unsecured floating rate term loans and fixed rate notes due in 2017 through 2018. Based on this refinancing assumption, all of the obligations other than the VIE unsecured floating rate term loan due prior to 2019 are reflected as maturities for 2019 and beyond. (1) Amortization of term debt due in 2017 and 2018 is assumed to be repaid with funds from the revolving credit agreement, which matures in 2020. Excluding our ability to repay funds with the revolving credit agreement, contractual debt maturities are $132 million and $121 million in 2017 and 2018, respectively. (2) Assumes current revolving credit agreement borrowings comes due in 2020 and credit facility is not extended. Contractual obligations and commitments The following table summarizes the expected cash outflows resulting from financial contracts and commitments as of the end of 2016. (1) Long-term debt includes scheduled principal payments only. See Note 7 to the consolidated financial statements for further information. (2) We have $635 million of outstanding borrowings under our revolving credit facility as of Dec. 31, 2016. We have not included estimated interest payments since payments into and out of the credit facility change daily. Interest on the senior notes is based on the stated cash coupon rate and excludes the amortization of debt issuance discount. The term loan interest rates are based on the actual rates as of Dec. 31, 2016. (3) See Note 13 to the consolidated financial statements. (4) Includes purchase obligations related to capital projects, interactive marketing agreements and other legally binding commitments. Amounts which we are liable for under purchase orders outstanding at Dec. 31, 2016, are reflected in the Consolidated Balance Sheets as accounts payable and accrued liabilities and are excluded from the table above. (5) Programming contracts include television station commitments to purchase programming to be produced in future years. This also includes amounts related to our network affiliation agreements. (6) Other noncurrent liabilities consist of both unfunded and under-funded postretirement benefit plans. Unfunded plans include the TEGNA Supplemental Executive Retirement Plan and the TEGNA Retiree Welfare Plan. Employer contributions, which equal the expected benefit payments, are reflected in the table above over the next ten-year period. Our under-funded plans include the TEGNA Retirement Plan and the G.B. Dealey Retirement Plan (merged into the TEGNA Retirement Plan effective Dec. 31, 2015). We expect contributions to the TEGNA Retirement Plan in 2017 of $22.3 million. TEGNA Retirement Plan contributions beyond the next fiscal year are excluded due to uncertainties regarding significant assumptions involved in estimating these contributions, such as interest rate levels as well as the amount and timing of invested asset returns. Due to uncertainty with respect to the timing of future cash flows associated with unrecognized tax benefits at December 31, 2016, we are unable to make reasonably reliable estimates of the period of cash settlement. Therefore, approximately $17 million of unrecognized tax benefits have been excluded from the contractual obligations table above. See Note 6 to the consolidated financial statements for a further discussion of income taxes. Capital stock In 2015, our Board of Directors approved an $825 million share repurchase program to be completed over a three-year period ending June 2018. As of December 31, 2016, we have $467 million remaining under this authorization. The table below summarizes our share repurchases during the past three years. The shares may be repurchased at management’s discretion, either in the open market or in privately negotiated block transactions. Management’s decision to repurchase shares will depend on price and other corporate developments. In connection with our announcement to spin-off our Cars.com business unit, we temporarily suspended repurchasing shares starting in July 2016 through early November 2016. Purchases may occur from time to time and no maximum purchase price has been set. Certain of the shares we previously acquired have been reissued in settlement of employee stock awards. Our common stock outstanding at December 31, 2016, totaled 214,487,800 shares, compared with 219,754,180 shares at December 31, 2015. Effects of inflation and changing prices and other matters Our results of operations and financial condition have not been significantly affected by inflation. The effects of inflation and changing prices on our property and equipment and related depreciation expense have been reduced as a result of an ongoing capital expenditure program and the availability of replacement assets with improved technology and efficiency. We are minimally exposed to foreign exchange rate risk primarily due to our majority ownership of CareerBuilder which uses several currencies but primarily the Canadian Dollar, British Pound Sterling and Euro as its functional currencies, which are then translated into U.S. dollars. Our foreign currency translation adjustment, related principally to CareerBuilder and reported as part of shareholders’ equity, totaled $29 million at December 31, 2016. Critical accounting policies and the use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe the following discussion addresses our most critical accounting policies, which are those that are important to the presentation of our financial condition and results of operations and require management’s most subjective and complex judgments. This commentary should be read in conjunction with our financial statements, selected financial data and the remainder of this Form 10-K. Revenue Recognition: We generate revenue from a diverse set of product and service offerings which include advertising, retransmission consent fees, and software and recruitment services. Revenue is recognized when persuasive evidence of an arrangement exists, performance under the contract has begun, the contract price is fixed or determinable and collectibility of the related transaction price is reasonably assured. Revenue from sales agreements that contain multiple deliverables is allocated to each element based on the relative best estimate of selling price. Elements are treated as separate units of accounting if there is standalone value upon delivery. Amounts received from customers in advance of revenue recognition are deferred as liabilities. Below is a detail discussion of revenue by our two reportable segments. Media Segment: The primary source of revenue for our Media Segment is through the sale of advertising time on its television stations. Advertising revenues are recognized, net of agency commissions, in the period when the advertisements are aired. Our Media Segment also earns revenue from retransmission consent arrangements. Under these agreements, we receive cash consideration from multichannel video programming distributors (e.g., cable and satellite providers) in return for our consent to permit the cable/satellite operator to retransmit our television signal. Retransmission consent fees are recognized over the contract period based on a negotiated fee per subscriber. Retransmission consent fee revenues have increased as a percentage of overall Media Segment revenue in recent years. In 2016, those revenues accounted for approximately 30% of overall Media Segment revenue compared to 18% in 2013. In addition, our Media Segment also generates online advertising revenue through the display of digital advertisements across its various digital platforms. Online advertising agreements typically take the form of an impression-based contract, fixed fee time-based contract or transaction based contract. The customers are billed for impressions delivered or click-throughs on their advertisements. An impression is the display of an advertisement to an end-user on the website and is a measure of volume. A click-through occurs when an end-user clicks on an impression. Revenue is recognized evenly over the contract term for fixed fee contracts where a minimum number of impressions or click-throughs is not guaranteed. Revenue is recognized as the service is delivered for transaction-based contracts. Digital Segment: The primary source of revenue for our Digital Segment is through the sale of online subscription advertising products. Cars.com sells subscription advertising products to car dealerships, and CareerBuilder earns revenue through various types of recruitment subscription products. The transaction price for the subscription products is recognized on a straight-line basis over the contract term as the service is provided to our customers. Revenue is recognized for our Digital Segment’s online display advertising arrangements (which includes Cars.com, CareerBuilder and G/O Digital) in the same manner as described above for Media Segments online advertising revenue. CareerBuilder service offerings include human capital SaaS and various other recruitment solutions (employment branding services and access to online resume databases). Generally, the human capital SaaS offering and access related to resume databases are subscription-based contracts for which revenue is recognized ratably over the subscription period. SaaS contracts are generally two to three year contracts. Recruitment solutions (which include sourcing and screening services) are more transactional based contracts; and therefore, revenue is recognized as delivery occurs. Goodwill: As of December 31, 2016, our goodwill balance was $4.07 billion and represented approximately 48% of our total assets. Goodwill represents the excess of acquisition cost over the fair value of assets acquired, including identifiable intangible assets, net of liabilities assumed. Goodwill is tested for impairment on an annual basis (first day of our fourth quarter) or between annual tests if events or changes in circumstances occurred that indicate the fair value of a reporting unit may be below its carrying amount. Our goodwill has been allocated to and is tested for impairment at a level referred to as the reporting unit. The level at which we test goodwill for impairment requires us to determine whether the operations below the business segment level constitute a business for which discrete financial information is available and segment management regularly reviews the operating results. For Media, goodwill is tested at the segment level. For Digital, the reporting units are the stand-alone digital businesses such as Cars.com and CareerBuilder. The following table shows the aggregate goodwill balance for these units summarized at the segment level: Before performing the annual two-step goodwill impairment test, we first have the option to perform a qualitative assessment to determine if the two-step quantitative test must be completed. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance, as well as company and specific reporting unit specifications. If after performing this assessment, we conclude it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then we are required to perform a two-step quantitative test. Otherwise, the two-step test is not required. In 2016, we elected not to perform the optional qualitative assessment of goodwill and instead performed the quantitative impairment test. When performing the first step of the quantitative test, we determine the fair value of each reporting unit and compare it to the carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds the fair value of the reporting unit, we perform the second step of the impairment test, as this is an indication that the reporting unit goodwill may be impaired. In the second step of the impairment test, we determine the implied fair value of the reporting unit’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then an impairment of goodwill has occurred and we must recognize an impairment loss for the difference between the carrying amount and the implied fair value of goodwill. We estimate the fair value of each reporting unit using a combination of an income approach using the discounted cash flow (DCF) analysis and a market-based valuation methodology using comparable public company trading values. Determining fair value requires the exercise of significant judgment, including the amount and timing of expected future cash flows, long-term growth rates, discount rates and relevant comparable public company earnings multiples. The cash flows employed in the DCF analysis are based on our best estimate of future sales, earnings and cash flows after considering factors such as general market conditions and recent operating performance. The discount rates utilized in the DCF analysis are based on the respective reporting unit’s weighted average cost of capital, which takes into account the relative weights of each component of its capital structure (equity and debt) and represents the expected cost of new capital, adjusted as appropriate to consider the risk inherent in future cash flows of the respective reporting unit. During the third quarter of 2016, we performed an interim impairment test for a small reporting unit within our Digital Segment, and as a result recorded a non-cash impairment charge of $15.2 million within asset impairment and facility consolidation charges (gains) in the accompanying Consolidated Statements of Income. See Note 4 to the consolidated financial statements for further discussion. In the fourth quarter of 2016, we completed our annual goodwill impairment test for each of our reporting units. The results of these tests indicated that the estimated fair values of all of our reporting units significantly exceeded their carrying values. For the Media Segment, a single reporting unit, the estimated value would need to decline by over 40% to fail step one of the quantitative goodwill impairment test. The Digital Segment balance represents primarily Cars.com and CareerBuilder. For both of these reporting units, the estimated value would need to decline by more than 20% to fail step one of the quantitative goodwill impairment test. We do not believe that any of our reporting units are currently at risk of incurring a goodwill impairment in the foreseeable future. Impairment assessment inherently involves management judgments regarding a number of assumptions described above. Fair value of the reporting units also depends on the future strength of the economy in our principal media and digital markets. New and developing competition as well as technological change could also adversely affect future fair value estimates. Due to the many variables inherent in the estimation of a reporting unit’s fair value and the relative size of our recorded goodwill, differences in assumptions could have a material effect on the estimated fair value of one or more of our reporting units and could result in a goodwill impairment charge in a future period. Indefinite Lived Intangibles: This asset grouping consists of FCC broadcast licenses related to our acquisitions of television stations, and trade names from the Cars.com and CareerBuilder acquisitions. As of December 31, 2016, indefinite lived intangible assets were $2.12 billion and represented approximately 25% of our total assets. Indefinite lived assets are not subject to amortization and, as a result, they are tested for impairment annually (on the first day of our fourth quarter), or more frequently if events or changes in circumstances suggest that the asset might be impaired. We have the option to first perform a qualitative assessment to determine if it is more likely than not that the fair value of the indefinite lived asset is more than its carrying amount. If that is the case, then we would not have to perform the quantitative analysis. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance of the indefinite lived asset. In 2016, we elected not to perform the optional qualitative assessment; and instead, we performed the quantitative impairment test. The fair value of each FCC broadcast license was determined using an income approach referred to as the Greenfield method. This method requires multiple assumptions relating to the future prospects of each individual television station including, but not limited to: (i) expected long-term market growth characteristics, (ii) station revenue shares within a market for a new entrant, (iii) future expected operating expenses, (iv) costs of capital and (v) appropriate discount rates. We performed a quantitative analysis on all of our FCC licenses on the impairment testing date and each fair value exceeded the carrying value by more than 30%, and therefore, concluded that no impairment existed. We completed our acquisition of Belo in late 2013 and London Broadcasting in mid-2014 and as a result recorded FCC licenses for all stations acquired. As these FCC licenses were recorded at fair value on the date of acquisition, any future declines in the fair value of the FCC license could result in an impairment charge. Factors that could cause the fair value to decline would be negative changes in any of the assumptions described in the above Greenfield method. The discount rate used generally has a significant impact to the valuation. For our 2016 impairment testing date, the discount rate had declined from when we completed our acquisition of Belo and London Broadcasting (2.0% for Belo and 1.5% for London Broadcasting). Future increases in the discount rate assumptions could cause a decline in the fair value of our FCC licenses which may result in an impairment charge. The estimates of fair value for the trade names are determined using the “relief from royalty” methodology, which is a variation of the income approach. Discount rate assumptions are based on an assessment of the risk inherent in the projected future cash flows generated by the intangible asset. Also subject to judgment are assumptions about royalty rates, which are based on the estimated rates at which similar trade names are being licensed in the marketplace. We completed our annual impairment testing of trade names and determined each fair value exceeded the carrying value by more than 10%, and therefore, concluded that no impairments existed. Although our trade name assets are not currently impaired, changes in future market rates or decreases in future cash flows and growth rates could result in an impairment charge in a future period. Other Long-Lived Assets (Property and Equipment and Amortizable Intangible Assets): As of December 31, 2016, other long-lived assets were $1.3 billion and represented approximately 16% of our total assets. Property and equipment are recorded at cost and depreciated on a straight-line method over the estimated useful lives of such assets. Changes in circumstances, such as technological advances or changes to our business model or capital strategy, could result in actual useful lives differing from our estimates. In cases where we determine the useful life of buildings and equipment should be shortened, we would, after evaluating for impairment, depreciate the asset over its revised remaining useful life thereby increasing depreciation expense. If an indicator is present, we review our property and equipment assets for potential impairment at the asset group level (generally at the local business level) by comparing the carrying value of such assets with the expected undiscounted cash flows to be generated by those asset groups/local business units. Due to expected continued cash flow in excess of carrying value from its businesses, no property or equipment assets were considered impaired. Our amortizable intangible assets consist mainly of customer relationships, acquired technology and retransmission agreements. These asset values are amortized ratably over their estimated useful lives. An impairment test of these assets would be triggered if the undiscounted cash flows from the related asset group (business unit) were to be less than the asset carrying value. We do not believe that any of our larger amortizable intangible assets (those with book values over $10 million) are at risk of requiring an impairment in the foreseeable future. Income Taxes: Our annual tax rate is based on our income, statutory tax rates, and tax planning opportunities available in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax expense and in evaluating our tax positions. Tax law requires certain items to be included in our tax returns at different times than when the items are reflected in the financial statements. The annual tax expense reflected in the Consolidated Statements of Income is different than that reported in our tax returns. Some of these differences are permanent (for example, expenses recorded for accounting purposes that are not deductible in the returns such as non-deductible goodwill) and some differences are temporary and reverse over time, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax liabilities generally represent tax expense recognized in the financial statements for which payment has been deferred, or expense for which a deduction has been taken already in the tax return but the expense has not yet been recognized in the financial statements. Deferred tax assets generally represent items that can be used as a tax deduction or credit in tax returns in future years for which a benefit has already been recorded in the financial statements. Valuation allowances are established when necessary to reduce deferred income tax assets to the amounts we believe are more likely than not to be recovered. In evaluating the amount of any such valuation allowance, we consider the existence of cumulative income or losses in recent years, the reversal of existing temporary differences, the existence of taxable income in prior carry back years, available tax planning strategies and estimates of future taxable income for each of our taxable jurisdictions. The latter two factors involve the exercise of significant judgment. As of December 31, 2016, deferred tax asset valuation allowances totaled $210 million, primarily related to federal and state capital losses, and state net operating losses available for carry forward to future years. Although realization is not assured, we believe it is more likely than not that all other deferred tax assets for which no valuation allowances have been established will be realized. This conclusion is based on our history of cumulative income in recent years and review of historical and projected future taxable income. We determine whether it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit is recorded in our financial statements. A tax position is measured as the portion of the tax benefit that is greater than 50% likely to be realized upon settlement with a taxing authority (that has full knowledge of all relevant information). We may be required to change our provision for income taxes when the ultimate treatment of certain items is challenged or agreed to by taxing authorities, when estimates used in determining valuation allowances on deferred tax assets significantly change, or when receipt of new information indicates the need for adjustment in valuation allowances. Future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported in the consolidated financial statements in the year these changes occur.

<s>[INST] Our company is comprised of a dynamic portfolio of media and digital businesses that provide content that matters and brands that deliver. Our media business includes 46 television stations operating in 38 markets, offering highquality television programming and digital content. Our digital business primarily consists of our Cars.com and CareerBuilder business units that operate in the automotive and human capital solutions industries. Cars.com is a leading online destination for automotive consumers offering credible, objective information about car shopping, selling and servicing. CareerBuilder helps companies target, attract and retain workforce talent through an array of product offerings including talent management software and other advertising and recruitment solutions. On September 7, 2016, we announced our intention to spinoff the Cars.com business unit into a separate standalone public company and we also announced our plans to conduct a strategic review of our 53% ownership interest in CareerBuilder. While we perform the necessary steps to complete the spin and strategic review, we will maintain the current operating and reporting structure and will continue to report the financial results of both entities in continuing operations within our Digital Segment. Fiscal year: Beginning in fiscal year 2015, we changed our financial reporting cycle to a calendar yearend. Accordingly, our 2015 fiscal year began on December 29, 2014 (the day after the end of the 2014 fiscal year) and ended on December 31, 2015. Historically, our fiscal year was a 5253 week fiscal year that ended on the last Sunday of the calendar year. As a result, our 2015 fiscal year had two more days than fiscal year 2016. The impact of the extra days in 2015 did not have a material impact on our financial statements; and therefore, we have not restated the historical results. Consolidated Results from Operations A consolidated summary of our results is presented below. Consolidated Operating Revenue Operating revenues increased $290 million, or 10%, in 2016 as compared to 2015. This increase is comprised of a $252 million increase from our Media Segment and a $39 million increase at our Digital Segment. Record Media Segment revenues of $1.93 billion were driven by political advertising revenue of $155 million, record Summer Olympics revenue of $56 million in the third quarter of 2016, and a substantial increase of retransmission revenue of $133 million and online revenue of $13 million. These increases were partially offset by a $20 million decrease in core advertising due in part to election year political displacement. Increases in the Digital Segment were driven by continued revenue growth at Cars.com of $37 million, G/O Digital of $28 million and CareerBuilder of $16 million. These increases at the Digital Segment were partially offset by the absence of $32 million of revenue contributed in 2015 by our PointRoll business, which was sold in November 2015. Operating revenues increased $425 million, or 16%, in 2015 as compared to 2014. This increase comprised a $435 million increase from our Digital Segment, partially offset by a $10 million decline at our Media Segment. Media Segment revenues for 2015 decreased 1% to $1.68 billion, as growth in retransmission revenue of $87 million, online revenue of $15 million, and higher core revenue of $26 million were offset by a decline of political advertising revenue of $138 million (from the record level of political advertising revenue of $159 million achieved in 2014). Digital Segment revenues totaled $1.37 billion for 2015, an increase of 47%. The increase reflects the impact of the Cars.com acquisition (acquired on October 1, 2014) as well as the strong organic growth of Cars.com revenue, as well as price increases for affiliates implemented October 1, 2014, resulting in an increase in revenue of $451 million in 2015. Partially offsetting the revenue increase at Cars.com, was a decrease of $20 million as [/INST] Positive. </s>

TEGNA INC

2018-03-01

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Executive Summary We are an innovative media company that serves the greater good of our communities. Our business includes 47 television stations operating in 39 markets, offering high-quality television programming and digital content. Each television station also has a robust digital presence across online, mobile and social platforms. On May 31, 2017, we completed the spin-off of our digital automotive marketplace business, Cars.com. In addition, on July 31, 2017, we completed the sale of our majority ownership stake in CareerBuilder. Our digital marketing services (DMS) business is now reported within our Media business. As a result of these strategic actions, we have disposed of substantially all of our Digital Segment business and have therefore classified substantially all of its historical financial results as discontinued operations for all periods presented. Historic Digital Segment results relate to our former Cofactor (sold in December 2016), Blinq (disposed in 2015) and PointRoll (sold in 2015) business units. Consolidated Results from Operations A consolidated summary of our results is presented below (in thousands). **** Not meaningful Revenues During 2017, we changed the way we present certain revenues, which we now call Advertising and Marketing Services, to better reflect the way we sell our products and services to our clients. This category includes all sources of our traditional television and digital revenues including Premion, DMS and other digital advertising and marketing revenues across our platforms. Also during 2017, the “Retransmission” revenue category was renamed “Subscription” to better reflect changes in that revenue stream, including the distribution of TEGNA stations on OTT streaming services. As a result of these changes, revenues are grouped into the following categories: Advertising & Marketing Services (AMS), political, subscription, other, and our former digital businesses that were not classified as discontinued operations.The following table summarizes the year-over-year changes in these select revenue categories (in thousands): **** Not meaningful Revenue decreased $101.1 million, or 5%, in 2017 as compared to 2016. This net decrease was primarily driven by lower political revenue of $131.6 million, due to an expected decrease reflecting the absence of 2016 politically related advertising spending. In addition, the decrease was due to a decline in AMS revenue of $98.1 million, or 8%, in 2017. This decline was primarily due to the absence of Olympic revenue in 2017 as compared to $57.3 million in 2016 and lower DMS revenue due to the conclusion of a transition services agreement with Gannett. Partially offsetting the overall AMS decline was an increase in digital revenue, including Premion revenue. Partially offsetting the overall decrease was an increase in subscription revenue of $137.0 million, or 24%, due to the recent renewal of certain retransmission agreements as well as annual rate increases under other existing retransmission agreements. Revenue increased $239.3 million, or 14%, in 2016 as compared to 2015. The increase was driven by political advertising, Summer Olympics advertising, and a substantial increase in subscription revenues. Political advertising revenue increased $133.4 million due to the presidential election year political spending. Political revenues are cyclical and higher in even years (e.g. 2016, 2018). Summer Olympic revenue of $57.3 million also contributed to the overall increase. Subscription revenues increased $133.1 million or 30% in 2016, reflecting retransmission agreements renewals, as well as annual rate increases for existing agreements. These increases were partially offset by a decrease of $40.9 million in revenue from our former digital businesses (Cofactor, Blinq, and PointRoll), which was sold in December 2016. Costs of Revenue Cost of revenue increased $138.3 million, or 17%, in 2017 as compared to 2016. This increase was primarily due to an $175.9 million increase in reverse compensation related programming costs (primarily driven by 11 of our stations paying NBC reverse compensation payments for the first time in 2017). This increase was partially offset by a decline in DMS costs of $18.7 million driven by the termination of the transition service agreement with Gannett, the absence of $11.4 million of expense related to our 2016 voluntary early retirement program, and a $7.4 million decrease in Cofactor expenses due to its disposition in 2016. Cost of revenue increased $67.3 million, or 9%, in 2016 as compared to 2015. This increase was primarily due to an $88.6 million increase in programming costs. Business Units - Selling, General and Administrative Expenses Business unit selling, general, and administrative expenses decreased $43.6 million, or 13%, in 2017 as compared to 2016. The decrease was primarily the result of a $19.3 million decline in DMS selling and advertising expense related to the termination of the transition service agreement with Gannett and a reduction of $2.2 million in severance expense. Also contributing to the decline was the absence of $8.6 million of Cofactor expenses, due to its disposition in December 2016, and the absence of $4.0 million of expense related to our 2016 voluntary early retirement program. Business unit selling, general, and administrative expenses increased $12.9 million, or 4%, in 2016 as compared to 2015. The increase is primarily due to $4.0 million of expense related to our voluntary early retirement program and $2.2 million of severance expense for our DMS business. Corporate - General and Administrative Expenses Our corporate costs are separated from our business expenses and are recorded as general and administrative expenses in our Consolidated Statements of Income. These costs include activities that are not directly attributable or allocable to our media business operations. This category primarily consists of broad corporate management functions including legal, human resources, and finance, as well as activities and costs not directly attributable to the operations of our media business. Corporate general and administrative expenses decreased $3.7 million, or 6%, in 2017 as compared to 2016. The decrease was primarily due to a reduction in severance expenses of $0.9 million incurred in 2017. The remaining difference is attributable to the right sizing of the corporate function in connection with the strategic actions impacting our former Digital Segment. Corporate general and administrative expenses decreased $2.4 million, or 4%, in 2016 as compared to 2015. The fluctuation is due to the right sizing of the corporate function following the 2015 publishing businesses spin-off. Depreciation Expense Depreciation expense decreased $0.3 million, or 1%, in 2017 as compared to 2016. The decrease was primarily due to recent declines in the purchase of property and equipment, partially offset by additional depreciation related to a change in useful lives of certain broadcasting assets, including accelerated depreciation expense of $1.5 million in connection with the FCC channel repack process. Depreciation expense decreased $6.8 million, or 11%, in 2016 as compared to 2015. The decrease was primarily due a decrease of $3.6 million in depreciation expense due to the sale of our corporate headquarters, and a $2.7 million decrease in depreciation expense due to the absence of property and equipment related to a business sold in 2015. Amortization of Intangible Assets Intangible asset amortization expense decreased $1.7 million, or 7%, in 2017 as compared to 2016 and $1.3 million, or 5%, in 2016 as compared to 2015. The decreases were a result of certain intangible assets associated with previous acquisitions reaching the end of their useful lives. Asset Impairment and Facility Consolidation Charges (Gains) Asset impairment and facility consolidation charges declined $27.7 million from a charge of $32.1 million in 2016 to a charge of $4.4 million in 2017. The 2017 charges primarily consisted of $0.9 million in net expenses related to Hurricane Harvey (expenses of $26.9 million, net of insurance proceeds of $26.0 million), $1.4 million related to the consolidation of office space at our DMS business unit and corporate headquarters, and $2.2 million of non-cash impairment charges incurred by our broadcast station related to a building sale. The 2016 charges were comprised of a goodwill impairment charge of $15.2 million (for our former Cofactor business), a $6.3 million impairment related to a programming asset, a $4.7 million impairment charge related to a long-lived-asset, and a $4.6 million lease related charge (for our former Cofactor business). Asset impairment and facility consolidation charges (gains) fluctuated $91.5 million from gains of $59.4 million in 2015 to charges of $32.1 million in 2016. The year-over-year fluctuation was primarily driven by the $89.9 million net gain from the sale of our corporate headquarters building in 2015. Operating Income Operating income decreased $162.3 million, or 23%, in 2017 as compared to 2016. The decrease was driven by the changes in revenue and operating expenses described above. Our operating margins were lower at 28.7% in 2017 compared to 35.3% in 2016, primarily driven by the increase in programming expenses and absence of $131.6 million of political revenue compared to 2016. Operating income increased $77.9 million, or 12%, in 2016 as compared to 2015, primarily driven by the changes in revenue and operating expenses discussed above. Our operating margins were consistent in 2016, 35.3%, compared to 35.7% in 2015, as 2016 increases in revenues were offset by 2016 increases in programming expenses and the absence of the 2015 gain on sale of our corporate headquarters building. Payroll and programming expense trends: Payroll and programming expenses are the two largest elements of our normal operating expenses, and are summarized below, expressed as a percentage of total pre-tax operating expenses. Payroll expenses as a percentage of total pre-tax operating expenses decreased in 2017 primarily due to increases in programming expenses, which now make up a larger percentage of operating costs, and lower headcount as a result of right sizing of the corporate function in connection with the strategic actions impacting our former Digital Segment, and at DMS driven by the conclusion of the transition service agreement with Gannett. Programming expenses as a percentage of total pre-tax operating expenses have increased due to an increase in reverse compensation payments (primarily driven by 11 of our stations paying NBC reverse compensation payments for the first time in 2017). Non-operating income and expense Equity income (loss): This income statement category reflects earnings or losses from our equity method investments. Equity income (loss) fluctuated $13.8 million from losses of $3.4 million in 2016 to earnings of $10.4 million in 2017. The fluctuation was primarily due to a $17.5 million gain we recorded in 2017 as a result of the sale of our Livestream investment. This gain was partially offset by a $2.6 million impairment of an equity method investment recorded in 2017. Between 2015 and 2016, equity (losses) increased $0.6 million, from a loss of $2.8 million in 2015 to a loss of $3.4 million in 2016. This is driven by fluctuations in our share of earnings from our equity method investments. Interest expense: Interest expense decreased $21.7 million, or 9%, in 2017 as compared to 2016, primarily due to lower average outstanding total debt balance, due to the $609.9 million mid-year paydown of our revolving credit facility and the accelerated repayment of $280 million of principal on unsecured notes due in October 2019 (which will result in approximately $14.4 million of interest expense savings in 2018). The total average outstanding debt was $3.59 billion in 2017 compared to $4.25 billion in 2016. The decline in outstanding debt was partially offset by an increase in the weighted average interest rate on total outstanding debt which was 5.57% in 2017, compared to 5.29% in 2016. Interest expense decreased $41.2 million, or 15%, in 2016 as compared to 2015, primarily due to lower average outstanding total debt balance and a lower average interest rate, reflecting the extinguishment of higher cost debt in 2015 and 2016, including the 10% senior notes and 7.125% notes that we repaid in April and November of 2016, respectively. The total average outstanding debt was $4.25 billion in 2016 compared to $4.37 billion in 2015. The weighted average interest rate on total outstanding debt was 5.29% in 2016, compared to 5.98% in 2015. A further discussion of our borrowing and related interest cost is presented in the “Liquidity and capital resources” section of this report beginning on page 26 and in Note 6 to the consolidated financial statements. Other non-operating expenses: Other non-operating expenses increased $11.8 million from $23.5 million in 2016 to $35.3 million in 2017. The 2017 non-operating expenses primarily consisted of $18.7 million in transaction costs associated with strategic actions (primarily the Cars.com spin-off). The 2017 non-operating expenses also consisted of $6.6 million in costs incurred in connection with the early extinguishment of debt, a $5.8 million loss associated with the write-off of a note receivable from one of our former equity method investments, and a $3.9 million impairment of our stock investment in Gannett. The 2016 non-operating expenses primarily consisted of $21.0 million in costs associated with the spin-off of our Cars.com business unit and acquisition related costs. Other non-operating expenses increased $14.8 million from $8.7 million in 2015 to $23.5 million in 2016. The 2016 non-operating expenses primarily consisted of $21.0 million in expenses associated with the spin-off of our Cars.com business unit. Our 2015 non-operating expenses consisted of $46.8 million in expenses related to the spin-off of our former publishing business and $5.9 million in costs incurred in connection with the early extinguishment of debt. These 2015 expenses were offset by a gain of $43.8 million on the sale of a business. (Benefit) provision for income taxes On December 22, 2017, Pub. L. No. 115-97, commonly known as the Tax Cuts and Jobs Act (the Act), was enacted into law. Among other provisions, the Act lowered the corporate tax rate from 35% to 21% as of January 1, 2018. The Act also contains certain provisions that will partially reduce the benefit of the lower corporate tax rate, most notably for us is the repeal of the domestic manufacturing deduction. Overall, we believe the Act will be beneficial to us, lowering our effective tax rate and cash tax payments. We are required to revalue our deferred tax assets and deferred tax liabilities as of the Act’s enactment date to reflect the future impact of the 21% corporate tax rate. This resulted in a one-time $221 million deferred tax benefit being recorded in the fourth quarter statement of income, and a reduction to our December 31, 2017 net deferred tax liability as compared to the ending 2016 net deferred tax liability. This deferred tax benefit will be updated upon the filing of our 2017 income tax returns in late 2018. We reported pre-tax income from continuing operations attributable to TEGNA of $310.7 million for 2017. The effective tax rate on pre-tax income was -44.2% including a 71% or $221 million one-time deferred tax benefit recorded in conjunction with the Act. We reported pre-tax income from continuing operations attributable to TEGNA of $449.3 million for 2016. The effective tax rate on pre-tax income was 31.2%. The 2017 effective tax rate decreased as compared to 2016 primarily due to the recognition of the one-time deferred tax benefit recorded in conjunction with the Act. We reported pre-tax income from continuing operations attributable to TEGNA of $345.6 million for 2015. The 2015 provision for income taxes reflects nondeductible transaction costs and effective tax rate changes associated with the spin-off of our former publishing business. The effective tax rate in 2015 was 33.6%. Taking into account the Act’s new 21% corporate tax rate and the Act’s other provisions, we currently anticipate the combined federal and state effective tax rate will be between 23% and 25% for calendar year 2018. We expect our cash taxes will decline by approximately $35 million in 2018 as a result of the new legislation, and plan to reinvest the proceeds to pursue organic and inorganic growth opportunities during 2018. Further information concerning income tax matters is contained in Note 5 of the consolidated financial statements. Net income from continuing operations Net income from continuing operations and related per share amounts are presented in the table below (in thousands, except per share amounts). We reported net income from continuing operations of $448.0 million or $2.06 per diluted share for 2017 compared to $309.1 million or $1.41 per diluted share for 2016. Our 2017 earnings per share was benefited by approximately $1.02 as a result of one-time deferred tax benefit recorded in connection with the Act (as discussed above). Earnings per share also benefited from a net decrease of approximately 2.2 million diluted shares from December 31, 2016 to December 31, 2017, and approximately 10.0 million diluted shares from December 31, 2015, to December 31, 2016, as a result of share repurchases, which were partially offset by share issuances under our stock-based award programs. Operating results non-GAAP information Presentation of non-GAAP information: We use non-GAAP financial performance and liquidity measures to supplement the financial information presented on a GAAP basis. These non-GAAP financial measures should not be considered in isolation from, or as a substitute for, the related GAAP measures, nor should they be considered superior to the related GAAP measures, and should be read together with financial information presented on a GAAP basis. Also, our non-GAAP measures may not be comparable to similarly titled measures of other companies. Management and our Board of Directors use the non-GAAP financial measures for purposes of evaluating business unit and consolidated company performance. Furthermore, the Executive Compensation Committee of our Board of Directors uses non-GAAP measures such as Adjusted EBITDA, non-GAAP net income, non-GAAP EPS, Adjusted revenues and free cash flow to evaluate management’s performance. Therefore, we believe that each of the non-GAAP measures presented provides useful information to investors and other stakeholders by allowing them to view our business through the eyes of management and our Board of Directors, facilitating comparisons of results across historical periods and focus on the underlying ongoing operating performance of our business. We discuss in this Form 10-K non-GAAP financial performance measures that exclude from our reported GAAP results the impact of “special items” consisting of severance expense, charges related to asset impairment and facility consolidations, gain on sale and an impairment of equity method investments, gains/losses related to business disposals, costs associated with debt repayment, TEGNA Foundation donations, costs associated with the Cars.com spin-off transaction, and certain tax benefits associated with the impact of tax reform that was enacted in December 2017. We believe that such expenses, charges and gains are not indicative of normal, ongoing operations. Such items vary from period to period and are significantly impacted by the timing and nature of these events. Therefore, while we may incur or recognize these types of expenses, charges and gains in the future, we believe that removing these items for purposes of calculating the non-GAAP financial measures provides investors with a more focused presentation of our ongoing operating performance. We discuss Adjusted EBITDA (with and without corporate expenses), a non-GAAP financial performance measure that we believe offers a useful view of the overall operation of its businesses. We define Adjusted EBITDA as net income from continuing operations before (1) interest expense, (2) income taxes, (3) equity income (losses) in unconsolidated investments, net, (4) other non-operating items such as spin-off transaction expenses and investment income, (5) severance expense, (6) facility consolidation charges, (7) impairment charges, (8) depreciation and (9) amortization. The most directly comparable GAAP financial measure to Adjusted EBITDA is Net income from continuing operations. Users should consider the limitations of using Adjusted EBITDA, including the fact that this measure does not provide a complete measure of our operating performance. Adjusted EBITDA is not intended to purport to be an alternate to net income as a measure of operating performance or to cashflows from operating activities as a measure of liquidity. In particular, Adjusted EBITDA is not intended to be a measure of free cash flow available for management’s discretionary expenditures, as this measure does not consider certain cash requirements, such as working capital needs, capital expenditures, contractual commitments, interest payments, tax payments and other debt service requirements. We also consider adjusted revenues to be an important non-GAAP financial measure. Our adjusted revenue is calculated by taking total company revenues on a GAAP basis and adjusting it to exclude (1) estimated incremental Olympic and Super Bowl revenue, (2) political revenues, (3) revenues from a previously sold business (Cofactor), and (4) revenues associated with a discontinued portion of our DMS business. These adjustments are made to our reported revenue on a GAAP basis in order to evaluate and assess our core operations on a comparable basis, and it represents the ongoing operations of our broadcast business. We also discuss free cash flow, a non-GAAP liquidity measure. Free cash flow is defined as “net cash flow from operating activities” as reported on the statement of cash flows reduced by “purchase of property and equipment”. We believe that free cash flow is a useful measure for management and investors to evaluate the level of cash generated by operations and the ability of its operations to fund investments in new and existing businesses, return cash to shareholders under the company’s capital program, repay indebtedness, add to our cash balance, or use in other discretionary activities. We use free cash flow to monitor cash available for repayment of indebtedness and in discussions with the investment community. Like Adjusted EBITDA, free cash flow is not intended to be a measure of cash flow available for management’s discretionary use. Discussion of special charges and credits affecting reported results: Our results for the year ended December 31, 2017, included the following items we consider “special items” and are not indicative of our normal ongoing operations: • Severance charges which included payroll and related benefit costs; • Operating asset impairment related to damage caused by Hurricane Harvey and the consolidation of office space at our DMS business unit and corporate headquarters; • Gain on sale and an impairment of equity method investments; • Other non-operating expenses associated with costs of the spin-off of our Cars.com business unit, charitable donations made to the TEGNA Foundation, non-cash asset impairment charges associated with write off of a note receivable from an equity method investment; costs incurred in connection with the early extinguishment of debt; and • Special deferred tax benefits related to tax reform that was enacted in December 2017, deferred tax remeasurement attributable to the spin-off of our Cars.com business unit and a deferred tax adjustment related to a previously-disposed business. Results for the year ended December 31, 2016, included the following special items: • Severance charges primarily related to a voluntary retirement program at our Media Segment (which included payroll and related benefit costs); • Non-cash asset impairment and facility consolidation charges primarily associated with goodwill, operating assets, and an operating lease; • Impairment of an equity method investment; • Non-operating costs primarily associated with the anticipated spin-off of our Cars.com business unit, acquisition related costs, loss on sale of Cofactor business, and equity method investment impairments; and • Special tax benefit related to the release of a portion of our capital loss valuation allowance due to the sale of certain deferred compensation plan investments. Below are reconciliations of certain line items impacted by special items to the most directly comparable financial measure calculated and presented in accordance with GAAP on our Consolidated Statements of Income (in thousands, except per share amounts): Non-GAAP consolidated results The following is a comparison of our as adjusted non-GAAP financial results between 2017 and 2016. Changes between the periods are driven by the same factors summarized above in the “Results of Operations” section within Management’s Discussion and Analysis of Financial Condition and Results of Operations (in thousands, except per share amounts). **** Not meaningful Adjusted Revenues Reconciliations of adjusted revenues to our revenues presented in accordance with GAAP on our Consolidated Statements of Income are presented below (in thousands): Adjusted EBITDA - Non-GAAP Reconciliations of Adjusted EBITDA (inclusive and exclusive of Corporate expenses) to net income from continuing operations presented in accordance with GAAP on our Consolidated Statements of Income is presented below: **** Not meaningful Adjusted EBITDA margin was 36% (without corporate expense) and 33% including corporate. Our total Adjusted EBITDA decreased $211.4 million or 25% in 2017 compared to 2016. The decrease was primarily driven by higher programming costs (primarily driven by 11 of our stations paying NBC reverse compensation payments for first time in 2017) and the expected absence of Olympic and political revenue in 2017. Free cash flow reconciliation Our free cash flow, a non-GAAP liquidity measure, was $309.3 million for the year ended December 31, 2017, compared to $588.6 million for the same period in 2016. Cash flows include the operations of our former publishing businesses (through its spin-off date of June 29, 2015), Cars.com (through its spin-off date of May 31, 2017), and CareerBuilder (through its date of sale on July 31, 2017). Our 2017 free cash flow was lower than 2016 due to the same factors affecting cash flow from operating activities summarized within “Liquidity and capital resources” discussed below. Reconciliations from “Net cash flow from operating activities” to “Free cash flow” are presented below (in thousands): FINANCIAL POSITION Liquidity and capital resources Our cash generation capability and financial condition, together with our significant borrowing capacity under our revolving credit agreement, are sufficient to fund our capital expenditures, interest expense, dividends, share repurchases, investments in strategic initiatives and other operating requirements. Over the longer term, we expect to continue to fund debt maturities, acquisitions and investments through a combination of cash flows from operations, borrowings under our revolving credit agreement and funds raised in the capital markets. As we summarize below, during 2017 we have completed several strategic actions that have positioned us to be able to pursue strategic acquisition opportunities that may develop in our sector, invest in new content and revenue initiatives, and grow revenue in fiscal year 2018. During the second quarter we completed our spin-off of Cars.com which resulted in a one-time tax-free cash distribution of $650.0 million to TEGNA. We used $609.9 million of the distribution proceeds to fully pay down our then outstanding revolving credit agreement borrowings. On July 31, 2017, we sold our controlling ownership interest in CareerBuilder. Our share of the pre-tax net cash proceeds from the sale was $198.3 million, net of cash transferred of $36.6 million. Additionally, prior to the sale, CareerBuilder issued a final dividend to its selling shareholders, of which $25.8 million was retained by TEGNA. In October 2017, we used the net proceeds from the CareerBuilder sale and cash on hand, including the remaining cash distribution proceeds from Cars.com of $40.1 million, to early retire $280.0 million of principal of unsecured notes due in October 2019. Our strategic actions and operating cash flows enabled our Board of Directors to approve two key capital allocation initiatives. First, we have been paying a regular quarterly cash dividend. We paid dividends totaling $90.2 million in 2017. Second, in the third quarter of 2017, our Board of Directors approved a new share repurchase program for up to $300 million of our common stock over the next three years. See the “Capital stock” section below for more information on the share repurchase program. As of December 31, 2017, our total long-term debt, net of unamortized discounts and deferred financing costs, was $3.01 billion. Cash and cash equivalents as of December 31, 2017 totaled $98.8 million. Our operations have historically generated strong positive cash flow which, along with availability under our existing revolving credit facility, has provided adequate liquidity to meet our internal investment requirements, as well as acquisitions. Our financial and operating performance, as well as our ability to generate sufficient cash flow to maintain compliance with credit facility covenants, are subject to certain risk factors; see Item 1A - Risk Factors for further discussion. Our cash flows include the operations of Cars.com (through its spin-off date of May 31, 2017) and CareerBuilder (through its date of sale on July 31, 2017). The following table provides a summary of our cash flow information followed by a discussion of the key elements of our cash flows (in thousands): Operating Activities 2017 compared to 2016: Our net cash flow from operating activities was $386.2 million in 2017, compared to $683.4 million in 2016. The decrease was primarily due to higher programming costs of $175.9 million (primarily due to the NBC affiliation agreement), the decline in political revenue of $131.6 million, and the decline of approximately $230.9 million of operating cash flow from Cars.com and CareerBuilder. These decreases were partially offset by an increase in subscription revenue of $137.0 million and declines in tax payments of $51.6 million and interest payments of $25.0 million. Also partially offsetting the net operating cash flow decrease was a cash inflow received in 2017 of $32.6 million from a spectrum channel sharing agreement. 2016 compared to 2015: Our net cash flow from operating activities was $683.4 million in 2016, compared to $651.2 million in 2015. Operating cash flow in 2016 increased due to the absence of any pension contributions to our principal retirement plan (we made a special $100.0 million contribution in 2015 at the time of the publishing spin). In addition, operating cash flow increased due to higher revenue in 2016 largely driven by political spending. Partially offsetting these increases in cash flow from operating activities was a $101.0 million increase in income tax payments (due to higher taxable income), and the absence of our former publishing businesses which generated approximately $27.0 million of operating cash flow in the first half of 2015 (through the spin-off date of June 29, 2015). Investing Activities 2017 compared to 2016: Net cash provided by investing activities was $174.8 million in 2017 compared to cash used for investing activities of $273.3 million in 2016. The 2017 net cash inflow was primarily a result of the sale of the majority of our ownership in CareerBuilder, which provided $198.3 million of proceeds, net of cash transferred. Additionally, we had cash inflow of $36.5 million from the sale of assets, primarily comprised of proceeds of $21.3 million from the sale of our partial ownership in Livestream and $14.6 million from the sale of our Gannett Co., Inc., common stock. These inflows were partially offset by purchases of property and equipment of $76.9 million in 2017. The 2016 net cash used for investing activities of $273.3 million was primarily comprised of $206.1 million paid for the acquisitions of businesses (net of cash acquired), including DealerRater, Aurico, and Workterra. DealerRater was part of the Cars.com spin-off and Aurico and Workterra were included in the sale of our majority ownership in CareerBuilder, both occurring in 2017. Also contributing to the net outflow was the purchase of property and equipment in the amount of $94.8 million. Partially offsetting these outflows was $40.0 million of inflow from the sale of investments, primarily consisting of non-operating investments. 2016 compared to 2015: Net cash used by investing activities was $273.3 million in 2016 compared to cash provided by investing activities of $217.3 million in 2015. The difference between periods was primarily attributable to proceeds received in 2015 of $411.0 million related to sales of assets (primarily the sales of our corporate headquarters and Seattle broadcast buildings) and the sale of businesses (primarily Gannett Healthcare, Clipper and PointRoll). The year-over-year change was also attributable to the increase in cash paid for acquisitions from $54.0 million in 2015 to $206.1 million in 2016. Financing Activities 2017 compared to 2016: Net cash used for financing activities was $539.1 million in 2017 compared to $462.4 million in 2016. The 2017 net outflow of cash for financing activities was primarily due to debt activity and dividends. With regards to 2017 debt activity, prior to the completion of the spin-off, Cars.com borrowed approximately $675.0 million under a revolving credit facility agreement, while incurring $6.2 million of debt issuance costs. The proceeds were used to make a one-time tax-free cash distribution of $650.0 million from Cars.com to TEGNA. We used most of the cash received to pay down our then-outstanding revolving credit balance of $609.9 million. Total net payments on the revolving credit facility in 2017 were $635.0 million. Additionally, we used $412.3 million to pay down other existing debt, $90.2 million to pay dividends, and $23.5 million to repurchase common stock. The 2016 net financing outflow of $462.4 million was primarily a result of stock repurchases of $161.9 million and dividend payments of $121.6 million. Additionally, we had a net debt outflow of $137.6 million primarily comprised of $310.0 million of borrowings which were partially offset by debt repayments of $447.6 million. 2016 compared to 2015: Net cash used for financing activities was $462.4 million in 2016 compared to $857.8 million in 2015. The difference between periods is primarily due to 2016 decreases in: debt repayments of $170.0 million; repurchases of our common stock of $109.0 million; and a one-time cash transfer in 2015 of $63.0 million to our former publishing businesses in connection with its spin-off. Long-term debt As of December 31, 2017, our outstanding debt, net of unamortized discounts and deferred financing costs, was $3.01 billion and mainly is in the form of fixed rate notes. See “Note 6 Long-term debt” to our consolidated financial statements for a table summarizing the components of our long-term debt. Our primary source of long-term debt is our revolving credit facility that expires on June 29, 2020 (the Amended and Restated Competitive Advance and Revolving Credit Agreement). On August 1, 2017, we amended our Amended and Restated Competitive Advance and Revolving Credit Agreement. Under the amended terms, our maximum total leverage ratio will remain at 5.0x through June 30, 2018, after which, as amended, it will be reduced to 4.75x through June 2019 and then to 4.5x until the expiration date of the credit agreement on June 29, 2020. Commitment fees on the revolving credit agreement are equal to 0.25% - 0.40% of the undrawn commitments, depending upon our leverage ratio, and are computed on the average daily undrawn balance under the revolving credit agreement and paid each quarter. Under the Amended and Restated Competitive Advance and Revolving Credit Agreement, we may borrow at an applicable margin above the Eurodollar base rate (LIBOR loan) or the higher of the Prime Rate, the Federal Funds Effective Rate plus 0.50%, or the one month LIBOR rate plus 1.00% (ABR loan). The applicable margin is determined based on our leverage ratio but differs between LIBOR loans and ABR loans. For LIBOR-based borrowing, the margin varies from 1.75% to 2.50%. For ABR-based borrowing, the margin will vary from 0.75% to 1.50%. Total commitments under the Amended and Restated Competitive Advance and Revolving Credit Agreement are $1.5 billion. As of December 31, 2017, we were in compliance with all covenants contained in our debt and credit agreements. Below is a summary of our 2017 debt activity: • In connection with and prior to the completion of its spin-off, Cars.com borrowed an aggregate principal amount of approximately $675.0 million under a revolving credit facility agreement. The proceeds were used to make a tax-free distribution of $650.0 million from Cars.com to TEGNA. In the second quarter of 2017, we used $609.9 million of the tax-free distribution proceeds to fully pay down our then-outstanding revolving credit agreement borrowings plus accrued interest. • In October 2017, we used the net proceeds from the CareerBuilder sale and other cash on hand, including the remaining cash distribution from Cars.com, to retire $280.0 million of principal of our unsecured notes due in October 2019 on an accelerated basis. We redeemed the 5.125% notes by paying 101.281% of the outstanding principal amount in accordance with the original terms. • As of December 31, 2017, we had unused borrowing capacity of $1.49 billion under our revolving credit facility. On February 15, 2018 we acquired the assets of KFMB-TV, the CBS affiliate in San Diego, KFMB-D2 (the CW station in San Diego), and radio stations KFMB-AM and KFMB-FM in San Diego. The transaction price was approximately $325 million in cash, which we funded through the use of available cash and borrowings under our revolving credit facility. We also have an effective shelf registration statement on Form S-3 on file with the U.S. Securities and Exchange Commission under which an unspecified amount of securities may be issued, subject to a $7.0 billion limit established by the Board of Directors. Proceeds from the sale of such securities may be used for general corporate purposes, including capital expenditures, working capital, securities repurchase programs, repayment of debt and financing of acquisitions. We may also invest borrowed funds that are not required for other purposes in short-term marketable securities. Our debt maturities may be repaid with cash flow from operating activities, accessing capital markets or a combination of both. The following schedule of annual maturities of the principal amount of total debt assumes we use available capacity under our revolving credit agreement to refinance unsecured floating rate term loans and fixed rate notes due in 2018 and 2019. Based on this refinancing assumption, all of the obligations other than the VIE unsecured floating rate term loan due prior to 2020 are reflected as maturities for 2020 (in thousands). (1) Amortization of term debt due in 2018 and 2019 are assumed to be repaid with funds from the revolving credit agreement, which matures in 2020. Excluding our ability to repay funds with the revolving credit agreement, contractual debt maturities is $121 million in 2018 and $420 million in 2019. (2) Assumes current revolving credit agreement borrowings comes due in 2020 and credit facility is not extended. Contractual obligations and commitments The following table summarizes the expected cash outflows resulting from financial contracts and commitments as of the end of 2017 (in thousands). (1) Long-term debt includes scheduled principal payments only. We have contractual debt maturities of $121 million in 2018. See Note 6 to the consolidated financial statements for further information. (2) We have no outstanding borrowings under our revolving credit facility as of December 31, 2017. Interest on the senior notes is based on the stated cash coupon rate and excludes the amortization of debt issuance discount. The floating rate term loan interest rates are based on the actual rates as of December 31, 2017. (3) See Note 12 to the consolidated financial statements. (4) Includes purchase obligations pertaining to technology related capital projects, news and market data services, and other legally binding commitments. Amounts which we are liable for under purchase orders outstanding at December 31, 2017, are reflected in the Consolidated Balance Sheets as accounts payable and accrued liabilities and are excluded from the table above. (5) Programming contracts include television station commitments to purchase programming to be produced in future years. This also includes amounts related to our network affiliation agreements. (6) Other noncurrent liabilities consist of both unfunded and under-funded postretirement benefit plans. Unfunded plans include the TEGNA Supplemental Retirement Plan and the TEGNA Retiree Welfare Plan. Employer contributions, which equal the expected benefit payments, are reflected in the table above over the next ten-year period. Our under-funded pension plan is the TEGNA Retirement Plan (TRP). We expect contributions to the TEGNA Retirement Plan in 2018 of $10.7 million and $30.6 million for the SERP. TRP contributions beyond the next fiscal year are excluded due to uncertainties regarding significant assumptions involved in estimating these contributions, such as interest rate levels as well as the amount and timing of invested asset returns. Due to uncertainty with respect to the timing of future cash flows associated with unrecognized tax benefits at December 31, 2017, we are unable to make reasonably reliable estimates of the period of cash settlement. Therefore, approximately $15 million of unrecognized tax benefits have been excluded from the contractual obligations table above. See Note 5 to the consolidated financial statements for a further discussion of income taxes. Capital stock On September 19, 2017, our Board of Directors authorized a new share repurchase program for up to $300.0 million over the next three years. As of December 31, 2017, we have $285.0 million remaining under this authorization. The table below summarizes our share repurchases during the past three years (in thousands). The shares may be repurchased at management’s discretion, either in the open market or in privately negotiated block transactions. Management’s decision to repurchase shares will depend on price and other corporate developments. Purchases may occur from time to time and no maximum purchase price has been set. Certain of the shares we previously acquired have been reissued in settlement of employee stock awards. Our common stock outstanding at December 31, 2017, totaled 214,930,653 shares, compared with 214,487,800 shares at December 31, 2016. Effects of inflation and changing prices and other matters Our results of operations and financial condition have not been significantly affected by inflation. The effects of inflation and changing prices on our property and equipment and related depreciation expense have been reduced as a result of an ongoing capital expenditure program and the availability of replacement assets with improved technology and efficiency. Critical accounting policies and the use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe the following discussion addresses our most critical accounting policies, which are those that are important to the presentation of our financial condition and results of operations and require management’s most subjective and complex judgments. This commentary should be read in conjunction with our financial statements, selected financial data and the remainder of this Form 10-K. Revenue Recognition: Revenue is recognized when persuasive evidence of an arrangement exists, performance under the contract has begun, the contract price is fixed or determinable and collectibility of the related transaction price is reasonably assured. Revenue from sales agreements that contain multiple deliverables is allocated to each element based on the relative best estimate of selling price. Elements are treated as separate units of accounting if there is standalone value upon delivery. Amounts received from customers in advance of revenue recognition are deferred as liabilities. Our primary source of revenue is through the sale of advertising time on our television stations. Advertising revenues are recognized, net of agency commissions, in the period when the advertisements are aired. We also earn subscription revenue (formerly retransmission revenue) from retransmission consent arrangements. Under these agreements, we receive cash consideration from multichannel video programming distributors (e.g., cable and satellite providers) and over the top (OTT) providers in return for our consent to permit the cable/satellite/OTT provider to retransmit our television signal. Consent fees are recognized over the contract period based on a negotiated fee per subscriber. Subscription revenues have increased as a percentage of overall revenue in recent years. In 2017, such revenues accounted for approximately 38% of overall revenue compared to 29% in 2016. In addition, we also generate online advertising revenue through the display of digital advertisements across various digital platforms. Online advertising agreements typically take the form of an impression-based contract, fixed fee time-based contract or transaction based contract. The customers are billed for impressions delivered or click-throughs on their advertisements. An impression is the display of an advertisement to an end-user on the website and is a measure of volume. A click-through occurs when an end-user clicks on an advertisement. Revenue is recognized evenly over the contract term for fixed fee contracts where a minimum number of impressions or click-throughs is not guaranteed. Revenue is recognized as the service is delivered for impression and transaction based contracts. Goodwill: As of December 31, 2017, our goodwill balance was $2.58 billion and represented approximately 52% of our total assets. Goodwill represents the excess of acquisition cost over the fair value of assets acquired, including identifiable intangible assets, net of liabilities assumed. Goodwill is tested for impairment on an annual basis (first day of our fourth quarter) or between annual tests if events or changes in circumstances occurred that indicate the fair value of a reporting unit may be below its carrying amount. Goodwill is tested for impairment at a level referred to as the reporting unit. A reporting unit is a business for which discrete financial information is available and segment management regularly reviews the operating results. The level at which we test goodwill for impairment requires us to determine whether the operations below the operating segment level constitute a reporting unit. We have determined that our one segment, Media, consists of a single reporting unit. Before performing the annual goodwill impairment test quantitatively, we first have the option to perform a qualitative assessment to determine if the quantitative test must be completed. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance, as well as company and specific reporting unit specifications. If after performing this assessment, we conclude it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then we are required to perform the quantitative test. Otherwise, the quantitative test is not required. In 2017, we elected not to perform the optional qualitative assessment of goodwill and instead performed the quantitative impairment test. When performing the quantitative test, we determine the fair value of the reporting unit and compare it to the carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds the fair value of the reporting unit, the reporting unit’s goodwill is impaired and we recognize an impairment loss equal to the difference between the reporting unit’s carrying amount and fair value. We estimate the fair value of our reporting unit based on a market-based valuation methodology, which is primarily based on our consolidated market capitalization plus a control premium. In the fourth quarter of 2017, we completed our annual goodwill impairment test for our reporting unit. The results of the test indicated that the estimated fair value of our reporting unit significantly exceeded the carrying value. For the Media reporting unit, the estimated value would need to decline by over 70% to fail the quantitative goodwill impairment test. We do not believe that the reporting unit is currently at risk of incurring a goodwill impairment in the foreseeable future. Impairment assessment inherently involves management judgments regarding a number of assumptions described above. Fair value of the reporting unit also depends on the future strength of the economy in our principal media markets. New and developing competition as well as technological change could also adversely affect future fair value estimates. Due to the many variables inherent in the estimation of the reporting unit’s fair value and the relative size of our recorded goodwill, differences in assumptions could have a material effect on the estimated fair value of our reporting unit and could result in a goodwill impairment charge in a future period. In connection with the strategic review and sale process for CareerBuilder, during the second quarter of 2017, we performed an interim impairment test for our former CareerBuilder reporting unit within our Digital Segment, and as a result recorded a goodwill impairment charge of $332.9 million which has been recorded within loss from discontinued operations in the accompanying Consolidated Statements of Income. Indefinite Lived Intangibles: This asset grouping consists of FCC broadcast licenses related to our acquisitions of television stations. As of December 31, 2017, indefinite lived intangible assets were $1.19 billion and represented approximately 24% of our total assets. Indefinite lived assets are not subject to amortization and, as a result, they are tested for impairment annually (on the first day of our fourth quarter), or more frequently if events or changes in circumstances suggest that the asset might be impaired. We have the option to first perform a qualitative assessment to determine if it is more likely than not that the fair value of the indefinite lived asset is more than its carrying amount. If that is the case, then we would not have to perform the quantitative analysis. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance of the indefinite lived asset. In 2017, we elected not to perform the optional qualitative assessment; and instead, we performed the quantitative impairment test. The fair value of each FCC broadcast license was determined using an income approach referred to as the Greenfield method. This method requires multiple assumptions relating to the future prospects of each individual television station including, but not limited to: (i) expected long-term market growth characteristics, (ii) station revenue shares within a market for a new entrant, (iii) future expected operating expenses, (iv) costs of capital and (v) appropriate discount rates. We performed a quantitative analysis on all of our FCC licenses on the impairment testing date and each fair value exceeded the carrying value by more than 30%, and therefore, concluded that no impairment existed. Future increases in discount rate assumptions could cause a decline in the fair value of our FCC licenses which may result in a future impairment charge. For example, a 50 basis point increase in the discount rate would cause the fair value of our FCC license with the lowest clearance to exceed its carrying value by 20%. Pension Liabilities: Certain employees participate in qualified and nonqualified defined benefit pension plans (see Note 7 to Financial Statements). Our principal defined benefit pension plan is the TEGNA Retirement Plan (TRP). We also sponsor the TEGNA Supplemental Retirement Plan (SERP) for certain employees. Substantially all participants in the TRP and SERP had their benefits frozen before 2009, and in December 2017, we froze all remaining accruing benefits for certain grandfathered SERP participants. We recognize the net funded status of these postretirement benefit plans under GAAP as a liability on our Consolidated Balance Sheets. There is a corresponding non-cash adjustment to accumulated other comprehensive loss, net of tax benefits recorded as deferred tax assets, in stockholders’ equity. The GAAP funded status represents the difference between the fair value of each plan’s assets and the benefit obligation of the plan. The GAAP benefit obligation represents the present value of the estimated future benefits we currently expect to pay to plan participants based on past service. The plan assets and benefit obligations are measured at December 31 of each year, or more frequently, upon the occurrence of certain events such as a plan amendment, settlement or curtailment. The amounts we record are measured using actuarial valuations, which are dependent upon key assumptions such as discount rates, participant mortality rates and the expected long-term rate of return on plan assets. The assumptions we make affect both the calculation of the benefit obligations as of the measurement date and the calculation of net periodic pension expense in subsequent periods. When reassessing these assumptions we consider past and current market conditions and make judgments about future market trends. We also consider factors such as the timing and amounts of expected contributions to the plans and benefit payments to plan participants. The most important assumptions include the discount rate applied to pension plan obligations and the expected long-term rate of return on plan assets related for the TRP (the SERP is an unfunded plan). The discount rate assumption is based on investment yields available at year-end on corporate bonds rated AA and above with a maturity to match the expected benefit payment stream. A decrease in discount rates would increase pension obligations. We establish the expected long-term rate of return by developing a forward-looking, long-term return assumption for each pension fund asset class, taking into account factors such as the expected real return for the specific asset class and inflation. A single, long-term rate of return is then calculated as the weighted average of the target asset allocation percentages and the long-term return assumption for each asset class. We apply the expected long-term rate of return to the fair value of its pension assets in determining the dollar amount of its expected return. Changes in the expected long-term return on plan assets would increase or decrease pension plan expense. For December 31, 2017 measurement, we assumed a rate of 7.00% for our long-term expected return on pension assets used for our TRP plan. As an indication of the sensitivity of pension expense to the long-term rate of return assumption, a plus or minus 50 basis points change in the expected rate of return on pension assets (with all other assumptions held constant) would have decreased or increased estimated pension plan expense for 2018 by approximately $2.1 million. The effects of actual results differing from these assumptions are accumulated as unamortized gains and losses. For the December 31, 2017 measurement, the assumption used for the discount rate was 3.65% for our principal retirement plan. As an indication of the sensitivity of pension liabilities to the discount rate assumption, a plus or minus 50 basis points change in the discount rate at the end of 2017 (with all other assumptions held constant) would have decreased or increased plan obligations by approximately $27.0 million. A 50 basis points change in the discount rate used to calculate 2018 expense would have changed total pension plan expense for 2017 by approximately $0.5 million. Income Taxes: Our annual tax rate is based on our income, statutory tax rates, and tax planning opportunities available in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax expense and in evaluating our tax positions. Tax law requires certain items to be included in our tax returns at different times than when the items are reflected in the financial statements. The annual tax expense reflected in the Consolidated Statements of Income is different than that reported in our tax returns. Some of these differences are permanent (for example, expenses recorded for accounting purposes that are not deductible in the returns such as non-deductible goodwill) and some differences are temporary and reverse over time, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax liabilities generally represent tax expense recognized in the financial statements for which payment has been deferred, or expense for which a deduction has been taken already in the tax return but the expense has not yet been recognized in the financial statements. Deferred tax assets generally represent items that can be used as a tax deduction or credit in tax returns in future years for which a benefit has already been recorded in the financial statements, as well as tax losses that can be carried over and used in future years. Valuation allowances are established when necessary to reduce deferred income tax assets to the amounts we believe are more likely than not to be recovered. In evaluating the amount of any such valuation allowance, we consider the existence of cumulative income or losses in recent years, the reversal of existing temporary differences, the existence of taxable income in prior carry back years, available tax planning strategies and estimates of future taxable income for each of our taxable jurisdictions. The latter two factors involve the exercise of significant judgment. As of December 31, 2017, deferred tax asset valuation allowances totaled $136.4 million, primarily related to federal and state capital losses, and state net operating losses available for carry forward to future years. Although realization is not assured, we believe it is more likely than not that all other deferred tax assets for which no valuation allowances have been established will be realized. This conclusion is based on our history of cumulative income in recent years and review of historical and projected future taxable income. We determine whether it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit is recorded in our financial statements. A tax position is measured as the portion of the tax benefit that is greater than 50% likely to be realized upon settlement with a taxing authority (that has full knowledge of all relevant information). We may be required to change our provision for income taxes when the ultimate treatment of certain items is challenged or agreed to by taxing authorities, when estimates used in determining valuation allowances on deferred tax assets significantly change, or when receipt of new information indicates the need for adjustment in valuation allowances. Future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported in the consolidated financial statements in the year these changes occur.

<s>[INST] We are an innovative media company that serves the greater good of our communities. Our business includes 47 television stations operating in 39 markets, offering highquality television programming and digital content. Each television station also has a robust digital presence across online, mobile and social platforms. On May 31, 2017, we completed the spinoff of our digital automotive marketplace business, Cars.com. In addition, on July 31, 2017, we completed the sale of our majority ownership stake in CareerBuilder. Our digital marketing services (DMS) business is now reported within our Media business. As a result of these strategic actions, we have disposed of substantially all of our Digital Segment business and have therefore classified substantially all of its historical financial results as discontinued operations for all periods presented. Historic Digital Segment results relate to our former Cofactor (sold in December 2016), Blinq (disposed in 2015) and PointRoll (sold in 2015) business units. Consolidated Results from Operations A consolidated summary of our results is presented below (in thousands). **** Not meaningful Revenues During 2017, we changed the way we present certain revenues, which we now call Advertising and Marketing Services, to better reflect the way we sell our products and services to our clients. This category includes all sources of our traditional television and digital revenues including Premion, DMS and other digital advertising and marketing revenues across our platforms. Also during 2017, the “Retransmission” revenue category was renamed “Subscription” to better reflect changes in that revenue stream, including the distribution of TEGNA stations on OTT streaming services. As a result of these changes, revenues are grouped into the following categories: Advertising & Marketing Services (AMS), political, subscription, other, and our former digital businesses that were not classified as discontinued operations.The following table summarizes the yearoveryear changes in these select revenue categories (in thousands): **** Not meaningful Revenue decreased $101.1 million, or 5%, in 2017 as compared to 2016. This net decrease was primarily driven by lower political revenue of $131.6 million, due to an expected decrease reflecting the absence of 2016 politically related advertising spending. In addition, the decrease was due to a decline in AMS revenue of $98.1 million, or 8%, in 2017. This decline was primarily due to the absence of Olympic revenue in 2017 as compared to $57.3 million in 2016 and lower DMS revenue due to the conclusion of a transition services agreement with Gannett. Partially offsetting the overall AMS decline was an increase in digital revenue, including Premion revenue. Partially offsetting the overall decrease was an increase in subscription revenue of $137.0 million, or 24%, due to the recent renewal of certain retransmission agreements as well as annual rate increases under other existing retransmission agreements. Revenue increased $239.3 million, or 14%, in 2016 as compared to 2015. The increase was driven by political advertising, Summer Olympics advertising, and a substantial increase in subscription revenues. Political advertising revenue increased $133.4 million due to the presidential election year political spending. Political revenues are cyclical and higher in even years (e.g. 2016, 2018). Summer Olympic revenue of $57.3 million also contributed to the overall increase. Subscription revenues increased $133.1 million or 30% in 2016, reflecting retransmission agreements renewals, as well as annual rate increases for existing agreements. These increases were partially offset by a decrease of $40.9 million in revenue from our former digital businesses (Cofactor, Blinq, and PointRoll), which was sold in December 2016. Costs of Revenue Cost of revenue increased $138.3 million, or 17%, in 2017 as compared to 2016. This increase was primarily due to an $175.9 million increase in reverse compensation related programming costs (primarily driven [/INST] Positive. </s>

TEGNA INC

2019-03-01

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Executive Summary We are an innovative media company that serves the greater good of our communities. Our business includes 49 television stations operating in 41 markets, offering high-quality television programming and digital content. Each television station also has a robust digital presence across online, mobile and social platforms. Beyond integrated broadcast advertising products and services, we deliver results for advertisers through extensive solutions including our Over the Top (OTT) local advertising network, Premion; and our digital marketing services (DMS) business, a one-stop shop for local businesses to connect with consumers through digital marketing. On May 31, 2017, we completed the spin-off of our digital automotive marketplace business, Cars.com. In addition, on July 31, 2017, we completed the sale of our majority ownership stake in CareerBuilder. Our digital marketing services (DMS) business is now reported within our Media business. As a result of these strategic actions, we have disposed of substantially all of our Digital Segment business and have therefore classified substantially all of its historical financial results as discontinued operations for all periods presented. We now operate one operating and reportable segment “Media.” Our operating results are subject to seasonal fluctuations. Generally, the second and fourth quarters operating results are stronger than the first and third quarter. This is driven by the second quarter usually reflecting increased spring seasonal advertising, while the fourth quarter typically includes increased advertising related to the holiday season. In addition, our operating results are subject to significant fluctuations from political advertising. In even numbered years, political spending is usually significantly higher than in odd numbered years due to advertising for the local and national elections. Additionally, every four years, we typically experience even further increases in political advertising in connection with the presidential election. Consolidated Results from Operations A consolidated summary of our results is presented below (in thousands). **** Not meaningful Revenues Our Advertising and Marketing Services (AMS) category includes all sources of our traditional television advertising and digital revenues including Premion and other digital advertising and marketing revenues across our platforms. Our Subscription revenue category includes revenue earned from cable and satellite providers for the right to carry our signals and the distribution of TEGNA stations on OTT streaming services. The following table summarizes the year-over-year changes in our revenue categories (in thousands): **** Not meaningful Revenue increased $304.3 million, or 16%, in 2018 as compared to 2017. This net increase was primarily due to an increase in 2018 political revenue of $210.4 million, driven by the mid-term elections cycle. Also contributing to the net increase was subscription revenue which increased $122.1 million, or 17%, primarily due to annual rate increases under existing retransmission agreements and increases from OTT streaming service providers. These increases were partially offset by a decrease in AMS revenue of $32.9 million, or 3%, in 2018. Increases in AMS from Winter Olympic and Super Bowl advertising, the KFMB station acquisition, and digital advertising (primarily Premion) were offset by declines in digital marketing services (DMS) revenue (primarily due to conclusion of a transition service agreement with Gannett in June 2017) and a softening of demand and the impact of election year political displacement of traditional television advertising. Revenue decreased $101.1 million, or 5%, in 2017 as compared to 2016. This net decrease was primarily driven by lower political revenue of $131.6 million, due to an expected decrease from 2016 politically related advertising spending. In addition, the decrease reflected a decline in AMS revenue of $98.1 million, or 8%, in 2017. This decline was primarily due to the absence of Olympic revenue in 2017 as compared to $57.3 million in 2016 and lower DMS revenue due to the conclusion of a transition services agreement with Gannett. Partially offsetting the overall AMS decline was an increase in digital revenue, including Premion revenue. Partially offsetting the overall decrease was an increase in subscription revenue of $137.0 million, or 24%, due to the renewal of certain retransmission agreements as well as annual rate increases under other existing retransmission agreements. Costs of revenues, exclusive of depreciation Cost of revenue increased $132.2 million, or 14%, in 2018 as compared to 2017. The increase was primarily due to a $63.3 million increase in programming costs (due to the growth in subscription revenues), a $43.5 million increase in digital expenses (primarily due to OTT inventory costs and investments made in the Premion business), and a $13.3 million increase from our KFMB station acquisition, production of original content (Daily Blast LIVE!, local news, and Sister Circle), and variable editorial costs tied to increased revenues (event coverage costs of Olympics and Super Bowl). These increases were partially offset by a decline in DMS costs of $9.3 million due to the conclusion of the transition services agreement with Gannett. Cost of revenue increased $138.3 million, or 17%, in 2017 as compared to 2016. This increase was primarily due to an $175.9 million increase in reverse compensation related programming costs (primarily driven by 11 of our stations paying NBC reverse compensation payments for the first time in 2017). This increase was partially offset by a decline in DMS costs of $18.7 million driven by the termination of the transition service agreement with Gannett, the absence of $11.4 million of expense related to our 2016 voluntary early retirement program, and a $7.4 million decrease in Cofactor expenses due to its disposition in 2016. Business units - Selling, general and administrative expenses, exclusive of depreciation Business unit selling, general, and administrative expenses increased $27.9 million, or 10%, in 2018 as compared to 2017. The increase was primarily driven by a $10.8 million increase due to higher selling costs related to incremental revenue from the mid-term elections, Olympics and Super Bowl. The remaining net $17.1 million increase was primarily due to the acquisition of KFMB and higher legal costs associated with the ongoing Department of Justice investigation - see Note 13 to the consolidated financial statements for further information. Business unit selling, general, and administrative expenses decreased $43.6 million, or 13%, in 2017 as compared to 2016. The decrease was primarily the result of a $19.3 million decline in DMS selling and advertising expense related to the termination of the transition service agreement with Gannett and a reduction of $2.2 million in severance expense. Also contributing to the decline was the absence of $8.6 million of Cofactor expenses, due to its disposition in December 2016, and the absence of $4.0 million of expense related to our 2016 voluntary early retirement program. Corporate - General and administrative expenses, exclusive of depreciation Our corporate costs are separated from our business expenses and are recorded as general and administrative expenses in our Consolidated Statements of Income. These costs include activities that are not directly attributable or allocable to our media business operations. This category primarily consists of broad corporate management functions including legal, human resources, and finance, as well as activities and costs not directly attributable to the operations of our media business. Corporate general and administrative expenses decreased $2.5 million, or 5%, in 2018 as compared to 2017. The decrease was primarily due to lower corporate expenses associated with operational efficiencies associated with right-sizing and stream-lining of the corporate function following the spin-off of Cars.com and the sale of our majority interest in CareerBuilder in 2017. These reductions were partially offset by $5.5 million in severance expense incurred in the third quarter of 2018 due to a reduction in force. Corporate general and administrative expenses decreased $3.7 million, or 6%, in 2017 as compared to 2016. The decrease was primarily due to a reduction in severance expenses of $0.9 million incurred in 2017. The remaining difference is attributable to the right-sizing and stream-lining of the corporate function in connection with the strategic actions impacting our former Digital Segment. Depreciation expense Depreciation expense increased $0.9 million, or 2%, in 2018 as compared to 2017. The increase was due primarily to the assets acquired in the KFMB acquisition, partially offset by assets becoming fully depreciated. Depreciation expense decreased $0.3 million, or 1%, in 2017 as compared to 2016. The decrease was primarily due to declines in the purchase of property and equipment, partially offset by additional depreciation related to a change in useful lives of certain broadcasting assets, including accelerated depreciation expense of $1.5 million in connection with the FCC channel repack process. Amortization of intangible assets Intangible asset amortization expense increased $9.3 million, or 43%, in 2018 as compared to 2017. The increase was primarily due to incremental amortization expense resulting from our acquisition of KFMB. Intangible asset amortization expense decreased $1.7 million, or 7%, in 2017 as compared to 2016. The decrease was a result of certain intangible assets associated with previous acquisitions reaching the end of their useful lives. Asset impairment and other (gains) charges We had other net gains of $11.7 million in 2018 compared to charges of $4.4 million in 2017. The 2018 net gains primarily consist of $7.4 million of reimbursements received from the Federal Communications Commission related to the spectrum repack initiative. Also contributing was a $6.0 million gain recognized on the sale of real estate in Houston. The 2017 charges primarily consisted of $0.9 million in net expenses related to Hurricane Harvey (expenses of $26.9 million, net of insurance proceeds of $26.0 million), $1.4 million related to the consolidation of office space at our DMS business unit and corporate headquarters, and $2.2 million of non-cash impairment charges incurred by our broadcast station related to a building sale. Asset impairment charges declined $27.7 million from charges of $32.1 million in 2016 to charges of $4.4 million in 2017. The 2017 charges primarily due to the factors discussed in the paragraph above. The 2016 charges were comprised of a goodwill impairment charge of $15.2 million (for our former Cofactor business), a $6.3 million impairment related to an internally produced programming asset, a $4.7 million impairment charge related to a long-lived-asset, and a $4.6 million lease related charge (for our former Cofactor business). Operating income Operating income increased $152.6 million, or 28%, in 2018 as compared to 2017. The increase was driven by the changes in revenue and operating expenses described above. Our operating margins were 31.6% in 2018 compared to 28.7% in 2017, primarily driven by increases in political and subscription revenue in 2018. Operating income decreased $162.3 million, or 23%, in 2017 as compared to 2016, primarily driven by the changes in revenue and operating expenses discussed above. Our operating margins were lower at 28.7% in 2017, compared to 35.3% in 2016, primarily driven by the increase in programming expenses and absence of $131.6 million of political revenue compared to 2016. Programming and payroll expense trends Programming and payroll expenses are the two largest elements of our operating expenses, and are summarized below, expressed as a percentage of total operating expenses. Programming expenses as a percentage of total operating expenses have increased due to an increase in reverse compensation payments to our network affiliation partners associated with higher subscription revenues. Payroll expenses have increased during 2018 primarily due to the acquisition of KFMB, but as a percentage of total operating expenses have decreased in 2018 primarily due to increases in programming expenses, which now make up a larger percentage of operating costs. Non-operating income and expense Equity income (loss): This income statement category reflects earnings or losses from our equity method investments. Equity income increased $3.4 million, or 33%, from $10.4 million in 2017 to $13.8 million in 2018. The 2018 income was primarily due to $14.2 million of equity earnings from our CareerBuilder investment, resulting from a one-time $17.9 million gain recorded in connection with our share of the gain on sale of its subsidiary, Economic Modeling, LLC (EMSI). The 2017 income was primarily due to a $17.5 million gain we recorded as a result of the sale of our Livestream investment. This income was partially offset by a $2.6 million impairment of an equity method investment. Equity income (loss) fluctuated $13.8 million, from a loss of $3.4 million in 2016 to an income of $10.4 million in 2017. The fluctuation was primarily due to the $17.5 million gain we recorded as a result of the sale of our Livestream investment, partially offset by the $2.6 million impairment of an equity method investment recorded in 2017. Interest expense: Interest expense decreased $18.2 million, or 9%, in 2018 as compared to 2017, primarily due to lower average outstanding total debt balance, partially offset by higher interest rates. The total average outstanding debt was $3.09 billion in 2018 compared to $3.59 billion in 2017. The decline in outstanding debt was partially offset by an increase in the weighted average interest rate on total outstanding debt which was 5.90% in 2018, compared to 5.57% in 2017. Interest expense decreased $21.7 million, or 9%, in 2017 as compared to 2016, primarily due to lower average outstanding total debt balance, due to the $609.9 million mid-year paydown of our revolving credit facility and the accelerated repayment of $280.0 million of principal on unsecured notes due in October 2019. The total average outstanding debt was $3.59 billion in 2017 compared to $4.25 billion in 2016. The decline in outstanding debt was partially offset by an increase in the weighted average interest rate on total outstanding debt which was 5.57% in 2017, compared to 5.29% in 2016. A further discussion of our borrowing and related interest cost is presented in the “Liquidity and capital resources” section of this report beginning on page 25 and in Note 6 to the consolidated financial statements. Other non-operating expenses: Other non-operating expenses decreased $23.8 million, or 67%, from $35.3 million in 2017 to $11.5 million in 2018. The decrease is driven by lower business acquisition/disposition related transaction costs of $5.7 million and lower pension expense of $4.3 million (see Note 7 to the consolidated financial statements). In addition, in 2017 we incurred the following expenses that did not repeat in 2018; $6.6 million of costs incurred in connection with the early extinguishment of debt, a $5.8 million loss associated with the write-off of a note receivable from one of our former equity method investments, and a $3.9 million impairment of our stock investment in Gannett. Other non-operating expenses increased $11.8 million from $23.5 million in 2016 to $35.3 million in 2017. The 2017 non-operating expenses primarily consisted of the components described above. The 2016 non-operating expenses primarily consisted of $21.0 million in costs associated with the spin-off of our Cars.com business unit. Provision (benefit) for income taxes We reported pre-tax income from continuing operations attributable to TEGNA of $508.7 million for 2018. The effective tax rate on pre-tax income was 21.1%. The 2018 effective tax rate reflects the 21.0% U.S. federal statutory that was effective January 1, 2018 as a result of the Tax Cuts and Jobs Act (Tax Act) enacted in December 2017. The tax expense for state taxes was partially offset by a tax benefit from finalizing provisional amounts recorded in 2017 from the Tax Act. The 2018 effective tax rate increased compared to 2017 primarily due to the one-time deferred benefit recorded in 2017 in conjunction with the Tax Act. We reported pre-tax income from continuing operations attributable to TEGNA of $310.7 million for 2017. The effective tax rate on pre-tax income was -44.2% including a 71.2% or $221.1 million one-time deferred tax benefit recorded in conjunction with the Tax Act. We reported pre-tax income from continuing operations attributable to TEGNA of $449.3 million for 2016. The effective tax rate on pre-tax income was 31.2%. The 2017 effective tax rate decreased as compared to 2016 primarily due to the recognition of the one-time deferred tax benefit recorded in conjunction with the Tax Act. Further information concerning income tax matters is contained in Note 5 of the consolidated financial statements. Net income from continuing operations Net income from continuing operations and related per share amounts are presented in the table below (in thousands, except per share amounts). We reported net income from continuing operations of $401.3 million or $1.85 per diluted share for 2018 compared to $448.0 million or $2.06 per diluted share for 2017. Our 2017 earnings per share was benefited by approximately $1.02 as a result of one-time deferred tax benefit recorded in connection with the Tax Act (as discussed above). Earnings per share also benefited from net decreases in diluted shares of approximately 0.9 million and 2.2 million in 2018 and 2017, respectively. The decreases in both years were due to share repurchases, which were partially offset by share issuances under our stock-based award programs. Operating results non-GAAP information Presentation of non-GAAP information: We use non-GAAP financial performance and liquidity measures to supplement the financial information presented on a GAAP basis. These non-GAAP financial measures should not be considered in isolation from, or as a substitute for, the related GAAP measures, nor should they be considered superior to the related GAAP measures, and should be read together with financial information presented on a GAAP basis. Also, our non-GAAP measures may not be comparable to similarly titled measures of other companies. Management and our Board of Directors use the non-GAAP financial measures for purposes of evaluating business unit and consolidated company performance. Furthermore, the Leadership Development and Compensation Committee of our Board of Directors uses non-GAAP measures such as Adjusted EBITDA, non-GAAP net income, non-GAAP EPS, Adjusted revenues and free cash flow to evaluate management’s performance. Therefore, we believe that each of the non-GAAP measures presented provides useful information to investors and other stakeholders by allowing them to view our business through the eyes of management and our Board of Directors, facilitating comparisons of results across historical periods and focus on the underlying ongoing operating performance of our business. We discuss in this Form 10-K non-GAAP financial performance measures that exclude from our reported GAAP results the impact of “special items” consisting of severance expense, charges related to asset impairment and other (gains) charges, net gain on sale of equity method investments, gains/losses related to business disposals, costs associated with debt repayment, TEGNA Foundation donations, certain non-operating expenses (business acquisition, pension payment timing related charges, and transaction costs), and costs associated with the Cars.com spin-off transaction. In addition, we have income tax special items associated with tax impacts associated with the acquisition of KFMB; and deferred tax benefit adjustments related to adjusting provisional tax impacts of the Tax Act and a partial capital loss valuation allowance release, both resulting from completion of our 2017 federal income tax return in the third quarter. We believe that such expenses, charges and gains are not indicative of normal, ongoing operations. Such items vary from period to period and are significantly impacted by the timing and nature of these events. Therefore, while we may incur or recognize these types of expenses, charges and gains in the future, we believe that removing these items for purposes of calculating the non-GAAP financial measures provides investors with a more focused presentation of our ongoing operating performance. We discuss Adjusted EBITDA (with and without corporate expenses), a non-GAAP financial performance measure that we believe offers a useful view of the overall operation of its businesses. We define Adjusted EBITDA as net income from continuing operations before (1) interest expense, (2) income taxes, (3) equity income (losses) in unconsolidated investments, net, (4) other non-operating expenses (income), (5) severance expense, (6) asset impairment and other (gains) charges, (7) impairment charges, (8) depreciation and (9) amortization. The most directly comparable GAAP financial measure to Adjusted EBITDA is Net income from continuing operations. Users should consider the limitations of using Adjusted EBITDA, including the fact that this measure does not provide a complete measure of our operating performance. Adjusted EBITDA is not intended to purport to be an alternate to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity. In particular, Adjusted EBITDA is not intended to be a measure of free cash flow available for management’s discretionary expenditures, as this measure does not consider certain cash requirements, such as working capital needs, capital expenditures, contractual commitments, interest payments, tax payments and other debt service requirements. We also consider adjusted revenues to be an important non-GAAP financial measure. Our adjusted revenue is calculated by taking total company revenues on a GAAP basis and adjusting it to exclude (1) estimated incremental Olympic and Super Bowl revenue, (2) political revenues, and (3) revenues associated with a discontinued portion of our DMS business. These adjustments are made to our reported revenue on a GAAP basis in order to evaluate and assess our core operations on a comparable basis, and it represents the ongoing operations of our media business. We also discuss free cash flow, a non-GAAP liquidity measure. Free cash flow is defined as “net cash flow from operating activities” as reported on the statement of cash flows reduced by “purchase of property and equipment” and increased by “reimbursement from spectrum repacking”. We believe that free cash flow is a useful measure for management and investors to evaluate the level of cash generated by operations and the ability of its operations to fund investments in new and existing businesses, return cash to shareholders under the company’s capital program, repay indebtedness, add to our cash balance, or use in other discretionary activities. We use free cash flow to monitor cash available for repayment of indebtedness and in discussions with the investment community. Like Adjusted EBITDA, free cash flow is not intended to be a measure of cash flow available for management’s discretionary use. Discussion of special charges and credits affecting reported results: Our results for the year ended December 31, 2018, included the following items we consider “special items” and are not indicative of our normal ongoing operations: • Operating asset impairment and other net gains primarily consists of a gain recognized on the sale of real estate in Houston and gains due to reimbursements from the FCC for required spectrum repacking. These gains are partially offset by an early lease termination payment; • Severance charges which included payroll and related benefit costs due to restructuring at our DMS business and at our corporate headquarters; • Other non-operating items associated with business acquisition and integration costs, a charitable donation made to the TEGNA Foundation, and an impairment of a debt investment; • Pension payment timing related charges related to the acceleration of previously deferred pension costs as a result of lump sum SERP payments made to certain former executives; • A gain recognized in our equity income in unconsolidated investments, related to our share of CareerBuilder’s gain on the sale of its EMSI business; • Tax provision impacts related to our acquisition of KFMB; and • Deferred tax benefits related to adjusting the provisional tax impacts of the Tax Act and a partial capital loss valuation allowance release, both resulting from the completion of our 2017 federal income tax return in the third quarter of 2018. Results for the year ended December 31, 2017, included the following special items: • Severance charges which included payroll and related benefit costs; • Operating asset impairment related to damage caused by Hurricane Harvey and the consolidation of office space at our DMS business unit and corporate headquarters; • Gain on sale and an impairment of equity method investments; • Other non-operating expenses associated with costs of the spin-off of our Cars.com business unit, charitable donations made to the TEGNA Foundation, non-cash asset impairment charges associated with write off of a note receivable from an equity method investment; costs incurred in connection with the early extinguishment of debt; and • Special deferred tax benefits related to the Tax Act, deferred tax remeasurement attributable to the spin-off of our Cars.com business unit and a deferred tax adjustment related to a previously-disposed business. Below are reconciliations of certain line items impacted by special items to the most directly comparable financial measure calculated and presented in accordance with GAAP on our Consolidated Statements of Income (in thousands, except per share amounts): Non-GAAP consolidated results The following is a comparison of our as adjusted non-GAAP financial results between 2018 and 2017. Changes between the periods are driven by the same factors summarized above in the “Results of Operations” section within Management’s Discussion and Analysis of Financial Condition and Results of Operations (in thousands, except per share amounts). **** Not meaningful Adjusted Revenues Reconciliations of adjusted revenues to our revenues presented in accordance with GAAP on our Consolidated Statements of Income are presented below (in thousands): Excluding the impacts of incremental Olympic and Super Bowl revenue, Political advertising revenue, and the discontinued digital marketing transition services agreement, total company adjusted revenues on a comparable basis increased 5% in 2018. This is primarily attributable to increases in subscription revenue, partially offset by declines in AMS revenue as described in the Results from Operations section above. Adjusted EBITDA - Non-GAAP Reconciliations of Adjusted EBITDA (inclusive and exclusive of Corporate expenses) to net income from continuing operations presented in accordance with GAAP on our Consolidated Statements of Income is presented below (in thousands): **** Not meaningful Adjusted EBITDA margin was 38% (without corporate expense) and 35% including corporate. Our total Adjusted EBITDA increased $149.4 million or 24% in 2018 compared to 2017. The increase was driven by an increase in political, Olympic, and Super Bowl advertising and increases in subscription revenue, partially offset by higher programming costs and investments in Premion associated with its revenue growth. Free cash flow reconciliation Our free cash flow, a non-GAAP liquidity measure, was $469.4 million for the year ended December 31, 2018, compared to $312.5 million for the same period in 2017. Cash flows include the operations of our former publishing businesses (through its spin-off date of June 29, 2015), Cars.com (through its spin-off date of May 31, 2017), and CareerBuilder (through its date of sale on July 31, 2017). Our 2018 free cash flow was higher than 2017 due to the same factors affecting cash flow from operating activities summarized within “Liquidity and capital resources” discussed below. We also present our free cash flow information in our “Selected Financial Data” table on page 70. Reconciliations from “Net cash flow from operating activities” to “Free cash flow” are presented below (in thousands): FINANCIAL POSITION Liquidity and capital resources Our cash generation capability and financial condition, together with our significant borrowing capacity under our revolving credit agreement, are sufficient to fund our capital expenditures, interest expense, dividends, share repurchases, investments in strategic initiatives and other operating requirements. Over the longer term, we expect to continue to fund debt maturities, acquisitions and investments through a combination of cash flows from operations, borrowings under our revolving credit agreement and funds raised in the capital markets. Our operations have historically generated strong positive cash flow which, along with availability under our existing revolving credit facility, has provided adequate liquidity to meet our internal investment requirements, as well as acquisitions. On February 15, 2018, we acquired San Diego television and radio stations (KFMB) for $328.4 million which was financed with a borrowing of $220.0 million under our revolving credit facility and cash on hand. In addition, on January 2, 2019, we acquired, for approximately $108.9 million in cash, television stations in Toledo, OH and Midland-Odessa, TX, which was funded using available cash and borrowings under our revolving credit facility. Following the Cars.com spin-off on May 31, 2017, we announced that we would begin paying a regular quarterly cash dividend of $0.07 per share. We paid dividends totaling $60.3 million in 2018 and $90.2 million in 2017. We expect to continue paying comparable regular cash dividends in the future. The rate and frequency of future dividends will depend on future earnings, capital requirements and financial condition and other factors considered relevant by our Board of Directors. Further on June 21, 2018, we extended the term and our permitted total leverage ratio under our Amended and Restated Competitive Advance and Revolving Credit Agreement (see details of the amendment discussed in ‘Long-term debt’ section on page 27). We have completed several strategic actions that have positioned us to continue to pursue strategic acquisition opportunities that may develop in our sector, and invest in new content and revenue initiatives. Our financial and operating performance, as well as our ability to generate sufficient cash flow to maintain compliance with credit facility covenants, are subject to certain risk factors; see Item 1A - Risk Factors for further discussion. Our cash flows include the operations of Cars.com (through its spin-off date of May 31, 2017) and CareerBuilder (through its date of sale on July 31, 2017). The following table provides a summary of our cash flow information followed by a discussion of the key elements of our cash flows (in thousands): Operating Activities 2018 compared to 2017: Cash flow from operating activities was $527.2 million in 2018, compared to $389.4 million in 2017. The increase in net cash flow from operating activities was primarily due to the $210.4 million increase in political revenue in 2018. As political advertisements are paid upfront, they provide an immediate benefit to operating cash flow as compared to non-political advertising which is billed and collected in arrears after the advertisement has been delivered. Also contributing to the increase was higher subscription revenue of approximately $122.1 million, and a decline in tax payments of $91.8 million, resulting primarily from lower tax rates following the enactment of the Tax Act. These increases were partially offset by the absence of approximately $107.8 million of operating cash flow related to Cars.com and CareerBuilder which were spun-off and sold, respectively, during 2017, higher programming costs of approximately $63.3 million, a decline in AMS revenue of approximately $32.9 million, an increase of $24.4 million in pension payments and contributions in 2018, and the absence of spectrum channel share proceeds in 2018 as compared to an inflow of proceeds of $32.6 million in 2017. 2017 compared to 2016: Our net cash flow from operating activities was $389.4 million in 2017, compared to $678.7 million in 2016. The decrease was primarily due to higher programming costs of $175.9 million (primarily due to the NBC affiliation agreement), the decline in political revenue of $131.6 million, and the decline of approximately $230.9 million of operating cash flow from Cars.com and CareerBuilder. These decreases were partially offset by an increase in subscription revenue of $137.0 million and declines in tax payments of $51.6 million and interest payments of $25.0 million. Also partially offsetting the net operating cash flow decrease was a cash inflow received in 2017 of $32.6 million from a spectrum channel sharing agreement. Investing Activities 2018 compared to 2017: Cash flow used for investing activities was $374.4 million in 2018, compared to cash provided by investing activities of $176.2 million in 2017. The cash used for investing activities in 2018 was primarily due to our acquisition of KFMB for $328.4 million and purchases of property and equipment of $65.2 million. The cash provided by investing activities in 2017 was primarily a result of the sale of the majority of our ownership in CareerBuilder, which provided $198.3 million of proceeds, net of cash transferred. Additionally, we had cash inflow of $37.9 million from the sale of assets, primarily comprised of proceeds of $14.6 million from the sale of Gannett Co., Inc., common stock and $21.3 million from the sale of our investment in Livestream. Lastly, we received insurance proceeds of $16.5 million as reimbursement for damaged caused by hurricanes. These inflows were partially offset by purchases of property and equipment of $76.9 million in 2017. 2017 compared to 2016: Net cash provided by investing activities was $176.2 million in 2017 compared to cash used for investing activities of $272.8 million in 2016. The 2017 net cash inflow was caused by the factors described above. The 2016 net cash used for investing activities of $272.8 million was primarily comprised of $206.1 million paid for the acquisitions of businesses (net of cash acquired), including DealerRater, Aurico, and Workterra. DealerRater was part of the Cars.com spin-off and Aurico and Workterra were included in the sale of our majority ownership in CareerBuilder, both occurring in 2017. Also contributing to the net outflow was the purchase of property and equipment in the amount of $94.8 million. Partially offsetting these outflows was $40.0 million of inflow from the sale of investments, primarily consisting of non-operating investments. Financing Activities 2018 compared to 2017: Cash flow used by financing activities was $145.0 million in 2018, compared to $542.7 million for the same period in 2017. The change was primarily due to debt activity and dividend payments. Activity on our revolving credit facility in 2018 resulted in a net inflow of $50.0 million, which includes an inflow of $220.0 million to partially fund our acquisition of KFMB, offset by repayments made subsequent to completion of the acquisition. With regards to 2017 debt activity, prior to the completion of the spin-off, Cars.com borrowed approximately $675.0 million under a revolving credit facility agreement, while incurring $6.2 million of debt issuance costs. The proceeds were used to make a one time tax-free cash distribution of $650.0 million from Cars.com to TEGNA. We used most of the cash received to pay down our then outstanding revolving credit balance of $609.9 million. Total net payments on the revolving credit facility in 2017 were $635.0 million. Additionally, in the fourth quarter of 2017 we early retired $280.0 million of outstanding debt that matures in October 2019. Also contributing to the fluctuation were dividend payments which resulted in cash outflows of $60.3 million in 2018 as compared to $90.2 million in 2017 (due to reduced dividend per share amount following the Cars.com spin-off on May 31, 2017). 2017 compared to 2016: Net cash used for financing activities was $542.7 million in 2017 compared to $462.4 million 2016. The 2017 net outflow of cash for financing activities was primarily due to debt activity and dividends as discussed above. The 2016 net financing outflow of $462.4 million was primarily a result of stock repurchases of $161.9 million and dividend payments of $121.6 million. Additionally, we had a net debt outflow of $137.6 million primarily comprised of $310.0 million of borrowings which were partially offset by debt repayments of $447.6 million. Long-term debt As of December 31, 2018, our outstanding debt, net of unamortized discounts and deferred financing costs, was $2.94 billion and mainly is in the form of fixed rate notes. See “Note 6 Long-term debt” to our consolidated financial statements for a table summarizing the components of our long-term debt. Approximately $2.69 billion of our debt has a fixed interest rate (which represents approximately 90% of our total principal debt obligation) which minimizes our impact to potential future rising interest rates. Our primary source of long-term debt is our revolving credit facility (the Amended and Restated Competitive Advance and Revolving Credit Agreement). Under the terms of the credit facility our permitted total leverage ratio is at 5.0x through June 30, 2019, reducing to 4.75x for the fiscal quarter ending September 30, 2019 through the end of the fiscal quarter ending June 30, 2020, and then reducing to 4.50x for the fiscal quarter ending September 30, 2020 and thereafter. Commitment fees on the revolving credit agreement are equal to 0.25% - 0.40% of the undrawn commitments, depending upon our leverage ratio, and are computed on the average daily undrawn balance under the revolving credit agreement and paid each quarter. Under the Amended and Restated Competitive Advance and Revolving Credit Agreement, we may borrow at an applicable margin above the Eurodollar base rate (LIBOR loan) or the higher of the Prime Rate, the Federal Funds Effective Rate plus 0.50%, or the one month LIBOR rate plus 1.00% (ABR loan). The applicable margin is determined based on our leverage ratio but differs between LIBOR loans and ABR loans. For LIBOR-based borrowing, the margin varies from 1.75% to 2.50%. For ABR-based borrowing, the margin will vary from 0.75% to 1.50%. Total commitments under the Amended and Restated Competitive Advance and Revolving Credit Agreement are $1.51 billion. As of December 31, 2018, we were in compliance with all covenants contained in our debt and credit agreements. Below is a summary of our 2018 debt activity: • On February 15, 2018 we acquired the assets of KFMB-TV, the CBS affiliate in San Diego, KFMB-D2 (the CW station in San Diego), and radio stations KFMB-AM and KFMB-FM in San Diego. The transaction price was approximately $328.4 million in cash, $220.0 million of which we funded through borrowings under our revolving credit facility and the remainder through the use of available cash. • On June 21, 2018, we entered into an amendment of our Amended and Restated Competitive Advance and Revolving Credit Agreement. Under the amended terms, the $1.51 billion of revolving credit commitments and letter of credit commitments have been extended until June 21, 2023. The amendment also extended our permitted total leverage ratio to remain at 5.0x through June 30, 2019, reducing to 4.75x for the first quarter ending September 30, 2019 through the end of the fiscal quarter ending June 30, 2020, and then reducing to 4.5x for the fiscal quarter ending September 30, 2020 and thereafter. • As of December 31, 2018, we had unused borrowing capacity of $1.44 billion under our revolving credit facility. On January 2, 2019 we completed our acquisition of WTOL, the CBS affiliate in Toledo, OH, and KWES, the NBC affiliate in Midland-Odessa, TX from Gray Television, Inc. for $108.9 million in cash. The acquisition was funded through the use of available cash and borrowings under our revolving credit facility. We also have an effective shelf registration statement on Form S-3 on file with the U.S. Securities and Exchange Commission under which an unspecified amount of securities may be issued, subject to a $7.0 billion limit established by the Board of Directors. Proceeds from the sale of such securities may be used for general corporate purposes, including capital expenditures, working capital, securities repurchase programs, repayment of debt and financing of acquisitions. We may also invest borrowed funds that are not required for other purposes in short-term marketable securities. Our debt maturities may be repaid with cash flow from operating activities, accessing capital markets or a combination of both. The following schedule of annual maturities of the principal amount of total debt assumes we use available capacity under our revolving credit agreement to refinance unsecured floating rate term loans and fixed rate notes due in 2019, 2020, and 2021. Based on this refinancing assumption, all of the obligations due in 2019 and 2020, and a portion of those due in 2021, are reflected as maturities for 2023 (in thousands). (1) Debt payments due in 2019, 2020 and 2021 are assumed to be repaid with funds from the revolving credit agreement, up to our maximum borrowing capacity. The revolving credit agreement expires in 2023. Excluding our ability to repay funds with the revolving credit agreement, contractual debt maturities are $420 million for 2019, $725 million in 2020, and $350 million in 2021. (2) Assumes current revolving credit agreement borrowings comes due in 2023 and credit facility is not extended. Contractual obligations and commitments The following table summarizes the expected cash outflows resulting from financial contracts and commitments as of the end of 2018 (in thousands). (1) Long-term debt includes scheduled principal payments only. We have contractual debt maturities of $420 million in 2019. See Note 6 to the consolidated financial statements for further information. (2) We have $50 million of outstanding borrowings under our revolving credit facility as of December 31, 2018. Interest on the senior notes is based on the stated cash coupon rate and excludes the amortization of debt issuance discount. The floating rate term loan interest rates are based on the actual rates as of December 31, 2018. (3) See Note 13 to the consolidated financial statements. (4) Our talent and employment contracts primarily secure our on-air talent and other personnel for our television stations through multi-year talent and employment agreements. We expect our contracts will be renewed or replaced with similar agreements upon their expiration. Amounts due under the contracts, assuming the contracts are not terminated prior to their expiration, are included in the contractual commitments table. (5) Includes purchase obligations pertaining to technology related capital projects, news and market data services, and other legally binding commitments. Amounts which we are liable for under purchase orders outstanding as of December 31, 2018 are reflected in the Consolidated Balance Sheets as accounts payable and accrued liabilities and are excluded from the table above. (6) Programming contracts include television station commitments to purchase programming to be produced in future years. This also includes amounts related to our network affiliation agreements. Network affiliation agreements may include variable fee components such as subscriber levels, which in have been estimated and reflected in the table above. (7) Other noncurrent liabilities consist of both unfunded and under-funded postretirement benefit plans. Unfunded plans include the TEGNA Supplemental Retirement Plan and the TEGNA Retiree Welfare Plan. Employer contributions, which equal the expected benefit payments, are reflected in the table above over the next ten-year period. Our under-funded pension plan is the TEGNA Retirement Plan (TRP). In 2019, we expect contributions to the TEGNA Retirement Plan and SERP of $3.8 million and $7.8 million, respectively. TRP contributions beyond the next fiscal year are excluded due to uncertainties regarding significant assumptions involved in estimating these contributions, such as interest rate levels as well as the amount and timing of invested asset returns. Due to uncertainty with respect to the timing of future cash flows associated with unrecognized tax benefits at December 31, 2018, we are unable to make reasonably reliable estimates of the period of cash settlement. Therefore, approximately $12.8 million of unrecognized tax benefits have been excluded from the contractual obligations table above. See Note 5 to the consolidated financial statements for a further discussion of income taxes. Off-Balance Sheet Arrangements Off-balance sheet arrangements as defined by the Securities and Exchange Commission include the following four categories: obligations under certain guarantee contracts; retained or contingent interests in assets transferred to an unconsolidated entity or similar arrangements that serve as credit, liquidity or market risk support; obligations under certain derivative arrangements classified as equity; and obligations under material variable interests. As of December 31, 2018, we had no material off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources. Capital stock On September 19, 2017, our Board of Directors authorized a new share repurchase program for up to $300.0 million over the next three years. As of December 31, 2018, we have $279.1 million remaining under this authorization. The table below summarizes our share repurchases during the past three years (in thousands). The shares may be repurchased at management’s discretion, either in the open market or in privately negotiated block transactions. Management’s decision to repurchase shares will depend on price and other corporate developments. Purchases may occur from time to time and no maximum purchase price has been set. Certain of the shares we previously acquired have been reissued in settlement of employee stock awards. Our common stock outstanding at December 31, 2018, totaled 215,758,630 shares, compared with 214,930,653 shares at December 31, 2017. Effects of inflation and changing prices and other matters Our results of operations and financial condition have not been significantly affected by inflation. The effects of inflation and changing prices on our property and equipment and related depreciation expense have been reduced as a result of an ongoing capital expenditure program and the availability of replacement assets with improved technology and efficiency. Critical accounting policies and the use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe the following discussion addresses our most critical accounting policies, which are those that are important to the presentation of our financial condition and results of operations and require management’s most subjective and complex judgments. This commentary should be read in conjunction with our financial statements, selected financial data and the remainder of this Form 10-K. Revenue Recognition: Revenue is recognized upon the transfer of control of promised services to our customers in an amount that reflects the consideration we expect to receive in exchange for those services. Revenue is recognized net of any taxes collected from customers, which are subsequently remitted to governmental authorities. Amounts received from customers in advance of providing services to our customers are recorded as deferred revenue. Our primary source of revenue is earned through the sale of advertising and marketing services (AMS). This revenue stream includes all sources of our traditional television and radio advertising, as well as digital revenues including Premion, our digital marketing services (DMS) business unit and other digital advertising across our platforms. Contracts within this revenue stream are short-term in nature (most often three months or less). Contracts generally consist of multiple deliverables, such as television commercials, or digital advertising solutions, that we have identified as individual performance obligations. Before performing under the contract we establish the transaction price with our customer based on the agreed upon rates for each performance obligation. There is no material variability in the transaction price during the term of the contract. Revenue is recognized as we fulfill our performance obligations to our customers. For our AMS revenue stream, we measure the fulfillment of our performance obligations based on the airing of the individual television commercials or display of digital advertisements. This measure is most appropriate as it aligns our revenue recognition with the value we are providing to our customers. The price of each individual commercial and digital advertisement is negotiated with our customer and is determined based on multiple factors, including, but not limited to, the programming and day-part selected, supply of available inventory, our station’s viewership ratings and overall market conditions (e.g., timing of the year and strength of U.S. economy). Customers are billed monthly and payment is generally due 30 days after the date of invoice. Commission costs related to these contracts are expensed as incurred due to the short-term nature of the contracts. We also earn subscription revenue from retransmission consent contracts with multichannel video programming distributors (e.g., cable and satellite providers) and over the top providers (companies that deliver video content to consumers over the Internet). Under these multi-year contracts, we have performance obligations to provide our customers with our stations’ signals, as well as our consent to retransmit those signals to their customers. Subscription revenue is recognized in accordance with the guidance for licensing intellectual property utilizing a usage based method. The amount of revenue earned is based on the number of subscribers to which our customers retransmit our signal, and the negotiated fee per subscriber included in our contract agreement. Our customers submit payments monthly, generally within 60-90 days after the month that service was provided. Our performance obligations are satisfied, and revenue is recognized, as we provide our consent for our customers to retransmit our signal. This measure toward satisfaction of our performance obligations and recognition of revenue is the most appropriate as it aligns our revenue recognition with the value that we are delivering to our customers through our retransmission consent. We also generate revenue from the sale of political advertising. Contracts within this revenue stream are short-term in nature (typically weekly or monthly buys during political campaigns). Customers pre-pay these contracts and we therefore defer the associated revenue until the advertising has been delivered, at which time we have satisfied our performance obligations and recognize revenue. Commission costs related to these contracts are expensed as incurred due to the short-term nature of the contracts. Our remaining revenue is comprised of various other services, primarily production services (for news content and commercials) and sublease rental income. Revenue is recognized as these various services are provided to our customers. In instances where we sell services from more than one revenue stream to the same customer at the same time, we recognize one contract and allocate the transaction price to each deliverable element (e.g. performance obligation) based on the relative fair value of each element. Goodwill: As of December 31, 2018, our goodwill balance was $2.6 billion and represented approximately 49% of our total assets. Goodwill represents the excess of acquisition cost over the fair value of assets acquired, including identifiable intangible assets, net of liabilities assumed. Goodwill is tested for impairment on an annual basis (first day of our fourth quarter) or between annual tests if events or changes in circumstances occurred that indicate the fair value of a reporting unit may be below its carrying amount. Goodwill is tested for impairment at a level referred to as the reporting unit. A reporting unit is a business for which discrete financial information is available and segment management regularly reviews the operating results. The level at which we test goodwill for impairment requires us to determine whether the operations below the operating segment level constitute a reporting unit. We have determined that our one segment, Media, consists of a single reporting unit. Before performing the annual goodwill impairment test quantitatively, we first have the option to perform a qualitative assessment to determine if the quantitative test must be completed. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance, as well as company and specific reporting unit specifications. If after performing this assessment, we conclude it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then we are required to perform the quantitative test. Otherwise, the quantitative test is not required. In 2018, we elected not to perform the optional qualitative assessment of goodwill and instead performed the quantitative impairment test. When performing the quantitative test, we determine the fair value of the reporting unit and compare it to the carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds the fair value of the reporting unit, the reporting unit’s goodwill is impaired and we recognize an impairment loss equal to the difference between the reporting unit’s carrying amount and fair value. We estimate the fair value of our one reporting unit based on a market-based valuation methodology, which is primarily based on our consolidated market capitalization plus a control premium. In the fourth quarter of 2018, we completed our annual goodwill impairment test for our reporting unit. The results of the test indicated that the estimated fair value of our reporting unit significantly exceeded the carrying value. For our reporting unit, the estimated value would need to decline by over 50% to fail the quantitative goodwill impairment test. We do not believe that the reporting unit is currently at risk of incurring a goodwill impairment in the foreseeable future. Impairment assessment inherently involves management judgments regarding a number of assumptions described above. Fair value of the reporting unit also depends on the future strength of the economy in our principal media markets. New and developing competition as well as technological change could also adversely affect future fair value estimates. Due to the many variables inherent in the estimation of the reporting unit’s fair value and the relative size of our recorded goodwill, differences in assumptions could have a material effect on the estimated fair value of our reporting unit and could result in a goodwill impairment charge in a future period. Indefinite Lived Intangibles: This asset grouping consists of FCC broadcast licenses related to our acquisitions of television stations. As of December 31, 2018, indefinite lived intangible assets were $1.38 billion and represented approximately 26% of our total assets. Indefinite lived assets are not subject to amortization and, as a result, they are tested for impairment annually (on the first day of our fourth quarter), or more frequently if events or changes in circumstances suggest that the asset might be impaired. We have the option to first perform a qualitative assessment to determine if it is more likely than not that the fair value of the indefinite lived asset is more than its carrying amount. If that is the case, then we would not have to perform the quantitative analysis. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance of the indefinite lived asset. In 2018, we elected not to perform the optional qualitative assessment; and instead, we performed the quantitative impairment test. The fair value of each FCC broadcast license was determined using an income approach referred to as the Greenfield method. This method requires multiple assumptions relating to the future prospects of each individual television station including, but not limited to: (i) expected long-term market growth characteristics, (ii) station revenue shares within a market for a new entrant, (iii) future expected operating expenses, (iv) costs of capital and (v) appropriate discount rates. We performed a quantitative analysis on all of our FCC licenses on the impairment testing date and each fair value exceeded the carrying value by more than 40% with the exception of our recently acquired KFMB television and radio stations, which had clearances of 3% and 4%, respectively. Clearances for our KFMB stations are lower to due to recently recording the intangible assets at fair value upon our acquisition of KFMB in February 2018. Since their acquisition, the FCC licenses for the KFMB television and radio stations have increased in value, due to operating performance and market factors that have improved since acquisition. Based on our quantitative analysis performed, we concluded that no impairment existed. Future increases in discount rate assumptions could cause a decline in the fair value of our FCC licenses which may result in a future impairment charge. For example, a 50 basis point increase in the discount rate would cause the fair value of our FCC licenses (excluding the KFMB licenses) to exceed its carrying value by 30%. KFMB FCC licenses would be impaired by less than $10.0 million as a result of a 50 basis point increase in the discount rate. Pension Liabilities: Certain employees participate in qualified and non-qualified defined benefit pension plans (see Note 7 to consolidated financial statements). Our principal defined benefit pension plan is the TEGNA Retirement Plan (TRP). We also sponsor the TEGNA Supplemental Retirement Plan (SERP) for certain employees. Substantially all participants in the TRP and SERP had their benefits frozen before 2009, and in December 2017, we froze all remaining accruing benefits for certain grandfathered SERP participants. We recognize the net funded status of these postretirement benefit plans under GAAP as a liability on our Consolidated Balance Sheets. There is a corresponding non-cash adjustment to accumulated other comprehensive loss, net of tax benefits recorded as deferred tax assets, in stockholders’ equity. The GAAP funded status represents the difference between the fair value of each plan’s assets and the benefit obligation of the plan. The GAAP benefit obligation represents the present value of the estimated future benefits we currently expect to pay to plan participants based on past service. The plan assets and benefit obligations are measured at December 31 of each year, or more frequently, upon the occurrence of certain events such as a plan amendment, settlement, or curtailment. The amounts we record are measured using actuarial valuations, which are dependent upon key assumptions such as discount rates, participant mortality rates and the expected long-term rate of return on plan assets. The assumptions we make affect both the calculation of the benefit obligations as of the measurement date and the calculation of net periodic pension expense in subsequent periods. When reassessing these assumptions we consider past and current market conditions and make judgments about future market trends. We also consider factors such as the timing and amounts of expected contributions to the plans and benefit payments to plan participants. The most important assumptions include the discount rate applied to pension plan obligations and the expected long-term rate of return on plan assets related for the TRP (the SERP is an unfunded plan). The discount rate assumption is based on investment yields available at year-end on corporate bonds rated AA and above with a maturity to match the expected benefit payment stream. A decrease in discount rates would increase pension obligations. We establish the expected long-term rate of return by developing a forward-looking, long-term return assumption for each pension fund asset class, taking into account factors such as the expected real return for the specific asset class and inflation. A single, long-term rate of return is then calculated as the weighted average of the target asset allocation percentages and the long-term return assumption for each asset class. We apply the expected long-term rate of return to the fair value of its pension assets in determining the dollar amount of its expected return. Changes in the expected long-term return on plan assets would increase or decrease pension plan expense. For 2018 we assumed a rate of 7.0% for our long-term expected return on pension assets used for our TRP plan. As an indication of the sensitivity of pension expense to the long-term rate of return assumption, a plus or minus 50 basis points change in the expected rate of return on pension assets (with all other assumptions held constant) would have decreased or increased estimated pension plan expense for 2018 by approximately $1.9 million. The effects of actual results differing from these assumptions are accumulated as unamortized gains and losses. For the December 31, 2018 measurement, the assumption used for the discount rate was 4.35% for our principal retirement plan. As an indication of the sensitivity of pension liabilities to the discount rate assumption, a plus or minus 50 basis points change in the discount rate at the end of 2018 (with all other assumptions held constant) would have decreased or increased plan obligations by approximately $24.0 million. A 50 basis points change in the discount rate used to calculate 2018 expense would have changed total pension plan expense for 2018 by approximately $0.4 million. Income Taxes: Our annual tax rate is based on our income, statutory tax rates, and tax planning opportunities available in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax expense and in evaluating our tax positions. Tax law requires certain items to be included in our tax returns at different times than when the items are reflected in the financial statements. The annual tax expense reflected in the Consolidated Statements of Income is different than what is reported in our tax returns. Some of these differences are permanent (for example, expenses recorded for accounting purposes that are not deductible in the returns such as non-deductible goodwill) and some differences are temporary and reverse over time, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax liabilities generally represent tax expense recognized in the financial statements for which payment has been deferred, or expense for which a deduction has been taken already in the tax return but the expense has not yet been recognized in the financial statements. Deferred tax assets generally represent items that can be used as a tax deduction or credit in tax returns in future years for which a benefit has already been recorded in the financial statements, as well as tax losses that can be carried over and used in future years. Valuation allowances are established when necessary to reduce deferred income tax assets to the amounts we believe are more likely than not to be recovered. In evaluating the amount of any such valuation allowance, we consider the existence of cumulative income or losses in recent years, the reversal of existing temporary differences, the existence of taxable income in prior carry back years, available tax planning strategies and estimates of future taxable income for each of our taxable jurisdictions. The latter two factors involve the exercise of significant judgment. As of December 31, 2018, deferred tax asset valuation allowances totaled $125.9 million, primarily related to federal and state capital losses, and state net operating losses available for carry forward to future years. Although realization is not assured, we believe it is more likely than not that all other deferred tax assets for which no valuation allowances have been established will be realized. This conclusion is based on our history of cumulative income in recent years and review of historical and projected future taxable income. We determine whether it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit is recorded in our financial statements. A tax position is measured as the portion of the tax benefit that is greater than 50% likely to be realized upon settlement with a taxing authority (that has full knowledge of all relevant information). We may be required to change our provision for income taxes when the ultimate treatment of certain items is challenged or agreed to by taxing authorities, when estimates used in determining valuation allowances on deferred tax assets significantly change, or when receipt of new information indicates the need for adjustment in valuation allowances. Future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported in the consolidated financial statements in the year these changes occur.

<s>[INST] We are an innovative media company that serves the greater good of our communities. Our business includes 49 television stations operating in 41 markets, offering highquality television programming and digital content. Each television station also has a robust digital presence across online, mobile and social platforms. Beyond integrated broadcast advertising products and services, we deliver results for advertisers through extensive solutions including our Over the Top (OTT) local advertising network, Premion; and our digital marketing services (DMS) business, a onestop shop for local businesses to connect with consumers through digital marketing. On May 31, 2017, we completed the spinoff of our digital automotive marketplace business, Cars.com. In addition, on July 31, 2017, we completed the sale of our majority ownership stake in CareerBuilder. Our digital marketing services (DMS) business is now reported within our Media business. As a result of these strategic actions, we have disposed of substantially all of our Digital Segment business and have therefore classified substantially all of its historical financial results as discontinued operations for all periods presented. We now operate one operating and reportable segment “Media.” Our operating results are subject to seasonal fluctuations. Generally, the second and fourth quarters operating results are stronger than the first and third quarter. This is driven by the second quarter usually reflecting increased spring seasonal advertising, while the fourth quarter typically includes increased advertising related to the holiday season. In addition, our operating results are subject to significant fluctuations from political advertising. In even numbered years, political spending is usually significantly higher than in odd numbered years due to advertising for the local and national elections. Additionally, every four years, we typically experience even further increases in political advertising in connection with the presidential election. Consolidated Results from Operations A consolidated summary of our results is presented below (in thousands). **** Not meaningful Revenues Our Advertising and Marketing Services (AMS) category includes all sources of our traditional television advertising and digital revenues including Premion and other digital advertising and marketing revenues across our platforms. Our Subscription revenue category includes revenue earned from cable and satellite providers for the right to carry our signals and the distribution of TEGNA stations on OTT streaming services. The following table summarizes the yearoveryear changes in our revenue categories (in thousands): **** Not meaningful Revenue increased $304.3 million, or 16%, in 2018 as compared to 2017. This net increase was primarily due to an increase in 2018 political revenue of $210.4 million, driven by the midterm elections cycle. Also contributing to the net increase was subscription revenue which increased $122.1 million, or 17%, primarily due to annual rate increases under existing retransmission agreements and increases from OTT streaming service providers. These increases were partially offset by a decrease in AMS revenue of $32.9 million, or 3%, in 2018. Increases in AMS from Winter Olympic and Super Bowl advertising, the KFMB station acquisition, and digital advertising (primarily Premion) were offset by declines in digital marketing services (DMS) revenue (primarily due to conclusion of a transition service agreement with Gannett in June 2017) and a softening of demand and the impact of election year political displacement of traditional television advertising. Revenue decreased $101.1 million, or 5%, in 2017 as compared to 2016. This net decrease was primarily driven by lower political revenue of $131.6 million, due to an expected decrease from 2016 politically related advertising spending. In addition, the decrease reflected a decline in AMS revenue of $98.1 million, or 8%, in 2017. This decline was primarily due to the absence of Olympic revenue in 2017 as compared to $57.3 million in 2016 and lower DMS revenue due to the conclusion of a transition services agreement with Gannett. Partially offsetting the overall AMS decline was an increase in digital revenue, including Premion revenue. Partially offsetting the overall decrease was an increase in subscription revenue of $137.0 million, or 24%, due to the renewal of certain retransmission [/INST] Positive. </s>

TEGNA INC

2020-03-02

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction We are an innovative media company that serves the greater good of our communities. Our business includes 62 television stations and four radio stations in 51 U.S. markets, we are the largest owner of top four network affiliates in the top 25 markets among independent station groups, reaching approximately 39% of U.S. television households. Each television station also has a robust digital presence across online, mobile and social platforms, reaching consumers whenever, wherever they are. We have been consistently honored with the industry’s top awards, including Edward R. Murrow, George Polk, Alfred I. DuPont and Emmy Awards. Through TEGNA Marketing Solutions (TMS), our integrated sales and back-end fulfillment operations, we deliver results for advertisers across television, email, social, and Over the Top (OTT) platforms, including Premion, our OTT advertising network. We have one operating and reportable segment. The primary sources of our revenues are: 1) advertising & marketing services (AMS) revenues, which include local and national non-political television advertising, digital marketing services (including Premion), and advertising on the stations’ websites and tablet and mobile products; 2) subscription revenues, reflecting fees paid by satellite, cable, OTT (companies that deliver video content to consumers over the Internet) and telecommunications providers to carry our television signals on their systems; 3) political advertising revenues, which are driven by even year election cycles at the local and national level (e.g. 2020, 2018) and particularly in the second half of those years; and 4) other services, such as production of programming and advertising material. Our revenues and operating results are subject to seasonal fluctuations. Generally, our second and fourth quarter revenues and operating results are stronger than those we report for the first and third quarter. This is driven by the second quarter reflecting increased spring seasonal advertising, while the fourth quarter typically includes increased advertising related to the holiday season. In even years, our advertising revenue benefits significantly from the Olympics when carried on NBC, our largest network affiliation. To a lesser extent, the Super Bowl can influence our advertising results, the degree to which depending on which network broadcast’s the event. In addition, our revenue and operating results are subject to significant fluctuations across yearly periods resulting from political advertising. In even numbered years, political spending is usually significantly higher than in odd numbered years due to advertising for the local and national elections. Additionally, every four years, we typically experience even greater increases in political advertising in connection with the presidential election. The strong demand for advertising from political advertisers in these even years can result in the significant use of our available inventory (leading to a “crowd out” effect), which can diminish our AMS revenue from our non-political advertising customers in the even year of a two year election cycle, particularly in the fourth quarter of those years. As discussed above in “Business Overview” section of Item 1, during 2019 we acquired multiple local television stations and two multicast networks in four different business acquisitions for an aggregate purchase price of approximately $1.5 billion. The four acquisitions are collectively referred to as the “Recent Acquisitions” in the results of operations discussion that follows. The inclusion of the operating results from these Recent Acquisitions for the periods subsequent to their acquisition impacts the year-to-year comparability of our consolidated operating results in 2019. Consolidated Results from Operations The following discussion is a comparison of our consolidated results on a GAAP basis. The year-to-year comparison of financial results is not necessarily indicative of future results. In addition, see the section on page 23 titled ‘Operating results non GAAP information’ for additional tables presenting information which supplements our financial information provided on a GAAP basis. For a comparative discussion of our results of operations for the years ended December 31, 2018 and December 31, 2017, see “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our annual report on Form 10-K for the year ended December 31, 2018, filed with the SEC on March 1, 2019. A consolidated summary of our results is presented below (in thousands). *** Not meaningful (1) This increase in corporate expense was driven by acquisition-related costs totaling $30.7 million in 2019 due to the Recent Acquisitions (principally advisory fees). In addition, our 2019 Corporate expense includes $6.1 million of advisory fees related to activism defense. Excluding these advisory fees, corporate expenses were down approximately $9.1 million. See the section on page 23 titled ‘Operating results non-GAAP information’ for additional tables and information regarding our Corporate expense on a non-GAAP basis. Revenues Our AMS category includes all sources of our traditional television advertising and digital revenues including Premion and other digital advertising and marketing revenues across our platforms. Our Subscription revenue category includes revenue earned from cable and satellite providers for the right to carry our signals and the distribution of TEGNA stations on OTT streaming services. The following table summarizes the year-over-year changes in our revenue categories (in thousands): *** Not meaningful Total revenues increased $92.2 million in 2019 as compared to 2018. Our Recent Acquisitions contributed total revenues of $185.0 million in 2019. Excluding Recent Acquisitions, total revenues decreased $92.8 million. This decrease was primarily due to a $200.4 million reduction in political advertising, reflecting significantly fewer elections compared to 2018. This decrease was partially offset by an increase in subscription revenue of $96.6 million, primarily due to annual rate increases under existing retransmission agreements and an increase in AMS revenue of $8.6 million (due to higher digital revenue). Cost of revenues Cost of revenues increased $162.3 million in 2019 as compared to 2018. Our Recent Acquisitions added cost of revenues of $95.0 million. Excluding our Recent Acquisitions, cost of revenues increased $67.3 million. This increase was primarily due to a $61.1 million increase in programming costs, due to the growth in subscription revenues (certain programming cost are linked to such revenues), and higher severance expense of $3.7 million incurred in 2019 as compared to 2018. Partially offsetting this increase was a reduction of $8.6 million of digital costs as a result of the fourth quarter 2018 reduction in force and rebranding of our digital business unit (which resulted in lower third party digital platform costs in 2019, see Note 13 to the consolidated financial statements for further details). Business units - Selling, general and administrative expenses Business unit selling, general, and administrative expenses increased $11.5 million in 2019 as compared to 2018. Our Recent Acquisitions added business unit selling, general and administrative (SG&A) expenses of $25.7 million. Excluding the Recent Acquisitions, SG&A expenses decreased $14.2 million. The decrease was primarily the result of an $11.1 million reduction of professional and legal costs (due to the settlement of the Department of Justice Antitrust Division matter in June 2019, see Note 13 to the consolidated financial statements for further details). Corporate - General and administrative expenses Our corporate costs are separated from our business expenses and are recorded as general and administrative expenses in our Consolidated Statement of Income. This category primarily consists of broad corporate management functions including Legal, Human Resources, and Finance, as well as activities and costs not directly attributable to the operations of our media business. In addition, beginning in 2019, we now record acquisition-related costs within our Corporate operating expense. Prior to 2019, such costs were recorded in other non-operating items, net. Corporate general and administrative expenses increased $27.7 million in 2019 as compared to 2018. The increase was primarily due to $30.7 million in acquisition-related costs (principally advisory fees) associated with the Recent Acquisitions. Also contributing to the increase was $6.1 million of advisory fees related to activism defense. Excluding these professional fees, corporate expenses were down approximately $9.1 million, primarily due to a decline in severance expense of $5.3 million in 2019 as compared to 2018 as well as the full-year impact of certain cost-saving initiatives implemented in 2018. Depreciation Depreciation expense increased $4.6 million in 2019 as compared to 2018. Our Recent Acquisitions added $5.8 million. Excluding the impact of Recent Acquisitions, there was a $1.2 million decline in our depreciation expense. Amortization of intangible assets Intangible asset amortization expense increased $19.3 million in 2019 as compared to 2018. The increase was due to our Recent Acquisitions. Spectrum repacking reimbursements and other, net We had other net gains of $5.3 million in 2019 compared to net gains of $11.7 million in 2018. The 2019 net gains consisted of gains of $17.0 million of reimbursements received from the Federal Communications Commission for required spectrum repacking and a gain of $2.9 million as a result of the sale of certain real estate. These gains were partially offset by a $5.5 million in contract termination charge and incremental transition costs related to bringing our national sales organization in-house and $9.1 million of non-cash charges to reduce the value of certain assets classified as held-for-sale. The 2018 net gains primarily consisted of $7.4 million of spectrum repack reimbursements and a $6.0 million gain recognized on the sale of real estate in Houston. Operating income Operating income decreased $139.5 million in 2019 as compared to 2018. Our Recent Acquisitions added $39.1 million in operating income. Excluding the impact of Recent Acquisitions, operating income decreased $178.6 million which was driven by the changes in revenue and operating expenses described above. Our operating margins were 24.3% in 2019 compared to 31.6% in 2018, primarily reflecting the typical decline of high-margin political advertising revenue in odd calendar years ($195.1 million lower). Programming and payroll expense trends Programming and payroll expenses are the two largest elements of our operating expenses, and are summarized below, expressed as a percentage of total operating expenses. Programming expenses as a percentage of total operating expenses have increased due to an increase in reverse compensation payments to our network affiliation partners associated with higher subscription revenues (certain affiliation partners are compensated based on a percentage of subscription revenues). Payroll expenses have increased during 2019 primarily due to our Recent Acquisitions, but as a percentage of total operating expenses have decreased in 2019 primarily due to increases in programming expenses, which make up a larger percentage of operating costs. Non-operating income and expense Equity income: This income statement category reflects earnings or losses from our equity method investments. Equity income decreased $3.6 million from $13.8 million in 2018 to $10.1 million in 2019. The 2019 income was primarily due to a gain of $12.2 million recognized in connection with the sale of investment in Captivate. The 2018 income was primarily due to $14.2 million of equity earnings from our CareerBuilder investment, resulting from a $17.9 million gain recorded in connection with our share of the gain on sale of its subsidiary, Economic Modeling, LLC. Interest expense: Interest expense increased $13.4 million in 2019 as compared to 2018, primarily due to a higher average outstanding total debt balance, partially offset by lower interest rates. The total average outstanding debt was $3.37 billion in 2019 compared to $3.09 billion in 2018. The impact of the increase in outstanding debt was partially offset by a decrease in the weighted average interest rate on total outstanding debt, which was 5.85% in 2019 compared to 5.90% in 2018. A further discussion of our borrowing and related interest cost is presented in the “Liquidity and capital resources” section of this report beginning on page 29 and in Note 6 to the consolidated financial statements. Other non-operating items, net: Other non-operating items decreased $23.5 million from a net expense of $11.5 million in 2018 to a net income of $12.0 million in 2019. This decrease was primarily due to the absence of $15.4 million acquisition-related costs which were classified as non-operating in 2018. Beginning in 2019, such cost are now classified as a corporate operating cost. In addition, we recognized a $7.3 million gain in the second quarter of 2019 due to the write-up of our prior investment in the Justice and Quest multicast networks at the time of our acquisition. Provision for income taxes We reported pre-tax income from continuing operations attributable to TEGNA of $375.7 million for 2019. The effective tax rate on pre-tax income was 23.8%. The 2019 effective tax rate increased compared to 21.1% in 2018 primarily due to a 2019 valuation allowance recorded on a minority investment, higher nondeductible transaction costs incurred in 2019, and the 2018 effective tax rate included benefits from finalizing provisional amounts related to the Tax Cuts and Jobs Act (Tax Act). Partially offsetting the increase were higher tax benefits from the release of uncertain tax positions in 2019. The release of uncertain tax positions in 2019 was primarily related to the lapse of certain federal and state statutes of limitation as well as various state audit settlements. We reported pre-tax income from continuing operations attributable to TEGNA of $508.7 million for 2018. The effective tax rate on pre-tax income was 21.1%. The 2018 effective tax rate reflects the 21.0% U.S. federal statutory that was effective January 1, 2018 as a result of the Tax Act enacted in December 2017. The tax expense for state taxes was partially offset by a tax benefit from finalizing provisional amounts recorded in 2017 from the Tax Act. Further information concerning income tax matters is contained in Note 5 of the consolidated financial statements. Net income from continuing operations Net income from continuing operations and related per share amounts are presented in the table below (in thousands, except per share amounts). Our 2019 earnings per share was lower than 2018, primarily due to the $195.1 million reduction in political advertising, reflecting significantly fewer elections compared to 2018. Operating results non-GAAP information Presentation of non-GAAP information: We use non-GAAP financial performance to supplement the financial information presented on a GAAP basis. These non-GAAP financial measures should not be considered in isolation from, or as a substitute for, the related GAAP measures, nor should they be considered superior to the related GAAP measures, and should be read together with financial information presented on a GAAP basis. Also, our non-GAAP measures may not be comparable to similarly titled measures of other companies. Management and our Board of Directors use the non-GAAP financial measures for purposes of evaluating company performance. Furthermore, the Leadership Development and Compensation Committee of our Board of Directors uses non-GAAP measures such as Adjusted EBITDA, non-GAAP net income, non-GAAP EPS, free cash flow and Adjusted revenues to evaluate management’s performance. Therefore, we believe that each of the non-GAAP measures presented provides useful information to investors and other stakeholders by allowing them to view our business through the eyes of management and our Board of Directors, facilitating comparisons of results across historical periods and focus on the underlying ongoing operating performance of our business. We also believe these non-GAAP measures are frequently used by investors, securities analysts and other interested parties in their evaluation of our business and other companies in the broadcast industry. We discuss in this Form 10-K non-GAAP financial performance measures that exclude from our reported GAAP results the impact of “special items” consisting of spectrum repacking reimbursements and other, net, gains on sale of equity method investments, acquisition-related costs, advisory fees related to activism defense, severance costs, gains on equity method investments and certain non-operating expenses (TEGNA foundation donation and pension payment timing related charges). In addition, we have income tax special items associated with the tax impacts related to the Recent Acquisitions (including the 2018 acquisition of KFMB), adjustments related to previously-disposed businesses, and adjustments related to provisional tax impacts of tax reform. We believe that such expenses and gains are not indicative of normal, ongoing operations. While these items may be recurring in nature and should not be disregarded in evaluation of our earnings performance, it is useful to exclude such items when analyzing current results and trends compared to other periods as these items can vary significantly from period to period depending on specific underlying transactions or events that may occur. Therefore, while we may incur or recognize these types of expenses, charges and gains in the future, we believe that removing these items for purposes of calculating the non-GAAP financial measures provides investors with a more focused presentation of our ongoing operating performance. We discuss Adjusted EBITDA (with and without corporate expenses), a non-GAAP financial performance measure that we believe offers a useful view of the overall operation of our businesses. We define Adjusted EBITDA as net income before (1) interest expense, (2) income taxes, (3) equity income in unconsolidated investments, net, (4) other non-operating items, net, (5) severance expense, (6) acquisition-related costs, (7) advisory fees related to activism defense, (8) spectrum repacking reimbursements and other, net, (9) depreciation and (10) amortization. We believe these adjustments facilitate company-to-company operating performance comparisons by removing potential differences caused by variations unrelated to operating performance, such as capital structures (interest expense), income taxes, and the age and book appreciation of property and equipment (and related depreciation expense). The most directly comparable GAAP financial measure to Adjusted EBITDA is Net income. Users should consider the limitations of using Adjusted EBITDA, including the fact that this measure does not provide a complete measure of our operating performance. Adjusted EBITDA is not intended to purport to be an alternate to net income as a measure of operating performance or to cash flows from operating activities as a measure of liquidity. In particular, Adjusted EBITDA is not intended to be a measure of cash flow available for management’s discretionary expenditures, as this measure does not consider certain cash requirements, such as working capital needs, capital expenditures, contractual commitments, interest payments, tax payments and other debt service requirements. We also consider adjusted revenues to be an important non-GAAP financial measure. Our adjusted revenue is calculated by taking total company revenues on a GAAP basis and adjusting it to exclude (1) estimated incremental Olympic and Super Bowl revenue and (2) political revenues. These adjustments are made to our reported revenue on a GAAP basis in order to evaluate and assess our core operations on a comparable basis, and it represents the ongoing operations of our media business. We also discuss free cash flow, a non-GAAP performance measure. Beginning in the first quarter of 2019 we began using a new methodology to compute free cash flow. The change in methodology was determined to be preferable as it better reflects how the Board of Directors reviews the performance of the business and it more closely aligns to how other companies in the broadcast industry calculate this non-GAAP performance metric. The most directly comparable GAAP financial measure to free cash flow is Net income from continuing operations. Free cash flow is calculated as non-GAAP Adjusted EBITDA (as defined above), further adjusted by adding back (1) stock-based compensation, (2) non-cash 401(k) company match, (3) syndicated programming amortization, (4) pension reimbursements, (5) dividends received from equity method investments and (6) reimbursements from spectrum repacking. This is further adjusted by deducting payments made for (1) syndicated programming, (2) pension, (3) interest, (4) taxes (net of refunds) and (5) purchases of property and equipment. Like Adjusted EBITDA, free cash flow is not intended to be a measure of cash flow available for management’s discretionary use. As described in “Forward Looking Financial Information” below, we provided guidance ranges for non-GAAP Corporate expenses and Free Cash Flow as a percentage of Revenue (FCF as % Revenue). We also provided Adjusted EBITDA margin guidance. We are not able to reconcile non-GAAP Corporate expenses, or in the case of Adjusted EBITDA margin and FCF as % Revenue, their key inputs of Adjusted EBITDA or Free Cash Flow to their comparable GAAP financial measures without unreasonable efforts because certain information necessary to calculate such measures on a GAAP basis is unavailable, dependent on future events outside of our control and cannot be predicted. Examples of such information include (1) government reimbursement for spectrum repacking, the amount and timing of which are uncertain (2) share based compensation, which is impacted by future share price movement in our stock price and also dependent on future hiring and attrition (3) expenses related to acquisitions and dispositions, the timing and volume of which cannot be predicted. In addition, we believe such reconciliations could imply a degree of precision that might be confusing or misleading to investors. The actual effect of the reconciling items that we may exclude from these non-GAAP expense numbers, when determined, may be significant to the calculation of the comparable GAAP measures. Discussion of special charges and credits affecting reported results: Our results during 2019 and 2018 included the following items we consider “special items” that while at times recurring, can vary significantly from period to period: Results for the year ended December 31, 2019: • Severance expense which include payroll and related benefit costs at our stations and corporate headquarters; • Acquisition-related costs which primarily includes advisory fees associated with business acquisitions; • Advisory fees related to activism defense; • Spectrum repacking reimbursements and other, net is comprised of gains due to reimbursements from the FCC for required spectrum repacking, non-cash charges to reduce the value of certain assets classified as held-for-sale, gains recognized on the sale of real estate, and a contract termination and incremental transition costs related to bringing our national sales organization in-house; • Gains recognized in our equity income in unconsolidated investments as a result of the sale of two investments; • Other non-operating items primarily relates to a gain for the remeasurement of our previously held ownership in Justice Network and Quest to fair value, a charitable donation made to the TEGNA Foundation, costs incurred in connection with the early extinguishment of debt, and a gain due to an observable price increase in an equity investment; and • Realization of discrete tax benefits related to one of the Recent Acquisitions and a previously-disposed business. Results for the year ended December 31, 2018: • Severance expense which include payroll and related benefit costs due to restructuring at our DMS business and at our corporate headquarters; • Spectrum repacking reimbursements and other, net, is comprised of gains due to reimbursements from the FCC for required spectrum repacking and a gain recognized on the sale of real estate in Houston. These gains are partially offset by an early lease termination payment; • Other non-operating items associated with business acquisition-related costs, a deferred tax provision impact related to our acquisition of KFMB, a charitable donation made to the TEGNA Foundation, and an impairment of a debt investment; • Pension lump-sum payment charge as a result of payments that were made to certain SERP plan participants in early 2018; • A gain recognized in our equity income in unconsolidated investments, related to our share of CareerBuilder’s gain on the sale of its EMSI business; and • Deferred tax benefits related to adjusting the provisional tax impacts of the tax reform (enacted in December 2017) and a partial capital loss valuation allowance release, both resulting from the completion of our 2017 federal income tax return in the third quarter of 2018. Below are reconciliations of certain line items impacted by special items to the most directly comparable financial measure calculated and presented in accordance with GAAP on our Consolidated Statements of Income (in thousands, except per share amounts): Non-GAAP consolidated results The following is a comparison of our as adjusted non-GAAP financial results between 2019 and 2018. Changes between the periods are driven by the same factors summarized above in the “Results of Operations” section within Management’s Discussion and Analysis of Financial Condition and Results of Operations (in thousands, except per share amounts). Adjusted Revenues Reconciliations of adjusted revenues to our revenues presented in accordance with GAAP on our Consolidated Statements of Income are presented below (in thousands): Excluding the impacts of incremental Olympic and Super Bowl revenue and Political advertising revenue, total company adjusted revenues on a comparable basis increased 16% in 2019. This is primarily attributable to increases in subscription revenue and increases in AMS revenue as described in the Results from Operations section above. Adjusted EBITDA - Non-GAAP Reconciliations of Adjusted EBITDA (inclusive and exclusive of Corporate expenses) to net income from continuing operations presented in accordance with GAAP on our Consolidated Statements of Income is presented below (in thousands): *** Not meaningful Adjusted EBITDA margin was 33% (without corporate expense) and 31% including corporate. Our total Adjusted EBITDA decreased $73.3 million or 9% in 2019 compared to 2018. Our Recent Acquisitions added $64.3 million of Adjusted EBITDA. Excluding the Recent Acquisitions, Adjusted EBITDA was lower by $137.6 million. This decrease was primarily driven by the operational factors discussed above within the revenue and operating expense fluctuation explanation sections, most notably, the expected decline of political revenue and absence of revenue associated with the Winter Olympics. Free cash flow reconciliation Our free cash flow, a non-GAAP liquidity measure, was $376.2 million for the year ended December 31, 2019, compared to $486.7 million for the same period in 2018. Our free cash flow in 2019 is lower compared to 2018 due to lower EBITDA, higher tax payments and higher purchases of property and equipment. Reconciliations from “Net income from continuing operations” to “Free cash flow” are presented below (in thousands): Forward Looking Financial Information As announced on January 9, 2020, we updated our full-year 2020 financial guidance on certain items including subscription revenue following the successful negotiation of significant distribution agreements during the fourth quarter of 2019, interest expense following the completion of our $1.0 billion refinancing in early 2020 and amortization expense following the completion of appraisals related to the Recent Acquisitions. We also updated our guidance regarding depreciation, capital expenditures, and leverage ratio. We now expect the following full-year 2020 guidance metrics: Full Year 2020 Key Guidance Metrics Including All Acquisitions As Reported1 Subscription Revenue + mid-twenties percent Political Revenue >$300 million Non-GAAP Corporate Expenses $41 - 43 million Depreciation $66 - 69 million Amortization $73 - 75 million Interest Expense $220 - 225 million Total Capital Expenditures2 $62 - 66 million Non-Recurring Cap Ex3 $20 - 24 million Effective Tax Rate 23.5 - 24.5% Leverage Ratio ~4.0x by year end (4.6x by mid-year) Free Cash Flow as a % of est. combined 2019/20 Revenue 19 - 20% Free Cash Flow as a % of est. combined 2020/21 Revenue 19 - 20% 1 Includes legacy TEGNA business and multicast networks Justice and Quest, Dispatch stations and Nexstar/Tribune station acquisitions subsequent to their acquisition dates; assumes no additional acquisitions or share buyback. 2 Prior to reimbursements for repack. 3 Approximately $7 million related to spectrum repacking; the remaining is related to investments in key projects such as our new master control, traffic streaming and monitoring platform. Preliminary 2021 Outlook During 2021, we anticipate the following revenue and Adjusted EBITDA guidance: • We expect total revenue to grow percentage-wise in the mid-to-high twenties in 2021 compared to 2019 (prior non-election cycle odd year), driven by our newly renegotiated retransmission rates, accretive acquisitions and ongoing revenue growth from Premion. • Projected 2021 subscription and AMS revenue growth will all but offset the expected decline of political revenue in 2021 (based on 2020 guided amount above). • Our 2021 Adjusted EBITDA margin is expected to be in line with the 2019 margin benefiting from approximately $50 million in incremental cost savings from initiatives underway. FINANCIAL POSITION Liquidity and capital resources Our operations have historically generated strong and dependable cash flows which, along with availability under our existing revolving credit facility, have been sufficient to fund our capital expenditures, interest expense, dividends, investments in strategic initiatives (including acquisitions) and other operating requirements. During 2019, we used these sources of cash to opportunistically access the credit markets to complete the following four acquisitions with an aggregate purchase price of approximately $1.5 billion: • Nexstar Stations: On September 19, 2019, we completed the acquisition of 11 local television stations, including eight Big Four Affiliates from Nexstar Media Group. The purchase price was approximately $769.1 million and was financed through the use of a portion of a $1.1 billion Senior Notes issued on September 13, 2019 and borrowing under our revolving credit facility. • Dispatch Stations: On August 8, 2019, we completed the acquisition of Dispatch Broadcast Group’s two top-rated television stations and two radio stations. The purchase price was approximately $560.5 million which was financed through available cash and borrowing under our revolving credit facility. • Justice and Quest Multicast Networks: On June 18, 2019, we completed the acquisition of the remaining approximately 85% interest that we did not previously own in the multicast networks Justice Network and Quest from Cooper Media. Cash paid for this transaction was $77.1 million and was funded through available cash and borrowing under our revolving credit facility. • Gray stations: On January 2, 2019, we completed the acquisition of two television stations, WTOL, the CBS affiliate in Toledo, OH, and KWES, the NBC affiliate in Midland-Odessa from Gray Television, Inc. for approximately $109.9 million. The acquisition was funded through the use of available cash and borrowings under our revolving credit facility. As we summarize in the Long-term debt section below, during 2019 we completed several strategic actions which have positioned us to continue to pursue strategic acquisition opportunities that may develop in our sector, invest in new content and revenue initiatives, and grow revenue in fiscal year 2020. Over the longer term, we expect to continue to fund debt maturities, acquisitions and investments through a combination of cash flows from operations, borrowings under our revolving credit facility and funds raised in the capital markets. Since 2017, we have been paying a regular quarterly cash dividend of $0.07 per share. We paid dividends totaling $60.6 million in 2019 and $60.3 million in 2018. We expect to continue paying comparable regular cash dividends in the future. The rate and frequency of future dividends will depend on future earnings, capital requirements and financial condition and other factors considered relevant by our Board of Directors. Our financial and operating performance, as well as our ability to generate sufficient cash flow to maintain compliance with credit facility covenants, are subject to certain risk factors; see Item 1A. “Risk Factors” for further discussion. As of December 31, 2019, we were in compliance with all covenants contained in our debt agreements and credit facility. As of December 31, 2019, our leverage ratio, calculated in accordance with our revolving credit agreement and term loan agreements, was 4.72x, well below the permitted leverage ratio of less than 5.5x. The following table provides a summary of our cash flow information for the three years ended December 31, 2019 followed by a discussion of the key elements of our cash flows (in thousands): Operating Activities Cash flow from operating activities was $297.5 million in 2019, compared to $527.2 million in 2018. The $229.7 million net decrease in cash flow from operating activities was primarily due to a $195.1 million decrease in political revenue, for which customers pre-pay, the absence of the Olympics in 2018 and lower Super Bowl related revenue, and a decline in certain payables and accruals (due to refunds paid to certain Premion customers and the payment of legal fees related to the Department of Justice matter described in Note 13 of the consolidated financial statements). Also contributing to the decline was an increase in tax payments of $21.2 million. These amounts were partially offset by a decline in pension payments of $22.1 million. Investing Activities Cash flow used for investing activities was $1.56 billion in 2019, compared to $374.4 million in 2018. The increase of $1.19 billion was primary due to cash used in 2019 for Recent Acquisitions. In 2019, we used $1.51 billion for the acquisition of the Gray Stations, Justice/Quest multicast networks, and the Dispatch and Nexstar stations as compared to the 2018 acquisition of KFMB for $328.4 million. Financing Activities Cash flow provided by financing activities was $1.16 billion in 2019, compared to cash used for financing of $145.0 million in 2018. The change was primarily due to the issuance of $1.1 billion of Senior Notes in 2019. The proceeds from this note offering were used to finance a portion of the acquisition of the Nexstar Stations, and along with borrowing under the revolving credit facility, were used to repay the remaining $320 million of notes due in October 2019 and early repay $290 million of our $600 million unsecured notes due in July 2020. Debt repayments in 2018 were $121.1 million. In 2019, we had net borrowings of $853.0 million on our revolving credit facility as compared to $50 million in 2018. The borrowings in 2019 were primarily used to finance the Recent Acquisitions while the 2018 borrowings were primarily used to partially finance the acquisition of KFMB. For a comparative discussion of changes in our cash flow comparing the years ended December 31, 2018 and December 31, 2017, see “Part II, Item 7. Financial Position” of our annual report on Form 10-K for the year ended December 31, 2018, filed with the SEC on March 1, 2019. Long-term debt As of December 31, 2019, our total principal debt outstanding was $4.2 billion, cash and cash equivalents totaled $29.4 million, and we had unused borrowing capacity of $594.8 million under our revolving credit facility. As of December 31, 2019, approximately $3.18 billion, or 76%, of our debt has a fixed interest rate. During 2019, we completed several strategic actions which have positioned us to continue to pursue strategic acquisition opportunities that may develop in our sector, invest in new content and revenue initiatives, and grow revenue in fiscal year 2020. See “Note 6 Long-term debt” to our consolidated financial statements for a table summarizing the components of our long-term debt. Our primary source for funding short-term cash requirements is our revolving credit facility. On August 15, 2019, we amended our revolving credit facility. Under the amended terms, the $1.51 billion of revolving credit commitments and letter of credit commitments have been extended until August 15, 2024. The amendment increased our permitted total leverage ratio as follows: The amendment also increased the amount of unrestricted cash that we are allowed to offset debt by in our leverage ratio calculation to $500.0 million. Under our revolving credit facility, we may borrow at an applicable margin above the Eurodollar base rate (LIBOR loan) or the higher of the Prime Rate, the Federal Funds Effective Rate plus 0.50%, or the one month LIBOR rate plus 1.00% (ABR loan). The applicable margin is determined based on our leverage ratio but differs between LIBOR loans and ABR loans. For LIBOR-based borrowing, the margin varies from 1.75% to 2.50%. For ABR-based borrowing, the margin will vary from 0.75% to 1.50%. Total commitments are $1.51 billion. On September 13, 2019, we completed a private placement offering of $1.1 billion aggregate principal amount of unsecured notes bearing an interest rate of 5.00% which are due in September 2029. The proceeds from this note offering were used to finance a portion of the acquisition of the Nexstar Stations, and along with borrowing under the revolving credit facility, were used to repay the remaining $320 million of notes bearing fixed rate interest at 5.125% which had become due in October 2019. Additionally we early repaid $290 million of our $600 million unsecured notes bearing fixed interest at 5.125% which are due in July 2020. On January 9, 2020 we completed a private placement offering of $1.0 billion senior notes bearing an interest rate of 4.625% which are due in March 2028. These senior notes, as well as those issued in September 2019, include customary market covenants and call provisions consistent with our past issuances. On February 11, 2020 we used the net proceeds to repay the remaining $310 million principal amount of our 5.125% Senior Notes due 2020, the $650 million principal amount of our 6.375% Senior Notes due 2023, a $13.8 million call premium on our 6.375% Senior Notes due 2023 and borrowings under our revolving credit facility. We also have an effective shelf registration statement on Form S-3 on file with the U.S. Securities and Exchange Commission under which an unspecified amount of securities may be issued, subject to a $7.0 billion limit established by the Board of Directors. Proceeds from the sale of such securities may be used for general corporate purposes, including capital expenditures, working capital, securities repurchase programs, repayment of debt and financing of acquisitions. We may also invest borrowed funds that are not required for other purposes in short-term marketable securities. We expect our existing cash and cash equivalents, cash flow from our operations, and borrowing capacity under the revolving credit facility will be sufficient to satisfy our debt service obligations, capital expenditure requirements, and working capital needs for the next twelve months. Our debt maturities may be repaid with cash flow from operating activities, accessing capital markets or a combination of both. The following schedule of annual maturities of the principal amount of total debt assumes we use available capacity under our revolving credit facility to refinance unsecured floating rate term loans payments and unsecured notes due in 2020 and 2021 to the extent of the then undrawn capacity. Based on this refinancing assumption, all maturities repaid utilizing the revolver in 2020 and 2021 are reflected as maturities for 2024, the year the revolving credit facility expires (in thousands). (1) Debt payments due in 2020 and 2021 are assumed to be repaid with funds from the revolving credit facility, up to our maximum borrowing capacity. The revolving credit facility expires in 2024. Excluding our ability to repay funds with the revolving credit facility, contractual debt maturities are $435 million in 2020, $350 million in 2021, $650 million in 2023 and $1.2 billion in 2024. (2) Assumes the then current revolving credit facility borrowings come due in 2024 and the revolving credit facility is not extended. Contractual obligations and commitments The following table summarizes the expected cash outflows resulting from financial contracts and commitments as of the end of 2019 (in thousands). (1) Long-term debt includes scheduled principal payments only. We have contractual debt maturities of $435.0 million in 2020. See Note 6 to the consolidated financial statements for further information. (2) Interest on the senior notes is based on the stated cash coupon rate and excludes the amortization of debt issuance discount. The floating rate term loan interest rates are based on the actual rates as of December 31, 2019. We have $903.0 million of outstanding borrowings under our revolving credit facility as of December 31, 2019. We have not included estimated interest payments in the table above since payments into and out of the credit facility change daily. For illustrative purposes, assuming the December 31, 2019 revolving credit facility balance does not change during 2020 and rates remain at the same level as those existing as of December 31, 2019, we estimate interest payments in 2020 would be approximately $38.8 million. (3) See Note 8 to the consolidated financial statements. (4) Our talent and employment contracts primarily secure our on-air talent and other personnel for our television stations through multi-year talent and employment agreements. We expect our contracts will be renewed or replaced with similar agreements upon their expiration. Amounts due under the contracts, assuming the contracts are not terminated prior to their expiration, are included in the contractual commitments table. (5) Includes purchase obligations pertaining to technology related capital projects, news and market data services, and other legally binding commitments. Amounts which we are liable for under purchase orders outstanding as of December 31, 2019 are reflected in the Consolidated Balance Sheets as accounts payable and accrued liabilities and are excluded from the table above. (6) Programming contracts include television station commitments to purchase programming to be produced in future years. This also includes amounts related to our network affiliation agreements. Network affiliation agreements may include variable fee components such as subscriber levels, which in have been estimated and reflected in the table above. (7) Other noncurrent liabilities consist of both unfunded and under-funded postretirement benefit plans. Unfunded plans include the TEGNA Supplemental Retirement Plan and the TEGNA Retiree Welfare Plan. Employer contributions, which equal the expected benefit payments, are reflected in the table above over the next ten-year period. Our under-funded pension plan is the TEGNA Retirement Plan (TRP). In 2020, we expect no contributions to the TRP and $6.7 million to the SERP. TRP contributions beyond the next fiscal year are excluded due to uncertainties regarding significant assumptions involved in estimating these contributions, such as interest rate levels as well as the amount and timing of invested asset returns. Due to uncertainty with respect to the timing of future cash flows associated with unrecognized tax benefits as of December 31, 2019, we are unable to make reasonably reliable estimates of the period of cash settlement. Therefore, approximately $8.1 million of unrecognized tax benefits have been excluded from the contractual obligations table above. See Note 5 to the consolidated financial statements for a further discussion of income taxes. Off-Balance Sheet Arrangements Off-balance sheet arrangements as defined by the Securities and Exchange Commission include the following four categories: obligations under certain guarantee contracts; retained or contingent interests in assets transferred to an unconsolidated entity or similar arrangements that serve as credit, liquidity or market risk support; obligations under certain derivative arrangements classified as equity; and obligations under material variable interests. As of December 31, 2019, we had no material off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources. Capital stock On September 19, 2017, our Board of Directors authorized a new share repurchase program for up to $300.0 million of our common stock over the next three years. As of December 31, 2019, we have $279.1 million remaining under this authorization. As a result of our Recent Acquisitions during 2019, we have suspended share repurchases under this program. The table below summarizes our share repurchases during the past three years (in thousands). The shares may be repurchased at management’s discretion, either in the open market or in privately negotiated block transactions. Management’s decision to repurchase shares will depend on price and other corporate developments. Purchases may occur from time to time and no maximum purchase price has been set. Certain of the shares we previously acquired have been reissued in settlement of employee stock awards. Our common stock outstanding as of December 31, 2019, totaled 217,463,550 shares, compared with 215,758,630 shares as of December 31, 2018. Critical accounting policies and the use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe the following discussion addresses our most critical accounting policies, which are those that are material to the presentation of our financial condition and results of operations and require management’s most subjective and complex judgments. This commentary should be read in conjunction with our consolidated financial statements, selected financial data and the remainder of this Form 10-K. Goodwill: As of December 31, 2019, our goodwill balance was $3.0 billion and represented approximately 42% of our total assets. Goodwill represents the excess of acquisition cost over the fair value of assets acquired, including identifiable intangible assets, net of liabilities assumed. Goodwill is tested for impairment at a level referred to as the reporting unit. A reporting unit is a business for which discrete financial information is available and segment management regularly reviews the operating results. The level at which we test goodwill for impairment requires us to determine whether the operations below the operating segment level constitute a reporting unit. We have determined that our one segment, Media, consists of a single reporting unit. Goodwill is tested for impairment on an annual basis (first day of our fourth quarter) or between annual tests if events or changes in circumstances occurred that indicate the fair value of a reporting unit may be below its carrying amount. Before performing the annual goodwill impairment test quantitatively, we first have the option to perform a qualitative assessment to determine if the quantitative test must be completed. The qualitative assessment considers events and circumstances such as macroeconomic conditions, industry and market conditions, cost factors and overall financial performance, as well as company and specific reporting unit specifications. If after performing this assessment, we conclude it is more likely than not that the fair value of a reporting unit is less than its carrying amount, then we are required to perform the quantitative test. Otherwise, the quantitative test is not required. In 2019, we elected not to perform the optional qualitative assessment of goodwill and instead performed the quantitative impairment test. When performing the quantitative test, we determine the fair value of the reporting unit and compare it to the carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds the fair value of the reporting unit, the reporting unit’s goodwill is impaired and we recognize an impairment loss equal to the difference between the reporting unit’s carrying amount and fair value. We estimate the fair value of our one reporting unit based on a market-based valuation methodology, which is primarily based on our consolidated market capitalization plus a control premium. In the fourth quarter of 2019, we completed our annual goodwill impairment test for our reporting unit. The results of the test indicated that the estimated fair value of our reporting unit significantly exceeded the carrying value. For our reporting unit, the estimated value would need to decline by over 50% to fail the quantitative goodwill impairment test. We do not believe that the reporting unit is currently at risk of incurring a goodwill impairment in the foreseeable future. Impairment assessment inherently involves management judgments regarding the assumptions described above. Fair value of the reporting unit also depends on the future strength of the economy in our principal media markets. New and developing competition as well as technological change could also adversely affect future fair value estimates. Due to the many variables inherent in the estimation of the reporting unit’s fair value and the relative size of our recorded goodwill, differences in assumptions could have a material effect on the estimated fair value of our reporting unit and could result in a goodwill impairment charge in a future period. Indefinite Lived Intangibles: Consist entirely of FCC broadcast licenses related to our acquisitions of television stations. As of December 31, 2019, indefinite lived intangible assets were $2.1 billion and represented approximately 30% of our total assets. The FCC broadcast licenses are recorded at their estimated fair value as of the date of the business acquisition. We determine the fair value of each FCC broadcast license using an income approach referred to as the Greenfield method. The Greenfield method utilizes a discounted cash flow model that incorporates several key assumptions, including market revenues, long-term growth projections, estimated market share for a typical market participant, estimated profit margins based on market size and station type, and a discount rate (determined using a weighted average cost of capital). Since these licenses are considered indefinite lived intangible assets we do not amortize them, rather they are tested for impairment annually (on the first day of our fourth quarter), or more often if circumstances dictate, for impairment and written down to fair value as required. We have the option to first perform a qualitative assessment to determine if it is more likely than not that the fair value of the indefinite lived asset is more than its carrying amount. If that is the case, then we do not need to perform the quantitative analysis. The qualitative assessment considers trends in macroeconomic conditions, industry and market conditions, cost factors and overall financial performance of the indefinite lived asset. In 2019, we elected to perform the optional qualitative assessment for all of our licenses, including our FCC license from the KFMB acquisition (which had limited headroom in 2018 due to the fact that we had recently recorded the intangible asset at fair value upon acquiring the station in February of 2018). In performing the qualitative impairment analysis, we analyzed trends in the significant inputs used in the fair value determination of the FCC license assets. This included reviewing trends in market revenues, market share, profit margins, long-term expected growth rates, and changes in discount rate. The results of our qualitative procedures showed improvement in the significant inputs from the prior year (including those related to the KFMB FCC license). As such, we concluded it was more likely than not that the fair value of all of our indefinite lived FCC broadcast licenses was more than their carrying amounts. As such, we did not perform a quantitative test in 2019. Pension Liabilities: Certain employees participate in qualified and non-qualified defined benefit pension plans (see Note 7 to consolidated financial statements). Our principal defined benefit pension plan is the TEGNA Retirement Plan (TRP). We also sponsor the TEGNA Supplemental Retirement Plan (SERP) for certain employees. Substantially all participants in the TRP and SERP had their benefits frozen before 2009, and in December 2017, we froze all remaining accruing benefits for certain grandfathered SERP participants. We recognize the net funded status of these postretirement benefit plans as a liability on our Consolidated Balance Sheets. There is a corresponding non-cash adjustment to accumulated other comprehensive loss, net of tax benefits recorded as deferred tax assets, in stockholders’ equity. The funded status represents the difference between the fair value of each plan’s assets and the benefit obligation of the plan. The benefit obligation represents the present value of the estimated future benefits we currently expect to pay to plan participants based on past service. The plan assets and benefit obligations are measured as of December 31 of each year, or more frequently, upon the occurrence of certain events such as a plan amendment, settlement, or curtailment. The amounts we record are measured using actuarial valuations, which are dependent upon key assumptions such as discount rates, participant mortality rates and the expected long-term rate of return on plan assets. The assumptions we make affect both the calculation of the benefit obligations as of the measurement date and the calculation of net periodic pension expense in subsequent periods. When reassessing these assumptions we consider past and current market conditions and make judgments about future market trends. We also consider factors such as the timing and amounts of expected contributions to the plans and benefit payments to plan participants. The most important assumptions include the discount rate applied to pension plan obligations and the expected long-term rate of return on plan assets related for the TRP (the SERP is an unfunded plan). The discount rate assumption is based on investment yields available at year-end on corporate bonds rated AA and above with a maturity to match the expected benefit payment stream. A decrease in discount rates would increase pension obligations. We establish the expected long-term rate of return by developing a forward-looking, long-term return assumption for each pension fund asset class, taking into account factors such as the expected real return for the specific asset class and inflation. A single, long-term rate of return is then calculated as the weighted average of the target asset allocation percentages and the long-term return assumption for each asset class. We apply the expected long-term rate of return to the fair value of its pension assets in determining the dollar amount of its expected return. Changes in the expected long-term return on plan assets would increase or decrease pension plan expense. For 2019, we assumed a rate of 6.75% for our long-term expected return on pension assets used for our TRP plan. As an indication of the sensitivity of pension expense to the long-term rate of return assumption, a plus or minus 50 basis points change in the expected rate of return on pension assets (with all other assumptions held constant) would have decreased or increased estimated pension plan expense for 2019 by approximately $1.9 million. The effects of actual results differing from these assumptions are accumulated as unamortized gains and losses. For the December 31, 2019 measurement, the assumption used for the discount rate was 3.30% for our principal retirement plan. As an indication of the sensitivity of pension liabilities to the discount rate assumption, a plus or minus 50 basis points change in the discount rate as of the end of 2019 (with all other assumptions held constant) would have decreased or increased plan obligations by approximately $28.0 million. For 2019, the discount rate used to determine the pension expense was 4.35%. A 50 basis points change in this discount rate would have changed total pension plan expense for 2019 by approximately $0.4 million. Income Taxes: Our annual tax rate is based on our income, statutory tax rates, and tax planning opportunities available in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax expense and in evaluating our tax positions. Tax law requires certain items to be included in our tax returns at different times than when the items are reflected in the financial statements. The annual tax expense reflected in the Consolidated Statements of Income is different than that reported in our tax returns. Some of these differences are permanent (for example, expenses recorded for accounting purposes that are not deductible in the returns such as certain entertainment expenses) and some differences are temporary and reverse over time, such as depreciation expense. Temporary differences create deferred tax assets and liabilities. Deferred tax liabilities generally represent tax expense recognized in the financial statements for which payment has been deferred, or expense for which a deduction has been taken already in the tax return but the expense has not yet been recognized in the financial statements. Deferred tax assets generally represent items that can be used as a tax deduction or credit in tax returns in future years for which a benefit has already been recorded in the financial statements, as well as tax losses that can be carried over and used in future years. Valuation allowances are established when necessary to reduce deferred income tax assets to the amounts we believe are more likely than not to be recovered. In evaluating the amount of any such valuation allowance, we consider the existence of cumulative income or losses in recent years, the reversal of existing temporary differences, the existence of taxable income in prior carry back years, available tax planning strategies and estimates of future taxable income for each of our taxable jurisdictions. The latter two factors involve the exercise of significant judgment. As of December 31, 2019, deferred tax asset valuation allowances totaled $45.7 million, primarily related to minority investments, federal and state capital losses, state interest disallowance carryovers, and state net operating losses available for carry forward to future years. Although realization is not assured, we believe it is more likely than not that all other deferred tax assets for which no valuation allowances have been established will be realized. This conclusion is based on our history of cumulative income in recent years and review of historical and projected future taxable income. We determine whether it is more likely than not that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit is recorded in our financial statements. A tax position is measured as the portion of the tax benefit that is greater than 50% likely to be realized upon settlement with a taxing authority (that has full knowledge of all relevant information). We may be required to change our provision for income taxes when the ultimate treatment of certain items is challenged or agreed to by taxing authorities, when estimates used in determining valuation allowances on deferred tax assets significantly change, or when receipt of new information indicates the need for adjustment in valuation allowances. Future events, such as changes in tax laws, tax regulations, or interpretations of such laws or regulations, could have an impact on the provision for income tax and the effective tax rate. Any such changes could significantly affect the amounts reported in the consolidated financial statements in the year these changes occur.

<s>[INST] We are an innovative media company that serves the greater good of our communities. Our business includes 62 television stations and four radio stations in 51 U.S. markets, we are the largest owner of top four network affiliates in the top 25 markets among independent station groups, reaching approximately 39% of U.S. television households. Each television station also has a robust digital presence across online, mobile and social platforms, reaching consumers whenever, wherever they are. We have been consistently honored with the industry’s top awards, including Edward R. Murrow, George Polk, Alfred I. DuPont and Emmy Awards. Through TEGNA Marketing Solutions (TMS), our integrated sales and backend fulfillment operations, we deliver results for advertisers across television, email, social, and Over the Top (OTT) platforms, including Premion, our OTT advertising network. We have one operating and reportable segment. The primary sources of our revenues are: 1) advertising & marketing services (AMS) revenues, which include local and national nonpolitical television advertising, digital marketing services (including Premion), and advertising on the stations’ websites and tablet and mobile products; 2) subscription revenues, reflecting fees paid by satellite, cable, OTT (companies that deliver video content to consumers over the Internet) and telecommunications providers to carry our television signals on their systems; 3) political advertising revenues, which are driven by even year election cycles at the local and national level (e.g. 2020, 2018) and particularly in the second half of those years; and 4) other services, such as production of programming and advertising material. Our revenues and operating results are subject to seasonal fluctuations. Generally, our second and fourth quarter revenues and operating results are stronger than those we report for the first and third quarter. This is driven by the second quarter reflecting increased spring seasonal advertising, while the fourth quarter typically includes increased advertising related to the holiday season. In even years, our advertising revenue benefits significantly from the Olympics when carried on NBC, our largest network affiliation. To a lesser extent, the Super Bowl can influence our advertising results, the degree to which depending on which network broadcast’s the event. In addition, our revenue and operating results are subject to significant fluctuations across yearly periods resulting from political advertising. In even numbered years, political spending is usually significantly higher than in odd numbered years due to advertising for the local and national elections. Additionally, every four years, we typically experience even greater increases in political advertising in connection with the presidential election. The strong demand for advertising from political advertisers in these even years can result in the significant use of our available inventory (leading to a “crowd out” effect), which can diminish our AMS revenue from our nonpolitical advertising customers in the even year of a two year election cycle, particularly in the fourth quarter of those years. As discussed above in “Business Overview” section of Item 1, during 2019 we acquired multiple local television stations and two multicast networks in four different business acquisitions for an aggregate purchase price of approximately $1.5 billion. The four acquisitions are collectively referred to as the “Recent Acquisitions” in the results of operations discussion that follows. The inclusion of the operating results from these Recent Acquisitions for the periods subsequent to their acquisition impacts the yeartoyear comparability of our consolidated operating results in 2019. Consolidated Results from Operations The following discussion is a comparison of our consolidated results on a GAAP basis. The yeartoyear comparison of financial results is not necessarily indicative of future results. In addition, see the section on page 23 titled ‘Operating results non GAAP information’ for additional tables presenting information which supplements our financial information provided on a GAAP basis. For a comparative discussion of our results of operations for the years ended December 31, 2018 and December 31, 2017, see “Part II, Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our annual report on Form 10K for the year ended December 31, 2018, filed with the SEC on March 1, 2019. A consolidated summary of our results is presented below (in thousands [/INST] Negative. </s>

HUMANA INC

2015-02-18

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Executive Overview General Humana Inc., headquartered in Louisville, Ky., is a leading health and well-being company focused on making it easy for people to achieve their best health with clinical excellence through coordinated care. Our strategy integrates care delivery, the member experience, and clinical and consumer insights to encourage engagement, behavior change, proactive clinical outreach and wellness for the millions of people we serve across the country. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, which excludes depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Business Segments On January 1, 2014, we reclassified certain of our businesses from our Healthcare Services segment to our Employer Group segment to correspond with internal management reporting changes. Our reportable segments remain the same and prior period segment financial information has been recast to conform to the 2014 presentation. This is further described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We manage our business with three reportable segments: Retail, Employer Group, and Healthcare Services. In addition, the Other Businesses category includes businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on well-being solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources. The Retail segment consists of Medicare and commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and financial protection products, marketed directly to individuals, and includes our contract with CMS to administer the LI-NET prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and Long-Term Support Services benefits, collectively our state-based contracts. The Employer Group segment consists of Medicare and commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and voluntary benefit products, as well as administrative services only, or ASO, products and our health and wellness products primarily marketed to employer groups. The Healthcare Services segment includes services offered to our health plan members as well as to third parties including pharmacy solutions, provider services, home based services, integrated behavioral health services, and predictive modeling and informatics services. The Other Businesses category consists of our military services, primarily our TRICARE South Region contract, Puerto Rico Medicaid, and closed-block long-term care insurance policies. The results of each segment are measured by income before income taxes. Transactions between reportable segments consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, home based, and behavioral health, to our Retail and Employer Group customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often utilize the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at the corporate level. These corporate amounts are reported separately from our reportable segments and included with intersegment eliminations. Seasonality One of the product offerings of our Retail segment is Medicare stand-alone prescription drug plans, or PDPs, under the Medicare Part D program. Our quarterly Retail segment earnings and operating cash flows are impacted by the Medicare Part D benefit design and changes in the composition of our membership. The Medicare Part D benefit design results in coverage that varies as a member’s cumulative out-of-pocket costs pass through successive stages of a member’s plan period, which begins annually on January 1 for renewals. These plan designs generally result in us sharing a greater portion of the responsibility for total prescription drug costs in the early stages and less in the latter stages. As a result, the PDP benefit ratio generally decreases as the year progresses. In addition, the number of low-income senior members as well as year-over-year changes in the mix of membership in our stand-alone PDP products affects the quarterly benefit ratio pattern. Our Employer Group segment also experiences seasonality in the benefit ratio pattern. However, the effect is opposite of Medicare stand-alone PDP in the Retail segment, with the Employer Group’s benefit ratio increasing as fully-insured members progress through their annual deductible and maximum out-of-pocket expenses. Similarly, certain of our fully-insured individual commercial medical products in our Retail segment experience seasonality in the benefit ratio akin to the Employer Group segment, including the effect of existing members transitioning to policies compliant with the Health Care Reform Law. In addition, the Retail segment also experiences seasonality in the operating cost ratio as a result of costs incurred in the second half of the year associated with the Medicare and individual health care exchange marketing seasons. 2014 Highlights Consolidated • Our 2014 results reflect the continued implementation of our strategy to offer our members affordable health care combined with a positive consumer experience in growing markets. At the core of this strategy is our integrated care delivery model, which unites quality care, high member engagement, and sophisticated data analytics. Our approach to primary, physician-directed care for our members aims to provide quality care that is consistent, integrated, cost-effective, and member-focused, provided by both employed physicians and physicians with network contract arrangements. A core element of the model is to offer assistance to providers in transitioning from a fee-for-service to a value-based arrangement. The model is designed to improve health outcomes and affordability for individuals and for the health system as a whole, while offering our members a simple, seamless healthcare experience. We believe this strategy is positioning us for long-term growth in both membership and earnings. At December 31, 2014, approximately 709,000 members, or 29.0%, of our individual Medicare Advantage membership were in risk arrangements under our integrated care delivery model, as compared to 561,500 members, or 27.1%, at December 31, 2013. • Year-over-year comparisons of our results were impacted by investments in health care exchanges and state-based contracts as well as higher specialty prescription drug costs associated with a new treatment for Hepatitis C, partially offset by membership growth in our Medicare Advantage, Medicare stand-alone PDP, and individual commercial medical offerings as well as increased membership in our clinical programs. • In September 2014, we paid the federal government $562 million for the annual health insurance industry fee. This fee is not deductible for tax purposes, which has significantly increased our effective income tax rate in 2014. Year-over-year comparisons of the operating cost ratio are negatively impacted by this and other fees mandated by the Health Care Reform Law beginning in 2014. Likewise, year-over-year comparisons of the benefit ratio reflect the inclusion of these mandated fees in the pricing of our products for 2014. In 2015, the health insurance industry fee increases by 41% for the industry taken as a whole. Accordingly, absent changes in market share, we would expect a 41% increase in our fee in 2015. The health insurance industry fee is further described below under the section titled “Health Care Reform.” • Year-over-year comparisons of diluted earnings per common share are favorably impacted by a lower number of shares used to compute diluted earnings per common share reflecting the impact of share repurchases. • Our operating cash flow of $1.6 billion for the year ended December 31, 2014 compared to operating cash flow of $1.7 billion for the year ended December 31, 2013. For 2014, the effect of the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law impacted the timing of our operating cash flows, as we built a receivable of $679 million in 2014 that is expected to be collected in 2015. • Our 2014 financing cash flows have been negatively impacted by the timing of payments to and receipts from CMS associated with Medicare Part D reinsurance subsidies for which we do not assume risk. Claims payments were $945 million higher than receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk during 2014. We are experiencing higher specialty prescription drug costs associated with a new treatment for Hepatitis C than were contemplated in our bids which is resulting in higher reinsurance subsidy receivable balances in 2014 that will be settled in 2015 under the terms of our contracts with CMS. • We continue to focus on disciplined capital allocation. In 2014, we issued senior notes and received net proceeds of $1.7 billion, redeemed our $500 million 6.45% senior notes for cash totaling approximately $560 million, repurchased 5.7 million shares of our common stock for $730 million in open market transactions (which excludes another $100 million of stock held back pursuant to an accelerated share repurchase program), and paid dividends to stockholders of $172 million. Retail Segment • On April 7, 2014, CMS announced final 2015 Medicare benchmark payment rates and related technical factors impacting the bid benchmark premiums, which we refer to as the Final Rate Notice. We believe the Final Rate Notices together with the impact of payment cuts associated with the Health Care Reform Law, quality bonuses, sunset of the Star quality CMS demonstration in 2015, risk coding modifications, the impact of the health insurance industry fee, and other funding formula changes, indicate 2015 Medicare Advantage funding cuts of approximately 2%. We believe we have effectively designed Medicare Advantage products based upon these levels of rate reduction while continuing to remain competitive compared to both the combination of Medicare FFS with a supplement policy as well as Medicare Advantage products offered by our competitors. Failure to execute these strategies may result in a material adverse effect on our results of operations, financial position, and cash flows. • Medicare Advantage premiums are tied to the achievement of certain quality performance measures (Star Ratings). Beginning in 2015, plans must have a Star Rating of four or higher to qualify for bonus money. Star Ratings issued by CMS in October 2014 indicated that plans covering 92% of our Medicare Advantage membership for the 2015 plan year achieved a Star Rating of 4.0 or higher. We have 23 Medicare Advantage plans that achieved a rating of four or more stars, an increase from 18 the previous year. We are offering one Medicare Advantage plan that achieved a 5.0 Star Rating, our CarePlus Health Plans, Inc. HMO plan in Florida, as well as five Medicare Advantage plans that achieved a 4.5 Star Rating. Plans that earn an overall Star Rating of five become eligible to enroll members year round. • As discussed in the detailed Retail segment results of operations discussion that follows, for the year ended December 31, 2014, our Retail segment pretax income declined by 14.4% primarily due to the same factors discussed above for our consolidated results. • Individual Medicare Advantage membership increased 377,500 members, or 18.2%, from December 31, 2013 to December 31, 2014 reflecting net membership additions, particularly for our HMO offerings, for the 2014 plan year as well as dual eligible members from state-based contracts in Virginia and Illinois. January 1, 2015 individual Medicare Advantage membership increased approximately 257,000 members, or 10.5%, from December 31, 2014 reflecting net membership additions for the 2015 enrollment season, primarily in our HMO offerings. • Medicare stand-alone PDP membership increased 717,800 members, or 21.9%, from December 31, 2013 to December 31, 2014 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2014 plan year. January 1, 2015 Medicare stand-alone PDP membership, excluding the LI-NET prescription drug plan program, increased approximately 230,500 members, or 5.8%, from December 31, 2014 reflecting net membership additions for the 2015 enrollment season. • Our state-based Medicaid membership as of December 31, 2014 increased 213,000 members from December 31, 2013, primarily due to the addition of members under our Florida Medicaid and Florida Long-Term Support Services contracts. • Individual commercial medical membership of 1,148,100 at December 31, 2014 increased 548,000 members, or 91.3%, from December 31, 2013 primarily reflecting new sales, both on-exchange and off-exchange, of plans compliant with the Health Care Reform Law. At December 31, 2014, individual commercial medical membership in plans compliant with the Health Care Reform Law, both on-exchange and off-exchange, was 686,300 members. In addition, federal and state regulatory changes in December 2013 allowed certain individuals to remain in their existing underwritten health plans that are not compliant with the Health Care Reform Law, which has led to much higher than previously expected retention of our existing underwritten health plans. We believe that this is occurring at other health insurance issuers as well and will result in an overall deterioration of the risk pool in plans compliant with the Health Care Reform Law, as more previously underwritten members remain with their current health plans rather than enter the exchanges. However, we expect that the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law will mitigate this deterioration to some extent. Employer Group Segment • As discussed in the detailed Employer Group segment results of operations discussion that follows, the Employer Group segment pretax income declined 10.3% for the year ended December 31, 2014 primarily reflecting higher utilization, mainly due to higher specialty prescription drug costs associated with a new treatment for Hepatitis C, as well as the continuing impact of transitional policy changes which allowed individuals to remain in plans not compliant with the Health Care Reform Law. • Fully-insured group Medicare Advantage membership of 489,700 at December 31, 2014 increased 60,600 members, or 14.1%, from 429,100 at December 31, 2013 primarily due to the January 2014 addition of a new large group account. • Membership in HumanaVitality®, our wellness and loyalty rewards program, rose 36.2% to 3,856,800 at December 31, 2014 from 2,831,000 at December 31, 2013 primarily due to the addition of group Medicare members as well as individual Medicare Advantage and fully-insured individual commercial medical membership growth. Healthcare Services Segment • As discussed in the detailed Healthcare Services segment results of operations discussion that follows, our Healthcare Services segment pretax income improved 41.8% for the year ended December 31, 2014 primarily due to a decline in the operating cost ratio in 2014 on a revenue base that reflects growth from our pharmacy solutions and home based services businesses as they serve our growing Medicare membership. • Programs to enhance the quality of care for members are key elements of our integrated care delivery model. We have accelerated our process for identifying and reaching out to members in need of clinical intervention. At December 31, 2014, we had approximately 420,700 members with complex chronic conditions in the Humana Chronic Care Program, a 50.1% increase compared with approximately 280,200 members at December 31, 2013, reflecting enhanced predictive modeling capabilities and focus on proactive clinical outreach and member engagement, particularly for our Medicare Advantage membership. We believe these initiatives lead to better health outcomes for our members and lower health care costs. Other Businesses • Year-over-year comparisons within Other Businesses are impacted by the loss of our Medicaid contracts in Puerto Rico effective September 30, 2013 and a reduction in benefits expense in 2013 related to a favorable settlement of contract claims with the United States Department of Defense, or DoD, associated with previously disclosed litigation. In addition, as discussed in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, during 2013, we recorded net benefits expense of $243 million ($154 million after-tax, or $0.99 per diluted common share) for reserve strengthening related to our non-strategic closed-block of long-term care insurance policies acquired in connection with the 2007 acquisition of KMG. Health Care Reform The Health Care Reform Law enacted significant reforms to various aspects of the U.S. health insurance industry. Implementation dates of the Health Care Reform Law began in September 2010 and will continue through 2018, and many aspects of the Health Care Reform Law are already effective and have been implemented by us. Certain significant provisions of the Health Care Reform Law include, among others, mandated coverage requirements, mandated benefits and guarantee issuance associated with commercial medical insurance, rebates to policyholders based on minimum benefit ratios, adjustments to Medicare Advantage premiums, the establishment of federally-facilitated or state-based exchanges coupled with programs designed to spread risk among insurers, an annual insurance industry premium-based assessment, and a three-year commercial reinsurance fee. Certain provisions of the Health Care Reform Law became effective in 2014, including: • All individual and group health plans must guarantee issuance and renew coverage without pre-existing condition exclusions or health-status rating adjustments; • The elimination of annual limits on coverage on certain benefits; • The establishment of federally-facilitated, federal-state partnerships or state-based exchanges for individuals and small employers (with up to 100 employees) coupled with programs designed to spread risk among insurers; • The introduction of plan designs based on set actuarial values; • The establishment of a minimum benefit ratio of 85% for Medicare Advantage plans with penalties up to and including termination of Medicare Advantage contracts for continued failure to meet the minimum; and • Insurance industry assessments, including an annual health insurance industry fee and a three-year $25 billion industry wide commercial reinsurance fee. The annual health insurance industry fee levied on the insurance industry is $8 billion in 2014 with increasing annual amounts thereafter, growing to $14 billion by 2017, and is not deductible for income tax purposes, which significantly increased our effective income tax rate in 2014 to approximately 47.2%. In 2014, we paid the federal government $562 million for the annual health insurance industry fee. In 2015, the health insurance industry fee increases by 41% for the industry taken as a whole. Accordingly, absent changes in market share, we would expect a 41% increase in our fee in 2015. In addition, statutory accounting for the health insurance industry fee required us to restrict surplus in the year preceding payment of the health insurance industry fee beginning in 2014. Accordingly, in addition to recording the full-year 2014 assessment in the first quarter of 2014, we were required to restrict surplus for the 2015 assessment ratably in 2014. The Health Care Reform Law also specifies benefit design guidelines, limits rating and pricing practices, encourages additional competition (including potential incentives for new market entrants), establishes federally-facilitated or state-based exchanges for individuals and small employers (with up to 100 employees) coupled with programs designed to spread risk among insurers (subject to federal administrative action), and expands eligibility for Medicaid programs (subject to state-by-state implementation of this expansion). In addition, the Health Care Reform Law has increased and will continue to increase federal oversight of health plan premium rates and could adversely affect our ability to appropriately adjust health plan premiums on a timely basis. Financing for these reforms comes, in part, from material additional fees and taxes on us (as discussed above) and other health plans and individuals which began in 2014, as well as reductions in certain levels of payments to us and other health plans under Medicare as described in this report. As discussed above, it is reasonably possible that the Health Care Reform Law and related regulations, as well as future legislative changes, including legislative restrictions on our ability to manage our provider network or otherwise operate our business, or regulatory restrictions on profitability, including by comparison of our Medicare Advantage profitability to our non-Medicare Advantage business profitability and a requirement that they remain within certain ranges of each other, in the aggregate may have a material adverse effect on our results of operations (including restricting revenue, enrollment and premium growth in certain products and market segments, restricting our ability to expand into new markets, increasing our medical and operating costs, further lowering our Medicare payment rates and increasing our expenses associated with the non-deductible health insurance industry fee and other assessments); our financial position (including our ability to maintain the value of our goodwill); and our cash flows (including the receipt of amounts due under the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law in 2015 related to claims paid in 2014, which payments may be subject to federal administrative action). We intend for the discussion of our financial condition and results of operations that follows to assist in the understanding of our financial statements and related changes in certain key items in those financial statements from year to year, including the primary factors that accounted for those changes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and behavioral health services, to our Retail and Employer Group customers and are described in Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Comparison of Results of Operations for 2014 and 2013 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2014 and 2013: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs as a percentage of total revenues less investment income. Summary Net income was $1.1 billion, or $7.36 per diluted common share, in 2014 compared to $1.2 billion, or $7.73 per diluted common share, in 2013. Net income for 2014 includes expenses of $0.15 per diluted common share associated with a loss on extinguishment of debt for the redemption of certain senior notes in 2014 and net income for 2013 includes benefits expense of $0.99 per diluted common share for reserve strengthening associated with our closed-block of long-term care insurance policies included with Other Businesses as discussed in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data as well as the benefit of a reduction in benefits expense in 2013 related to a favorable settlement of contract claims with the DoD. Excluding these items, the increase in net income primarily resulted from higher pretax income in our Healthcare Services segment substantially offset by lower pretax income in our Retail and Employer Group segments. In addition, 2014 was favorably impacted by a lower number of shares used to compute diluted earnings per common share reflecting the impact of share repurchases. Premiums Revenue Consolidated premiums increased $7.1 billion, or 18.4%, from 2013 to $46.0 billion for 2014 primarily due to increases in both Retail and Employer Group segment premiums mainly driven by higher average individual and group Medicare Advantage membership as well as higher individual commercial medical membership. In addition, year-over-year comparisons to the 2013 were negatively impacted by sequestration which became effective April 1, 2013. Premiums revenue for our Other Businesses declined primarily due to the loss of our Puerto Rico Medicaid contracts effective September 30, 2013. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Premiums revenue reflects changes in membership and average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership. Services Revenue Consolidated services revenue increased $55 million, or 2.6%, from 2013 to $2.2 billion for 2014 primarily due to an increase in services revenue in our Retail segment due to the acquisition of American Eldercare in September 2013. Investment Income Investment income totaled $377 million for 2014, an increase of $2 million from 2013, as higher average invested balances were partially offset by lower interest rates. Benefits Expense Consolidated benefits expense was $38.2 billion for 2014, an increase of $5.6 billion, or 17.2%, from 2013 primarily due to increases in both the Retail and Employer Group segments mainly driven by higher average individual and group Medicare Advantage membership as well as higher individual commercial medical membership. As more fully described herein under the section entitled “Benefits Expense Recognition”, actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $518 million in 2014 and $474 million in 2013. These increases in favorable medical claims reserve development primarily resulted from increased membership and better than originally expected utilization across most of our major business lines and increased financial recoveries. The increase in financial recoveries primarily resulted from claim audit process enhancements as well as increased volume of claim audits and expanded audit scope. All lines of business benefited from these improvements. The consolidated benefit ratio for 2014 was 83.0%, a decrease of 90 basis points from 2013 primarily due to reserve strengthening in 2013 associated with our closed-block of long-term care insurance policies included with Other Businesses as discussed above, as well as the loss of our Medicaid contracts in Puerto Rico effective September 30, 2013 which more than offset higher ratios year-over-year in the Retail and Employer Group segments. Operating Costs Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs increased $1,284 million, or 20.2%, in 2014 compared to 2013 primarily due to costs mandated by the Health Care Reform Law, including the non-deductible health insurance industry fee, and investments in health care exchanges and state-based contracts, partially offset by operating cost efficiencies. The consolidated operating cost ratio for 2014 was 15.9%, increasing 40 basis points from 2013 primarily due to increases in the operating cost ratios in our Retail and Employer Group segments due to the same factors impacting consolidated operating costs as described above. Depreciation and Amortization Depreciation and amortization for 2014 totaled $333 million, unchanged from 2013. Interest Expense Interest expense was $192 million for 2014 compared to $140 million for 2013, an increase of $52 million, or 37.1%. In September 2014, we issued $400 million of 2.625% senior notes due October 1, 2019, $600 million of 3.85% senior notes due October 1, 2024 and $750 million of 4.95% senior notes due October 1, 2044. In October 2014, we redeemed the $500 million 6.45% senior unsecured notes due June 1, 2016, at 100% of the principal amount plus applicable premium for early redemption and accrued and unpaid interest to the redemption date. We recognized a loss on extinguishment of debt, included in interest expense, of approximately $37 million in connection with the redemption of these notes. Income Taxes Our effective tax rate during 2014 was 47.2% compared to the effective tax rate of 35.9% in 2013. The non-deductible nature of the health insurance industry fee levied on the insurance industry beginning in 2014 as mandated by the Health Care Reform Law increased our effective tax rate by approximately 9.4 percentage points for 2014. See Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. Retail Segment (a) Individual commercial medical membership includes Medicare Supplement members. (b) Specialty products include dental, vision, and other supplemental health and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Retail segment pretax income was $1.1 billion in 2014, a decrease of $185 million, or 14.4%, compared to 2013 primarily driven by investment spending for health care exchanges and state-based contracts and higher specialty prescription drug costs associated with a new treatment for Hepatitis C, partially offset by Medicare Advantage and individual commercial medical membership growth as well as increased membership in our clinical programs. Enrollment • Individual Medicare Advantage membership increased 377,500 members, or 18.2%, from December 31, 2013 to December 31, 2014 reflecting net membership additions, particularly for our HMO offerings, for the 2014 plan year as well as dual eligible members from state-based contracts in Virginia and Illinois. Individual Medicare Advantage membership at December 31, 2014 includes 18,300 dual eligible members from state-based contracts. • Medicare stand-alone PDP membership increased 717,800 members, or 21.9%, from December 31, 2013 to December 31, 2014 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2014 plan year. • Individual commercial medical membership increased 548,000 members, or 91.3%, from December 31, 2013 to December 31, 2014 primarily reflecting new sales, both on-exchange and off-exchange, of plans compliant with the Health Care Reform Law. • State-based Medicaid membership increased 213,000 members, or 249.1%, from December 31, 2013 to December 31, 2014 primarily driven by the addition of members under our Florida Medicaid and Florida Long-Term Support Services contracts. • Individual specialty membership increased 123,300 members, or 11.8%, from December 31, 2013 to December 31, 2014 primarily driven by increased membership in dental and vision offerings. Premiums revenue • Retail segment premiums increased $6.8 billion, or 24.8%, from 2013 to 2014 primarily due to membership growth across all lines of business, particularly for our individual Medicare Advantage, individual commercial medical, primarily on the health care exchanges, and state-based Medicaid businesses. Individual Medicare Advantage average membership increased 17.0% in 2014. Individual Medicare Advantage per member premiums decreased approximately 1.4% in 2014 compared to 2013, primarily due to Medicare rate reductions and the impact of sequestration which became effective on April 1, 2013. Benefits expense • The Retail segment benefit ratio of 84.3% for 2014 increased 10 basis points from 2013 primarily due to higher specialty prescription drug costs associated with a new treatment for Hepatitis C, higher planned clinical investment spending, and higher benefit ratios associated with members from state-based contracts, partially offset by increased membership in our clinical programs and the inclusion of the health insurance industry fee in the pricing of our products. • The Retail segment’s benefits expense for 2014 included the beneficial effect of $385 million in favorable prior-year medical claims reserve development versus $332 million in 2013. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 110 basis points in 2014 versus approximately 120 basis points in 2013. Operating costs • The Retail segment operating cost ratio of 12.4% for 2014 increased 150 basis points from 2013 primarily due to the non-deductible health insurance industry fee mandated by the Health Care Reform Law and investment spending for health care exchanges and state-based contracts, partially offset by scale efficiencies from Medicare and individual commercial medical membership growth. Employer Group Segment (a) Specialty products include dental, vision, and other supplemental health and voluntary benefit products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Employer Group segment pretax income decreased $36 million, or 10.3%, to $314 million in 2014 primarily reflecting higher utilization, mainly due to higher specialty prescription drug costs associated with a new treatment for Hepatitis C, as well as the continuing impact of transitional policy changes which allowed individuals to remain in plans not compliant with the Health Care Reform Law. Enrollment • Fully-insured group Medicare Advantage membership increased 60,600 members, or 14.1%, from December 31, 2013 to December 31, 2014 primarily due to the addition of a new large group account. • Fully-insured commercial group medical membership decreased 1,500 members, or 0.1% from December 31, 2013 as an increase in small group business membership was generally offset by lower membership in large group accounts. Approximately 65% of our fully-insured commercial group medical membership was in small group accounts at December 31, 2014 compared to 61% at December 31, 2013. • Group ASO commercial medical membership decreased 58,500 members, or 5.0%, from December 31, 2013 to December 31, 2014 primarily due to continued pricing discipline in a highly competitive environment for self-funded accounts. We expect our group ASO commercial medical membership to decline by approximately 400,000 to 425,000 members January 1, 2015 primarily due to the loss of a few large group accounts. • Group specialty membership decreased 278,100 members, or 4.1%, from December 31, 2013 to December 31, 2014 primarily due to declines in dental and vision membership related to our planned discontinuance of certain unprofitable product distribution partnerships. Premiums revenue • Employer Group segment premiums increased $1.0 billion, or 9.2%, from 2013 to 2014 primarily due to higher average group Medicare Advantage membership as well as an increase in fully-insured commercial group medical premiums per member that more than offset a slight decline in total membership for this segment. Benefits expense • The Employer Group segment benefit ratio increased 40 basis points from 83.5% in 2013 to 83.9% in 2014 primarily due to higher utilization, mainly due to higher specialty prescription drug costs associated with a new treatment for Hepatitis C, as well as the continuing impact of transitional policy changes, partially offset by the inclusion of the health insurance industry fee and other fees mandated by the Health Care Reform Law in our pricing. • The Employer Group segment’s benefits expense included the beneficial effect of $132 million in favorable prior-year medical claims reserve development versus $138 million in 2013. This favorable prior-year medical claims reserve development decreased the Employer Group segment benefit ratio by approximately110 basis points in 2014 versus approximately 130 basis points in 2013. Operating costs • The Employer Group segment operating cost ratio of 16.1% increased 20 basis points from 2013. This increase primarily reflects the impact of the non-deductible health insurance industry fee and other fees mandated by the Health Care Reform Law as well as a higher percentage of small group commercial business which carries a higher operating cost ratio than large group business. These increases were partially offset by an increase in group Medicare Advantage membership which generally carries a lower operating cost ratio than our commercial group medical membership as well as operating cost efficiencies. Healthcare Services Segment Pretax results • Healthcare Services segment pretax income of $739 million for 2014 increased $218 million from 2013. The increase is primarily due to a decline in the operating cost ratio in 2014 on a revenue base that reflects growth from our pharmacy solutions and home based services businesses as they serve our growing Medicare membership. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Employer Group segment membership increased to approximately 329 million in 2014, up 20% versus scripts of approximately 274 million in 2013. The increase primarily reflects growth associated with higher average medical membership for 2014 than in 2013. Services revenue • Services revenue for 2014 were relatively unchanged from 2013, increasing $2 million, or 0.2% , to $1.3 billion for 2014. Intersegment revenues • Intersegment revenues increased $4.1 billion, or 28.2%, from 2013 to $18.7 billion for 2014 primarily due to growth in our Medicare membership which resulted in higher utilization of our pharmacy solutions and home based services businesses. Operating costs • The Healthcare Services segment operating cost ratio of 95.5% for 2014 decreased 30 basis points from 95.8% for 2013 primarily due to an improvement in the ratio for our pharmacy solutions business partially offset by our investment in home based services and other businesses across the segment. Other Businesses Our Other Businesses pretax income of $78 million for 2014 compared to a pretax loss of $193 million for 2013. The pretax loss in 2013 included net expense of $243 million for reserve strengthening for our closed-block of long-term care insurance policies further discussed in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. In addition, from time to time, we evaluate alternatives for our businesses that do not meet our strategic, growth or profitability objectives. Among the businesses that we are currently evaluating is our closed block of long-term care insurance policies business. While no decision has been made with respect to any course of action, if we were to divest this business it is reasonably likely that we would have to recognize a material loss that will have a material adverse effect on our results of operations. Year-over-year comparisons also reflect the loss of our Medicaid contracts in Puerto Rico effective September 30, 2013 as well as a reduction in benefits expense in 2013 related to a favorable settlement of contract claims with the DoD associated with previously disclosed litigation. Comparison of Results of Operations for 2013 and 2012 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2013 and 2012: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs as a percentage of total revenues less investment income. Summary Net income was $1.2 billion, or $7.73 per diluted common share, in 2013 compared to $1.2 billion, or $7.47 per diluted common share, in 2012. The increase in net income primarily was driven by improved operating performance across most of our major business lines, including Medicare Advantage membership growth in our Retail and Employer group segments. These increases were partially offset by benefits expense of $0.99 per diluted common share in 2013 for reserve strengthening associated with our closed-block of long-term care insurance policies included with Other Businesses as discussed in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Year-over-year comparisons of diluted earnings per common share are favorably impacted by a lower number of shares used to compute diluted earnings per common share in 2013 reflecting the impact of share repurchases. Premiums Revenue Consolidated premiums increased $1.8 billion, or 4.9%, from 2012 to $38.8 billion for 2013 primarily due to increases in both Retail and Employer Group segment premiums mainly driven by higher average individual and group Medicare Advantage membership, partially offset by the impact of sequestration which became effective April 1, 2013 as well as a decline in premiums for Other Businesses. The decline in premiums for Other Businesses primarily reflects the transition to the current TRICARE South Region contract effective April 1, 2012, and the termination of the Puerto Rico Medicaid contracts effective September 30, 2013. As discussed in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, on April 1, 2012, we began delivering services under the current TRICARE South Region contract that the DHA awarded to us on February 25, 2011. We account for revenues under the current contract net of estimated healthcare costs similar to an administrative services fee only agreement, and as such there are no premiums recognized under the current contract. Our previous contract was accounted for similar to our fully-insured products and as such we recognized premiums under the previous contract. Services Revenue Consolidated services revenue increased $383 million, or 22.2%, from 2012 to $2.1 billion for 2013 primarily due to an increase in services revenue in our Healthcare Services segment and an increase in services revenue for our Other Businesses due to the transition to the current TRICARE South Region contract on April 1, 2012. The increase in services revenue in our Healthcare Services segment primarily resulted from the acquisitions of Metropolitan on December 21, 2012 and SeniorBridge on July 6, 2012, and growth in our provider services operations. Investment Income Investment income totaled $375 million for 2013, a decrease of $16 million from 2012, as higher average invested balances were more than offset by lower interest rates and lower net realized capital gains year-over-year. Benefits Expense Consolidated benefits expense was $32.6 billion for 2013, an increase of $1.6 billion, or 5.1%, from 2012 primarily due to a year-over-year increase in the Retail and Employer Group segments benefits expense, mainly driven by an increase in the average number of Medicare members, partially offset by a decrease in benefits expense for Other Businesses in 2013. The decrease in benefits expense for Other Businesses primarily was due to the transition to the current administrative services only TRICARE South Region contract on April 1, 2012 and the termination of the Puerto Rico Medicaid contracts effective September 30, 2013. We do not record benefits expense under the current TRICARE South Region contract. Our previous contract was accounted for similarly to our fully-insured products and as such we recorded benefits expense under the previous contract. Retail segment benefits expense increased $1.9 billion, or 8.9%, from 2012 to 2013 primarily due to membership growth. As more fully described herein under the section entitled “Benefits Expense Recognition”, actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $474 million in 2013 and $257 million in 2012. These increases in favorable medical claims reserve development primarily resulted from claims trend for the prior year ultimately developing more favorably than originally expected across most of our major business lines and increased financial recoveries. The increase in financial recoveries primarily resulted from claim audit process enhancements as well as increased volume of claim audits and expanded audit scope. The consolidated benefit ratio for 2013 was 83.9%, an increase of 20 basis points from 2012 primarily due to reserve strengthening associated with our closed-block of long-term care insurance policies included with Other Businesses as discussed above, partially offset by the increase in favorable prior-year medical claims reserve development of $217 million from 2012 to 2013. Operating Costs Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs increased $525 million, or 9.0%, in 2013 compared to 2012 primarily due to an increase in operating costs in our Retail and Healthcare Services segments. The increase in the Retail segment primarily reflects investment spending for exchanges under the Health Care Reform Law and new state-based contracts as well as increased marketing spending for Medicare. The consolidated operating cost ratio for 2013 was 15.5%, increasing 40 basis points from 2012. The impact of the current TRICARE South Region contract being accounted for as an administrative services fee only arrangement beginning April 1, 2012 was partially offset by improved operating leverage in our Retail and Employer Group segments. Depreciation and Amortization Depreciation and amortization for 2013 totaled $333 million, an increase of $38 million, or 12.9%, from 2012 primarily due to capital expenditures and depreciation and amortization associated with 2012 and 2013 acquisitions. Interest Expense Interest expense was $140 million for 2013 compared to $105 million for 2012, an increase of $35 million, or 33.3%. In December 2012, we issued $600 million of 3.15% senior notes due December 1, 2022 and $400 million of 4.625% senior notes due December 1, 2042. Income Taxes Our effective tax rate during 2013 was 35.9% compared to the effective tax rate of 36.1% in 2012. See Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. Retail Segment (a) Specialty products include dental, vision, and other supplemental health and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Retail segment pretax income was $1.3 billion in 2013, an increase of $122 million, or 10.5%, compared to 2012 primarily reflecting improved operating performance over the prior year. The improved operating performance primarily was driven by membership growth as well as a decrease in the operating cost ratio. Enrollment • Individual Medicare Advantage membership increased 141,100 members, or 7.3%, from December 31, 2012 to December 31, 2013 reflecting net membership additions for the 2013 enrollment season and sales to newly-eligible Medicare beneficiaries throughout the year. Effective January 1, 2013, we divested approximately 12,600 members acquired with Arcadian Management Services, Inc. in accordance with our previously disclosed agreement with the United States Department of Justice. • Medicare stand-alone PDP membership increased 219,000 members, or 7.2%, from December 31, 2012 to December 31, 2013 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2013 enrollment season. • Individual commercial medical membership increased 78,700 members, or 15.1%, from December 31, 2012 to December 31, 2013 primarily reflecting net new sales in 2013. On October 1, 2013, the initial open enrollment period began for plans effective January 1, 2014 offered through federally facilitated, federal-state partnerships or state-based exchanges for individuals and small employers (with up to 100 employees), including certain metropolitan areas in the 14 states where Humana has public exchange offerings. • State-based Medicaid membership increased 33,400 members, or 64.1%, from December 31, 2012 to December 31, 2013, primarily driven by the addition of our Kentucky Medicaid contract and Florida Long-Term Support Services contracts, including American Eldercare. • Individual specialty membership increased 93,800 members, or 9.9%, from December 31, 2012 to December 31, 2013 primarily driven by increased membership in dental and vision offerings. Premiums revenue • Retail segment premiums increased $2.2 billion, or 8.8%, from 2012 to 2013 primarily due to a 7.6% increase in average individual Medicare Advantage membership in 2013. Individual Medicare Advantage per member premiums increased approximately 0.5% in 2013 compared to 2012, primarily reflecting the impact of sequestration which became effective on April 1, 2013. Benefits expense • The Retail segment benefit ratio of 84.2% for 2013 was comparable to that of 2012. The Retail segment’s benefits expense for 2013 included the beneficial effect of $332 million in favorable prior-year medical claims reserve development versus $192 million in 2012. This change in favorable prior-year medical claims reserve development primarily was driven by claims trend for the prior year ultimately developing more favorably than originally expected and increased financial recoveries. The increase in financial recoveries primarily resulted from claim audit process enhancements as well as increased volume of claim audits and expanded audit scope. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 130 basis points in 2013 versus approximately 80 basis points in 2012. Operating costs • The Retail segment operating cost ratio of 10.9% for 2013 decreased 20 basis points from 2012. This decrease reflects scale efficiencies associated with servicing higher year-over-year membership together with our continued focus on operating cost efficiencies, partially offset by investment spending for exchanges under the Health Care Reform Law and new state-based contracts as well as increased Medicare marketing spending. Employer Group Segment (a) Specialty products include dental, vision, and other supplemental health and voluntary benefit products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Employer Group segment pretax income increased $38 million, or 12.2%, to $350 million in 2013 reflecting improved operating performance primarily due to group Medicare Advantage membership growth and lower benefit and operating cost ratios, as described below. Enrollment • Fully-insured commercial group medical membership increased 25,200 members, or 2.1% from December 31, 2012 as higher small group business membership was partially offset by lower membership in large group accounts. Approximately 61% of our fully-insured commercial group medical membership was in small group accounts at December 31, 2013 compared to 59% at December 31, 2012. • Fully-insured group Medicare Advantage membership increased 58,300 members, or 15.7%, from December 31, 2012 to December 31, 2013 primarily due to the January 2013 addition of a new large group retirement account. • Effective January 1, 2013 we lost our sole group Medicare Advantage ASO account which had 27,700 members at December 31, 2012. • Group ASO commercial medical membership decreased 74,900 members, or 6.1%, from December 31, 2012 to December 31, 2013 primarily due to continued pricing discipline in a highly competitive environment for self-funded accounts. • Group specialty membership decreased 355,400 members, or 5.0%, from December 31, 2012 to December 31, 2013 primarily due to a decline in vision membership related to our planned discontinuance of certain unprofitable product distribution partnerships. Premiums revenue • Employer Group segment premiums increased $792 million, or 7.8%, from 2012 to 2013 primarily due to higher average group Medicare Advantage medical membership. Benefits expense • The Employer Group segment benefit ratio decreased 10 basis points from 83.6% in 2012 to 83.5% in 2013 primarily due to higher favorable prior-year medical claims reserve development, partially offset by growth in our group Medicare Advantage products which generally carry a higher benefit ratio than our fully-insured commercial group products. The Employer Group segment’s benefits expense included the beneficial effect of $138 million in favorable prior-year medical claims reserve development versus $48 million in 2012. The change in favorable prior-year medical claims reserve development from 2012 to 2013 primarily was driven by claims trend for the prior year ultimately developing more favorably than originally expected and increased financial recoveries. The increase in financial recoveries primarily resulted from claim audit process enhancements as well as increased volume of claim audits and expanded audit scope. This favorable prior-year medical claims reserve development decreased the Employer Group segment benefit ratio by approximately 130 basis points in 2013 versus approximately 50 basis points in 2012. Operating costs • The Employer Group segment operating cost ratio of 15.9% decreased 30 basis points from 2012. This decrease primarily reflects continued savings as a result of our operating cost reduction initiatives and growth in our group Medicare Advantage products which generally carry a lower operating cost ratio than our fully-insured commercial group products, partially offset by investment spending in technology capabilities. Healthcare Services Segment Pretax results • Healthcare Services segment pretax income of $521 million for 2013 increased $93 million from 2012 as revenue growth and the pretax income contribution from our home based services and pharmacy solutions businesses, as well as the acquisition of Metropolitan, were partially offset by previously-planned investment spending associated with the integration and build-out of provider practices. The growth in pretax income associated with our home based services business reflects the increase in home health services provided to our Medicare Advantage members. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Employer Group segment membership increased to approximately 274 million in 2013, up 15% versus scripts of approximately 238 million in 2012. The increase primarily reflects growth associated with higher average medical membership for 2013 than in 2012. Services revenue • Services revenue increased $257 million or 25.1% from 2012 to $1.3 billion for 2013 primarily due to the acquisitions of Metropolitan and SeniorBridge as well as growth in our provider services operations. Intersegment revenues • Intersegment revenues increased $2.6 billion, or 21.5%, from 2012 to $14.6 billion for 2013 primarily due to growth in our pharmacy solutions business as it serves our growing membership, particularly Medicare stand-alone PDP, and the acquisition of Metropolitan in the fourth quarter of 2012. Operating costs • The Healthcare Services segment operating cost ratio of 95.8% for 2013 decreased 30 basis points from 96.1% for 2012 primarily due to scale efficiencies associated with growth in our pharmacy solutions business. Other Businesses Our Other Businesses pretax loss of $193 million for 2013 compared to a pretax loss of $18 million for 2012. The pretax losses in 2013 and 2012 included net expense of $243 million and $29 million, respectively, for reserve strengthening for our closed-block of long-term care insurance policies further discussed in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. In addition, 2013 reflects the loss of our Medicaid contracts in Puerto Rico effective September 30, 2013 offset by the beneficial effect of a favorable settlement of contract claims with the DoD primarily associated with litigation settled in 2012. Liquidity Our primary sources of cash include receipts of premiums, services revenue, and investment and other income, as well as proceeds from the sale or maturity of our investment securities and borrowings. Our primary uses of cash include disbursements for claims payments, operating costs, interest on borrowings, taxes, purchases of investment securities, acquisitions, capital expenditures, repayments on borrowings, dividends, and share repurchases. Because premiums generally are collected in advance of claim payments by a period of up to several months, our business normally should produce positive cash flows during periods of increasing premiums and enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing premiums and enrollment. From period to period, our cash flows may also be affected by the timing of working capital items including taxes and assessments. The use of operating cash flows may be limited by regulatory requirements which require, among other items, that our regulated subsidiaries maintain minimum levels of capital and seek approval before paying dividends from the subsidiaries to the parent. Our use of operating cash flows derived from our non-insurance subsidiaries, such as in our Healthcare Services segment, is generally not restricted by Departments of Insurance. For 2014, the effect of the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law, commonly referred to as the 3Rs, impacted the timing of our operating cash flows, as we built a receivable in 2014 that is expected to be collected in 2015. The net receivable balance associated with the 3Rs was $679 million at December 31, 2014. In addition, our 2014 financing cash flows have been negatively impacted by the timing of payments to and receipts from CMS associated with Medicare Part D reinsurance subsidies for which we do not assume risk. We are experiencing higher specialty prescription drug costs associated with a new treatment for Hepatitis C than were contemplated in our bids which resulted in higher reinsurance subsidy receivables balances in 2014 that will be settled in 2015 under the terms of our contracts with CMS. Any amounts receivable or payable associated with these risk limiting programs and CMS subsidies may have an impact on regulated subsidiary liquidity, with any temporary shortfalls funded by the parent company. For additional information on our liquidity risk, please refer to Item 1A. - Risk Factors in this 2014 Form 10-K. Cash and cash equivalents increased to $1.9 billion at December 31, 2014 from $1.1 billion at December 31, 2013. The change in cash and cash equivalents for the years ended December 31, 2014, 2013 and 2012 is summarized as follows: Cash Flow from Operating Activities The change in operating cash flows over the three year period primarily results from the corresponding change in earnings, enrollment activity, and the timing of working capital items as discussed below. Cash flows were positively impacted by annual Medicare enrollment gains because premiums generally are collected in advance of claim payments by a period of up to several months. In addition, 2014 operating cash flows were impacted by lower earnings and increased receivables associated with the 3Rs, partially offset by an increase in benefits payable from growth in membership. Comparisons of our operating cash flows also are impacted by other changes in our working capital. The most significant drivers of changes in our working capital are typically the timing of receipts for premiums and payments of benefits expense. We illustrate these changes with the following summaries of receivables and benefits payable. The detail of total net receivables was as follows at December 31, 2014, 2013 and 2012: Medicare receivables are impacted by revenue growth associated with growth in individual and group Medicare membership and the timing of accruals and related collections associated with the CMS risk-adjustment model. The increases in commercial and other receivables in 2014 and 2013 primarily are due to growth in the business. In addition, the increase in commercial and other receivables in 2014 is primarily due to the commercial risk adjustment provision of the Health Care Reform Law which became effective in 2014. Military services receivables at December 31, 2014 and 2013 primarily consist of administrative services only fees owed from the federal government for administrative services provided under our current TRICARE South Region contract. The $409 million decrease in military services receivables from December 31, 2011 to December 31, 2012 primarily resulted from the transition to our current TRICARE South Region contract which we account for similar to an administrative services fee only agreement. As such, beginning April 1, 2012, payments of the federal government’s claims and related reimbursements for the current TRICARE South Region contract are classified with receipts (withdrawals) from contract deposits as a financing item in our consolidated statements of cash flows. The detail of benefits payable was as follows at December 31, 2014, 2013 and 2012: (1) IBNR represents an estimate of benefits payable for claims incurred but not reported (IBNR) and claims received but not processed at the balance sheet date. The level of IBNR is primarily impacted by membership levels, medical claim trends and the receipt cycle time, which represents the length of time between when a claim is initially incurred and when the claim form is received (i.e. a shorter time span results in a lower IBNR). (2) Reported claims in process represents the estimated valuation of processed claims that are in the post claim adjudication process, which consists of administrative functions such as audit and check batching and handling, as well as amounts owed to our pharmacy benefit administrator which fluctuate due to bi-weekly payments and the month-end cutoff. (3) Military services benefits payable primarily represents the run-out of the claims liability associated with our previous TRICARE South Region contract that expired on March 31, 2012. A corresponding receivable for reimbursement by the federal government is included in the military services receivable in the previous receivables table. (4) Other benefits payable include amounts owed to providers under capitated and risk sharing arrangements. The increase in benefits payable in 2014 primarily was due to an increase in IBNR, primarily as a result of Medicare Advantage and individual commercial membership growth, and an increase in the amount of processed but unpaid claims due to our pharmacy benefit administrator, which fluctuate due to month-end cutoff. These items were partially offset by a decrease in amounts owed to providers under capitated and risk sharing arrangements primarily related to the disbursement of a portion of our Medicare risk adjustment collections under our contractual obligations associated with our risk sharing arrangements. The increase in benefits payable in 2013 primarily was due to an increase in the amount of processed but unpaid claims due to our pharmacy benefit administrator, which fluctuate due to month-end cutoff, and an increase in IBNR, primarily as a result of Medicare Advantage membership growth. The increase in benefits payable in 2012 primarily was due to an increase in IBNR, primarily as a result of Medicare Advantage membership growth, partially offset by a $335 million decrease in the military services benefits payable due to the run-out of claims under the previous TRICARE South Region contract that expired on March 31, 2012, a decrease in the amounts owed to providers under capitated and risk sharing arrangements, and a decrease in the amounts due to our pharmacy benefit administrator which fluctuate due to month-end cutoff. Under the current TRICARE South Region contract effective April 1, 2012, the federal government retains the risk of the cost of health benefits and related benefit obligation as further described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Many provisions of the Health Care Reform Law became effective in 2014, including the commercial risk adjustment, risk corridor, and reinsurance provisions as well as the non-deductible health insurance industry fee. As discussed previously, the timing of payments and receipts associated with these provisions impacted our operating cash flows as we built a receivable in 2014 that is expected to be collected in 2015. The net receivable balance associated with the 3Rs was approximately $679 million at December 31, 2014, including certain amounts recorded in receivables as noted above. In September 2014, we paid the federal government $562 million for the annual health insurance industry fee. In addition to the timing of receipts for premiums and services revenues, payments of benefits expense, and amounts due under the risk limiting and health insurance industry fee provisions of the Health Care Reform Law, other working capital items impacting operating cash flows primarily resulted from the timing of payments for the Medicare Part D risk corridor provisions of our contracts with CMS and changes in the timing of the collection of pharmacy rebates. Cash Flow from Investing Activities Our ongoing capital expenditures primarily relate to our information technology initiatives, support of services in our provider services operations including medical and administrative facility improvements necessary for activities such as the provision of care to members, claims processing, billing and collections, wellness solutions, care coordination, regulatory compliance and customer service. Total capital expenditures, excluding acquisitions, were $528 million in 2014, $441 million in 2013, and $410 million in 2012. Excluding acquisitions, we expect total capital expenditures in 2015 to be in a range of approximately $575 million to $625 million primarily reflecting increased spending associated with growth in our provider services and pharmacy businesses in our Healthcare Services segment. Proceeds from sales and maturities of investment securities exceeded purchases by $411 million in 2014. These net proceeds were used to fund normal working capital needs due to an increase in receivables in 2014 that will be collected in 2015 associated with the 3Rs in addition to the timing of payments to and receipts from CMS associated with Medicare Part D reinsurance subsidies, as discussed below. We reinvested a portion of our operating cash flows in investment securities, primarily investment-grade fixed income securities, totaling $592 million in 2013 and $320 million in 2012. Cash consideration paid for acquisitions, net of cash acquired, was $18 million in 2014, $187 million in 2013, and $1.2 billion in 2012. Acquisitions in 2014 included health and wellness related acquisitions. Cash paid for acquisitions in 2013 primarily related to the American Eldercare and other health and wellness related acquisitions. In 2012, acquisitions included Metropolitan, Arcadian, SeniorBridge and other health and wellness and technology related acquisitions. Cash Flow from Financing Activities Claims payments were $945 million higher than receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk during 2014, $155 million higher during 2013, and $341 million higher during 2012. As discussed previously, our 2014 financing cash flows have been negatively impacted by the timing of payments to and receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk. We experienced higher specialty prescription drug costs associated with a new treatment for Hepatitis C than were contemplated in our bids which is resulting in higher subsidy receivable balances in 2014 that will be settled in 2015 under the terms of our contracts with CMS. Our net receivable for CMS subsidies and brand name prescription drug discounts was $1.7 billion at December 31, 2014 compared to $713 million at December 31, 2013. Refer to Note 6 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Under our current administrative services only TRICARE South Region contract that began April 1, 2012, reimbursements from the federal government equaled health care cost payments for which we do not assume risk in 2014. Health care cost payments were less than reimbursements by $5 million in 2013 and exceeded reimbursements by $56 million in 2012 due to the timing of such receipts. Receipts from HHS associated with cost sharing provisions of the Health Care Reform Law for which we do not assume risk were $26 million higher than claims payments for the year ended 2014. See Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for further description. We repurchased 5.7 million shares for $730 million in 2014, which excludes another $100 million of stock held back pending final settlement of an accelerated stock repurchase plan, 5.8 million shares for $502 million in 2013, and 6.3 million shares for $460 million in 2012 under share repurchase plans authorized by the Board of Directors. We also acquired common shares in connection with employee stock plans for an aggregate cost of $42 million in 2014, $29 million in 2013, and $58 million in 2012. As discussed further below, we paid dividends to stockholders of $172 million in 2014, $168 million in 2013, and $165 million in 2012. In September 2014, we issued $400 million of 2.625% senior notes due October 1, 2019, $600 million of 3.85% senior notes due October 1, 2024 and $750 million of 4.95% senior notes due October 1, 2044. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses, were $1.73 billion. We used a portion of the net proceeds to redeem our $500 million 6.45% senior unsecured notes. In December 2012, we issued $600 million of 3.15% senior notes due December 1, 2022 and $400 million of 4.625% senior notes due December 1, 2042. Our net proceeds, reduced for the discount and cost of the offering, were $990 million. We used the proceeds from the offering primarily to finance the acquisition of Metropolitan, including the retirement of Metropolitan’s indebtedness, and to pay related fees and expenses. In March 2012, we repaid, without penalty, junior subordinated long-term debt of $36 million. The remainder of the cash used in or provided by financing activities in 2014, 2013, and 2012 primarily resulted from proceeds from stock option exercises and the change in book overdraft. Future Sources and Uses of Liquidity Dividends The following table provides details of dividend payments, excluding dividend equivalent rights, in 2012, 2013, and 2014 under our Board approved quarterly cash dividend policy: In October 2014, the Board declared a cash dividend of $0.28 per share that was paid on January 30, 2015 to stockholders of record on December 31, 2014, for an aggregate amount of $42 million. Declaration and payment of future quarterly dividends is at the discretion of the Board and may be adjusted as business needs or market conditions change. Stock Repurchase Authorization In September 2014, the Board of Directors replaced its previously approved share repurchase authorization of up to $1 billion (of which $816 million remained unused) with the current authorization for repurchases of up to $2 billion of our common shares exclusive of shares repurchased in connection with employee stock plans, expiring on December 31, 2016. Under the current share repurchase authorization, shares may be purchased from time to time at prevailing prices in the open market, by block purchases, or in privately-negotiated transactions (including pursuant to an accelerated share repurchase agreement with investment banks), subject to certain regulatory restrictions on volume, pricing, and timing. As of February 18, 2015, the remaining authorized amount under the current authorization totaled approximately $1.37 billion, after giving effect to the $500 million accelerated share repurchase program we entered into in November 2014 with Goldman, Sachs & Co. Senior Notes In September 2014, we issued $400 million of 2.625% senior notes due October 1, 2019, $600 million of 3.85% senior notes due October 1, 2024 and $750 million of 4.95% senior notes due October 1, 2044. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses, were $1.73 billion. We used a portion of the net proceeds to redeem the $500 million 6.45% senior unsecured notes as discussed below. In October 2014, we redeemed the $500 million 6.45% senior unsecured notes due June 1, 2016, at 100% of the principal amount plus applicable premium for early redemption and accrued and unpaid interest to the redemption date, for cash totaling approximately $560 million. We recognized a loss on extinguishment of debt, included in interest expense, of approximately $37 million in connection with the redemption of these notes. Credit Agreement Our 5-year $1.0 billion unsecured revolving credit agreement expires July 2018. Under the credit agreement, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion bears interest at either LIBOR plus a spread or the base rate plus a spread. The LIBOR spread, currently 110 basis points, varies depending on our credit ratings ranging from 90 to 150 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, currently 15 basis points, may fluctuate between 10 and 25 basis points, depending upon our credit ratings. The competitive advance portion of any borrowings will bear interest at market rates prevailing at the time of borrowing on either a fixed rate or a floating rate based on LIBOR, at our option. The terms of the credit agreement include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow additional funds. In addition, the credit agreement contains customary restrictive and financial covenants as well as customary events of default, including financial covenants regarding the maintenance of a minimum level of net worth of $7.8 billion at December 31, 2014 and a maximum leverage ratio of 3.0:1. We are in compliance with the financial covenants, with actual net worth of $9.6 billion and actual leverage ratio of 1.4:1, as measured in accordance with the credit agreement as of December 31, 2014. In addition, the credit agreement includes an uncommitted $250 million incremental loan facility. At December 31, 2014, we had no borrowings outstanding under the credit agreement. We have outstanding letters of credit of $4 million issued under the credit agreement at December 31, 2014. No amounts have been drawn on these letters of credit. Accordingly, as of December 31, 2014, we had $996 million of remaining borrowing capacity under the credit agreement, none of which would be restricted by our financial covenant compliance requirement. We have other customary, arms-length relationships, including financial advisory and banking, with some parties to the credit agreement. Commercial Paper In October 2014, we entered into a commercial paper program pursuant to which we may issue short-term, unsecured commercial paper notes privately placed on a discount basis through certain broker dealers. Amounts available under the program may be borrowed, repaid and re-borrowed from time to time, with the aggregate face or principal amounts outstanding under the program at any time not to exceed $1 billion. The net proceeds of issuances have been and are expected to be used for general corporate purposes, including to repurchase shares of our common stock. The maximum principal amount of commercial paper borrowings outstanding at any one time during the year ended December 31, 2014 was $175 million. There were no outstanding borrowings at December 31, 2014. Liquidity Requirements We believe our cash balances, investment securities, operating cash flows, and funds available under our credit agreement and our commercial paper program or from other public or private financing sources, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, acquisitions, future expansion opportunities, and capital expenditures for at least the next twelve months, as well as to refinance or repay debt, and repurchase shares. Adverse changes in our credit rating may increase the rate of interest we pay and may impact the amount of credit available to us in the future. Our investment-grade credit rating at December 31, 2014 was BBB+ according to Standard & Poor’s Rating Services, or S&P, and Baa3 according to Moody’s Investors Services, Inc., or Moody’s. A downgrade by S&P to BB+ or by Moody’s to Ba1 triggers an interest rate increase of 25 basis points with respect to $750 million of our senior notes. Successive one notch downgrades increase the interest rate an additional 25 basis points, or annual interest expense by $2 million, up to a maximum 100 basis points, or annual interest expense by $8 million. In addition, we operate as a holding company in a highly regulated industry. Humana Inc., our parent company, is dependent upon dividends and administrative expense reimbursements from our subsidiaries, certain of which are subject to regulatory restrictions. We continue to maintain significant levels of aggregate excess statutory capital and surplus in our state-regulated insurance subsidiaries. Cash, cash equivalents, and short-term investments at the parent company increased to $1.4 billion at December 31, 2014 from $508 million at December 31, 2013 primarily due to net proceeds of $1.73 billion from the September 2014 issuance of senior notes, offset by the $560 million senior note redemption discussed above and share repurchases. Our use of operating cash flows derived from our non-insurance subsidiaries, such as in our Healthcare Services segment, is generally not restricted by Departments of Insurance. Our subsidiaries paid dividends to the parent of $927 million in 2014, $967 million in 2013, and $1.2 billion in 2012. The declines in dividends to the parent in 2013 and 2014 primarily were a result of higher surplus requirements associated with premium growth. Refer to our parent company financial statements and accompanying notes in Schedule I - Parent Company Financial Information. Regulatory requirements, including subsidiary dividends to the parent, are discussed in more detail in the following section. Excluding Puerto Rico subsidiaries, the amount of ordinary dividends that may be paid to our parent company in 2015 is approximately $800 million in the aggregate. In September 2014, we paid the federal government $562 million for the annual health insurance industry fee attributed to calendar year 2014, in accordance with the Health Care Reform Law. In 2015, the health insurance industry fee increases by 41% for the industry taken as a whole. Accordingly, absent changes in market share, we would expect a 41% increase in our fee in 2015. Regulatory Requirements For a detailed discussion of our regulatory requirements, including aggregate statutory capital and surplus as well as dividends paid from the subsidiaries to the parent, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Contractual Obligations We are contractually obligated to make payments for years subsequent to December 31, 2014 as follows: (1) Interest includes the estimated contractual interest payments under our debt agreements. (2) We lease facilities, computer hardware, and other furniture and equipment under long-term operating leases that are noncancelable and expire on various dates through 2027. We sublease facilities or partial facilities to third party tenants for space not used in our operations which partially mitigates our operating lease commitments. An operating lease is a type of off-balance sheet arrangement. Assuming we acquired the asset, rather than leased such asset, we would have recognized a liability for the financing of these assets. See also Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. (3) Purchase obligations include agreements to purchase services, primarily information technology related services, or to make improvements to real estate, in each case that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum levels of service to be purchased; fixed, minimum or variable price provisions; and the appropriate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. (4) Includes future policy benefits payable ceded to third parties through 100% coinsurance agreements as more fully described in Note 19 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We expect the assuming reinsurance carriers to fund these obligations and reflected these amounts as reinsurance recoverables included in other long-term assets on our consolidated balance sheet. Amounts payable in less than one year are included in trade accounts payable and accrued expenses in the consolidated balance sheet. Off-Balance Sheet Arrangements As of December 31, 2014, we were not involved in any special purpose entity, or SPE, transactions. For a detailed discussion off-balance sheet arrangements, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Guarantees and Indemnifications For a detailed discussion our guarantees and indemnifications, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Government Contracts For a detailed discussion of our government contracts, including our Medicare, Military, and Medicaid contracts, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and accompanying notes, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements and accompanying notes requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We continuously evaluate our estimates and those critical accounting policies related primarily to benefits expense and revenue recognition as well as accounting for impairments related to our investment securities, goodwill, and long-lived assets. These estimates are based on knowledge of current events and anticipated future events and, accordingly, actual results ultimately may differ from those estimates. We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements. Benefits Expense Recognition Benefits expense is recognized in the period in which services are provided and includes an estimate of the cost of services which have been incurred but not yet reported, or IBNR. IBNR represents a substantial portion of our benefits payable as follows: Our reserving practice is to consistently recognize the actuarial best point estimate within a level of confidence required by actuarial standards. Actuarial standards of practice generally require a level of confidence such that the liabilities established for IBNR have a greater probability of being adequate versus being insufficient, or such that the liabilities established for IBNR are sufficient to cover obligations under an assumption of moderately adverse conditions. Adverse conditions are situations in which the actual claims are expected to be higher than the otherwise estimated value of such claims at the time of the estimate. Therefore, in many situations, the claim amounts ultimately settled will be less than the estimate that satisfies the actuarial standards of practice. We develop our estimate for IBNR using actuarial methodologies and assumptions, primarily based upon historical claim experience. Depending on the period for which incurred claims are estimated, we apply a different method in determining our estimate. For periods prior to the most recent three months, the key assumption used in estimating our IBNR is that the completion factor pattern remains consistent over a rolling 12-month period after adjusting for known changes in claim inventory levels and known changes in claim payment processes. Completion factors result from the calculation of the percentage of claims incurred during a given period that have historically been adjudicated as of the reporting period. For the most recent three months, the incurred claims are estimated primarily from a trend analysis based upon per member per month claims trends developed from our historical experience in the preceding months, adjusted for known changes in estimates of recent hospital and drug utilization data, provider contracting changes, changes in benefit levels, changes in member cost sharing, changes in medical management processes, product mix, and weekday seasonality. The completion factor method is used for the months of incurred claims prior to the most recent three months because the historical percentage of claims processed for those months is at a level sufficient to produce a consistently reliable result. Conversely, for the most recent three months of incurred claims, the volume of claims processed historically is not at a level sufficient to produce a reliable result, which therefore requires us to examine historical trend patterns as the primary method of evaluation. Changes in claim processes, including recoveries of overpayments, receipt cycle times, claim inventory levels, outsourcing, system conversions, and processing disruptions due to weather or other events affect views regarding the reasonable choice of completion factors. Claim payments to providers for services rendered are often net of overpayment recoveries for claims paid previously, as contractually allowed. Claim overpayment recoveries can result from many different factors, including retroactive enrollment activity, audits of provider billings, and/or payment errors. Changes in patterns of claim overpayment recoveries can be unpredictable and result in completion factor volatility, as they often impact older dates of service. The receipt cycle time measures the average length of time between when a medical claim was initially incurred and when the claim form was received. Increases in electronic claim submissions from providers decrease the receipt cycle time. If claims are submitted or processed on a faster (slower) pace than prior periods, the actual claim may be more (less) complete than originally estimated using our completion factors, which may result in reserves that are higher (lower) than required. Medical cost trends potentially are more volatile than other segments of the economy. The drivers of medical cost trends include increases in the utilization of hospital facilities, physician services, new higher priced technologies and medical procedures, and new prescription drugs and therapies, as well as the inflationary effect on the cost per unit of each of these expense components. Other external factors such as government-mandated benefits or other regulatory changes, the tort liability system, increases in medical services capacity, direct to consumer advertising for prescription drugs and medical services, an aging population, lifestyle changes including diet and smoking, catastrophes, and epidemics also may impact medical cost trends. Internal factors such as system conversions, claims processing cycle times, changes in medical management practices and changes in provider contracts also may impact our ability to accurately predict estimates of historical completion factors or medical cost trends. All of these factors are considered in estimating IBNR and in estimating the per member per month claims trend for purposes of determining the reserve for the most recent three months. Additionally, we continually prepare and review follow-up studies to assess the reasonableness of the estimates generated by our process and methods over time. The results of these studies are also considered in determining the reserve for the most recent three months. Each of these factors requires significant judgment by management. The completion and claims per member per month trend factors are the most significant factors impacting the IBNR estimate. The portion of IBNR estimated using completion factors for claims incurred prior to the most recent three months is generally less variable than the portion of IBNR estimated using trend factors. The following table illustrates the sensitivity of these factors assuming moderate adverse experience and the estimated potential impact on our operating results caused by reasonably likely changes in these factors based on December 31, 2014 data: (a) Reflects estimated potential changes in benefits payable at December 31, 2014 caused by changes in completion factors for incurred months prior to the most recent three months. (b) Reflects estimated potential changes in benefits payable at December 31, 2014 caused by changes in annualized claims trend used for the estimation of per member per month incurred claims for the most recent three months. (c) The factor change indicated represents the percentage point change. The following table provides a historical perspective regarding the accrual and payment of our benefits payable, excluding military services. Components of the total incurred claims for each year include amounts accrued for current year estimated benefits expense as well as adjustments to prior year estimated accruals. The following table summarizes the changes in estimate for incurred claims related to prior years attributable to our key assumptions. As previously described, our key assumptions consist of trend and completion factors estimated using an assumption of moderately adverse conditions. The amounts below represent the difference between our original estimates and the actual benefits expense ultimately incurred as determined from subsequent claim payments. (a) The factor change indicated represents the percentage point change. As previously discussed, our reserving practice is to consistently recognize the actuarial best estimate of our ultimate liability for claims. Actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $518 million in 2014, $474 million in 2013, and $257 million in 2012. The table below details our favorable medical claims reserve development related to prior fiscal years by segment for 2014, 2013, and 2012. The favorable medical claims reserve development for 2014, 2013, and 2012 primarily reflects the consistent application of trend and completion factors estimated using an assumption of moderately adverse conditions. In addition, the favorable medical claims reserve development during 2014 and 2013 reflects increased membership and better than originally expected utilization across most of our major business lines and increased financial recoveries. The increase in financial recoveries primarily resulted from claim audit process enhancements as well as increased volume of claim audits and expanded audit scope. All lines of business benefited from these improvements. We continually adjust our historical trend and completion factor experience with our knowledge of recent events that may impact current trends and completion factors when establishing our reserves. Because our reserving practice is to consistently recognize the actuarial best point estimate using an assumption of moderately adverse conditions as required by actuarial standards, there is a reasonable possibility that variances between actual trend and completion factors and those assumed in our December 31, 2014 estimates would fall towards the middle of the ranges previously presented in our sensitivity table. Benefits expense associated with military services and provisions associated with future policy benefits excluded from the previous table was as follows for the years ended December 31, 2014, 2013 and 2012: Due to the transition to the current TRICARE South Region contract on April 1, 2012, which is accounted for as an administrative services only contract as more fully described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, there was no military services benefits payable at December 31, 2014 or 2013. This transition is also the primary reason for the decline in military services benefits expense from 2012 to 2013. Future policy benefits payable of $2.3 billion and $2.2 billion at December 31, 2014 and 2013, respectively, represent liabilities for long-duration insurance policies including long-term care insurance, life insurance, annuities, and certain health and other supplemental policies sold to individuals for which some of the premium received in the earlier years is intended to pay anticipated benefits to be incurred in future years. At policy issuance, these reserves are recognized on a net level premium method based on interest rates, mortality, morbidity, and maintenance expense assumptions. Interest rates are based on our expected net investment returns on the investment portfolio supporting the reserves for these blocks of business. Mortality, a measure of expected death, and morbidity, a measure of health status, assumptions are based on published actuarial tables, modified based upon actual experience. The assumptions used to determine the liability for future policy benefits are established and locked in at the time each contract is issued and only change if our expected future experience deteriorates to the point that the level of the liability, together with the present value of future gross premiums, are not adequate to provide for future expected policy benefits and maintenance costs (i.e. the loss recognition date). Because these policies have long-term claim payout periods, there is a greater risk of significant variability in claims costs, either positive or negative. We perform loss recognition tests at least annually in the fourth quarter, and more frequently if adverse events or changes in circumstances indicate that the level of the liability, together with the present value of future gross premiums, may not be adequate to provide for future expected policy benefits and maintenance costs. Future policy benefits payable include $1.5 billion at December 31, 2014 and $1.4 billion at December 31, 2013 associated with a non-strategic closed block of long-term care insurance policies acquired in connection with the 2007 acquisition of KMG. Approximately 32,700 policies remain in force as of December 31, 2014. No new policies have been written since 2005 under this closed block. Future policy benefits payable includes amounts charged to accumulated other comprehensive income for an additional liability that would exist on our closed-block of long-term care insurance policies if unrealized gains on the sale of the investments backing such products had been realized and the proceeds reinvested at then current yields. There was $123 million of additional liability at December 31, 2014 and no additional liability at December 31, 2013. Amounts charged to accumulated other comprehensive income are net of applicable deferred taxes. Long-term care insurance policies provide nursing home and home health coverage for which premiums are collected many years in advance of benefits paid, if any. Therefore, our actual claims experience will emerge many years after assumptions have been established. The risk of a deviation of the actual interest, morbidity, mortality, and maintenance expense assumptions from those assumed in our reserves are particularly significant to our closed block of long-term care insurance policies. A prolonged period during which interest rates remain at levels lower than those anticipated in our reserving would result in shortfalls in investment income on assets supporting our obligation under long term care policies because the long duration of the policy obligations exceeds the duration of the supporting investment assets. Further, we monitor the loss experience of these long-term care insurance policies and, when necessary, apply for premium rate increases through a regulatory filing and approval process in the jurisdictions in which such products were sold. To the extent premium rate increases and/or loss experience vary from our loss recognition date assumptions, future adjustments to reserves could be required. During 2013, we recorded a loss for a premium deficiency with respect to our closed block of long-term care insurance policies. The premium deficiency was based on current and anticipated experience that had deteriorated from our locked-in assumptions from the previous December 31, 2010 loss recognition date, particularly as they related to emerging experience due to an increase in life expectancies and utilization of home health care services. Based on this deterioration, and combined with lower interest rates, we determined that our existing future policy benefits payable, together with the present value of future gross premiums, associated with our closed-block of long-term care insurance policies were not adequate to provide for future policy benefits and maintenance costs under these policies; therefore we unlocked and modified our assumptions based on current expectations. Accordingly, during 2013 we recorded $243 million of additional benefits expense, with a corresponding increase in future policy benefits payable of $350 million partially offset by a related reinsurance recoverable of $107 million included in other long-term assets. During 2012, we recorded a change in estimate associated with future policy benefits payable for our closed-block of long-term care insurance policies resulting in additional benefits expense of $29 million and a corresponding increase in future policy benefits payable. This change in estimate was based on current claim experience demonstrating an increase in the length of the time policyholders already in payment status remained in such status. Future policy benefits payable was increased to cover future payments to policyholders currently in payment status. For our closed block of long-term care policies, actuarial assumptions used to estimate reserves are inherently uncertain due to the potential changes in trends in mortality, morbidity, persistency (the percentage of policies remaining in-force) and interest rates. As a result, our long term care reserves may be subject to material increases if these trends develop adversely to our expectations. The estimated increase in reserves and additional benefit expense from hypothetically modeling adverse variations in our actuarial assumptions, in the aggregate, could be up to $300 million, net of reinsurance. Although such hypothetical revisions are not currently appropriate, we believe they could occur based on past variances in experience and our expectation of the ranges of future experience that could reasonably occur. Generally accepted accounting principles do not allow us to unlock our assumptions for favorable items. This hypothetical modeling does not contemplate a divestiture situation. We are evaluating alternatives related to our closed block of long term care policies. While no decision has been made with respect to any course of action, if we were to divest this business, it is reasonably likely that we would have to recognize a material loss and that loss could exceed the amount provided above. In addition, future policy benefits payable includes amounts of $210 million at December 31, 2014, $215 million at December 31, 2013, and $220 million at December 31, 2012 which are subject to 100% coinsurance agreements as more fully described in Note 19 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, and as such are offset by a related reinsurance recoverable included in other long-term assets. Revenue Recognition We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group on 30-day written notice. Our Medicare contracts with CMS renew annually. Our military services contracts with the federal government and our contracts with various state Medicaid programs generally are multi-year contracts subject to annual renewal provisions. Our commercial contracts establish rates on a per employee basis for each month of coverage based on the type of coverage purchased (single to family coverage options). Our Medicare and Medicaid contracts also establish monthly rates per member. However, our Medicare contracts also have additional provisions as outlined in the following separate section. Premiums revenue and administrative services only, or ASO, fees are estimated by multiplying the membership covered under the various contracts by the contractual rates. In addition, we adjust revenues for estimated changes in an employer’s enrollment and individuals that ultimately may fail to pay, and for estimated rebates under the minimum benefit ratios required under the Health Care Reform Law. . Enrollment changes not yet processed or not yet reported by an employer group or the government, also known as retroactive membership adjustments, are estimated based on available data and historical trends. We routinely monitor the collectibility of specific accounts, the aging of receivables, historical retroactivity trends, estimated rebates, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in the current period’s revenue. We bill and collect premium remittances from employer groups and members in our Medicare and other individual products monthly. We receive monthly premiums from the federal government and various states according to government specified payment rates and various contractual terms. Changes in revenues from CMS for our Medicare products resulting from the periodic changes in risk-adjustment scores derived from medical diagnoses for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured. Medicare Risk-Adjustment Provisions CMS utilizes a risk-adjustment model which apportions premiums paid to Medicare Advantage plans according to health severity. The risk-adjustment model pays more for enrollees with predictably higher costs. Under the risk-adjustment methodology, all Medicare Advantage plans must collect and submit the necessary diagnosis code information from hospital inpatient, hospital outpatient, and physician providers to CMS within prescribed deadlines. The CMS risk-adjustment model uses this diagnosis data to calculate the risk-adjusted premium payment to Medicare Advantage plans. Rates paid to Medicare Advantage plans are established under an actuarial bid model, including a process that bases our payments on a comparison of our beneficiaries’ risk scores, derived from medical diagnoses, to those enrolled in the government’s Medicare FFS program. We generally rely on providers, including certain providers in our network who are our employees, to code their claim submissions with appropriate diagnoses, which we send to CMS as the basis for our payment received from CMS under the actuarial risk-adjustment model. We also rely on providers to appropriately document all medical data, including the diagnosis data submitted with claims. We estimate risk-adjustment revenues based on medical diagnoses for our membership. The risk-adjustment model is more fully described in Item 1. - Business under the section titled “Individual Medicare.” Investment Securities Investment securities totaled $9.5 billion, or 41% of total assets at December 31, 2014, and $9.8 billion, or 47% of total assets at December 31, 2013. Debt securities, detailed below, comprised this entire investment portfolio at December 31, 2014 and 2013. The fair value of debt securities were as follows at December 31, 2014 and 2013: Approximately 96% of our debt securities were investment-grade quality, with a weighted average credit rating of AA- by S&P at December 31, 2014. Most of the debt securities that were below investment-grade were rated BB, the higher end of the below investment-grade rating scale. Our investment policy limits investments in a single issuer and requires diversification among various asset types. Tax-exempt municipal securities included pre-refunded bonds of $199 million at December 31, 2014 and $222 million at December 31, 2013. These pre-refunded bonds were secured by an escrow fund consisting of U.S. government obligations sufficient to pay off all amounts outstanding at maturity. The ratings of these pre-refunded bonds generally assume the rating of the government obligations at the time the fund is established. Tax-exempt municipal securities that were not pre-refunded were diversified among general obligation bonds of U.S. states and local municipalities as well as special revenue bonds. General obligation bonds, which are backed by the taxing power and full faith of the issuer, accounted for $1.0 billion of these municipals in the portfolio. Special revenue bonds, issued by a municipality to finance a specific public works project such as utilities, water and sewer, transportation, or education, and supported by the revenues of that project, accounted for $1.8 billion of these municipals. Our general obligation bonds are diversified across the U.S. with no individual state exceeding 11%. In addition, certain monoline insurers guarantee the timely repayment of bond principal and interest when a bond issuer defaults and generally provide credit enhancement for bond issues related to our tax-exempt municipal securities. We have no direct exposure to these monoline insurers. We owned $484 million and $548 million at December 31, 2014 and 2013, respectively, of tax-exempt securities guaranteed by monoline insurers. The equivalent weighted average S&P credit rating of these tax-exempt securities without the guarantee from the monoline insurer was AA. Our direct exposure to subprime mortgage lending is limited to investment in residential mortgage-backed securities and asset-backed securities backed by home equity loans. The fair value of securities backed by Alt-A and subprime loans was $1 million at December 31, 2014 and 2013. There are no collateralized debt obligations or structured investment vehicles in our investment portfolio. The percentage of corporate securities associated with the financial services industry was 21% at December 31, 2014 and 23% at December 31, 2013. Gross unrealized losses and fair values aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows at December 31, 2014: Under the other-than-temporary impairment model for debt securities held, we recognize an impairment loss in income in an amount equal to the full difference between the amortized cost basis and the fair value when we have the intent to sell the debt security or it is more likely than not we will be required to sell the debt security before recovery of our amortized cost basis. However, if we do not intend to sell the debt security, we evaluate the expected cash flows to be received as compared to amortized cost and determine if a credit loss has occurred. In the event of a credit loss, only the amount of the impairment associated with the credit loss is recognized currently in income with the remainder of the loss recognized in other comprehensive income. When we do not intend to sell a security in an unrealized loss position, potential other-than-temporary impairment is considered using a variety of factors, including the length of time and extent to which the fair value has been less than cost; adverse conditions specifically related to the industry, geographic area or financial condition of the issuer or underlying collateral of a security; payment structure of the security; changes in credit rating of the security by the rating agencies; the volatility of the fair value changes; and changes in fair value of the security after the balance sheet date. For debt securities, we take into account expectations of relevant market and economic data. For example, with respect to mortgage and asset-backed securities, such data includes underlying loan level data and structural features such as seniority and other forms of credit enhancements. A decline in fair value is considered other-than-temporary when we do not expect to recover the entire amortized cost basis of the security. We estimate the amount of the credit loss component of a debt security as the difference between the amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate of future cash flows discounted at the implicit interest rate at the date of purchase. The risks inherent in assessing the impairment of an investment include the risk that market factors may differ from our expectations, facts and circumstances factored into our assessment may change with the passage of time, or we may decide to subsequently sell the investment. The determination of whether a decline in the value of an investment is other than temporary requires us to exercise significant diligence and judgment. The discovery of new information and the passage of time can significantly change these judgments. The status of the general economic environment and significant changes in the national securities markets influence the determination of fair value and the assessment of investment impairment. There is a continuing risk that declines in fair value may occur and additional material realized losses from sales or other-than-temporary impairments may be recorded in future periods. The recoverability of our non-agency residential and commercial mortgage-backed securities is supported by factors such as seniority, underlying collateral characteristics and credit enhancements. These residential and commercial mortgage-backed securities at December 31, 2014 primarily were composed of senior tranches having high credit support, with over 99% of the collateral consisting of prime loans. The weighted average credit rating of all commercial mortgage-backed securities was AA+ at December 31, 2014. All issuers of securities we own that were trading at an unrealized loss at December 31, 2014 remain current on all contractual payments. After taking into account these and other factors previously described, we believe these unrealized losses primarily were caused by an increase in market interest rates in the current markets than when the securities were purchased. At December 31, 2014, we did not intend to sell the securities with an unrealized loss position in accumulated other comprehensive income, and it is not likely that we will be required to sell these securities before recovery of their amortized cost basis. As a result, we believe that the securities with an unrealized loss were not other-than-temporarily impaired at December 31, 2014. There were no material other-than-temporary impairments in 2014, 2013, or 2012. Goodwill and Long-lived Assets At December 31, 2014, goodwill and other long-lived assets represented 24% of total assets and 59% of total stockholders’ equity, compared to 27% and 61%, respectively, at December 31, 2013. We are required to test at least annually for impairment at a level of reporting referred to as the reporting unit, and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. A reporting unit either is our operating segments or one level below the operating segments, referred to as a component, which comprise our reportable segments. A component is considered a reporting unit if the component constitutes a business for which discrete financial information is available that is regularly reviewed by management. We are required to aggregate the components of an operating segment into one reporting unit if they have similar economic characteristics. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition. The carrying amount of goodwill for our reportable segments has been retrospectively adjusted to conform to the 2014 segment change discussed in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We use a two-step process to review goodwill for impairment. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. Our strategy, long-range business plan, and annual planning process support our goodwill impairment tests. These tests are performed, at a minimum, annually in the fourth quarter, and are based on an evaluation of future discounted cash flows. We rely on this discounted cash flow analysis to determine fair value. However outcomes from the discounted cash flow analysis are compared to other market approach valuation methodologies for reasonableness. We use discount rates that correspond to a market-based weighted-average cost of capital and terminal growth rates that correspond to long-term growth prospects, consistent with the long-term inflation rate. Key assumptions in our cash flow projections, including changes in membership, premium yields, medical and operating cost trends, and certain government contract extensions, are consistent with those utilized in our long-range business plan and annual planning process. If these assumptions differ from actual, including the impact of the Health Care Reform Law, the estimates underlying our goodwill impairment tests could be adversely affected. Goodwill impairment tests completed in each of the last three years did not result in an impairment loss. The fair value of our reporting units with significant goodwill exceeded carrying amounts by a substantial margin. A 100 basis point increase in the discount rate would not have a significant impact on the amount of margin for any of our reporting units with significant goodwill. Long-lived assets consist of property and equipment and other finite-lived intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. We periodically review long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation or amortization for these assets. There were no material impairment losses in the last three years.

<s>[INST] General Humana Inc., headquartered in Louisville, Ky., is a leading health and wellbeing company focused on making it easy for people to achieve their best health with clinical excellence through coordinated care. Our strategy integrates care delivery, the member experience, and clinical and consumer insights to encourage engagement, behavior change, proactive clinical outreach and wellness for the millions of people we serve across the country. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, which excludes depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Business Segments On January 1, 2014, we reclassified certain of our businesses from our Healthcare Services segment to our Employer Group segment to correspond with internal management reporting changes. Our reportable segments remain the same and prior period segment financial information has been recast to conform to the 2014 presentation. This is further described in Note 2 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data. We manage our business with three reportable segments: Retail, Employer Group, and Healthcare Services. In addition, the Other Businesses category includes businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on wellbeing solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources. The Retail segment consists of Medicare and commercial fullyinsured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and financial protection products, marketed directly to individuals, and includes our contract with CMS to administer the LINET prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and LongTerm Support Services benefits, collectively our statebased contracts. The Employer Group segment consists of Medicare and commercial fullyinsured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and voluntary benefit products, as well as administrative services only, or ASO, products and our health and wellness products primarily marketed to employer groups. The Healthcare Services segment includes services offered to our health plan members as well as to third parties including pharmacy solutions, provider services, home based services, integrated behavioral health services, and predictive modeling and informatics services. The Other Businesses category consists of our military services, primarily our TRICARE South Region contract, Puerto Rico Medicaid, and closedblock longterm care insurance policies. The results of each segment are measured by income before income taxes. Transactions between reportable segments consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, home based, and behavioral health, to our Retail and Employer Group customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often utilize the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at the corporate level. These corporate amounts are reported separately from our reportable segments and included with intersegment eliminations. Seasonality One of the product offerings of our Retail segment is Medicare standalone prescription drug plans, or PDPs, under the Medicare Part D program. Our quarterly Retail segment earnings and operating cash flows are impacted by the Medicare Part D benefit design and changes in the composition of our membership. The Medicare Part D benefit design results in coverage that varies as a member’s cumulative outofpocket costs pass through successive stages of a member’s plan period, which begins annually on January 1 for [/INST] Negative. </s>

HUMANA INC

2016-02-18

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Executive Overview General Humana Inc., headquartered in Louisville, Kentucky, is a leading health and well-being company focused on making it easy for people to achieve their best health with clinical excellence through coordinated care. Our strategy integrates care delivery, the member experience, and clinical and consumer insights to encourage engagement, behavior change, proactive clinical outreach and wellness for the millions of people we serve across the country. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, excluding depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Aetna Merger On July 2, 2015, we entered into an Agreement and Plan of Merger, which we refer to in this report as the Merger Agreement, with Aetna Inc. and certain wholly owned subsidiaries of Aetna Inc., which we refer to collectively as Aetna, which sets forth the terms and conditions under which we will merge with, and become a wholly owned subsidiary of Aetna, a transaction we refer to in this report as the Merger. A copy of the Merger Agreement was filed as Exhibit 2.1 to our Current Report on Form 8-K filed with the U.S. Securities and Exchange Commission on July 7, 2015. Under the terms of the Merger Agreement, at the closing of the Merger, each outstanding share of our common stock will be converted into the right to receive (i) 0.8375 of a share of Aetna common stock and (ii) $125 in cash. The total transaction was estimated at approximately $37 billion including the assumption of Humana debt, based on the closing price of Aetna common shares on July 2, 2015. The Merger Agreement includes customary restrictions on the conduct of our business prior to the completion of the Merger, generally requiring us to conduct our business in the ordinary course and subjecting us to a variety of customary specified limitations absent Aetna’s prior written consent, including, for example, limitations on dividends (we agreed that our quarterly dividend will not exceed $0.29 per share) and repurchases of our securities (we agreed to suspend our share repurchase program), restrictions on our ability to enter into material contracts, and negotiated thresholds for capital expenditures, capital contributions, acquisitions and divestitures of businesses. On October 19, 2015, our stockholders approved the adoption of the Merger Agreement at a special stockholder meeting. Of the 129,240,721 shares voting at the meeting, more than 99% voted in favor of the adoption of the Merger Agreement, which represented approximately 87% of our total outstanding shares of common stock as of the September 16, 2015 record date. Also on October 19, 2015, the holders of Aetna outstanding shares approved the issuance of Aetna common stock in the Merger at a special meeting of Aetna shareholders. The Merger is subject to customary closing conditions, including, among other things, (i) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and the receipt of necessary approvals under state insurance and healthcare laws and regulations and pursuant to certain licenses of certain of Humana’s subsidiaries, (ii) the absence of legal restraints and prohibitions on the consummation of the Merger, (iii) listing of the Aetna common stock to be issued in the Merger on the New York Stock Exchange, (iv) subject to the relevant standards set forth in the Merger Agreement, the accuracy of the representations and warranties made by each party, (v) material compliance by each party with its covenants in the Merger Agreement, and (vi) no “Company Material Adverse Effect” with respect to us and no “Parent Material Adverse Effect” with respect to Aetna, in each case since the execution of and as defined in the Merger Agreement. In addition, Aetna’s obligation to consummate the Merger is subject to (a) the condition that the required regulatory approvals do not impose any condition that, individually or in the aggregate, would reasonably be expected to have a “Regulatory Material Adverse Effect” (as such term is defined in the Merger Agreement), and (b) CMS has not imposed any sanctions with respect to our Medicare Advantage, or MA, business that, individually or in the aggregate, is or would reasonably be expected to be material and adverse to us and our subsidiaries, taken as a whole. The Merger is currently expected to close in the second half of 2016. Business Segments On January 1, 2015, we realigned certain of our businesses among our reportable segments to correspond with internal management reporting changes and renamed our Employer Group segment to the Group segment. Our three reportable segments remain Retail, Group, and Healthcare Services. The more significant realignments included reclassifying Medicare benefits offered to groups to the Retail segment from the Group segment, bringing all of our Medicare offerings, which are now managed collectively, together in one segment, recognizing that in some instances we market directly to individuals that are part of a group Medicare account. In addition, we realigned our military services business, primarily consisting of our TRICARE South Region contract previously included in the Other Businesses category, to our Group segment as we consider this contract with the government to be a group account. Prior period segment financial information has been recast to conform to the 2015 presentation. This is further described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We manage our business with three reportable segments: Retail, Group, and Healthcare Services. In addition, the Other Businesses category includes businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on well-being solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources. The Retail segment consists of Medicare benefits, marketed to individuals or directly via group accounts, as well as individual commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and financial protection products. In addition, the Retail segment also includes our contract with CMS to administer the LI-NET prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and Long-Term Support Services benefits, collectively our state-based contracts. The Group segment consists of employer group commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and voluntary insurance benefits, as well as administrative services only, or ASO products. In addition, our Group segment includes our health and wellness products (primarily marketed to employer groups) and military services business, primarily our TRICARE South Region contract. The Healthcare Services segment includes services offered to our health plan members as well as to third parties, including pharmacy solutions, provider services, home based services, and clinical programs, as well as services and capabilities to advance population health. We will continue to report under the category of Other Businesses those businesses which do not align with the reportable segments described above, primarily our closed-block long-term care insurance policies. The results of each segment are measured by income before income taxes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and home based services as well as clinical programs, to our Retail and Group customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often use the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at a corporate level. These corporate amounts are reported separately from our reportable segments and are included with intersegment eliminations. Seasonality One of the product offerings of our Retail segment is Medicare stand-alone prescription drug plans, or PDPs, under the Medicare Part D program. Our quarterly Retail segment earnings and operating cash flows are impacted by the Medicare Part D benefit design and changes in the composition of our membership. The Medicare Part D benefit design results in coverage that varies as a member’s cumulative out-of-pocket costs pass through successive stages of a member’s plan period, which begins annually on January 1 for renewals. These plan designs generally result in us sharing a greater portion of the responsibility for total prescription drug costs in the early stages and less in the latter stages. As a result, the PDP benefit ratio generally decreases as the year progresses. In addition, the number of low-income senior members as well as year-over-year changes in the mix of membership in our stand-alone PDP products affects the quarterly benefit ratio pattern. Our Group segment also experiences seasonality in the benefit ratio pattern. However, the effect is opposite of Medicare stand-alone PDP in the Retail segment, with the Group segment’s benefit ratio increasing as fully-insured members progress through their annual deductible and maximum out-of-pocket expenses. Similarly, certain of our fully-insured individual commercial medical products in our Retail segment experience seasonality in the benefit ratio akin to the Group segment, including the effect of existing previously underwritten members transitioning to policies compliant with the Health Care Reform Law with us and other carriers. As previously underwritten members transition, it results in policy lapses and the release of reserves for future policy benefits partially offset by the recognition of previously deferred acquisition costs. These policy lapses generally occur during the first quarter of the new coverage year following the open enrollment period reducing the benefit ratio in the first quarter. The recognition of a premium deficiency reserve for our individual commercial medical business compliant with the Health Care Reform Law in the fourth quarter of 2015, discussed in more detail in the highlights that follow, negatively impacted the benefit ratio pattern in 2015 and conversely is expected to favorably impact the benefit ratio in 2016 for this business. The quarterly benefit ratio pattern for our individual commercial medical business compliant with the Health Care Reform Law will be relatively flat throughout 2016 as opposed to the increasing benefit ratio pattern exhibited in prior years. In addition, the Retail segment also experiences seasonality in the operating cost ratio as a result of costs incurred in the second half of the year associated with the Medicare and individual health care exchange marketing seasons. 2015 Highlights Consolidated • Our 2015 results reflect the continued implementation of our strategy to offer our members affordable health care combined with a positive consumer experience in growing markets. At the core of this strategy is our integrated care delivery model, which unites quality care, high member engagement, and sophisticated data analytics. Our approach to primary, physician-directed care for our members aims to provide quality care that is consistent, integrated, cost-effective, and member-focused, provided by both employed physicians and physicians with network contract arrangements. The model is designed to improve health outcomes and affordability for individuals and for the health system as a whole, while offering our members a simple, seamless healthcare experience. We believe this strategy is positioning us for long-term growth in both membership and earnings. We offer providers a continuum of opportunities to increase the integration of care and offer assistance to providers in transitioning from a fee-for-service to a value-based arrangement. These include performance bonuses, shared savings and shared risk relationships. At December 31, 2015, approximately 1,633,100 members, or 59.3%, of our individual Medicare Advantage members were in value-based relationships under our integrated care delivery model, as compared to 1,301,000 members, or 53.6%, at December 31, 2014. • On June 1, 2015, we completed the sale of our wholly owned subsidiary, Concentra Inc., or Concentra, to MJ Acquisition Corporation, a joint venture between Select Medical Holdings Corporation and Welsh, Carson, Anderson & Stowe XII, L.P., a private equity fund, for approximately $1,055 million in cash, excluding approximately $22 million of transaction costs. In connection with the sale, we recognized a pre-tax gain, net of transaction costs, of $270 million, or $1.57 per diluted common share in 2015. • During 2015, we recorded transaction costs in connection with the Merger of approximately $23.1 million, or $0.14 per diluted common share. Certain costs associated with the transaction are not deductible for tax purposes. • Excluding the impact of the sale of Concentra and transaction costs associated with the Merger, our pretax results for 2015 as compared to 2014 reflect year-over-year improvement in the Group and Healthcare Services segment pretax results and higher investment income, partially offset by a year-over-year decline in Retail segment pretax results as discussed in the detailed segment results discussion that follows. • Year-over-year comparisons of the operating cost ratio are impacted by an increase in 2015 of the non-deductible health insurance industry fee mandated by the Health Care Reform Law. Likewise, year-over-year comparisons of the benefit ratio reflect the increase in this fee in the pricing of our products for 2015 which reduces our benefit ratio. • Investment income increased $97 million in 2015, primarily due to higher realized capital gains in 2015 as a result of the repositioning of our portfolio given recent market volatility and anticipated changes to interest rates. • Year-over-year comparisons of diluted earnings per common share are favorably impacted by a lower number of shares used to compute diluted earnings per common share reflecting the impact of share repurchases. • Operating cash flow provided by operations was $868 million for the year ended December 31, 2015 as compared to operating cash flow of $1.6 billion for the year ended December 31, 2014. The decrease in our operating cash flows primarily reflects the effect of significant growth in individual commercial medical and group Medicare Advantage membership in the prior year and changes in the timing of other working capital items related to the growth in our pharmacy business and growth in net receivables under the commercial risk adjustment, reinsurance, and risk corridor programs under the Health Care Reform Law, commonly referred to as the 3Rs. Prior year cash flows were favorably impacted from the typical pattern of claim payments that lagged premium receipts related to new membership. Individual commercial medical added 548,000 new members in 2014 compared to a decline of 90,400 members in 2015. Likewise, group Medicare Advantage added 60,600 new members in 2014 compared to a decline of 5,600 members in 2015. • In 2015, we paid the federal government $867 million for the annual non-deductible health insurance industry fee compared to our payment of $562 million in 2014. This fee is not deductible for tax purposes, which significantly increased our effective income tax rate beginning in 2014. The health insurance industry fee is further described below under the section titled "Health Care Reform." The Consolidated Appropriations Act, 2016, enacted on December 18, 2015, included a one-time one year suspension in 2017 of the health insurer fee. This will significantly reduce our effective tax rate in 2017. • During 2015, we repurchased 1.85 million shares in open market transactions for $329 million and paid dividends to stockholders of $172 million. Pursuant to the Merger Agreement, after July 2, 2015, we are prohibited from repurchasing any of our outstanding securities without the prior written consent of Aetna, other than repurchases of shares of our common stock in connection with the exercise of outstanding stock options or the vesting or settlement of outstanding restricted stock awards. Accordingly, as announced on July 3, 2015, we have suspended our share repurchase program. Our remaining repurchase authorization was $1.04 billion as of July 3, 2015. The Merger does not impact our ability and intent to continue quarterly dividend payments prior to the closing of the Merger consistent with our historical dividend payments. Under the terms of the Merger Agreement, we have agreed with Aetna that our quarterly dividend will not exceed $0.29 per share prior to the closing of the Merger. Retail Segment • On April 6, 2015, CMS announced final 2016 Medicare benchmark payment rates and related technical factors impacting the bid benchmark premiums, which we refer to as the Final Rate Notice. We believe the Final Rate Notice, together with the impact of payment cuts associated with the Health Care Reform Law, quality bonuses, risk coding modifications, and other funding formula changes, indicated 2016 Medicare Advantage funding increases for us of approximately 1.0% on average. Although the overall rate adjustment is positive, geographic-specific impacts may vary significantly from this average, particularly in Florida. We believe we have effectively designed Medicare Advantage products based upon the applicable level of rate changes while continuing to remain competitive compared to both the combination of original Medicare with a supplement policy and Medicare Advantage products offered by our competitors. Failure to execute these strategies may result in a material adverse effect on our results of operations, financial position, and cash flows. • In 2015, our Retail segment pretax income decreased by $409 million, or 30.5%, from 2014 primarily due to higher Medicare Advantage and individual commercial medical benefit ratios year-over-year, including the impact of benefits expense associated with a premium deficiency reserve for certain of our individual commercial products for the 2016 coverage year as described further below and in the results of operations discussion that follows. The higher benefit ratios were partially offset by declines in the Retail segment operating cost ratios, Medicare membership growth, and higher investment income year-over-year. • Individual Medicare Advantage operating results for 2015 included significant membership growth but were negatively impacted by certain developments related to our product pricing assumptions for 2015. These developments primarily related to lower-than-expected 2015 financial claim recovery levels (included in medical claims reserve development) and lower-than-anticipated reductions in inpatient admissions. Claims data from the fourth quarter of 2015 and early 2016 indicate that inpatient admissions continue to develop favorably versus expectations and claim recoveries have stabilized. We are closely monitoring these favorable trends. • Operating results for our individual commercial medical business compliant with the Health Care Reform Law have been challenged primarily due to unanticipated modifications in the program subsequent to the passing of the Health Care Reform Law, resulting in higher covered population morbidity and the ensuing enrollment and claims issues causing volatility in claims experience. The benefit ratios associated with many of our individual commercial medical products, in particular Health Care Reform Law compliant offerings, significantly exceeded prior expectations for fiscal year 2015, driven primarily by the on-going impact of the transitional policies, special enrollment period exemptions associated with the program, and government-mandated product designs that attracted higher-utilizing members . Additionally, on June 30, 2015, CMS issued data with respect to the reinsurance and risk adjustment premium stabilization programs for the 2014 plan year which indicated a healthier risk profile comparison for our membership relative to state averages than had been previously anticipated. This resulted in adjustments to certain of the 3Rs during 2015. We took a number of actions in 2015 to improve the profitability of our individual commercial medical business in 2016.These actions were subject to regulatory restrictions in certain geographies and included premium increases for the 2016 coverage year related generally to the first half of 2015 claims experience, the discontinuation of certain products as well as exit of certain markets for 2016, network improvements, enhancements to claims and clinical processes and administrative cost control. Despite these actions, the deterioration in the second half of 2015 claims experience together with 2016 open enrollment results indicating the retention of many high-utilizing members for 2016 resulted in a probable future loss. As a result of our assessment of the profitability of our individual medical policies compliant with the Health Care Reform Law, in the fourth quarter of 2015, we recorded a provision for probable future losses (premium deficiency reserve) for the 2016 coverage year of $176 million, or $0.74 per diluted common share. The premium deficiency reserve includes the estimated benefit of approximately $340 million associated with risk corridor provisions expected for the 2016 coverage year. In light of the premium deficiency reserve recognized in the fourth quarter of 2015 for the 2016 coverage year, results for this business for 2016 are expected to primarily include results associated with the wind-down of plans that are not compliant with the Health Care Reform Law, including the related release of policy reserves, as well as indirect administrative costs associated with plans that are compliant with the Health Care Reform Law. We are continuing to evaluate our participation in the individual commercial medical line of business for 2017. • Individual Medicare Advantage membership of 2,753,400 at December 31, 2015 increased 325,500 members, or 13.4%, from 2,427,900 at December 31, 2014 reflecting net membership additions, particularly for our Health Maintenance Organization, or HMO, offerings, for the 2015 plan year. January 2016 individual Medicare Advantage membership approximated 2,811,000, increasing approximately 57,600 members, or 2%, from December 31, 2015 reflecting net membership additions during the recently completed 2016 annual election period for Medicare beneficiaries. For full year 2016, we anticipate net membership growth in our individual Medicare Advantage offerings of 100,000 to 120,000. • Group Medicare Advantage membership of 484,100 at December 31, 2015 decreased 5,600 members, or 1.1%, from 489,700 at December 31, 2014. For full year 2016, we expect a net membership decline in our Group Medicare Advantage offerings of 120,000 to 125,000 members primarily due to the loss of a large account that converted to a private exchange offering. Approximately 50% of members from that account selected an individual Humana offering for 2016, with the majority enrolling in a Medicare supplement plan. • Medicare stand-alone PDP membership of 4,557,900 at December 31, 2015 increased 563,900 members, or 14.1%, from 3,994,000 at December 31, 2014 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2015 plan year. January 2016 Medicare stand-alone PDP membership (excluding transitional growth from the LI-NET prescription drug plan program) increased approximately 240,000 members, or 5%, from December 31, 2015 reflecting net membership additions, primarily for our Humana-Walmart plan offering, during the recently completed 2016 annual election period for Medicare beneficiaries. For full year 2016, we anticipate net membership growth in our Medicare stand-alone PDP offerings of 300,000 to 330,000. • Our state-based Medicaid membership of 373,700 at December 31, 2015 increased 56,900 members, or 18.0%, from 316,800 at December 31, 2014 primarily driven by the addition of members under our Florida Medicaid contract. • Individual commercial medical membership of 1,057,700 at December 31, 2015 decreased 90,400 members, or 7.9%, from 1,148,100 at December 31, 2014 primarily reflecting the loss of approximately 150,000 members due to termination by CMS for lack of proper eligibility documentation from the member as well as the loss of members who had subscribed to plans that were not compliant with the Health Care Reform Law. These declines were partially offset by an increase in membership in plans that are compliant with the Health Care Reform Law, primarily off-exchange. Individual commercial medical membership in plans compliant with the Health Care Reform Law experienced growth in 2015, but at a lesser rate than in 2014. At December 31, 2015, individual commercial medical membership in plans compliant with the Health Care Reform Law, both on-exchange and off-exchange, was 757,900 members, an increase of 71,600 members or 10.4% from December 31, 2014. We expect a net decline in individual commercial medical membership (excluding Medicare Supplement) for full year 2016 of 200,000 to 300,000, primarily reflecting increases in premiums as well as benefit redesigns that took effect on January 1, 2016. This membership expectation takes into account plans compliant with the Health Care Reform Law, both on and off exchange, and legacy plans that are not compliant with the Health Care Reform Law. Membership estimates for 2016 include the expectation of coverage termination by 50% to 60% of the approximately 100,000 members impacted by plan discontinuances. Group Segment • Group segment pretax income grew $107 million, or 70.9%, for the year ended December 31, 2015 primarily due to improvement in the operating cost ratio partially offset by an increase in the benefit ratio as discussed in the results of operations discussion that follows. • Membership in HumanaVitality®, our wellness and loyalty rewards program, rose 2.0% to 3,932,300 at December 31, 2015 from 3,856,800 at December 31, 2014. Healthcare Services Segment • Year-over-year comparisons of results of operations are impacted by the completion of the sale of Concentra on June 1, 2015. • As discussed in the detailed Healthcare Services segment results of operations discussion that follows, our Healthcare Services segment pretax income increased $243 million, or 32.9%, for the year ended December 31, 2015. This increase was primarily due to higher earnings from our pharmacy solutions and home based services businesses as they serve our growing Medicare membership. High levels of Medicare membership growth as well as increased engagement of members in clinical programs have resulted in higher usage of services across this segment. In addition, improved operating efficiency in the pharmacy business primarily was driven by lower cost of goods associated with increased purchasing scale and lower cost-to-fill primarily due to improvements in technology. • Programs to enhance the quality of care for members are key elements of our integrated care delivery model. We have expanded our identification of and outreach to members in need of clinical intervention. At December 31, 2015, we enrolled approximately 590,300 Medicare Advantage members with complex chronic conditions in the Humana Chronic Care Program, a 40.3% increase compared with approximately 420,700 members at December 31, 2014, reflecting enhanced predictive modeling capabilities and focus on proactive clinical outreach and member engagement. We believe these initiatives lead to better health outcomes for our members and lower health care costs. Health Care Reform The Health Care Reform Law enacted significant reforms to various aspects of the U.S. health insurance industry. Certain significant provisions of the Health Care Reform Law include, among others, mandated coverage requirements, mandated benefits and guarantee issuance associated with commercial medical insurance, rebates to policyholders based on minimum benefit ratios, adjustments to Medicare Advantage premiums, the establishment of federally-facilitated or state-based exchanges coupled with programs designed to spread risk among insurers, and the introduction of plan designs based on set actuarial values. In addition, the Health Care Reform Law established insurance industry assessments, including an annual health insurance industry fee and a three-year $25 billion industry wide commercial reinsurance fee. The annual health insurance industry fee levied on the insurance industry was $8 billion in 2014 and $11.3 billion in each of 2015 and 2016, with increasing annual amounts thereafter, and is not deductible for income tax purposes, which significantly increased our effective income tax rate. Our effective tax rate for 2015 was approximately 47.5%, including the favorable impact of the sale of Concentra on June 1, 2015. Our effective tax rate for 2016 is expected to be approximately 49% to 51%, excluding the impact of transaction costs associated with the Merger. In 2015, we paid the federal government $867 million for the annual health insurance industry fee, a 54.3% increase from $562 million in 2014, primarily reflecting an increase in the total industry fee. We expect our portion of the annual health insurance industry fee for 2016 to be higher than in 2015 given growth in our market share. The Consolidated Appropriations Act, 2016, enacted on December 18, 2015, included a one-time one year suspension in 2017 of the health insurer fee. This will significantly reduce our effective tax rate in 2017. The health insurance industry fee levied on the insurance industry was previously expected to be $14 billion in 2017. In addition, the Health Care Reform Law expands federal oversight of health plan premium rates and could adversely affect our ability to appropriately adjust health plan premiums on a timely basis. Financing for these reforms comes, in part, from material additional fees and taxes on us (as discussed above) and other health plans and individuals which began in 2014, as well as reductions in certain levels of payments to us and other health plans under Medicare as described in this 2015 10-K. As noted above, the Health Care Reform Law required the establishment of health insurance exchanges for individuals and small employers to purchase health insurance that became effective January 1, 2014, with an annual open enrollment period. Insurers participating on the health insurance exchanges must offer a minimum level of benefits and are subject to guidelines on setting premium rates and coverage limitations. We may be adversely selected by individuals who have a higher acuity level than the anticipated pool of participants in this market. In addition, the risk corridor, reinsurance, and risk adjustment provisions of the Health Care Reform Law, established to apportion risk for insurers, may not be effective in appropriately mitigating the financial risks related to our products. In addition, regulatory changes to the implementation of the Health Care Reform Law that allowed individuals to remain in plans that are not compliant with the Health Care Reform Law or to enroll outside of the annual enrollment period may have an adverse effect on our pool of participants in the health insurance exchange. In addition, states may impose restrictions on our ability to increase rates. All of these factors may have a material adverse effect on our results of operations, financial position, or cash flows if our premiums are not adequate or do not appropriately reflect the acuity of these individuals. Any variation from our expectations regarding acuity, enrollment levels, adverse selection, or other assumptions used in setting premium rates could have a material adverse effect on our results of operations, financial position, and cash flows and could impact our decision to participate or continue in the program in certain states. As discussed above, it is reasonably possible that the Health Care Reform Law and related regulations, as well as future legislative changes, including legislative restrictions on our ability to manage our provider network or otherwise operate our business, or regulatory restrictions on profitability, including by comparison of our Medicare Advantage profitability to our non-Medicare Advantage business profitability and a requirement that they remain within certain ranges of each other, in the aggregate may have a material adverse effect on our results of operations (including restricting revenue, enrollment and premium growth in certain products and market segments, restricting our ability to expand into new markets, increasing our medical and operating costs, further lowering our Medicare payment rates and increasing our expenses associated with the non-deductible health insurance industry fee and other assessments); our financial position (including our ability to maintain the value of our goodwill); and our cash flows (including the delayed receipt of amounts due under the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law). During 2015, we received our interim settlement associated with our risk corridor receivables for the 2014 coverage year. The interim settlement, representing only 12.6% of risk corridor receivables for the 2014 coverage year, was funded by HHS in accordance with previous guidance, utilizing funds HHS collected from us and other carriers under the 2014 risk corridor program. The risk corridor program is a three year program and HHS guidance provides that risk corridor collections over the life of the three year program will first be applied to any shortfalls from previous benefit years before application to current year obligations. Risk corridor payables to issuers are obligations of the United States Government under the Health Care Reform law which requires the Secretary of HHS to make full payments to issuers. In the event of a shortfall at the end of the three year program, HHS has asserted it will explore other sources of funding for risk corridor payments, subject to the availability of appropriations. We intend for the discussion of our financial condition and results of operations that follows to assist in the understanding of our financial statements and related changes in certain key items in those financial statements from year to year, including the primary factors that accounted for those changes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and home based services as well as clinical programs, to our Retail and Group customers and are described in Note 17 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this 2015 10-K. Comparison of Results of Operations for 2015 and 2014 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2015 and 2014: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs, excluding depreciation and amortization, as a percentage of total revenues less investment income. Summary Net income was $1.3 billion, or $8.44 per diluted common share, in 2015 compared to $1.1 billion, or $7.36 per diluted common share, in 2014. The completion of the sale of Concentra on June 1, 2015 resulted in an after-tax gain of $1.57 per diluted common share in 2015. Excluding the impact of the sale of Concentra, the decrease primarily was due to a decline in Retail segment pretax results, including expense of $0.74 per diluted common share for a premium deficiency reserve for certain of our individual commercial medical products for the 2016 coverage year, and an increase in the effective tax rate as discussed below. These items were partially offset by year-over-year improvement in the Group and Healthcare Services segment pretax results and higher investment income. In addition, 2015 includes expenses of $0.14 per diluted common share for transaction costs associated with the Merger, certain of which are not deductible for tax purposes. Net income for 2014 includes expenses of $0.15 per diluted common share associated with a loss on extinguishment of debt for the redemption of certain senior notes in 2014. Year-over-year comparisons of diluted earnings per common share are also favorably impacted by a lower number of shares used to compute diluted earnings per common share in 2015 reflecting the impact of share repurchases. Premiums Revenue Consolidated premiums increased $6.5 billion, or 14.0%, from 2014 to $52.4 billion for 2015 primarily reflecting higher premiums in both the Retail and Group segments. These higher premiums were primarily driven by average membership growth in the Retail segment and an increase in fully-insured group commercial medical per member premiums in the Group segment. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Premiums revenue reflects changes in membership and average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership. Services Revenue Consolidated services revenue decreased $758 million, or 35.0%, from 2014 to $1.4 billion for 2015 primarily due to the completion of the sale of Concentra on June 1, 2015 as well as the loss of certain large group ASO accounts as a result of continued discipline in pricing of services for self-funded accounts amid a highly competitive environment. Investment Income Investment income totaled $474 million for 2015, an increase of $97 million, or 25.7%, from 2014, primarily due to higher realized capital gains in 2015 as a result of the repositioning of our portfolio given recent market volatility and anticipated changes to interest rates, with higher average invested balances being substantially offset by lower interest rates. Benefits Expense Consolidated benefits expense was $44.3 billion for 2015, an increase of $6.1 billion, or 16.0%, from 2014 primarily due to an increase in the Retail segment mainly driven by higher average Medicare Advantage membership and individual commercial medical on-exchange and off-exchange membership in plans compliant with the Health Care Reform Law. As more fully described herein under the section entitled “Benefits Expense Recognition”, actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $236 million in 2015 and $518 million in 2014. The decline in prior-period medical claims reserve development year over-year primarily was due to Medicare Advantage and individual commercial medical claims development in the Retail segment as discussed further in the segment results of operations discussion that follows. The consolidated benefit ratio for 2015 was 84.5%, an increase of 150 basis points from 2014 primarily due to increases in the Retail segment, including the impact of a recognizing a premium deficiency reserve for certain of our individual commercial medical products for the 2016 coverage year, and Group segment ratios as discussed in the segment results of operations discussions that follows. The increase in benefits expense associated with the recognition of the premium deficiency reserve increased the consolidated benefit ratio by approximately 30 basis points in 2015. Favorable prior-period medical claims reserve development decreased the consolidated benefit ratio by approximately 50 basis points in 2015 versus approximately 110 basis points in 2014. Operating Costs Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs decreased $321 million, or 4.2%, from 2014 to $7.3 billion in 2015 primarily due to cost management initiatives across all lines of business as well as the completion of the sale of Concentra on June 1, 2015, partially offset by increases in costs mandated by the Health Care Reform Law, including the non-deductible health insurance industry fee. The consolidated operating cost ratio for 2015 was 13.6%, decreasing 230 basis points from 2014 primarily due to decreases in the operating cost ratios in the Group and Retail segments reflecting cost management initiatives, as well as the completion of the sale of Concentra on June 1, 2015. Concentra carried a higher operating cost ratio. Depreciation and Amortization Depreciation and amortization for 2015 totaled $355 million, increasing $22 million, or 6.6% from 2014 reflecting higher depreciation expense from capital expenditures. Interest Expense Interest expense was $186 million for 2015 compared to $192 million for 2014, a decrease of $6 million, or 3.1%, primarily reflecting a higher average long-term debt balance due to the issuance of senior notes in September 2014, partially offset by the recognition of a loss on extinguishment of debt of approximately $37 million in October 2014 for the redemption of our $500 million 6.45% senior unsecured notes due June 1, 2016. Income Taxes Our effective tax rate during 2015 was 47.5% compared to the effective tax rate of 47.2% in 2014. The increase in the effective tax rate primarily was due to an increase in the non-deductible health insurance industry fee from 2014, substantially offset by the favorable tax effect of the gain on the sale of Concentra. See Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. Our effective tax rate for 2016 is expected to be approximately 49% to 51%, excluding the impact of any non-deductible transaction costs associated with the Merger. Retail Segment (a) Individual commercial medical membership includes Medicare Supplement members. (b) Specialty products include dental, vision, and other supplemental health and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Retail segment pretax income was $930 million in 2015, a decrease of $409 million, or 30.5%, compared to 2014 primarily driven by an increase in the benefit ratio for 2015, including the impact of recognizing a premium deficiency reserve of approximately $176 million for certain of our individual commercial medical products for the 2016 coverage year, partially offset by a decline in the operating cost ratio, Medicare Advantage membership growth, and higher investment income year-over-year. Enrollment • Individual Medicare Advantage membership increased 325,500 members, or 13.4%, from December 31, 2014 to December 31, 2015 reflecting net membership additions, particularly for our HMO offerings, for the 2015 plan year. • Group Medicare Advantage membership decreased 5,600 members, or 1.1%, from December 31, 2014 to December 31, 2015. • Medicare stand-alone PDP membership increased 563,900 members, or 14.1%, from December 31, 2014 to December 31, 2015 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2015 plan year. • Individual commercial medical membership decreased 90,400 members, or 7.9%, from December 31, 2014 to December 31, 2015 primarily reflecting the loss of approximately 150,000 members due to termination by CMS for lack of proper eligibility documentation from the member as well as the loss of members who had subscribed to plans that were not compliant with the Health Care Reform Law. These declines were partially offset by an increase in membership in plans that are compliant with the Health Care Reform Law, primarily off-exchange. • State-based Medicaid membership increased 56,900 members, or 18.0%, from December 31, 2014 to December 31, 2015 primarily driven by the addition of members under our Florida Medicaid contract. • Individual specialty membership decreased 12,700 members, or 1.1%, from December 31, 2014 to December 31, 2015 primarily driven by a membership decline in supplemental health and financial protection product and vision offerings. Premiums revenue • Retail segment premiums increased $6.4 billion, or 16.1%, from 2014 to 2015 primarily due to membership growth across our Medicare Advantage, state-based Medicaid, and Medicare stand-alone PDP lines of business, as well as a heavier percentage of individual commercial medical business in higher premium plans compliant with the Health Care Reform Law. Average Medicare Advantage membership increased 11.8% in 2015. Benefits expense • The Retail segment benefit ratio of 86.7% for 2015 increased 180 basis points from 2014 primarily due to higher than expected medical costs as compared to the assumptions used in our pricing, the recognition of a premium deficiency reserve in the fourth quarter of 2015 for certain of our individual commercial medical products for the 2016 coverage year, and unfavorable year-over-year comparisons of prior-period medical claims reserve development as discussed below. In addition, the increase reflects higher benefit ratios associated with a greater number of members from state-based contracts and the impact of the change in estimate for the 2014 net 3Rs receivables in 2015. These items were partially offset by the impact of the increase in the health insurance industry fee included in the pricing of our products. In addition, the 2015 period was favorably impacted by the release of reserves for future policy benefits as individual commercial medical members transitioned to plans compliant with the Health Care Reform Law. We experienced higher than expected medical costs as compared to the assumptions used in our pricing for 2015 primarily due to lower-than-expected 2015 Medicare Advantage financial claim recovery levels and lower-than-anticipated reductions in inpatient admissions. In addition, medical claims associated with certain individual commercial medical products, in particular products compliant with the Health Care Reform Law, exceeded the assumptions used when we set pricing for 2015. We took a number of actions in 2015 to improve the profitability of our individual commercial medical business in 2016. These actions were subject to regulatory restrictions in certain geographies and included premium increases for the 2016 coverage year related generally to the first half of 2015 claims experience, the discontinuation of certain products as well as exit of certain markets for 2016, network improvements, enhancements to claims and clinical processes and administrative cost control. Despite these actions, the deterioration in the second half of 2015 claims experience together with 2016 open enrollment results indicating the retention of many high-utilizing members for 2016 resulted in a probable future loss. As a result of our assessment of the profitability of our individual medical policies compliant with the Health Care Reform Law, in the fourth quarter of 2015, we recorded a provision for probable future losses (premium deficiency reserve) for the 2016 coverage year of $176 million. The increase in benefits expense associated with the recognition of the premium deficiency reserve increased the Retail segment benefit ratio by approximately 40 basis points in 2015. • The Retail segment’s benefits expense for 2015 included the beneficial effect of $228 million in favorable prior-year medical claims reserve development versus $488 million in 2014. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 50 basis points in 2015 versus approximately 120 basis points in 2014. The year-over-year decline in prior-period medical claims reserve development primarily was due to the impact of lower financial claim recoveries due in part to our gradual implementation during 2014 of inpatient authorization review prior to admission as opposed to post adjudication, as well as higher than expected flu associated claims from the fourth quarter of 2014 and continued volatility in claims associated with individual commercial medical products. Operating costs • The Retail segment operating cost ratio of 11.2% for 2015 decreased 40 basis points from 2014 primarily reflecting administrative cost efficiencies associated with medical membership growth in the segment and other discretionary cost reductions, partially offset by the increase in the non-deductible health insurance industry fee. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 160 basis points in 2015 as compared to 120 basis points in 2014. Group Segment (a) Specialty products include dental, vision, and other voluntary benefit products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Group segment pretax income increased $107 million, or 70.9%, to $258 million in 2015 primarily reflecting improvement in the operating cost ratio partially offset by an increase in the benefit ratio as discussed below. Enrollment • Fully-insured commercial group medical membership decreased 57,200 members, or 4.6% from December 31, 2014 reflecting lower membership in both large and small group accounts. • Group ASO commercial medical membership decreased 393,600 members, or 35.6%, from December 31, 2014 to December 31, 2015 primarily due to the loss of certain large group accounts as a result of continued discipline in pricing of services for self-funded accounts amid a highly competitive environment. • Group specialty membership decreased 434,000 members, or 6.7%, from December 31, 2014 to December 31, 2015 primarily due to the loss of certain fully-insured group medical accounts that also had specialty coverage. Premiums revenue • Group segment premiums increased $113 million, or 1.8%, from 2014 to 2015 primarily due to an increase in fully-insured commercial medical per member premiums partially offset by a net decline in fully-insured commercial medical membership. Services revenue • Group segment services revenue decreased $65 million, or 8.5%, from 2014 to 2015 primarily due to a decline in group ASO commercial medical membership. Benefits expense • The Group segment benefit ratio increased 70 basis points from 79.5% in 2014 to 80.2% in 2015 primarily reflecting the impact of higher specialty drug costs, net of rebates, as well as higher outpatient costs and lower prior-period medical claims reserve development, partially offset by an increase in the non-deductible health insurance industry fee included in the pricing of our products. • The Group segment’s benefits expense included the beneficial effect of $7 million in favorable prior-year medical claims reserve development versus $29 million in 2014. This favorable prior-year medical claims reserve development decreased the Group segment benefit ratio by approximately 10 basis points in 2015 versus approximately 40 basis points in 2014. The year-over-year decline in favorable prior-period medical claims reserve development primarily was due to a relatively small number of higher severity claims in the 2015 period associated with prior periods. Operating costs • The Group segment operating cost ratio of 24.0% for 2015 decreased 250 basis points from 26.5% for 2014, reflecting a decline in our group ASO commercial medical membership which carries a higher operating cost ratio than our fully-insured commercial medical membership, as well as operating cost efficiencies associated with our fully-insured business. Operating cost efficiencies were the result of both sustainable cost reduction initiatives and discretionary reductions. These declines were partially offset by the impact of an increase in the non-deductible health insurance industry fee. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 140 basis points in 2015 as compared to 100 basis points in 2014. Healthcare Services Segment Pretax results • Healthcare Services segment pretax income of $981 million for 2015 increased $243 million, or 32.9%, from 2014 primarily due to higher earnings from our pharmacy solutions and home based services businesses as they serve our growing Medicare membership. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Group segment membership increased to approximately 398 million in 2015, up 21% versus scripts of approximately 329 million in 2014. The increase primarily reflects growth associated with higher average medical membership for 2015 than in 2014. Services revenue • Services revenue decreased $668 million, or 49.4%, from 2014 to $685 million for 2015 primarily due to the completion of the sale of Concentra on June 1, 2015. Intersegment revenues • Intersegment revenues increased $4.1 billion, or 21.6%, from 2014 to $22.9 billion for 2015 primarily due to growth in our Medicare membership which resulted in higher utilization of our Healthcare Services segment businesses. Operating costs • The Healthcare Services segment operating cost ratio of 95.2% for 2015 decreased 40 basis points from 95.6% for 2014 primarily due to lower operating costs in our pharmacy business together with discretionary cost reductions across the segment, partially offset by the increasing percentage of pharmacy business associated with lower margin specialty drugs. Improving operating efficiency in the pharmacy business was primarily driven by lower cost of goods associated with increased purchasing scale and lower cost-to-fill primarily due to improvements in technology. Comparison of Results of Operations for 2014 and 2013 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2014 and 2013: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs, excluding depreciation and amortization, as a percentage of total revenues less investment income. Summary Net income was $1.1 billion, or $7.36 per diluted common share, in 2014 compared to $1.2 billion, or $7.73 per diluted common share, in 2013. Net income for 2014 includes expenses of $0.15 per diluted common share associated with a loss on extinguishment of debt for the redemption of certain senior notes in 2014 and net income for 2013 includes benefits expense of $0.99 per diluted common share for reserve strengthening associated with our closed- block of long-term care insurance policies included with Other Businesses as discussed in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data as well as the benefit of a reduction in benefits expense in 2013 related to a favorable settlement of contract claims with the DoD. Excluding these items, the increase in net income primarily resulted from higher pretax income in our Healthcare Services segment substantially offset by lower pretax income in our Retail and Group segments. In addition, 2014 was favorably impacted by a lower number of shares used to compute diluted earnings per common share reflecting the impact of share repurchases. Premiums Revenue Consolidated premiums increased $7.1 billion, or 18.4%, from 2013 to $46.0 billion for 2014 primarily due to increases in both Retail and Group segment premiums mainly driven by higher average individual and group Medicare Advantage membership as well as higher individual commercial medical membership. In addition, year-over-year comparisons to 2013 were negatively impacted by sequestration which became effective April 1, 2013. Premiums revenue for our Other Businesses declined primarily due to the loss of our Puerto Rico Medicaid contracts effective September 30, 2013. Services Revenue Consolidated services revenue increased $55 million, or 2.6%, from 2013 to $2.2 billion for 2014 primarily due to an increase in services revenue in our Retail segment due to the acquisition of American Eldercare in September 2013. Investment Income Investment income totaled $377 million for 2014, an increase of $2 million from 2013, as higher average invested balances were partially offset by lower interest rates. Benefits Expense Consolidated benefits expense was $38.2 billion for 2014, an increase of $5.6 billion, or 17.2%, from 2013 primarily due to increases in both the Retail and Group segments mainly driven by higher average individual and group Medicare Advantage membership as well as higher individual commercial medical membership. We experienced favorable medical claims reserve development related to prior fiscal years of $518 million in 2014 and $474 million in 2013. These increases in favorable medical claims reserve development primarily resulted from increased membership and better than originally expected utilization across most of our major business lines and increased financial recoveries. The increase in financial recoveries primarily resulted from claim audit process enhancements as well as increased volume of claim audits and expanded audit scope. All lines of business benefited from these improvements. The consolidated benefit ratio for 2014 was 83.0%, a decrease of 90 basis points from 2013 primarily due to reserve strengthening in 2013 associated with our closed-block of long-term care insurance policies included with Other Businesses as discussed above, as well as the loss of our Medicaid contracts in Puerto Rico effective September 30, 2013 which more than offset higher ratios year-over-year in the Retail and Group segments. Operating Costs Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs increased $1,284 million, or 20.2%, in 2014 compared to 2013 primarily due to costs mandated by the Health Care Reform Law, including the non-deductible health insurance industry fee, and investments in health care exchanges and state-based contracts, partially offset by operating cost efficiencies. The consolidated operating cost ratio for 2014 was 15.9%, increasing 40 basis points from 2013 primarily due to increases in the operating cost ratios in our Retail and Group segments due to the same factors impacting consolidated operating costs as described above. Depreciation and Amortization Depreciation and amortization for 2014 totaled $333 million, unchanged from 2013. Interest Expense Interest expense was $192 million for 2014 compared to $140 million for 2013, an increase of $52 million, or 37.1%. In September 2014, we issued $400 million of 2.625% senior notes due October 1, 2019, $600 million of 3.85% senior notes due October 1, 2024 and $750 million of 4.95% senior notes due October 1, 2044. In October 2014, we redeemed the $500 million 6.45% senior unsecured notes due June 1, 2016, at 100% of the principal amount plus applicable premium for early redemption and accrued and unpaid interest to the redemption date, We recognized a loss on extinguishment of debt of approximately $37 million in October 2014 for the redemption of these notes. Income Taxes Our effective tax rate during 2014 was 47.2% compared to the effective tax rate of 35.9% in 2013. The non-deductible nature of the health insurance industry fee levied on the insurance industry beginning in 2014 as mandated by the Health Care Reform Law increased our effective tax rate by approximately 9.4 percentage points for 2014. Retail Segment (a) Individual commercial medical membership includes Medicare Supplement members. (b) Specialty products include dental, vision, and other supplemental health and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Retail segment pretax income was $1.3 billion in 2014, a decrease of $151 million, or 10.1%, compared to 2013 primarily driven by investment spending for health care exchanges and state-based contracts and higher specialty prescription drug costs associated with a new treatment for Hepatitis C, partially offset by Medicare Advantage and individual commercial medical membership growth as well as increased membership in our clinical programs. Enrollment • Individual Medicare Advantage membership increased 359,200 members, or 17.4%, from December 31, 2013 to December 31, 2014 reflecting net membership additions, particularly for our HMO offerings, for the 2014 plan year. • Fully-insured group Medicare Advantage membership increased 60,600 members, or 14.1%, from December 31, 2013 to December 31, 2014 primarily due to the addition of a new large group account. • Medicare stand-alone PDP membership increased 718,100 members, or 21.9%, from December 31, 2013 to December 31, 2014 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2014 plan year. • Individual commercial medical membership increased 548,000 members, or 91.3%, from December 31, 2013 to December 31, 2014 primarily reflecting new sales, both on-exchange and off-exchange, of plans compliant with the Health Care Reform Law. • State-based Medicaid membership increased 231,300 members, or 270.5%, from December 31, 2013 to December 31, 2014 primarily driven by the addition of members under our Florida Medicaid and Florida Long-Term Support Services contracts as well as 18,300 dual eligible members from state-based contracts in Virginia and Illinois. • Individual specialty membership increased 123,300 members, or 11.8%, from December 31, 2013 to December 31, 2014 primarily driven by increased membership in dental and vision offerings. Premiums revenue • Retail segment premiums increased $7.5 billion, or 23.6%, from 2013 to 2014 primarily due to membership growth across all lines of business, particularly for our Medicare Advantage, individual commercial medical, primarily on the health care exchanges, and state-based Medicaid businesses. Individual Medicare Advantage average membership increased 16.6% in 2014. Individual Medicare Advantage per member premiums decreased approximately 1.7% in 2014 compared to 2013, primarily due to Medicare rate reductions and the impact of sequestration which became effective on April 1, 2013. Benefits expense • The Retail segment benefit ratio of 84.9% for 2014 decreased 20 basis points from 2013 primarily due to increased membership in our clinical programs and the inclusion of the health insurance industry fee in the pricing of our products, partially offset by higher specialty prescription drug costs associated with a new treatment for Hepatitis C, higher planned clinical investment spending, and higher benefit ratios associated with members from state-based contracts. • The Retail segment’s benefits expense for 2014 included the beneficial effect of $488 million in favorable prior-year medical claims reserve development versus $428 million in 2013. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 120 basis points in 2014 versus approximately 130 basis points in 2013. Operating costs • The Retail segment operating cost ratio of 11.6% for 2014 increased 150 basis points from 2013 primarily due to the non-deductible health insurance industry fee mandated by the Health Care Reform Law and investment spending for health care exchanges and state-based contracts, partially offset by scale efficiencies from Medicare and individual commercial medical membership growth. Group Segment (a) Specialty products include dental, vision, and voluntary benefit products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Group segment pretax income decreased $89 million, or 37.1%, to $151 million in 2014 primarily reflecting higher utilization, mainly due to higher specialty prescription drug costs associated with a new treatment for Hepatitis C, as well as the continuing impact of transitional policy changes which allowed individuals to remain in plans not compliant with the Health Care Reform Law. Enrollment • Fully-insured commercial group medical membership decreased 1,500 members, or 0.1% from December 31, 2013 as an increase in small group business membership was generally offset by lower membership in large group accounts. Approximately 65% of our fully-insured commercial group medical membership was in small group accounts at December 31, 2014 compared to 61% at December 31, 2013. • Group ASO commercial medical membership decreased 58,500 members, or 5.0%, from December 31, 2013 to December 31, 2014 primarily due to continued pricing discipline in a highly competitive environment for self-funded accounts. • Group specialty membership decreased 278,100 members, or 4.1%, from December 31, 2013 to December 31, 2014 primarily due to declines in dental and vision membership related to our planned discontinuance of certain unprofitable product distribution partnerships. Premiums revenue • Group segment premiums increased $219.0 million, or 3.5%, from 2013 to 2014 primarily due to higher fully-insured commercial group medical premiums per member that more than offset a slight decline in total membership for this segment. Benefits expense • The Group segment benefit ratio increased 180 basis points from 77.7% in 2013 to 79.5% in 2014 primarily due to higher utilization, mainly due to higher specialty prescription drug costs associated with a new treatment for Hepatitis C, as well as the continuing impact of transitional policy changes, partially offset by the inclusion of the health insurance industry fee and other fees mandated by the Health Care Reform Law in our pricing. • The Group segment’s benefits expense included the beneficial effect of $29 million in favorable prior-year medical claims reserve development versus $42 million in 2013. This favorable prior-year medical claims reserve development decreased the Group segment benefit ratio by approximately 40 basis points in 2014 versus approximately 70 basis points in 2013. Operating costs • The Group segment operating cost ratio of 26.5% was unchanged from 2013, reflecting the impact of the non-deductible health insurance industry fee and other fees mandated by the Health Care Reform Law as well as a higher percentage of small group commercial business which carries a higher operating cost ratio than large group business, offset by operating cost efficiencies. Healthcare Services Segment Pretax results • Healthcare Services segment pretax income of $738 million for 2014 increased $218 million from 2013. The increase is primarily due to a decline in the operating cost ratio in 2014 on a revenue base that reflects growth from our pharmacy solutions and home based services businesses as they serve our growing Medicare membership. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Group segment membership increased to approximately 329 million in 2014, up 20% versus scripts of approximately 274 million in 2013. The increase primarily reflects growth associated with higher average medical membership for 2014 than in 2013. Services revenue • Services revenue for 2014 were relatively unchanged from 2013, increasing $3 million, or 0.2%, to $1.4 billion for 2014. Intersegment revenues • Intersegment revenues increased $4.2 billion, or 28.3%, from 2013 to $18.8 billion for 2014 primarily due to growth in our Medicare membership which resulted in higher utilization of our pharmacy solutions and home based services businesses. Operating costs • The Healthcare Services segment operating cost ratio of 95.6% for 2014 decreased 20 basis points from 95.8% for 2013 primarily due to an improvement in the ratio for our pharmacy solutions business partially offset by our investment in home based services and other businesses across the segment. Other Businesses Our Other Businesses pretax income of $1 million for 2014 compared to a pretax loss of $289 million for 2013. The pretax loss in 2013 included net expense of $243 million for reserve strengthening for our closed-block of long-term care insurance policies further discussed in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Year-over-year comparisons also reflect the loss of our Medicaid contracts in Puerto Rico effective September 30, 2013. Liquidity The Merger Agreement includes customary restrictions on the conduct of our business prior to the completion of the Merger, generally requiring us to conduct our business in the ordinary course and subjecting us to a variety of specified limitations absent Aetna’s prior written consent. Historically, our primary sources of cash have included receipts of premiums, services revenue, and investment and other income, as well as proceeds from the sale or maturity of our investment securities, borrowings, and proceeds from sales of businesses. Our primary uses of cash historically have included disbursements for claims payments, operating costs, interest on borrowings, taxes, purchases of investment securities, acquisitions, capital expenditures, repayments on borrowings, dividends, and share repurchases. Because premiums generally are collected in advance of claim payments by a period of up to several months, our business normally should produce positive cash flows during periods of increasing premiums and enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing premiums and enrollment. From period to period, our cash flows may also be affected by the timing of working capital items including premiums receivable, benefits payable, and other receivables and payables. Our cash flows are impacted by the timing of payments to and receipts from CMS associated with Medicare Part D subsidies for which we do not assume risk. The use of operating cash flows may be limited by regulatory requirements of state departments of insurance (or comparable state regulators) which require, among other items, that our regulated subsidiaries maintain minimum levels of capital and seek approval before paying dividends from the subsidiaries to the parent. Our use of operating cash flows derived from our non-insurance subsidiaries, such as in our Healthcare Services segment, is generally not restricted by state departments of insurance (or comparable state regulators). The effect of the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law impact the timing of our operating cash flows, as we build receivables for each coverage year that are expected to be collected in subsequent coverage years. On June 30, 2015 we received notification from CMS of risk adjustment and reinsurance settlement amounts for 2014. During 2015, we collected $392 million net for risk adjustment and reinsurance recoverable settlements associated with the 2014 coverage year. In addition, during 2015, we received our interim settlement associated with our risk corridor receivables for the 2014 coverage year. The interim settlement, representing only 12.6% of risk corridor receivables for the 2014 coverage year, was funded by HHS in accordance with previous guidance, utilizing funds HHS collected from us and other carriers under the 2014 risk corridor program. We collected $25 million net of payments for risk corridor associated with the 2014 coverage year during 2015. HHS provided guidance under the three year risk corridor program that future collections will first be applied to any shortfalls from previous coverage years before application to current year obligations. Risk corridor payables to issuers are obligations of the United States Government under the Health Care Reform law which requires the Secretary of HHS to make full payments to issuers. In the event of a shortfall at the end of the three year program, HHS has asserted it will explore other sources of funding for risk corridor payments, subject to the availability of appropriations. The remaining net receivable balance associated with the 3Rs was approximately $982 million at December 31, 2015, including $219 million related to the 2014 coverage year, and $679 million at December 31, 2014. Any amounts receivable or payable associated with these risk limiting programs may have an impact on subsidiary liquidity, with any temporary shortfalls funded by the parent company. For additional information on our liquidity risk, please refer to Item 1A. - Risk Factors in this 2015 Form 10-K. Cash and cash equivalents increased to $2.6 billion at December 31, 2015 from $1.9 billion at December 31, 2014. The change in cash and cash equivalents for the years ended December 31, 2015, 2014 and 2013 is summarized as follows: Cash Flow from Operating Activities The change in operating cash flows over the three year period primarily results from the corresponding change in earnings, enrollment activity, and the timing of working capital items as discussed below. The lower operating cash flows in 2015 primarily reflect the effect of significant growth in individual commercial medical and group Medicare Advantage membership in 2014 and changes in the timing of working capital items related to the growth in our pharmacy business. Operating cash flows for 2014 were favorably impacted and conversely operating cash flows for 2015 were negatively impacted from the typical pattern of claim payments that lagged premium receipts related to new membership in 2014. Individual commercial medical added 548,000 new members in 2014 compared to a decline of 90,400 members in 2015. Likewise, group Medicare Advantage added 60,600 new members in 2014 compared to a decline of 5,600 members in 2015. In addition, 2015 and 2014 operating cash flows were impacted by increased receivables associated with the 3Rs. The most significant drivers of changes in our working capital are typically the timing of payments of benefits expense and receipts for premiums. We illustrate these changes with the following summaries of benefits payable and receivables. The detail of benefits payable was as follows at December 31, 2015, 2014 and 2013: (1) IBNR represents an estimate of benefits payable for claims incurred but not reported (IBNR) at the balance sheet date and includes unprocessed claim inventories. The level of IBNR is primarily impacted by membership levels, medical claim trends and the receipt cycle time, which represents the length of time between when a claim is initially incurred and when the claim form is received (i.e. a shorter time span results in a lower IBNR). (2) Reported claims in process represents the estimated valuation of processed claims that are in the post claim adjudication process, which consists of administrative functions such as audit and check batching and handling, as well as amounts owed to our pharmacy benefit administrator which fluctuate due to bi-weekly payments and the month-end cutoff. (3) Premium deficiency reserve recognized in 2015 for our individual commercial medical business compliant with the Health Care Reform Law associated with the 2016 coverage year. (4) Other benefits payable include amounts owed to providers under capitated and risk sharing arrangements. The increases in benefits payable in 2015 and 2014 largely were due to an increase in IBNR. IBNR increased during 2015 primarily as a result of individual Medicare Advantage membership growth while during 2014 IBNR also increased as a result of individual Medicare Advantage membership growth as well as significant growth in individual commercial medical and group Medicare Advantage membership. As discussed previously, our cash flows are impacted by changes in enrollment. In 2014 (the first year plans compliant with the Health Care Reform Law were effective), membership in new fully-insured individual commercial medical plans compliant with the Health Care Reform Law grew as compared with a decline in membership in these plans in 2015. Similarly, growth in group Medicare Advantage membership in 2014 favorably impacted the 2014 cash flows while a decline in group Medicare Advantage membership in 2015 negatively impacted the 2015 cash flows. In addition, the increase in benefits payable in 2015 reflects the recognition of a premium deficiency reserve associated with our individual commercial medical products compliant with the Health Care Reform Law for the 2016 coverage year. An increase in the amount of processed but unpaid claims due to our pharmacy benefit administrator, which fluctuates due to month-end cutoff, also contributed to the benefits payable increase in each of 2015 and 2014. These items were partially offset by a decrease in amounts owed to providers under capitated and risk sharing arrangements in both 2015 and 2014, including the disbursement of a portion of our Medicare risk adjustment collections under our contractual obligations associated with our risk sharing arrangements. The increase in benefits payable in 2013 primarily was due to an increase in the amount of processed but unpaid claims due to our pharmacy benefit administrator and an increase in IBNR, primarily as a result of Medicare Advantage membership growth. The detail of total net receivables was as follows at December 31, 2015, 2014 and 2013: As disclosed previously, on June 1, 2015, we completed the sale of our wholly owned subsidiary Concentra. Net receivables associated with Concentra were classified as held-for-sale at December 31, 2014 and December 31, 2013 and excluded from the table above for comparative purposes. Medicare receivables are impacted by revenue growth associated with growth in individual and group Medicare membership and the timing of accruals and related collections associated with the CMS risk-adjustment model. The increases in commercial and other receivables in each of 2015, 2014, and 2013 primarily are due to growth in the business. Excluding the effect of classifying Concentra receivables as held-for-sale at December 31, 2014, the increase in commercial and other receivables from 2013 to 2014 is primarily due to the commercial risk adjustment provision of the Health Care Reform Law which became effective in 2014. Military services receivables at December 31, 2015, 2014, and 2013 primarily consist of administrative services only fees owed from the federal government for administrative services provided under our current TRICARE South Region contract. Many provisions of the Health Care Reform Law became effective in 2014, including the commercial risk adjustment, risk corridor, and reinsurance provisions as well as the non-deductible health insurance industry fee. As discussed previously, the timing of payments and receipts associated with these provisions impact our operating cash flows as we build receivables for each coverage year that are expected to be collected in subsequent coverage years. The net receivable balance associated with the 3Rs was approximately $982 million at December 31, 2015 and $679 million at December 31, 2014, including certain amounts recorded in receivables as noted above. In 2015, we paid the federal government $867 million for the annual health insurance industry fee compared to our payment of $562 million in 2014. In addition to the timing of payments of benefits expense, receipts for premiums and services revenues, and amounts due under the risk limiting and health insurance industry fee provisions of the Health Care Reform Law, other items impacting operating cash flows primarily resulted from the timing of working capital related to the growth in our pharmacy and payments for the Medicare Part D risk corridor provisions of our contracts with CMS. Cash Flow from Investing Activities On June 1, 2015, we completed the sale of Concentra for approximately $1,055 million in cash, excluding approximately $22 million of transaction costs. Our ongoing capital expenditures primarily relate to our information technology initiatives, support of services in our provider services operations including medical and administrative facility improvements necessary for activities such as the provision of care to members, claims processing, billing and collections, wellness solutions, care coordination, regulatory compliance and customer service. Total capital expenditures, excluding acquisitions, were $523 million in 2015, $528 million in 2014, and $441 million in 2013. In 2015, we purchased a $284 million note receivable directly from a third-party bank syndicate related to the financing of MCCI Holdings, LLC's business as described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. The purchase of this note is included with purchases of investment securities in our consolidated statement of cash flows. Proceeds from sales and maturities of investment securities exceeded purchases by $103 million in 2015 and $411 million in 2014. These net proceeds were used to fund normal working capital needs due to an increase in receivables associated with the 3Rs in addition to the timing of payments to and receipts from CMS associated with Medicare Part D reinsurance subsidies, as discussed below. We reinvested a portion of our operating cash flows in investment securities, primarily investment-grade fixed income securities, totaling $592 million in 2013. Cash consideration paid for acquisitions, net of cash acquired, was $38 million in 2015, $18 million in 2014, and $187 million in 2013. Acquisitions in 2015 and 2014 included health and wellness related acquisitions. Cash paid for acquisitions in 2013 primarily related to the American Eldercare and other health and wellness related acquisitions. Cash Flow from Financing Activities Claims payments were $361 million higher than receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk during 2015, $945 million higher during 2014, and $155 million higher during 2013. Our 2014 financing cash flows were negatively impacted by the timing of payments to and receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk. We experienced higher specialty prescription drug costs associated with a new treatment for Hepatitis C than were contemplated in our bids which resulted in higher subsidy receivable balances in 2014 that were settled in 2015 under the terms of our contracts with CMS. Our net receivable for CMS subsidies and brand name prescription drug discounts was $2.0 billion at December 31, 2015 compared to $1.7 billion at December 31, 2014. Refer to Note 6 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Under our administrative services only TRICARE South Region contract, health care cost payments for which we do not assume risk exceeded reimbursements from the federal government by $4 million in 2015 and were less than reimbursements from the federal government by $5 million in 2013. Reimbursements from the federal government equaled health care cost payments for which we do not assume risk in 2014. Receipts from HHS associated with cost sharing provisions of the Health Care Reform Law for which we do not assume risk were higher than claims payments by $69 million in 2015 and $26 million in 2014. See Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for further description. We repurchased 1.9 million shares for $329 million in 2015, 5.7 million shares for $730 million in 2014 (excludes another $100 million held back pending final settlement of an accelerated stock repurchase plan in March 2015), and 5.8 million shares for $502 million in 2013 under share repurchase plans authorized by the Board of Directors. We also acquired common shares in connection with employee stock plans for an aggregate cost of $56 million in 2015, $42 million in 2014, and $29 million in 2013. As discussed further below, we paid dividends to stockholders of $172 million in each of 2015 and 2014 and $168 million in 2013. We entered into a commercial paper program in October 2014. Net proceeds from the issuance of commercial paper were $298 million 2015 and the maximum principal amount outstanding at any one time during 2015 was $414 million. There were no net proceeds from the issuance of commercial paper in 2014 and the maximum principal amount outstanding at any one time during 2014 was $175 million. In September 2014, we issued $400 million of 2.625% senior notes due October 1, 2019, $600 million of 3.85% senior notes due October 1, 2024 and $750 million of 4.95% senior notes due October 1, 2044. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses, were $1.73 billion. We used a portion of the net proceeds to redeem our $500 million 6.45% senior unsecured notes. The remainder of the cash used in or provided by financing activities in 2015, 2014, and 2013 primarily resulted from proceeds from stock option exercises and the change in book overdraft. Future Sources and Uses of Liquidity Dividends The following table provides details of dividend payments, excluding dividend equivalent rights, in 2013, 2014, and 2015 under our Board approved quarterly cash dividend policy: The Merger discussed in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data does not impact our ability and intent to continue quarterly dividend payments prior to the closing of the Merger consistent with our historical dividend payments. Under the terms of the Merger Agreement, we have agreed with Aetna that our quarterly dividend will not exceed $0.29 per share prior to the closing of the Merger. Declaration and payment of future quarterly dividends is at the discretion of our Board and may be adjusted as business needs or market conditions change. In addition, under the terms of the Merger Agreement, we have agreed with Aetna to coordinate the declaration and payment of dividends so that our stockholders do not fail to receive a quarterly dividend around the time of the closing of the Merger. On October 29, 2015, the Board declared a cash dividend of $0.29 per share that was paid on January 29, 2016 to stockholders of record on December 30, 2015, for an aggregate amount of $43 million. Stock Repurchases In September 2014, our Board of Directors replaced a previous share repurchase authorization of up to $1 billion (of which $816 million remained unused) with a new current authorization for repurchases of up to $2 billion of our common shares exclusive of shares repurchased in connection with employee stock plans, expiring on December 31, 2016. Under the share repurchase authorization, shares may be purchased from time to time at prevailing prices in the open market, by block purchases, through plans designed to comply with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended, or in privately-negotiated transactions (including pursuant to accelerated share repurchase agreements with investment banks), subject to certain regulatory restrictions on volume, pricing, and timing. Pursuant to the Merger Agreement, after July 2, 2015, we are prohibited from repurchasing any of our outstanding securities without the prior written consent of Aetna, other than repurchases of shares of our common stock in connection with the exercise of outstanding stock options or the vesting or settlement of outstanding restricted stock awards. Accordingly, as announced on July 3, 2015, we have suspended our share repurchase program. Our remaining repurchase authorization was $1.04 billion as of July 3, 2015. Senior Notes In September 2014, we issued $400 million of 2.625% senior notes due October 1, 2019, $600 million of 3.85% senior notes due October 1, 2024 and $750 million of 4.95% senior notes due October 1, 2044. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses, were $1.73 billion. We used a portion of the net proceeds to redeem the 6.45% senior unsecured notes as discussed below. We previously issued $500 million of 6.45% senior notes due June 1, 2016 that were redeemed in October 2014, $500 million of 7.20% senior notes due June 15, 2018, $300 million of 6.30% senior notes due August 1, 2018, $600 million of 3.15% senior notes due December 1, 2022, $250 million of 8.15% senior notes due June 15, 2038, and $400 million of 4.625% senior notes due December 1, 2042. In October 2014, we redeemed the $500 million 6.45% senior unsecured notes due June 1, 2016, at 100% of the principal amount plus applicable premium for early redemption and accrued and unpaid interest to the redemption date, for cash totaling approximately $560 million. We recognized a loss on extinguishment of debt of approximately $37 million in October 2014 in connection with the redemption of these notes. Our senior notes, which are unsecured, may be redeemed at our option at any time at 100% of the principal amount plus accrued interest and a specified make-whole amount. The 7.20% and 8.15% senior notes are subject to an interest rate adjustment if the debt ratings assigned to the notes are downgraded (or subsequently upgraded). In addition, each series of our senior notes (other than the 6.30% senior notes) contain a change of control provision that may require us to purchase the notes under certain circumstances. On July 2, 2015 we entered into a Merger Agreement with Aetna that, when closed, may require redemption of the notes if the notes are downgraded below investment grade by both Standard & Poor’s Rating Services, or S&P and Moody’s Investors Services, Inc., or Moody’s. Credit Agreement Our 5-year $1.0 billion unsecured revolving credit agreement expires July 2018. Under the credit agreement, at our option, we can borrow on either a competitive advance basis or a revolving credit basis. The revolving credit portion bears interest at either LIBOR plus a spread or the base rate plus a spread. The LIBOR spread, currently 110 basis points, varies depending on our credit ratings ranging from 90 to 150 basis points. We also pay an annual facility fee regardless of utilization. This facility fee, currently 15 basis points, may fluctuate between 10 and 25 basis points, depending upon our credit ratings. The competitive advance portion of any borrowings will bear interest at market rates prevailing at the time of borrowing on either a fixed rate or a floating rate based on LIBOR, at our option. The terms of the credit agreement include standard provisions related to conditions of borrowing, including a customary material adverse effect clause which could limit our ability to borrow additional funds. In addition, the credit agreement contains customary restrictive and financial covenants as well as customary events of default, including financial covenants regarding the maintenance of a minimum level of net worth of $8.5 billion at December 31, 2015 and a maximum leverage ratio of 3.0:1. We are in compliance with the financial covenants, with actual net worth of $10.3 billion and an actual leverage ratio of 1.3:1, as measured in accordance with the credit agreement as of December 31, 2015. In addition, the credit agreement includes an uncommitted $250 million incremental loan facility. At December 31, 2015, we had no borrowings outstanding under the credit agreement and we had outstanding letters of credit of $1 million secured under the credit agreement. No amounts have been drawn on these letters of credit. Accordingly, as of December 31, 2015, we had $999 million of remaining borrowing capacity under the credit agreement, none of which would be restricted by our financial covenant compliance requirement. We have other customary, arms-length relationships, including financial advisory and banking, with some parties to the credit agreement. Commercial Paper In October 2014, we entered into a commercial paper program pursuant to which we may issue short-term, unsecured commercial paper notes privately placed on a discount basis through certain broker dealers. Amounts available under the program may be borrowed, repaid and re-borrowed from time to time, with the aggregate face or principal amount outstanding under the program at any time not to exceed $1 billion. The net proceeds of issuances have been and are expected to be used for general corporate purposes. The maximum principal amount outstanding at any one time during the year ended December 31, 2015 was $414 million. There was $299 million outstanding at December 31, 2015. Liquidity Requirements We believe our cash balances, investment securities, operating cash flows, and funds available under our credit agreement and our commercial paper program or from other public or private financing sources, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, acquisitions, future expansion opportunities, and capital expenditures for at least the next twelve months, as well as to refinance or repay debt, and repurchase shares. Adverse changes in our credit rating may increase the rate of interest we pay and may impact the amount of credit available to us in the future. Our investment-grade credit rating at December 31, 2015 was BBB+ according to Standard & Poor’s Rating Services, or S&P, and Baa3 according to Moody’s Investors Services, Inc., or Moody’s. A downgrade by S&P to BB+ or by Moody’s to Ba1 triggers an interest rate increase of 25 basis points with respect to $750 million of our senior notes. Successive one notch downgrades increase the interest rate an additional 25 basis points, or annual interest expense by $2 million, up to a maximum 100 basis points, or annual interest expense by $8 million. In addition, we operate as a holding company in a highly regulated industry. Humana Inc., our parent company, is dependent upon dividends and administrative expense reimbursements from our subsidiaries, most of which are subject to regulatory restrictions. We continue to maintain significant levels of aggregate excess statutory capital and surplus in our state-regulated operating subsidiaries. Cash, cash equivalents, and short-term investments at the parent company increased to $1.6 billion at December 31, 2015 from $1.4 billion at December 31, 2014. This increase primarily reflects proceeds from the sale of Concentra on June 1, 2015, proceeds from issuance of commercial paper and subsidiary dividends to the parent company, partially offset by funding of subsidiary working capital requirements, common stock repurchases, capital expenditures, and payment of stockholder dividends. Our use of operating cash derived from our non-insurance subsidiaries, such as our Healthcare Services segment, is generally not restricted by Departments of Insurance. Our regulated subsidiaries paid dividends to the parent of $493 million in 2015, $927 million in 2014, and $967 million in 2013. Subsidiary dividends in 2015 reflect the impact of losses for our individual commercial medical business compliant with the Health Care Reform Law and the November 5, 2015 revised statutory accounting guidance requiring the exclusion of risk corridor receivables from related statutory surplus described below. Refer to our parent company financial statements and accompanying notes in Schedule I - Parent Company Financial Information. Excluding Puerto Rico subsidiaries, the amount of ordinary dividends that may be paid to our parent company in 2016 is approximately $900 million, in the aggregate. Actual dividends paid may vary due to consideration of excess statutory capital and surplus and expected future surplus requirements related to, for example, premium volume and product mix. On November 5, 2015, the National Association of Insurance Commissioners, or NAIC, issued statutory accounting guidance for receivables associated with the risk corridor provisions under the Health Care Reform Law, which requires the receivables to be excluded from subsidiary surplus. This accounting guidance required additional capital contributions into certain subsidiaries during 2015. This statutory accounting guidance does not affect our financial statements prepared in accordance with generally accepted accounting principles, under which we have recorded a receivable for risk corridor amounts due to us as an obligation of the United States Government under the Health Care Reform Law. At December 31, 2015, our gross risk corridor receivable for the 2014 and 2015 coverage years in the aggregate was $459 million. We expect to record a risk corridor receivable of approximately $340 million in 2016 for the 2016 coverage year. Certain regulated subsidiaries recognized premium deficiency reserves for our individual commercial medical policies compliant with the Health Care Reform Law for the 2016 coverage year in the fourth quarter of 2015. Further, the statutory-based premium deficiency excludes the estimated benefit associated with the risk corridor provisions as a reduction in subsidiary surplus in accordance with the previously discussed November 5, 2015 statutory accounting guidance requiring the exclusion of risk corridor amounts from subsidiary surplus. As a result of the statutory-based premium deficiency, we will fund capital contributions into certain regulated subsidiaries of $450 million during the first quarter of 2016. In 2015, we paid the federal government $867 million for the annual health insurance industry fee and expect to pay a higher amount in 2016 given an increase in market share. The Consolidated Appropriations Act, 2016, enacted on December 18, 2015, included a one-time one year suspension in 2017 of the health insurer fee. Regulatory Requirements For a detailed discussion of our regulatory requirements, including aggregate statutory capital and surplus as well as dividends paid from the subsidiaries to the parent, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Contractual Obligations We are contractually obligated to make payments for years subsequent to December 31, 2015 as follows: (1) Interest includes the estimated contractual interest payments under our debt agreements. (2) We lease facilities, computer hardware, and other furniture and equipment under long-term operating leases that are noncancelable and expire on various dates through 2026. We sublease facilities or partial facilities to third party tenants for space not used in our operations which partially mitigates our operating lease commitments. An operating lease is a type of off-balance sheet arrangement. Assuming we acquired the asset, rather than leased such asset, we would have recognized a liability for the financing of these assets. See also Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. (3) Purchase obligations include agreements to purchase services, primarily information technology related services, or to make improvements to real estate, in each case that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum levels of service to be purchased; fixed, minimum or variable price provisions; and the appropriate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. (4) Includes future policy benefits payable ceded to third parties through 100% coinsurance agreements as more fully described in Note 19 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We expect the assuming reinsurance carriers to fund these obligations and reflected these amounts as reinsurance recoverables included in other long-term assets on our consolidated balance sheet. Amounts payable in less than one year are included in trade accounts payable and accrued expenses in the consolidated balance sheet. Off-Balance Sheet Arrangements As of December 31, 2015, we were not involved in any special purpose entity, or SPE, transactions. For a detailed discussion off-balance sheet arrangements, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Guarantees and Indemnifications For a detailed discussion our guarantees and indemnifications, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Government Contracts For a detailed discussion of our government contracts, including our Medicare, Military, and Medicaid contracts, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and accompanying notes, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements and accompanying notes requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We continuously evaluate our estimates and those critical accounting policies primarily related to benefits expense and revenue recognition as well as accounting for impairments related to our investment securities, goodwill, and long-lived assets. These estimates are based on knowledge of current events and anticipated future events and, accordingly, actual results ultimately may differ from those estimates. We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements. Benefits Expense Recognition Benefits expense is recognized in the period in which services are provided and includes an estimate of the cost of services which have been incurred but not yet reported, or IBNR. IBNR represents a substantial portion of our benefits payable as follows: Our reserving practice is to consistently recognize the actuarial best point estimate within a level of confidence required by actuarial standards. Actuarial standards of practice generally require a level of confidence such that the liabilities established for IBNR have a greater probability of being adequate versus being insufficient, or such that the liabilities established for IBNR are sufficient to cover obligations under an assumption of moderately adverse conditions. Adverse conditions are situations in which the actual claims are expected to be higher than the otherwise estimated value of such claims at the time of the estimate. Therefore, in many situations, the claim amounts ultimately settled will be less than the estimate that satisfies the actuarial standards of practice. We develop our estimate for IBNR using actuarial methodologies and assumptions, primarily based upon historical claim experience. Depending on the period for which incurred claims are estimated, we apply a different method in determining our estimate. For periods prior to the most recent two months, the key assumption used in estimating our IBNR is that the completion factor pattern remains consistent over a rolling 12-month period after adjusting for known changes in claim inventory levels and known changes in claim payment processes. Completion factors result from the calculation of the percentage of claims incurred during a given period that have historically been adjudicated as of the reporting period. For the most recent two months, the incurred claims are estimated primarily from a trend analysis based upon per member per month claims trends developed from our historical experience in the preceding months, adjusted for known changes in estimates of recent hospital and drug utilization data, provider contracting changes, changes in benefit levels, changes in member cost sharing, changes in medical management processes, product mix, and weekday seasonality. The completion factor method is used for the months of incurred claims prior to the most recent two months because the historical percentage of claims processed for those months is at a level sufficient to produce a consistently reliable result. Conversely, for the most recent two months of incurred claims, the volume of claims processed historically is not at a level sufficient to produce a reliable result, which therefore requires us to examine historical trend patterns as the primary method of evaluation. Changes in claim processes, including recoveries of overpayments, receipt cycle times, claim inventory levels, outsourcing, system conversions, and processing disruptions due to weather or other events affect views regarding the reasonable choice of completion factors. Claim payments to providers for services rendered are often net of overpayment recoveries for claims paid previously, as contractually allowed. Claim overpayment recoveries can result from many different factors, including retroactive enrollment activity, audits of provider billings, and/or payment errors. Changes in patterns of claim overpayment recoveries can be unpredictable and result in completion factor volatility, as they often impact older dates of service. The receipt cycle time measures the average length of time between when a medical claim was initially incurred and when the claim form was received. Increases in electronic claim submissions from providers decrease the receipt cycle time. If claims are submitted or processed on a faster (slower) pace than prior periods, the actual claim may be more (less) complete than originally estimated using our completion factors, which may result in reserves that are higher (lower) than required. Medical cost trends potentially are more volatile than other segments of the economy. The drivers of medical cost trends include increases in the utilization of hospital facilities, physician services, new higher priced technologies and medical procedures, and new prescription drugs and therapies, as well as the inflationary effect on the cost per unit of each of these expense components. Other external factors such as government-mandated benefits or other regulatory changes, the tort liability system, increases in medical services capacity, direct to consumer advertising for prescription drugs and medical services, an aging population, lifestyle changes including diet and smoking, catastrophes, and epidemics also may impact medical cost trends. Internal factors such as system conversions, claims processing cycle times, changes in medical management practices and changes in provider contracts also may impact our ability to accurately predict estimates of historical completion factors or medical cost trends. All of these factors are considered in estimating IBNR and in estimating the per member per month claims trend for purposes of determining the reserve for the most recent two months. Additionally, we continually prepare and review follow-up studies to assess the reasonableness of the estimates generated by our process and methods over time. The results of these studies are also considered in determining the reserve for the most recent two months. Each of these factors requires significant judgment by management. The completion and claims per member per month trend factors are the most significant factors impacting the IBNR estimate. The portion of IBNR estimated using completion factors for claims incurred prior to the most recent two months is generally less variable than the portion of IBNR estimated using trend factors. The following table illustrates the sensitivity of these factors assuming moderate adverse experience and the estimated potential impact on our operating results caused by reasonably likely changes in these factors based on December 31, 2015 data: (a) Reflects estimated potential changes in benefits payable at December 31, 2015 caused by changes in completion factors for incurred months prior to the most recent two months. (b) Reflects estimated potential changes in benefits payable at December 31, 2015 caused by changes in annualized claims trend used for the estimation of per member per month incurred claims for the most recent two months. (c) The factor change indicated represents the percentage point change. The following table provides a historical perspective regarding the accrual and payment of our benefits payable, excluding military services. Components of the total incurred claims for each year include amounts accrued for current year estimated benefits expense as well as adjustments to prior year estimated accruals. The following table summarizes the changes in estimate for incurred claims related to prior years attributable to our key assumptions. As previously described, our key assumptions consist of trend and completion factors estimated using an assumption of moderately adverse conditions. The amounts below represent the difference between our original estimates and the actual benefits expense ultimately incurred as determined from subsequent claim payments. (a) The factor change indicated represents the percentage point change. As previously discussed, our reserving practice is to consistently recognize the actuarial best estimate of our ultimate liability for claims. Actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $236 million in 2015, $518 million in 2014, and $474 million in 2013. The table below details our favorable medical claims reserve development related to prior fiscal years by segment for 2015, 2014, and 2013. The favorable medical claims reserve development for 2015, 2014, and 2013 primarily reflects the consistent application of trend and completion factors estimated using an assumption of moderately adverse conditions. The decline in favorable prior period development in 2015 primarily was due to the impact of lower financial claim recoveries due in part to our gradual implementation during 2014 of inpatient authorization review prior to admission as opposed to post adjudication, as well as higher than expected flu associated claims from the fourth quarter of 2014 and continued volatility in claims associated with individual commercial medical products. The higher favorable prior period development during 2014 and 2013 resulted from increased membership, better than originally expected utilization across most of our major business lines and increased financial recoveries. The increase in financial recoveries primarily resulted from claim audit process enhancements as well as increased volume of claim audits and expanded audit scope. All lines of business benefited from these improvements. We continually adjust our historical trend and completion factor experience with our knowledge of recent events that may impact current trends and completion factors when establishing our reserves. Because our reserving practice is to consistently recognize the actuarial best point estimate using an assumption of moderately adverse conditions as required by actuarial standards, there is a reasonable possibility that variances between actual trend and completion factors and those assumed in our December 31, 2015 estimates would fall towards the middle of the ranges previously presented in our sensitivity table. Benefits expense excluded from the previous table was as follows for the years ended December 31, 2015, 2014 and 2013: In the fourth quarter of 2015, we recognized a premium deficiency reserve for our individual commercial medical business compliant with the Health Care Reform Law associated with the 2016 coverage year as discussed in more detail in Note 7 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Military services benefits expense for 2015 and 2014 reflect expenses associated with our contracts with the Veterans Administration. Military services benefits expense for 2013 reflects the beneficial effect of a favorable settlement of contract claims with the DoD partially offset by expenses associated with our contracts with the Veterans Administration. Certain health policies sold to individuals prior to 2014 (the first year plans compliant with the Health Care Reform Law were effective) are accounted for as long-duration as more fully described below. The reduction in future policy benefits in 2015 reflects the release of reserves as individual commercial medical members transition to plans compliant with the Health Care Reform Law. Future policy benefits payable of $2.2 billion and $2.3 billion at December 31, 2015 and 2014, respectively, represent liabilities for long-duration insurance policies including long-term care insurance, life insurance, annuities, and certain health and other supplemental policies sold to individuals for which some of the premium received in the earlier years is intended to pay anticipated benefits to be incurred in future years. At policy issuance, these reserves are recognized on a net level premium method based on premium rate increase, interest rate, mortality, morbidity, persistency (the percentage of policies remaining in-force), and maintenance expense assumptions. Interest rates are based on our expected net investment returns on the investment portfolio supporting the reserves for these blocks of business. Mortality, a measure of expected death, and morbidity, a measure of health status, assumptions are based on published actuarial tables, modified based upon actual experience. The assumptions used to determine the liability for future policy benefits are established and locked in at the time each contract is issued and only change if our expected future experience deteriorates to the point that the level of the liability, together with the present value of future gross premiums, are not adequate to provide for future expected policy benefits and maintenance costs (i.e. the loss recognition date). Because these policies have long-term claim payout periods, there is a greater risk of significant variability in claims costs, either positive or negative. We perform loss recognition tests at least annually in the fourth quarter, and more frequently if adverse events or changes in circumstances indicate that the level of the liability, together with the present value of future gross premiums, may not be adequate to provide for future expected policy benefits and maintenance costs. Future policy benefits payable include $1.5 billion at December 31, 2015 and 2014 associated with a non-strategic closed block of long-term care insurance policies acquired in connection with the 2007 acquisition of KMG. Approximately 31,800 policies remain in force as of December 31, 2015. No new policies have been written since 2005 under this closed block. Future policy benefits payable includes amounts charged to accumulated other comprehensive income for an additional liability that would exist on our closed-block of long-term care insurance policies if unrealized gains on the sale of the investments backing such products had been realized and the proceeds reinvested at then current yields. There was no additional liability at December 31, 2015 and $123 million of additional liability at December 31, 2014. Amounts charged to accumulated other comprehensive income are net of applicable deferred taxes. Long-term care insurance policies provide nursing home and home health coverage for which premiums are collected many years in advance of benefits paid, if any. Therefore, our actual claims experience will emerge many years after assumptions have been established. The risk of a deviation of the actual interest, morbidity, mortality, and maintenance expense assumptions from those assumed in our reserves are particularly significant to our closed block of long-term care insurance policies. A prolonged period during which interest rates remain at levels lower than those anticipated in our reserving would result in shortfalls in investment income on assets supporting our obligation under long term care policies because the long duration of the policy obligations exceeds the duration of the supporting investment assets. Further, we monitor the loss experience of these long-term care insurance policies and, when necessary, apply for premium rate increases through a regulatory filing and approval process in the jurisdictions in which such products were sold. To the extent premium rate increases, interest rates, and/or loss experience vary from our loss recognition date assumptions, future material adjustments to reserves could be required. During 2013, we recorded a loss for a premium deficiency. The premium deficiency was based on current and anticipated experience that had deteriorated from our locked-in assumptions from the previous December 31, 2010 loss recognition date, particularly as they related to emerging experience due to an increase in life expectancies and utilization of home health care services. Based on this deterioration, and combined with lower interest rates, we determined that our existing future policy benefits payable, together with the present value of future gross premiums, associated with our closed block of long-term care insurance policies were not adequate to provide for future policy benefits and maintenance costs under these policies; therefore we unlocked and modified our assumptions based on current expectations. Accordingly, during 2013 we recorded $243 million of additional benefits expense, with a corresponding increase in future policy benefits payable of $350 million partially offset by a related reinsurance recoverable of $107 million included in other long-term assets. For our closed block of long-term care policies, actuarial assumptions used to estimate reserves are inherently uncertain due to the potential changes in trends in mortality, morbidity, persistency and interest rates as well as premium rate increases. As a result, our long term care reserves may be subject to material increases if these trends develop adversely to our expectations. The estimated increase in reserves and additional benefit expense from hypothetically modeling adverse variations in our actuarial assumptions, in the aggregate, could be up to $400 million, net of reinsurance. Although such hypothetical revisions are not currently appropriate, we believe they could occur based on past variances in experience and our expectation of the ranges of future experience that could reasonably occur, and any such revision could be material. Generally accepted accounting principles do not allow us to unlock our assumptions for favorable items. In addition, future policy benefits payable includes amounts of $205 million at December 31, 2015, $210 million at December 31, 2014, and $215 million at December 31, 2013 which are subject to 100% coinsurance agreements as more fully described in Note 19 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, and as such are offset by a related reinsurance recoverable included in other long-term assets. Revenue Recognition We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group on 30-day written notice. Our Medicare contracts with CMS renew annually. Our military services contracts with the federal government and our contracts with various state Medicaid programs generally are multi-year contracts subject to annual renewal provisions. Our commercial contracts establish rates on a per employee basis for each month of coverage based on the type of coverage purchased (single to family coverage options). Our Medicare and Medicaid contracts also establish monthly rates per member. However, our Medicare contracts also have additional provisions as outlined in the following separate section. Premiums revenue and administrative services only, or ASO, fees are estimated by multiplying the membership covered under the various contracts by the contractual rates. In addition, we adjust revenues for estimated changes in an employer’s enrollment and individuals that ultimately may fail to pay, and for estimated rebates under the minimum benefit ratios required under the Health Care Reform Law. Enrollment changes not yet processed or not yet reported by an employer group or the government, also known as retroactive membership adjustments, are estimated based on available data and historical trends. We routinely monitor the collectibility of specific accounts, the aging of receivables, historical retroactivity trends, estimated rebates, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in the current period’s revenue. We bill and collect premium from employer groups and members in our Medicare and other individual products monthly. We receive monthly premiums from the federal government and various states according to government specified payment rates and various contractual terms. Changes in revenues from for our Medicare and individual commercial medical products resulting from the periodic changes in risk-adjustment scores derived from medical diagnoses for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured. Medicare Risk-Adjustment Provisions CMS utilizes a risk-adjustment model which apportions premiums paid to Medicare Advantage plans according to health severity. The risk-adjustment model pays more for enrollees with predictably higher costs. Under the risk-adjustment methodology, all Medicare Advantage plans must collect and submit the necessary diagnosis code information from hospital inpatient, hospital outpatient, and physician providers to CMS within prescribed deadlines. The CMS risk-adjustment model uses this diagnosis data to calculate the risk-adjusted premium payment to Medicare Advantage plans. Rates paid to Medicare Advantage plans are established under an actuarial bid model, including a process that bases our payments on a comparison of our beneficiaries’ risk scores, derived from medical diagnoses, to those enrolled in the government’s Medicare FFS program. We generally rely on providers, including certain providers in our network who are our employees, to code their claim submissions with appropriate diagnoses, which we send to CMS as the basis for our payment received from CMS under the actuarial risk-adjustment model. We also rely on providers to appropriately document all medical data, including the diagnosis data submitted with claims. We estimate risk-adjustment revenues based on medical diagnoses for our membership. The risk-adjustment model is more fully described in Item 1. - Business under the section titled “Individual Medicare.” Investment Securities Investment securities totaled $9.1 billion, or 37% of total assets at December 31, 2015, and $9.5 billion, or 41% of total assets at December 31, 2014. Debt securities, detailed below, comprised this entire investment portfolio at December 31, 2015 and 2014. The fair value of debt securities were as follows at December 31, 2015 and 2014: Approximately 98% of our debt securities were investment-grade quality, with a weighted average credit rating of AA by S&P at December 31, 2015. Most of the debt securities that were below investment-grade were rated BB, the higher end of the below investment-grade rating scale. Our investment policy limits investments in a single issuer and requires diversification among various asset types. Tax-exempt municipal securities included pre-refunded bonds of $178 million at December 31, 2015 and $199 million at December 31, 2014. These pre-refunded bonds were secured by an escrow fund consisting of U.S. government obligations sufficient to pay off all amounts outstanding at maturity. The ratings of these pre-refunded bonds generally assume the rating of the government obligations at the time the fund is established. Tax-exempt municipal securities that were not pre-refunded were diversified among general obligation bonds of U.S. states and local municipalities as well as special revenue bonds. General obligation bonds, which are backed by the taxing power and full faith of the issuer, accounted for $1.0 billion of these municipals in the portfolio. Special revenue bonds, issued by a municipality to finance a specific public works project such as utilities, water and sewer, transportation, or education, and supported by the revenues of that project, accounted for $1.4 billion of these municipals. Our general obligation bonds are diversified across the U.S. with no individual state exceeding 11%. In addition, certain monoline insurers guarantee the timely repayment of bond principal and interest when a bond issuer defaults and generally provide credit enhancement for bond issues related to our tax-exempt municipal securities. We have no direct exposure to these monoline insurers. We owned $173 million and $484 million at December 31, 2015 and 2014, respectively, of tax-exempt securities guaranteed by monoline insurers. The equivalent weighted average S&P credit rating of these tax-exempt securities without the guarantee from the monoline insurer was AA. Our direct exposure to subprime mortgage lending is limited to investment in residential mortgage-backed securities and asset-backed securities backed by home equity loans. The fair value of securities backed by Alt-A and subprime loans was $1 million at December 31, 2015 and 2014. There are no collateralized debt obligations or structured investment vehicles in our investment portfolio. The percentage of corporate securities associated with the financial services industry was 25% at December 31, 2015 and 21% at December 31, 2014. Gross unrealized losses and fair values aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows at December 31, 2015: Under the other-than-temporary impairment model for debt securities held, we recognize an impairment loss in income in an amount equal to the full difference between the amortized cost basis and the fair value when we have the intent to sell the debt security or it is more likely than not we will be required to sell the debt security before recovery of our amortized cost basis. However, if we do not intend to sell the debt security, we evaluate the expected cash flows to be received as compared to amortized cost and determine if a credit loss has occurred. In the event of a credit loss, only the amount of the impairment associated with the credit loss is recognized currently in income with the remainder of the loss recognized in other comprehensive income. When we do not intend to sell a security in an unrealized loss position, potential other-than-temporary impairment is considered using a variety of factors, including the length of time and extent to which the fair value has been less than cost; adverse conditions specifically related to the industry, geographic area or financial condition of the issuer or underlying collateral of a security; payment structure of the security; changes in credit rating of the security by the rating agencies; the volatility of the fair value changes; and changes in fair value of the security after the balance sheet date. For debt securities, we take into account expectations of relevant market and economic data. For example, with respect to mortgage and asset-backed securities, such data includes underlying loan level data and structural features such as seniority and other forms of credit enhancements. A decline in fair value is considered other-than-temporary when we do not expect to recover the entire amortized cost basis of the security. We estimate the amount of the credit loss component of a debt security as the difference between the amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate of future cash flows discounted at the implicit interest rate at the date of purchase. The risks inherent in assessing the impairment of an investment include the risk that market factors may differ from our expectations, facts and circumstances factored into our assessment may change with the passage of time, or we may decide to subsequently sell the investment. The determination of whether a decline in the value of an investment is other than temporary requires us to exercise significant diligence and judgment. The discovery of new information and the passage of time can significantly change these judgments. The status of the general economic environment and significant changes in the national securities markets influence the determination of fair value and the assessment of investment impairment. There is a continuing risk that declines in fair value may occur and additional material realized losses from sales or other-than-temporary impairments may be recorded in future periods. The recoverability of our non-agency residential and commercial mortgage-backed securities is supported by factors such as seniority, underlying collateral characteristics and credit enhancements. These residential and commercial mortgage-backed securities at December 31, 2015 primarily were composed of senior tranches having high credit support, with over 99% of the collateral consisting of prime loans. The weighted average credit rating of all commercial mortgage-backed securities was AA+ at December 31, 2015. All issuers of securities we own that were trading at an unrealized loss at December 31, 2015 remain current on all contractual payments. After taking into account these and other factors previously described, we believe these unrealized losses primarily were caused by an increase in market interest rates in the current markets than when the securities were purchased. At December 31, 2015, we did not intend to sell the securities with an unrealized loss position in accumulated other comprehensive income, and it is not likely that we will be required to sell these securities before recovery of their amortized cost basis. As a result, we believe that the securities with an unrealized loss were not other-than-temporarily impaired at December 31, 2015. There were no material other-than-temporary impairments in 2015, 2014, or 2013. Goodwill and Long-lived Assets At December 31, 2015, goodwill and other long-lived assets represented 20% of total assets and 48% of total stockholders’ equity, compared to 24% and 59%, respectively, at December 31, 2014. We are required to test at least annually for impairment at a level of reporting referred to as the reporting unit, and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. A reporting unit either is our operating segments or one level below the operating segments, referred to as a component, which comprise our reportable segments. A component is considered a reporting unit if the component constitutes a business for which discrete financial information is available that is regularly reviewed by management. We are required to aggregate the components of an operating segment into one reporting unit if they have similar economic characteristics. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition. The carrying amount of goodwill for our reportable segments has been retrospectively adjusted to conform to the 2015 segment change discussed in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We use a two-step process to review goodwill for impairment. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. Our strategy, long-range business plan, and annual planning process support our goodwill impairment tests. These tests are performed, at a minimum, annually in the fourth quarter, and are based on an evaluation of future discounted cash flows. We rely on this discounted cash flow analysis to determine fair value. However outcomes from the discounted cash flow analysis are compared to other market approach valuation methodologies for reasonableness. We use discount rates that correspond to a market-based weighted-average cost of capital and terminal growth rates that correspond to long-term growth prospects, consistent with the long-term inflation rate. Key assumptions in our cash flow projections, including changes in membership, premium yields, medical and operating cost trends, and certain government contract extensions, are consistent with those utilized in our long-range business plan and annual planning process. If these assumptions differ from actual, including the impact of the Health Care Reform Law, the estimates underlying our goodwill impairment tests could be adversely affected. Goodwill impairment tests completed in each of the last three years did not result in an impairment loss. The fair value of our reporting units with significant goodwill exceeded carrying amounts by a substantial margin. A 100 basis point increase in the discount rate would not have a significant impact on the amount of margin for any of our reporting units with significant goodwill, with the exception of our provider services reporting unit in our Healthcare Services segment. The provider services reporting unit would decline to approximately 10% margin after factoring in a 100 basis point increase in the discount rate. Long-lived assets consist of property and equipment and other finite-lived intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. We periodically review long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation or amortization for these assets. There were no material impairment losses in the last three years.

<s>[INST] General Humana Inc., headquartered in Louisville, Kentucky, is a leading health and wellbeing company focused on making it easy for people to achieve their best health with clinical excellence through coordinated care. Our strategy integrates care delivery, the member experience, and clinical and consumer insights to encourage engagement, behavior change, proactive clinical outreach and wellness for the millions of people we serve across the country. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, excluding depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Aetna Merger On July 2, 2015, we entered into an Agreement and Plan of Merger, which we refer to in this report as the Merger Agreement, with Aetna Inc. and certain wholly owned subsidiaries of Aetna Inc., which we refer to collectively as Aetna, which sets forth the terms and conditions under which we will merge with, and become a wholly owned subsidiary of Aetna, a transaction we refer to in this report as the Merger. A copy of the Merger Agreement was filed as Exhibit 2.1 to our Current Report on Form 8K filed with the U.S. Securities and Exchange Commission on July 7, 2015. Under the terms of the Merger Agreement, at the closing of the Merger, each outstanding share of our common stock will be converted into the right to receive (i) 0.8375 of a share of Aetna common stock and (ii) $125 in cash. The total transaction was estimated at approximately $37 billion including the assumption of Humana debt, based on the closing price of Aetna common shares on July 2, 2015. The Merger Agreement includes customary restrictions on the conduct of our business prior to the completion of the Merger, generally requiring us to conduct our business in the ordinary course and subjecting us to a variety of customary specified limitations absent Aetna’s prior written consent, including, for example, limitations on dividends (we agreed that our quarterly dividend will not exceed $0.29 per share) and repurchases of our securities (we agreed to suspend our share repurchase program), restrictions on our ability to enter into material contracts, and negotiated thresholds for capital expenditures, capital contributions, acquisitions and divestitures of businesses. On October 19, 2015, our stockholders approved the adoption of the Merger Agreement at a special stockholder meeting. Of the 129,240,721 shares voting at the meeting, more than 99% voted in favor of the adoption of the Merger Agreement, which represented approximately 87% of our total outstanding shares of common stock as of the September 16, 2015 record date. Also on October 19, 2015, the holders of Aetna outstanding shares approved the issuance of Aetna common stock in the Merger at a special meeting of Aetna shareholders. The Merger is subject to customary closing conditions, including, among other things, (i) the expiration or termination of the applicable waiting period under the HartScottRodino Antitrust Improvements Act of 1976, as amended, and the receipt of necessary approvals under state insurance and healthcare laws and regulations and pursuant to certain licenses of certain of Humana’s subsidiaries, (ii) the absence of legal restraints and prohibitions on the consummation of the Merger, (iii) listing of the Aetna common stock to be issued in the Merger on the New York Stock Exchange, (iv) subject to the relevant standards set forth in the Merger Agreement, the accuracy of the representations and warranties made by each party, (v) material compliance by each party with its covenants in the Merger Agreement, and (vi) no “Company Material Adverse Effect” with respect to us and no “Parent Material Adverse Effect” with respect to Aetna, in each [/INST] Negative. </s>

HUMANA INC

2017-02-17

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Executive Overview General Humana Inc., headquartered in Louisville, Kentucky, is a leading health and well-being company focused on making it easy for people to achieve their best health with clinical excellence through coordinated care. Our strategy integrates care delivery, the member experience, and clinical and consumer insights to encourage engagement, behavior change, proactive clinical outreach and wellness for the millions of people we serve across the country. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, excluding depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Aetna Merger On July 2, 2015, we entered into an Agreement and Plan of Merger, which we refer to in this report as the Merger Agreement, with Aetna Inc. and certain wholly owned subsidiaries of Aetna Inc., which we refer to collectively as Aetna, which sets forth the terms and conditions under which we agreed to merge with, and become a wholly owned subsidiary of Aetna, a transaction we refer to in this report as the Merger. The Merger was subject to customary closing conditions, including, among other things, (i) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, and the receipt of necessary approvals under state insurance and healthcare laws and regulations and pursuant to certain licenses of certain of Humana’s subsidiaries, and (ii) the absence of legal restraints and prohibitions on the consummation of the Merger. On December 22, 2016, in order to extend the “End Date” (as defined in the Merger Agreement), Aetna and Humana each agreed to waive until 11:59 p.m. (Eastern time) on February 15, 2017 its right to terminate the Merger Agreement due to a failure of the Mergers to have been completed on or before December 31, 2016. On July 21, 2016, the U.S. Department of Justice and the attorneys general of certain U.S. jurisdictions filed a civil antitrust complaint in the U.S. District Court for the District of Columbia against us and Aetna, alleging that the Merger would violate Section 7 of the Clayton Antitrust Act and seeking a permanent injunction to prevent the Merger from being completed. On January 23, 2017, the Court ruled in favor of the DOJ and granted a permanent injunction of the proposed transaction. On February 14, 2017, we and Aetna agreed to mutually terminate the Merger Agreement, as our Board determined that an appeal of the Court's ruling would not be in the best interest of our stockholders. Under terms of the Merger Agreement, we are entitled to a breakup fee of $1 billion. Business Segments We manage our business with three reportable segments: Retail, Group, and Healthcare Services. In addition, the Other Businesses category includes businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on well-being solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources. The Retail segment consists of Medicare benefits, marketed to individuals or directly via group accounts, as well as individual commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and financial protection products. In addition, the Retail segment also includes our contract with CMS to administer the LI-NET prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and Long-Term Support Services benefits, collectively our state-based contracts. The Group segment consists of employer group commercial fully-insured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and voluntary insurance benefits, as well as administrative services only, or ASO products. In addition, our Group segment includes our health and wellness products (primarily marketed to employer groups) and military services business, primarily our TRICARE South Region contract. The Healthcare Services segment includes services offered to our health plan members as well as to third parties, including pharmacy solutions, provider services, home based services, and clinical programs, as well as services and capabilities to advance population health. We will continue to report under the category of Other Businesses those businesses which do not align with the reportable segments described above, primarily our closed-block long-term care insurance policies. The results of each segment are measured by income before income taxes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and home based services as well as clinical programs, to our Retail and Group customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often use the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at a corporate level. These corporate amounts are reported separately from our reportable segments and are included with intersegment eliminations. Seasonality One of the product offerings of our Retail segment is Medicare stand-alone prescription drug plans, or PDPs, under the Medicare Part D program. Our quarterly Retail segment earnings and operating cash flows are impacted by the Medicare Part D benefit design and changes in the composition of our membership. The Medicare Part D benefit design results in coverage that varies as a member’s cumulative out-of-pocket costs pass through successive stages of a member’s plan period, which begins annually on January 1 for renewals. These plan designs generally result in us sharing a greater portion of the responsibility for total prescription drug costs in the early stages and less in the latter stages. As a result, the PDP benefit ratio generally decreases as the year progresses. In addition, the number of low-income senior members as well as year-over-year changes in the mix of membership in our stand-alone PDP products affects the quarterly benefit ratio pattern. Our Group segment also experiences seasonality in the benefit ratio pattern. However, the effect is opposite of Medicare stand-alone PDP in the Retail segment, with the Group segment’s benefit ratio increasing as fully-insured members progress through their annual deductible and maximum out-of-pocket expenses. Similarly, certain of our fully-insured individual commercial medical products in our Retail segment experience seasonality in the benefit ratio akin to the Group segment, including the effect of existing previously underwritten members transitioning to policies compliant with the Health Care Reform Law with us and other carriers. As previously underwritten members transition, it results in policy lapses and the release of reserves for future policy benefits partially offset by the recognition of previously deferred acquisition costs. These policy lapses generally occur during the first quarter of the new coverage year following the open enrollment period reducing the benefit ratio in the first quarter. The recognition of a premium deficiency reserve for our individual commercial medical business compliant with the Health Care Reform Law in the fourth quarter of 2015, and subsequent changes in estimates, also impact the quarterly benefit ratio pattern for this business in 2016 and 2015. In addition, the Retail segment also experiences seasonality in the operating cost ratio as a result of costs incurred in the second half of the year associated with the Medicare and individual health care exchange marketing seasons. Highlights Consolidated • On February 14, 2017, we and Aetna agreed to mutually terminate the Merger Agreement. We also announced that the Board had approved a new authorization for share repurchases of up to $2.25 billion of our common stock exclusive of shares repurchased in connection with employee stock plans, expiring on December 31, 2017. Under this new authorization, we expect to complete a $1.5 billion accelerated share repurchase program in the first quarter of 2017. Under terms of the Merger Agreement, we are entitled to a breakup fee of $1 billion. • Our 2016 results reflect the continued implementation of our strategy to offer our members affordable health care combined with a positive consumer experience in growing markets. At the core of this strategy is our integrated care delivery model, which unites quality care, high member engagement, and sophisticated data analytics. Our approach to primary, physician-directed care for our members aims to provide quality care that is consistent, integrated, cost-effective, and member-focused, provided by both employed physicians and physicians with network contract arrangements. The model is designed to improve health outcomes and affordability for individuals and for the health system as a whole, while offering our members a simple, seamless healthcare experience. We believe this strategy is positioning us for long-term growth in both membership and earnings. We offer providers a continuum of opportunities to increase the integration of care and offer assistance to providers in transitioning from a fee-for-service to a value-based arrangement. These include performance bonuses, shared savings and shared risk relationships. At December 31, 2016, approximately 1,816,300 members, or 64.0%, of our individual Medicare Advantage members were in value-based relationships under our integrated care delivery model, as compared to 1,633,100 members, or 59.3%, at December 31, 2015. • On November 10, 2016, the U.S. Court of Federal Claims ruled in favor of the government in one of a series of cases filed by insurers, unrelated to us, against HHS to collect risk corridor payments, rejecting all of the insurer’s statutory, contract and Constitutional claims for payment. On November 18, 2016, HHS issued a memorandum indicating a significant funding shortfall for the 2015 coverage year, the second consecutive year of significant shortfalls. Given the successful challenge of the risk corridor provisions in court, Congressional inquiries into the funding of the risk corridor program, and significant funding shortfalls under the first two years of the program, during the fourth quarter of 2016 we wrote-off $583 million ($367 million after-tax, or $2.43 per diluted common share) in risk corridor receivables outstanding as of September 30, 2016, including $415 million associated with the 2014 and 2015 coverage years. At December 31, 2016, we estimate that we are entitled to collect a total of $619 million from HHS under the commercial risk corridor program for the 2014 through 2016 program years. • In the fourth quarter of 2016, we increased the future policy benefits expense by approximately $505 million ($318 million after tax, or $2.11 per diluted common share) for reserve strengthening associated with our closed block of long-term care insurance policies. This increase primarily was driven by emerging experience indicating longer claims duration, a prolonged lower interest rate environment, and an increase in policyholder life expectancies. • As discussed in the Retail segment highlights that follow, during 2015, we recognized a premium deficiency reserve of approximately $176 million for certain of our individual commercial medical products for the 2016 coverage year. During 2016, we increased this premium deficiency reserve associated with the 2016 coverage year by $208 million, or $0.87 per diluted common share. • During 2016, we recorded transaction and integration planning costs in connection with the Merger of approximately $104 million, or $0.64 per diluted common share. During 2015, we recorded transaction costs in connection with the Merger of approximately $23 million, or $0.14 per diluted common share. Certain costs associated with the transaction were not deductible for tax purposes. • On June 1, 2015, we completed the sale of our wholly owned subsidiary, Concentra Inc., or Concentra, to MJ Acquisition Corporation, a joint venture between Select Medical Holdings Corporation and Welsh, Carson, Anderson & Stowe XII, L.P., a private equity fund, for approximately $1,055 million in cash, excluding approximately $22 million of transaction costs. In connection with the sale, we recognized a pre-tax gain, net of transaction costs, of $270 million, or $1.57 per diluted common share in 2015. • Excluding the impact of the risk corridor receivables write-off, the long-term care reserve strengthening, the premium deficiency reserve recorded for the 2016 coverage year, and the sale of Concentra in 2015, the increase in pretax income primarily was due to year-over-year improvements in results for our individual Medicare Advantage business and Healthcare Services segment as well as increased profitability in our state-based contracts business. • Year-over-year comparisons of the operating cost ratio are impacted by the completion of the sale of Concentra on June 1, 2015. Concentra carried a higher operating cost ratio than our Group and Retail segments. This was partially offset by the risk corridor receivables write-off. • Investment income decreased $85 million in 2016, primarily due to lower realized capital gains in 2016 and lower interest rates partially offset by a higher average invested balance. • As disclosed in Note 2 to the consolidated financial statements included in this report, we elected to early adopt new accounting guidance related to accounting for employee share-based payments, which changes how income tax effects of employee share-based payments are recorded. We adopted this guidance prospectively effective January 1, 2016. The adoption of this new guidance resulted in the recognition of approximately $20 million of tax benefits in net income, or $0.12 per diluted common share, in the first quarter of 2016. • Operating cash flow provided by operations was $1.9 billion for the year ended December 31, 2016 as compared to operating cash flow provided by operations of $868 million for the year ended December 31, 2015. The increase in operating cash flow primarily was due to significantly favorable working capital items and higher earnings exclusive of the commercial risk corridor receivables write-off and the long-term care reserve strengthening in 2016, as well as the gain on sale of Concentra and the recognition of the premium deficiency reserve in 2015 discussed previously. The working capital changes year-over-year primarily reflect lower income tax payments, changes in the net receivable balance associated with the premium stabilization programs established under health care reform, or the 3R's, and the timing of payroll cycles resulting in one less payroll cycle in 2016, partially offset by the timing of payments for benefits expense. • In 2016, we paid the federal government $916 million for the annual non-deductible health insurance industry fee compared to our payment of $867 million in 2015. This fee is not deductible for tax purposes, which significantly increased our effective income tax rate beginning in 2014. The health insurance industry fee is further described below under the section titled "Health Care Reform." The Consolidated Appropriations Act, 2016, enacted on December 18, 2015, included a one-time one year suspension in 2017 of the health insurer fee. This suspension will significantly reduce our operating costs and effective tax rate in 2017. Our effective tax rate for 2017 is expected to be approximately 36% to 37%. The decline in the effective tax rate primarily is due to the suspension of the annual health insurance industry fee in 2017. • We paid dividends to stockholders of $177 million in 2016 as compared to $172 million in 2015. Retail Segment • On February 1, 2017, CMS issued its preliminary 2018 Medicare Advantage and Part D payment rates and proposed policy changes, which we refer to collectively as the Advance Notice. CMS has invited public comment on the Advance Notice before publishing final rates on April 3, 2017 (the Final Notice). In the Advance Notice, CMS estimates Medicare Advantage plans across the sector will, on average, experience a 0.25 percent increase in benchmark funding based on proposals included therein. As indicated by CMS, its estimate excludes the impact of fee-for-service county rebasing/re-pricing since the related impact is dependent upon finalization of certain data, which will be available with the publication of the Final Notice. CMS' estimate includes 40 basis points of negative impact associated with Star quality bonuses sector-wide. Excluding that item, CMS' estimate would be a 0.65 percent increase. Based on our preliminary analysis using the same factors CMS included in its estimate, the components of which are detailed on CMS' website, we anticipate the proposals in the Advance Notice would result in a change to our benchmark funding relatively in line with CMS' estimate, excluding the impact attributable to Star quality bonuses. We believe we can design our 2018 Medicare Advantage plan filings, including the applicable level of rate changes, to remain competitive compared to both the combination of original Medicare with a supplement policy and Medicare Advantage products offered by our competitors. Failure to execute these strategies may result in a material adverse effect on our results of operations, financial position, and cash flows. • The achievement of Star Ratings of four or higher qualifies Medicare Advantage plans for premium bonuses. Star Ratings for the 2018 bonus year issued by CMS in October 2016 indicated that the percentage of our July 31, 2016 Medicare Advantage membership in 4-Star plans or higher declined to approximately 37% from approximately 78% of our July 31, 2015 Medicare Advantage membership. The decline in membership in 4- Star rated plans does not take into account certain operational actions discussed below that we have taken and intend to take over the coming months to mitigate any potential negative impact of these published ratings on Star bonus revenues for 2018. We believe that the decline is primarily attributable to the impact of lower scores for certain Stars measures as a result of our 2015 comprehensive program audit by CMS. The Civil Monetary Penalty imposed by CMS following the audit resulted in a significant reduction to the Beneficiary Access and Plan Performance, or BAPP, measure. Additionally, an issue with the timeliness of appeal decisions noted in the audit resulted in automatic downgrades to two additional Star measures. Moreover, higher threshold levels for certain individual Star measures as compared to the previous year reduced our ratings on these measures. Thresholds for Star measures are calculated across the sector, without regard to weighted average membership of each plan. Together, these factors more than offset our improved Star rating performance in certain quality measures such as Healthcare Effectiveness Data and Information, or HEDIS. Our Healthcare Effectiveness Data and Information Set, or HEDIS, measures, demonstrating the achievement of clinical outcomes, are at record-high results for the company. Accordingly, we believe that our Star ratings for the 2018 bonus year do not accurately reflect our actual performance under certain Star measures. Consequently, we filed for reconsideration of certain of those ratings under the appropriate administrative process. We are also evaluating our contract structures for rationalization to mitigate the negative impact on Star bonus revenues for 2018. The ultimate financial impact to us related to 2018 Star bonus revenues is dependent upon multiple variables including, but not limited to, the number of Medicare Advantage members in 4-Star or higher rated plans and the geographic distribution of those members as well as a number of operational initiatives which would serve to mitigate the negative impact of our Star performance. Star results for the 2018 bonus year are not expected to materially impact our Medicare revenue for 2017 but could be material to 2018 Medicare revenues. • In 2016, our Retail segment pretax income increased by $7 million, or 0.8%, from 2015 primarily driven by the year-over-year improvement in our individual Medicare Advantage and state-based Medicaid businesses along with the impact of the premium deficiency reserve recorded in the fourth quarter of 2015 associated with certain individual commercial medical policies for the 2016 coverage year. These items were substantially offset by the write-off of commercial risk corridor receivables as described further below and in the results of operations discussion that follows. • Our Medicare Advantage results improved year-over-year primarily due to lower utilization and favorable year-over-year comparisons of prior-period medical claims reserve development. Operational initiatives are centered around optimizing the performance of our clinical programs to reduce medical cost trend. In addition our Medicare Advantage membership increased year-over-year as discussed below. • Operating results for our individual commercial medical business compliant with the Health Care Reform Law have been challenged primarily due to unanticipated modifications in the program subsequent to the passing of the Health Care Reform Law, resulting in higher covered population morbidity and the ensuing enrollment and claims issues causing volatility in claims experience. We took a number of actions in 2015 that we believed would improve the profitability of our individual commercial medical business in 2016. These actions were subject to regulatory restrictions in certain geographies and included premium increases for the 2016 coverage year related generally to the first half of 2015 claims experience, the discontinuation of certain products as well as exit of certain markets for 2016, network improvements, enhancements to claims and clinical processes and administrative cost control. Despite these actions, the deterioration in the second half of 2015 claims experience together with 2016 open enrollment results that included the retention of many high-utilizing members for 2016 resulted in a probable future loss. As a result of our assessment in the fourth quarter of 2015 of the profitability of our individual commercial medical policies compliant with the Health Care Reform Law, we recorded in that quarter a provision for probable future losses (premium deficiency reserve) for the 2016 coverage year of $176 million, or $0.74 per diluted common share. In 2016, we increased the premium deficiency reserve for the 2016 coverage year by $208 million, primarily as a result of unfavorable current and projected claims experience at that time. As of December 31, 2016, we had no remaining premium deficiency reserve. For 2017, we are offering on-exchange individual commercial medical plans in 11 states, a reduction from the 15 states in which we offered on-exchange coverage in 2016. In addition, we discontinued substantially all Health Care Reform Law compliant off-exchange individual commercial medical plans effective January 1, 2017. Our 2017 geographic presence for our individual commercial medical offerings covers 156 counties, down from our 2016 presence in 1,351 counties (covering both on-exchange and off-exchange offerings). Given recent competitor actions, including market exits resulting in the automatic assignment of members to our plans, as well as sales and renewal results from the open enrollment process, we now expect 2017 premiums associated with Health Care Reform Law compliant offerings to be in the range of $850 million to $900 million. By comparison, our full year 2016 premiums associated with Health Care Reform Law compliant offerings were $3.3 billion. The decrease from 2016 results reflects the adjustment to our geographic presence and product discontinuances, erosion of competitive position, partially offset by premium increases as well as the projected impact of certain competitor actions. On February 14, 2017, we announced we are exiting our individual commercial medical businesses January 1, 2018. As discussed previously, we have worked over the past several years to address market and programmatic challenges in order to keep coverage options available wherever we could offer a viable product. This has included pursuing business changes, such as modifying networks, restructuring product offerings, reducing the company’s geographic footprint and increasing premiums. All of these actions were taken with the expectation that our individual commercial medical business would stabilize to the point where we could continue to participate in the program. However, based on our initial analysis of data associated with our healthcare exchange membership following the 2017 open enrollment period, we are seeing further signs of an unbalanced risk pool. Therefore, we have decided that we cannot continue to offer this coverage for 2018. • Individual Medicare Advantage membership of 2,837,600 at December 31, 2016 increased 84,200 members, or 3.1%, from 2,753,400 at December 31, 2015 reflecting net membership additions, particularly for our Medicare Advantage Health Maintenance Organization, or HMO, offerings. January 2017 individual Medicare Advantage membership approximated 2,848,000, increasing approximately 10,400 members from December 31, 2016 reflecting net membership additions during the recently completed Annual Election Period for Medicare beneficiaries, including the loss of approximately 50,000 members in plans no longer offered for 2017. For full year 2017, we anticipate net membership growth in our individual Medicare Advantage offerings of 30,000 to 40,000. • Group Medicare Advantage membership of 355,400 at December 31, 2016 decreased 128,700 members, or 26.6%, from 484,100 at December 31, 2015 primarily reflecting the loss of a large account that moved to a private exchange offering on January 1, 2016. January 2017 group Medicare Advantage membership approximated 431,000, increasing approximately 75,600 members, or 21%, from December 31, 2016 reflecting net membership additions during the recently completed Annual Election Period for Medicare beneficiaries. For full year 2017, we expect net membership growth in our Group Medicare Advantage offerings of 70,000 to 80,000. • Medicare stand-alone PDP membership of 4,951,400 at December 31, 2016 increased 393,500 members, or 8.6%, from 4,557,900 at December 31, 2015 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2016 plan year. January 2017 Medicare stand-alone PDP membership (excluding transitional growth from the LI-NET prescription drug plan program) increased approximately 222,600 members, or 4%, from December 31, 2016 to 5,174,000 members reflecting net membership additions during the recently completed Annual Election Period for Medicare beneficiaries. For full year 2017, we anticipate net membership growth in our Medicare stand-alone PDP offerings of 320,000 to 340,000. • Our state-based Medicaid membership of 388,100 at December 31, 2016 increased 14,400 members, or 3.9%, from 373,700 at December 31, 2015 primarily driven by the addition of members under our Florida Medicaid contract. • Individual commercial medical membership of 654,800 at December 31, 2016 decreased 244,300 members, or 27.2%, from 899,100 at December 31, 2015 primarily reflecting the loss of on-exchange members due to product competitiveness, the loss of membership associated with the discontinuance of certain Health Care Reform Law compliant plans in 2016, the loss of membership associated with non-payment of premiums or termination by CMS due to lack of eligibility documentation, and the loss of members subscribing to plans that are not compliant with the Health Care Reform Law. At December 31, 2016, individual commercial medical membership in plans compliant with the Health Care Reform Law, both on-exchange and off-exchange, was 580,100 members, a decrease of 177,800 members or 23.5% from December 31, 2015. January 2017 individual commercial medical membership approximated 204,000, including 152,000 enrolled in plans compliant with the Health Care Reform Law. The decline of approximately 450,800 members, or 69%, from December 31, 2016 reflects net membership declines during the on-going open enrollment period for healthcare exchanges and the impact of product and service area reductions. Group Segment • Group segment pretax income for the year ended December 31, 2016 was essentially unchanged from the year ended December 31, 2015 as discussed in the results of operations discussion that follows. • On July 21, 2016, we were notified by the Defense Health Agency, or DHA, that we were awarded the TRICARE East Region contract, with delivery of health care services expected to commence on October 1, 2017. The new East Region is a combination of the current North Region and South Region. The next generation East Region and West Region contract awards are currently subject to protests by unsuccessful bidders in the U.S. Court of Federal Claims and before the DHA. Our current TRICARE South Region contract expires March 31, 2017. • Membership in Go365TM (known as HumanaVitality® prior to January 2017), our wellness and loyalty rewards program, declined 7.2% to 3,649,100 at December 31, 2016 from 3,932,300 at December 31, 2015 reflecting a decline in group Medicare Advantage membership from the loss of the large account on January 1, 2016 and a decline in individual commercial medical membership. Healthcare Services Segment • Year-over-year comparisons of results of operations are impacted by the completion of the sale of Concentra on June 1, 2015. • As discussed in the detailed Healthcare Services segment results of operations discussion that follows, our Healthcare Services segment pretax income increased $86 million, or 8.8%, for the year ended December 31, 2016. This increase was primarily due to incremental earnings associated with revenue growth from our pharmacy solutions business as it increased mail-order penetration and served our growing individual Medicare membership, partially offset by ongoing pressures in our provider services business reflecting significantly lower Medicare rates year-over-year associated with CMS' risk coding recalibration for 2016 in geographies where our provider assets are primarily located. • Programs to enhance the quality of care for members are key elements of our integrated care delivery model. At December 31, 2016, we enrolled approximately 622,300 Medicare Advantage members with complex chronic conditions in the Humana Chronic Care Program, a 5.4% increase compared with approximately 590,300 members at December 31, 2015, reflecting a greater focus on members living with the most chronic conditions. Enhanced predictive modeling capabilities and proactive clinical outreach and engagement of those members helped drive increased clinical program participation, offset by the loss of engaged members associated with the group Medicare Advantage account that termed on January 1, 2016 as discussed previously. We continue to refine our clinical management programs to help optimize the quality of healthcare for our members and ensure appropriate returns on our investments. Other Businesses • As previously disclosed, in the fourth quarter of 2016, we increased future policy benefits expense by approximately $505 million for reserve strengthening associated with our closed block of long-term care insurance policies. This increase primarily was driven by emerging experience indicating longer claims duration, a prolonged lower interest rate environment, and an increase in policyholder life expectancies as discussed further in Note 18 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this 2016 Form 10-K. Health Care Reform The Health Care Reform Law enacted significant reforms to various aspects of the U.S. health insurance industry. Certain significant provisions of the Health Care Reform Law include, among others, mandated coverage requirements, mandated benefits and guarantee issuance associated with commercial medical insurance, rebates to policyholders based on minimum benefit ratios, adjustments to Medicare Advantage premiums, the establishment of federally-facilitated or state-based exchanges coupled with programs designed to spread risk among insurers, and the introduction of plan designs based on set actuarial values. In addition, the Health Care Reform Law established insurance industry assessments, including an annual health insurance industry fee and a three-year $25 billion industry wide commercial reinsurance fee. The annual health insurance industry fee levied on the insurance industry was $8 billion in 2014 and $11.3 billion in each of 2015 and 2016, with increasing annual amounts starting in 2018, and is not deductible for income tax purposes, which significantly increased our effective income tax rate. Our effective tax rate for 2016 was approximately 60.5%. The Consolidated Appropriations Act, 2016, enacted on December 18, 2015, included a one-time one year suspension in 2017 of the health insurer fee. This suspension will significantly reduce our operating costs and effective tax rate in 2017. Our effective tax rate for 2017 is expected to be approximately 36% to 37%. The decline in the effective tax rate primarily is due to the suspension of the annual health insurance industry fee in 2017. The health insurance industry fee levied on the insurance industry was previously expected to be $14 billion in 2017. In 2016, we paid the federal government $916 million for the annual health insurance industry fee, a 5.7% increase from $867 million in 2015, primarily reflecting growth in our market share. In addition, the Health Care Reform Law expands federal oversight of health plan premium rates and could adversely affect our ability to appropriately adjust health plan premiums on a timely basis. Financing for these reforms comes, in part, from material additional fees and taxes on us (as discussed above) and other health plans and individuals which began in 2014, as well as reductions in certain levels of payments to us and other health plans under Medicare as described in this 2016 Form 10-K. As noted above, the Health Care Reform Law required the establishment of health insurance exchanges for individuals and small employers to purchase health insurance that became effective January 1, 2014, with an annual open enrollment period. Insurers participating on the health insurance exchanges must offer a minimum level of benefits and are subject to guidelines on setting premium rates and coverage limitations. We may be adversely selected by individuals who have a higher acuity level than the anticipated pool of participants in this market. In addition, the risk corridor, reinsurance, and risk adjustment provisions of the Health Care Reform Law, established to apportion risk for insurers, may not be effective in appropriately mitigating the financial risks related to our products, and audits of our submissions under these programs may result in returns of funds distributed. In addition, regulatory changes to the implementation of the Health Care Reform Law that allowed individuals to remain in plans that are not compliant with the Health Care Reform Law or to enroll outside of the annual enrollment period may have an adverse effect on our pool of participants in the health insurance exchange. In addition, states may impose restrictions on our ability to increase rates. All of these factors may have a material adverse effect on our results of operations, financial position, or cash flows if our premiums are not adequate or do not appropriately reflect the acuity of these individuals. Any variation from our expectations regarding acuity, enrollment levels, adverse selection, or other assumptions used in setting premium rates could have a material adverse effect on our results of operations, financial position, and cash flows and could impact our decision to participate or continue in the program in certain states. For 2017, we are offering on-exchange individual commercial medical plans in 11 states, a reduction from the 15 states in which we offered on-exchange coverage in 2016. In addition, we discontinued substantially all Health Care Reform Law compliant off-exchange individual commercial medical plans effective January 1, 2017. If we fail to effectively implement our operational and strategic initiatives with respect to the implementation of the Health Care Reform Law, our business may be materially adversely affected. Additionally, potential legislative changes, including activities to repeal or replace the Health Care Reform Law, creates uncertainty for our business, and we cannot predict when, or in what form, such legislative changes may occur. We may be unable to adjust our product offerings, geographic footprint, or pricing during any given year such legislative changes occur in sufficient time to mitigate any adverse effects. As discussed above, it is reasonably possible that the Health Care Reform Law and related regulations, as well as future legislative changes, including legislative restrictions on our ability to manage our provider network or otherwise operate our business, or regulatory restrictions on profitability, including by comparison of our Medicare Advantage profitability to our non-Medicare Advantage business profitability and a requirement that they remain within certain ranges of each other, in the aggregate may have a material adverse effect on our results of operations (including restricting revenue, enrollment and premium growth in certain products and market segments, restricting our ability to expand into new markets, increasing our medical and operating costs, further lowering our Medicare payment rates and increasing our expenses associated with the non-deductible health insurance industry fee and other assessments); our financial position (including our ability to maintain the value of our goodwill); and our cash flows (including the delayed receipt of amounts due under the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law). On November 10, 2016, the U.S. Court of Federal Claims ruled in favor of the government in one of a series of cases filed by insurers, unrelated to us, against HHS to collect risk corridor payments, rejecting all of the insurer’s statutory, contract and Constitutional claims for payment. On November 18, 2016, HHS issued a memorandum indicating a significant funding shortfall for the 2015 coverage year, the second consecutive year of significant shortfalls. Given the successful challenge of the risk corridor provisions in court, Congressional inquiries into the funding of the risk corridor program, and significant funding shortfalls under the first two years of the program, during the fourth quarter of 2016 we wrote-off $583 million in risk corridor receivables outstanding as of September 30, 2016, including $415 million associated with the 2014 and 2015 coverage years. From inception of the risk corridor program through December 31, 2016, we collected approximately $36 million from CMS for risk corridor receivables associated with the 2014 coverage year funded by HHS in accordance with previous guidance, utilizing funds HHS collected from us and other carriers under the 2014 and 2015 risk corridor program. We intend for the discussion of our financial condition and results of operations that follows to assist in the understanding of our financial statements and related changes in certain key items in those financial statements from year to year, including the primary factors that accounted for those changes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and home based services as well as clinical programs, to our Retail and Group customers and are described in Note 17 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this 2016 Form 10-K. Comparison of Results of Operations for 2016 and 2015 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2016 and 2015: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs, excluding depreciation and amortization, as a percentage of total revenues less investment income. Summary Net income for 2016 was $614 million, or $4.07 per diluted common share, in 2016 compared to $1.3 billion, or $8.44 per diluted common share, in 2015. Net income includes a write-off of $2.43 per diluted common share in receivables associated with the commercial risk corridor premium stabilization program and reserve strengthening for our non-strategic closed block of long-term care insurance business of $2.11 per diluted common share, as discussed below. These items were partially offset by the impact of the premium deficiency reserve of $0.74 per diluted common share recorded in the fourth quarter of 2015 for certain of our individual commercial medical products for the 2016 coverage year. In addition, the completion of the sale of Concentra on June 1, 2015 resulted in an after-tax gain of $1.57 per diluted common share in 2015. Excluding these items, the increase primarily was due to year-over-year improvement in results for our individual Medicare Advantage business and our Healthcare Services segment as well as increased profitability in our state-based Medicaid business, partially offset by an increase in the effective tax rate as discussed below. In addition, 2016 includes expenses of $0.64 per diluted common share and 2015 includes expenses of $0.14 per diluted common share for transaction and integration planning costs associated with the Merger, certain of which were not deductible for tax purposes. Premiums Revenue Consolidated premiums increased $612 million, or 1.2%, from 2015 to $53.0 billion for 2016 primarily reflecting higher premiums in the Retail segment mainly driven by average membership growth and per member premium increases for certain of our lines of business. These increases were partially offset by the write-off of $583 million of receivables associated with the commercial risk corridor premium stabilization program, the loss of premiums associated with a large group Medicare account that moved to a private exchange on January 1, 2016, and a decline in premiums revenue associated with fewer individual commercial medical members as discussed in our segment results of operations discussion that follows. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Premiums revenue reflects changes in membership and average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership. Services Revenue Consolidated services revenue decreased $437 million, or 31.1%, from 2015 to $1.0 billion for 2016 primarily due to the completion of the sale of Concentra on June 1, 2015. Investment Income Investment income totaled $389 million for 2016, a decrease of $85 million, or 17.9%, from 2015, primarily due to lower realized capital gains in 2016 and lower interest rates partially offset by a higher average invested balance. Benefits Expense Consolidated benefits expense was $45.0 billion for 2016, an increase of $738 million, or 1.7%, from 2015 primarily due to $505 million in incremental benefits expense for the reserve strengthening in our non-strategic closed block of long-term care insurance policies partially offset by the premium deficiency reserve recorded in the fourth quarter of 2015 for certain of our individual commercial medical products for the 2016 coverage year. Excluding the long-term care reserve strengthening and impact of the premium deficiency reserve, the increase is primarily due to an increase in the Retail segment mainly driven by higher average individual Medicare Advantage membership. As more fully described herein under the section entitled “Benefits Expense Recognition”, actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $582 million in 2016 and $236 million in 2015. The increase in prior-period medical claims reserve development year over-year primarily was due to favorable year-over-year comparisons for our Medicare Advantage and individual commercial medical businesses. The consolidated benefit ratio for 2016 was 84.9%, an increase of 40 basis points from 2015 primarily due to the incremental benefits expense for the reserve strengthening in our non-strategic closed block of long-term care insurance policies, the impact on the benefit ratio of lower consolidated premiums associated with the write-off of receivables for the commercial risk corridor premium stabilization program, and the impact of the premium deficiency reserve recorded in the fourth quarter of 2015 for certain of our individual commercial medical products for the 2016 coverage year. Excluding the impact of the write-off of the commercial risk corridor receivables and the premium deficiency reserve, these items were partially offset by year-over-year improvement in both the Retail and Group segment benefit ratios as discussed in the segment results of operations discussion that follows. Favorable prior-period medical claims reserve development decreased the consolidated benefit ratio by approximately 110 basis points in 2016 versus approximately 50 basis points in 2015. Operating Costs Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs decreased $41 million, or 0.6%, from 2015 to $7.3 billion in 2016 primarily due to the completion of the sale of Concentra on June 1, 2015 The consolidated operating cost ratio for 2016 was 13.5%, decreasing 10 basis points from 2015 primarily due to the completion of the sale of Concentra on June 1, 2015. Concentra carried a higher operating cost ratio than our Group and Retail segments. This was partially offset by the unfavorable year-over-year comparison associated with the temporary suspension of certain discretionary administrative costs in the latter half of 2015, along with the impact of the commercial risk corridor receivables write-off in the fourth quarter of 2016. In addition, transaction and integration planning costs associated with the Merger increased the operating cost ratio by 20 basis points in 2016. There was minimal impact for transaction costs to the operating cost ratio in 2015. Depreciation and Amortization Depreciation and amortization for 2016 of $354 million was relatively unchanged from 2015. Interest Expense Interest expense was $189 million for 2016 compared to $186 million for 2015, an increase of $3 million, or 1.6%. Income Taxes Our effective tax rate during 2016 was 60.5% compared to the effective tax rate of 47.5% in 2015 primarily reflecting lower pretax income year-over-year, the beneficial effect of the sale of Concentra on June 1, 2015 and the impact of non-deductible transaction costs associated with the Merger. Non-deductible transaction and integration planning costs associated with the Merger increased our effective tax rate by approximately 3.4 percentage points in 2016 versus approximately 0.4 percentage points in 2015. Conversely, the tax effect of the sale of Concentra reduced our effective tax rate by approximately 4.5 percentage points in 2015. See Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. Our effective tax rate for 2017 is expected to be approximately 36% to 37%. The decline in the effective tax rate primarily is due to the suspension of the annual health insurance industry fee in 2017. The effective tax rate for 2016 also reflects tax benefits associated with adopting new guidance related to the accounting for employee share-based payments effective January 1, 2016 as described in Note 2 to the condensed consolidated financial statements included in this report, which decreased our effective tax rate by approximately 1.2 percentage points in 2016. Retail Segment (a) Specialty products include dental, vision, and other supplemental health and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Retail segment pretax income was $937 million in 2016, an increase of $7 million, or 0.8%, compared to 2015 primarily driven by the year-over-year improvement in our individual Medicare Advantage and state-based Medicaid businesses along with the impact of the premium deficiency reserve recorded in the fourth quarter of 2015 associated with certain individual commercial medical policies for the 2016 coverage year. These items were substantially offset by the write-off of commercial risk corridor receivables as discussed below. Enrollment • Individual Medicare Advantage membership increased 84,200 members, or 3.1%, from December 31, 2015 to December 31, 2016 reflecting net membership additions, particularly for our HMO offerings, for the 2016 plan year. • Group Medicare Advantage membership decreased 128,700 members, or 26.6%, from December 31, 2015 to December 31, 2016 reflecting the loss of a large account that moved to a private exchange offering on January 1, 2016. • Medicare stand-alone PDP membership increased 393,500 members, or 8.6%, from December 31, 2015 to December 31, 2016 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2016 plan year. • Individual commercial medical membership decreased 244,300 members, or 27.2%, from December 31, 2015 to December 31, 2016 primarily reflecting the loss of on-exchange members due to product competitiveness, the loss of membership associated with the discontinuance of certain Health Care Reform Law compliant plans in 2016, the loss of membership associated with non-payment of premiums or termination by CMS due to lack of eligibility documentation, and the loss of members subscribing to plans that are not compliant with the Health Care Reform Law. • State-based Medicaid membership increased 14,400 members, or 3.9%, from December 31, 2015 to December 31, 2016 primarily driven by the addition of members under our Florida Medicaid contract. • Individual specialty membership decreased 65,000 members, or 5.6%, from December 31, 2015 to December 31, 2016 primarily due to the loss of individual commercial medical members that also had specialty coverage. Premiums revenue • Retail segment premiums increased $741 million, or 1.6%, from 2015 to 2016 primarily due to higher average membership for our individual Medicare Advantage and state-based Medicaid businesses and per member premium increases for certain lines of business. Average individual Medicare Advantage membership increased 3.9% in 2016. These items were partially offset by the write-off of approximately $583 million of receivables associated with the commercial risk corridor premium stabilization program, and declines in group Medicare Advantage (including the loss of a large group Medicare Advantage account) and individual commercial medical membership. Benefits expense • The Retail segment benefit ratio of 86.2% for 2016 decreased 50 basis points from 2015 primarily due to lower year-over-year Medicare Advantage utilization, favorable comparisons of prior-year medical claims reserve development, and the impact of the premium deficiency reserve recorded in the fourth quarter of 2015 for certain of our individual commercial medical products for the 2016 coverage year. These items were partially offset by the reduction of premiums related to the write-off of receivables associated with the commercial risk corridor premium stabilization program which increased the Retail segment benefit ratio by approximately 100 basis points in 2016. As previously disclosed, in the fourth quarter of 2015 we recorded a premium deficiency reserve associated with our 2016 individual commercial offerings compliant with the Health Care Reform Law, increasing our 2015 benefit ratio by 40 basis points. During 2016, we increased the premium deficiency reserve for the 2016 coverage year and recorded a change in estimate of $208 million with a corresponding increase in benefits expense primarily as a result of unfavorable current and projected claims experience. • The Retail segment’s benefits expense for 2016 included the beneficial effect of $535 million in favorable prior-year medical claims reserve development versus $228 million in 2015. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 110 basis points in 2016 versus approximately 50 basis points in 2015. The year-over-year increase in prior-period medical claims reserve development primarily was due to favorable year-over-year comparisons for our Medicare Advantage and individual commercial medical business. Operating costs • The Retail segment operating cost ratio of 11.5% for 2016 increased 30 basis points from 2015 primarily due to the impact on premiums of the write-off of receivables associated with the commercial risk corridor premium stabilization program, the unfavorable comparison to unusually low operating expenses in 2015 resulting from the temporary suspension of certain discretionary administrative costs, and the loss of a large group Medicare Advantage account which carried a lower operating cost ratio than that for our individual Medicare Advantage business. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 170 basis points in 2016 as compared to 160 basis points in 2015. Group Segment (a) Specialty products include dental, vision, and other voluntary benefit products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Group segment pretax income was relatively unchanged, decreasing $1 million, or 0.4%, to $257 million in 2016 as an increase in the operating cost ratio was substantially offset by improvement in the benefit ratio as discussed below. Enrollment • Fully-insured commercial group medical membership decreased 42,300 members, or 3.6% from December 31, 2015 reflecting lower membership in both large and small group accounts. • Group ASO commercial medical membership decreased 137,500 members, or 19.3%, from December 31, 2015 to December 31, 2016 primarily due to the loss of certain large group accounts as a result of continued discipline in pricing of services for self-funded accounts amid a highly competitive environment. • Group specialty membership decreased 195,600 members, or 3.2%, from December 31, 2015 to December 31, 2016 primarily due to the loss of several large stand-alone dental and vision accounts as well as the loss of certain fully-insured group medical accounts that also had specialty coverage. Premiums revenue • Group segment premiums decreased $132 million, or 2.0%, from 2015 to 2016 primarily due to a decline in fully-insured commercial medical membership as described above, partially offset by an increase in fully-insured commercial medical per member premiums. Services revenue • Group segment services revenue decreased $4 million, or 0.6%, from 2015 to 2016 primarily due to a decline in group ASO commercial medical membership. Benefits expense • The Group segment benefit ratio decreased 60 basis points from 80.2% in 2015 to 79.6% in 2016 primarily reflecting the beneficial effect of higher prior-year medical claims reserve development in 2016 and lower utilization. • The Group segment’s benefits expense included the beneficial effect of $46 million in favorable prior-year medical claims reserve development in 2016 versus $7 million in 2015. This favorable prior-year medical claims reserve development decreased the Group segment benefit ratio by approximately 70 basis points in 2016 versus approximately 10 basis points in 2015. Operating costs • The Group segment operating cost ratio of 24.6% for 2016 increased 60 basis points from 24.0% for 2015 primarily due to the unfavorable comparison to unusually low operating expenses in 2015 resulting from the temporary suspension of certain discretionary administrative costs. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 150 basis points in 2016 as compared to 140 basis points in 2015. Healthcare Services Segment Pretax results • Healthcare Services segment pretax income of $1,067 million for 2016 increased $86 million, or 8.8%, from 2015 primarily due to incremental earnings associated with revenue growth from our pharmacy solutions business as it increased mail-order penetration and served our growing individual Medicare membership. The increase was partially offset by ongoing pressures in our provider services business reflecting significantly lower Medicare rates year-over-year associated with CMS' risk coding recalibration for 2016 in geographies where our provider assets are primarily located. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Group segment membership increased to approximately 426 million in 2016, up 7% versus scripts of approximately 398 million in 2015. The increase primarily reflects growth associated with higher average medical membership for 2016 than in 2015. Services revenue • Services revenue decreased $428 million, or 62.5%, from 2015 to $257 million for 2016 primarily due to the completion of the sale of Concentra on June 1, 2015. Intersegment revenues • Intersegment revenues increased $1.9 billion, or 8.4%, from 2015 to $24.8 billion for 2016 primarily due to increased mail order penetration and growth in our individual Medicare Advantage and Medicare stand-alone PDP membership which resulted in increased engagement of members in clinical programs and higher utilization of services across the segment. Operating costs • The Healthcare Services segment operating cost ratio of 95.4% for 2016 increased slightly from 2015 primarily due to a higher operating cost ratio for our provider services business reflecting significantly lower Medicare rates year-over-year as discussed above, partially offset by operating cost efficiencies associated with our pharmacy operations. Other Businesses As previously disclosed, in the fourth quarter of 2016, we increased future policy benefits expense by approximately $505 million for reserve strengthening associated with our closed block of long-term care insurance policies. This increase primarily was driven by emerging experience indicating longer claims duration, a prolonged lower interest rate environment, and an increase in policyholder life expectancies as discussed further in Note 18 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this 2016 Form 10-K. Comparison of Results of Operations for 2015 and 2014 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2015 and 2014: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs, excluding depreciation and amortization, as a percentage of total revenues less investment income. Summary Net income was $1.3 billion, or $8.44 per diluted common share, in 2015 compared to $1.1 billion, or $7.36 per diluted common share, in 2014. The completion of the sale of Concentra on June 1, 2015 resulted in an after-tax gain of $1.57 per diluted common share in 2015. Excluding the impact of the sale of Concentra, the decrease primarily was due to a decline in Retail segment pretax results, including expense of $0.74 per diluted common share for a premium deficiency reserve for certain of our individual commercial medical products for the 2016 coverage year, and an increase in the effective tax rate as discussed below. These items were partially offset by year-over-year improvement in the Group and Healthcare Services segment pretax results and higher investment income. In addition, 2015 includes expenses of $0.14 per diluted common share for transaction costs associated with the Merger, certain of which were not deductible for tax purposes. Net income for 2014 includes expenses of $0.15 per diluted common share associated with a loss on extinguishment of debt for the redemption of certain senior notes in 2014. Year-over-year comparisons of diluted earnings per common share are also favorably impacted by a lower number of shares used to compute diluted earnings per common share in 2015 reflecting the impact of share repurchases. Premiums Revenue Consolidated premiums increased $6.5 billion, or 14.0%, from 2014 to $52.4 billion for 2015 primarily reflecting higher premiums in both the Retail and Group segments. These higher premiums were primarily driven by average membership growth in the Retail segment and an increase in fully-insured group commercial medical per member premiums in the Group segment. Services Revenue Consolidated services revenue decreased $758 million, or 35.0%, from 2014 to $1.4 billion for 2015 primarily due to the completion of the sale of Concentra on June 1, 2015 as well as the loss of certain large group ASO accounts as a result of continued discipline in pricing of services for self-funded accounts amid a highly competitive environment. Investment Income Investment income totaled $474 million for 2015, an increase of $97 million from 2014, primarily due to higher realized capital gains in 2015 as a result of the repositioning of our portfolio given recent market volatility and anticipated changes to interest rates, with higher average invested balances being substantially offset by lower interest rates. Benefits Expense Consolidated benefits expense was $44.3 billion for 2015, an increase of $6.1 billion, or 16.0%, from 2014 primarily due to an increase in the Retail segment mainly driven by higher average Medicare Advantage membership and individual commercial medical on-exchange and off-exchange membership in plans compliant with the Health Care Reform Law. As more fully described herein under the section entitled “Benefits Expense Recognition”, actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $236 million in 2015 and $518 million in 2014. The decline in prior-period medical claims reserve development year over-year primarily was due to Medicare Advantage and individual commercial medical claims development in the Retail segment as discussed further in the segment results of operations discussion that follows. The consolidated benefit ratio for 2015 was 84.5%, an increase of 150 basis points from 2014 primarily due to increases in the Retail segment, including the impact of recognizing a premium deficiency reserve for certain of our individual commercial medical products for the 2016 coverage year, and Group segment ratios as discussed in the segment results of operations discussion that follows. The increase in benefits expense associated with the recognition of the premium deficiency reserve increased the consolidated benefit ratio by approximately 30 basis points in 2015. Favorable prior-period medical claims reserve development decreased the consolidated benefit ratio by approximately 50 basis points in 2015 versus approximately 110 basis points in 2014. Operating Costs Consolidated operating costs decreased $321 million, or 4.2%, in 2015 compared to 2014 primarily due to cost management initiatives across all lines of business as well as the completion of the sale of Concentra on June 1, 2015, partially offset by increases in costs mandated by the Health Care Reform Law, including the non-deductible health insurance industry fee. The consolidated operating cost ratio for 2015 was 13.6%, decreasing 230 basis points from 2014 primarily due to decreases in the operating cost ratios in the Group and Retail segments reflecting cost management initiatives, as well as the completion of the sale of Concentra on June 1, 2015. Concentra carried a higher operating cost ratio. Depreciation and Amortization Depreciation and amortization for 2015 totaled $355 million, increasing $22 million, or 6.6% from 2014, reflecting higher depreciation expense from capital expenditures. Interest Expense Interest expense was $186 million for 2015 compared to $192 million for 2014, a decrease of $6 million, or 3.1%, primarily reflecting a higher average long-term debt balance due to the issuance of senior notes in September 2014, partially offset by the recognition of a loss on extinguishment of debt of approximately $37 million in October 2014 for the redemption of our $500 million 6.45% senior unsecured notes due June 1, 2016. Income Taxes Our effective tax rate during 2015 was 47.5% compared to the effective tax rate of 47.2% in 2014. The increase in the effective tax rate primarily was due to an increase in the non-deductible health insurance industry fee from 2014, substantially offset by the favorable tax effect of the gain on the sale of Concentra. See Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. Retail Segment (a) Specialty products include dental, vision, and other supplemental health and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Retail segment pretax income was $930 million in 2015, a decrease of $409 million, or 30.5%, compared to 2014 primarily driven by an increase in the benefit ratio for 2015, including the impact of recognizing a premium deficiency reserve of approximately $176 million for certain of our individual commercial medical products for the 2016 coverage year, partially offset by a decline in the operating cost ratio, Medicare Advantage membership growth, and higher investment income year-over-year. Enrollment • Individual Medicare Advantage membership increased 325,500 members, or 13.4%, from December 31, 2014 to December 31, 2015 reflecting net membership additions, particularly for our HMO offerings, for the 2015 plan year. • Group Medicare Advantage membership decreased 5,600 members, or 1.1%, from December 31, 2014 to December 31, 2015. • Medicare stand-alone PDP membership increased 563,900 members, or 14.1%, from December 31, 2014 to December 31, 2015 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2015 plan year. • Individual commercial medical membership decreased 117,100 members, or 11.5%, from December 31, 2014 to December 31, 2015 primarily reflecting the loss of approximately 150,000 members due to termination by CMS for lack of proper eligibility documentation from the member as well as the loss of members who had subscribed to plans that were not compliant with the Health Care Reform Law. These declines were partially offset by an increase in membership in plans that are compliant with the Health Care Reform Law, primarily off-exchange • State-based Medicaid membership increased 56,900 members, or 18.0%, from December 31, 2014 to December 31, 2015 primarily driven by the addition of members under our Florida Medicaid contract. • Individual specialty membership decreased 12,700 members, or 1.1%, from December 31, 2014 to December 31, 2015 primarily driven by a membership decline in supplemental health and financial protection product and vision offerings. Premiums revenue • Retail segment premiums increased $6.4 billion, or 16.1%, from 2014 to 2015 primarily due to membership growth across our Medicare Advantage, state-based Medicaid, and Medicare stand-alone PDP lines of business, as well as a heavier percentage of individual commercial medical business in higher premium plans compliant with the Health Care Reform Law. Average Medicare Advantage membership increased 11.8% in 2015. Benefits expense • The Retail segment benefit ratio of 86.7% for 2015 increased 180 basis points from 2014 primarily due to higher than expected medical costs as compared to the assumptions used in our pricing, the recognition of a premium deficiency reserve in the fourth quarter of 2015 for certain of our individual commercial medical products for the 2016 coverage year, and unfavorable year-over-year comparisons of prior-period medical claims reserve development as discussed below. In addition, the increase reflects higher benefit ratios associated with a greater number of members from state-based contracts and the impact of the change in estimate for the 2014 net 3Rs receivables in 2015. These items were partially offset by the impact of the increase in the health insurance industry fee included in the pricing of our products. In addition, the 2015 period was favorably impacted by the release of reserves for future policy benefits as individual commercial medical members transitioned to plans compliant with the Health Care Reform Law. • We experienced higher than expected medical costs as compared to the assumptions used in our pricing for 2015 primarily due to lower-than-expected 2015 Medicare Advantage financial claim recovery levels and lower-than-anticipated reductions in inpatient admissions. In addition, medical claims associated with certain individual commercial medical products, in particular products compliant with the Health Care Reform Law, exceeded the assumptions used when we set pricing for 2015. We took a number of actions in 2015 to improve the profitability of our individual commercial medical business in 2016. These actions were subject to regulatory restrictions in certain geographies and included premium increases for the 2016 coverage year related generally to the first half of 2015 claims experience, the discontinuation of certain products as well as exit of certain markets for 2016, network improvements, enhancements to claims and clinical processes and administrative cost control. Despite these actions, the deterioration in the second half of 2015 claims experience together with 2016 open enrollment results indicating the retention of many high-utilizing members for 2016 resulted in a probable future loss. As a result of our assessment of the profitability of our individual medical policies compliant with the Health Care Reform Law, in the fourth quarter of 2015, we recorded a provision for probable future losses (premium deficiency reserve) for the 2016 coverage year of $176 million. The increase in benefits expense associated with the recognition of the premium deficiency reserve increased the Retail segment benefit ratio by approximately 40 basis points in 2015. • The Retail segment’s benefits expense for 2015 included the beneficial effect of $228 million in favorable prior-year medical claims reserve development versus $488 million in 2014. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 50 basis points in 2015 versus approximately 120 basis points in 2014. The year-over-year decline in prior-period medical claims reserve development primarily was due to the impact of lower financial claim recoveries due in part to our gradual implementation during 2014 of inpatient authorization review prior to admission as opposed to post adjudication, as well as higher than expected flu associated claims from the fourth quarter of 2014 and continued volatility in claims associated with individual commercial medical products. Operating costs • The Retail segment operating cost ratio of 11.2% for 2015 decreased 40 basis points from 2014 primarily reflecting administrative cost efficiencies associated with medical membership growth in the segment and other discretionary cost reductions, partially offset by the increase in the non-deductible health insurance industry fee. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 160 basis points in 2015 as compared to 120 basis points in 2014. Group Segment (a) Specialty products include dental, vision, and voluntary benefit products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Group segment pretax income increased $107 million, or 70.9%, to $258 million in 2015 primarily reflecting improvement in the operating cost ratio partially offset by an increase in the benefit ratio as discussed below. Enrollment • Fully-insured commercial group medical membership decreased 57,200 members, or 4.6% from December 31, 2014 reflecting lower membership in both large and small group accounts. • Group ASO commercial medical membership decreased 393,600 members, or 35.6%, from December 31, 2014 to December 31, 2015 primarily due to the loss of certain large group accounts as a result of continued discipline in pricing of services for self-funded accounts amid a highly competitive environment. • Group specialty membership decreased 434,000 members, or 6.7%, from December 31, 2014 to December 31, 2015 primarily due to the loss of certain fully-insured group medical accounts that also had specialty coverage. Premiums revenue • Group segment premiums increased $113.0 million, or 1.8%, from 2014 to 2015 primarily due to an increase in fully-insured commercial medical per member premiums partially offset by a net decline in fully-insured commercial medical membership. Benefits expense • The Group segment benefit ratio increased 70 basis points from 79.5% in 2014 to 80.2% in 2015 primarily reflecting the impact of higher specialty drug costs, net of rebates, as well as higher outpatient costs and lower prior-period medical claims reserve development, partially offset by an increase in the non-deductible health insurance industry fee included in the pricing of our products. • The Group segment’s benefits expense included the beneficial effect of $7 million in favorable prior-year medical claims reserve development versus $29 million in 2014. This favorable prior-year medical claims reserve development decreased the Group segment benefit ratio by approximately 10 basis points in 2015 versus approximately 40 basis points in 2014. The year-over-year decline in favorable prior-period medical claims reserve development primarily was due to a relatively small number of higher severity claims in the 2015 period associated with prior periods. Operating costs • The Group segment operating cost ratio of 24.0% for 2015 decreased 250 basis points from 26.5% for 2014, reflecting a decline in our group ASO commercial medical membership which carries a higher operating cost ratio than our fully-insured commercial medical membership, as well as operating cost efficiencies associated with our fully-insured business. Operating cost efficiencies were the result of both sustainable cost reduction initiatives and discretionary reductions. These declines were partially offset by the impact of an increase in the non-deductible health insurance industry fee. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 140 basis points in 2015 as compared to 100 basis points in 2014. Healthcare Services Segment Pretax results • Healthcare Services segment pretax income of $981 million for 2015 increased $243 million, or 32.9%, from 2014 primarily due to higher earnings from our pharmacy solutions and home based services businesses as they serve our growing Medicare membership. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Group segment membership increased to approximately 398 million in 2015, up 21% versus scripts of approximately 329 million in 2014. The increase primarily reflects growth associated with higher average medical membership for 2015 than in 2014. Services revenue • Services revenue for 2015 decreased $668 million, or 49.4% from 2014, to $685 million for 2015, primarily due to the completion of the sale of Concentra on June 1, 2015. Intersegment revenues • Intersegment revenues increased $4.1 billion, or 21.6%, from 2014 to $22.9 billion for 2015 primarily due to growth in our Medicare membership which resulted in higher utilization of our Healthcare Services segment businesses. Operating costs • The Healthcare Services segment operating cost ratio of 95.2% for 2015 decreased 40 basis points from 95.6% for 2014 primarily due to lower operating costs in our pharmacy business together with discretionary cost reductions across the segment, partially offset by the increasing percentage of pharmacy business associated with lower margin specialty drugs. Improving operating efficiency in the pharmacy business was primarily driven by lower cost of goods associated with increased purchasing scale and lower cost-to-fill primarily due to improvements in technology. Liquidity Historically, our primary sources of cash have included receipts of premiums, services revenue, and investment and other income, as well as proceeds from the sale or maturity of our investment securities, borrowings, and proceeds from sales of businesses. Our primary uses of cash historically have included disbursements for claims payments, operating costs, interest on borrowings, taxes, purchases of investment securities, acquisitions, capital expenditures, repayments on borrowings, dividends, and share repurchases. Because premiums generally are collected in advance of claim payments by a period of up to several months, our business normally should produce positive cash flows during periods of increasing premiums and enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing premiums and enrollment. From period to period, our cash flows may also be affected by the timing of working capital items including premiums receivable, benefits payable, and other receivables and payables. Our cash flows are impacted by the timing of payments to and receipts from CMS associated with Medicare Part D subsidies for which we do not assume risk. The use of operating cash flows may be limited by regulatory requirements of state departments of insurance (or comparable state regulators) which require, among other items, that our regulated subsidiaries maintain minimum levels of capital and seek approval before paying dividends from the subsidiaries to the parent. Our use of operating cash flows derived from our non-insurance subsidiaries, such as in our Healthcare Services segment, is generally not restricted by state departments of insurance (or comparable state regulators). The effect of the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law impact the timing of our operating cash flows, as we build receivables for each coverage year that are expected to be collected in subsequent coverage years. During 2016, net collections under the 3Rs associated with prior coverage years were $383 million. We expect to collect the remaining $54 million of reinsurance recoverables related to prior coverage years in 2017. On November 10, 2016, the U.S. Court of Federal Claims ruled in favor of the government in one of a series of cases filed by insurers, unrelated to us, against HHS to collect risk corridor payments, rejecting all of the insurer’s statutory, contract and Constitutional claims for payment. On November 18, 2016, HHS issued a memorandum indicating a significant funding shortfall for the 2015 coverage year, the second consecutive year of significant shortfalls. Given the successful challenge of the risk corridor provisions in court, Congressional inquiries into the funding of the risk corridor program, and significant funding shortfalls under the first two years of the program, during the fourth quarter of 2016 we wrote-off $583 million in risk corridor receivables outstanding as of September 30, 2016, including $415 million associated with the 2014 and 2015 coverage years. From inception of the risk corridor program through December 31, 2016, we collected approximately $36 million from CMS for risk corridor receivables associated with the 2014 coverage year funded by HHS in accordance with previous guidance, utilizing funds HHS collected from us and other carriers under the 2014 and 2015 risk corridor program. The remaining net receivable balance associated with the 3Rs was approximately $456 million at December 31, 2016, including the $54 million related to the 2015 coverage year, as compared to $982 million at December 31, 2015. Any amounts receivable or payable associated with these risk limiting programs may have an impact on subsidiary liquidity, with any temporary shortfalls funded by the parent company. For additional information on our liquidity risk, please refer to Item 1A. - Risk Factors in this 2016 Form 10-K. Cash and cash equivalents increased to $3.9 billion at December 31, 2016 from $2.6 billion at December 31, 2015. The change in cash and cash equivalents for the years ended December 31, 2016, 2015 and 2014 is summarized as follows: Cash Flow from Operating Activities The change in operating cash flows over the three year period primarily results from the corresponding change in the timing of working capital items, earnings, and enrollment activity as discussed below. The increase in operating cash flows in 2016 primarily was due to significantly favorable working capital items and higher earnings exclusive of the commercial risk corridor receivables write-off and the long-term care reserve strengthening in 2016, as well as the gain on sale of Concentra and the recognition of the premium deficiency reserve in 2015 discussed previously. The working capital changes year-over-year primarily reflect lower income tax payments, changes in the net receivable balance associated with the premium stabilization programs established under health care reform, or the 3R's, and the timing of payroll cycles resulting in one less payroll cycle in 2016, partially offset by the timing of payments for benefits expense. The lower operating cash flows in 2015 primarily reflect the effect of significant growth in individual commercial medical and group Medicare Advantage membership in 2014 and changes in the timing of working capital items related to the growth in our pharmacy business. The most significant drivers of changes in our working capital are typically the timing of payments of benefits expense and receipts for premiums. We illustrate these changes with the following summaries of benefits payable and receivables. The detail of benefits payable was as follows at December 31, 2016, 2015 and 2014: (1) IBNR represents an estimate of benefits payable for claims incurred but not reported (IBNR) at the balance sheet date and includes unprocessed claim inventories. The level of IBNR is primarily impacted by membership levels, medical claim trends and the receipt cycle time, which represents the length of time between when a claim is initially incurred and when the claim form is received (i.e. a shorter time span results in a lower IBNR). (2) Reported claims in process represents the estimated valuation of processed claims that are in the post claim adjudication process, which consists of administrative functions such as audit and check batching and handling, as well as amounts owed to our pharmacy benefit administrator which fluctuate due to bi-weekly payments and the month-end cutoff. (3) Premium deficiency reserve recognized for our individual commercial medical business compliant with the Health Care Reform Law associated with the 2016 coverage year. (4) Other benefits payable include amounts owed to providers under capitated and risk sharing arrangements. The decrease in benefits payable in 2016 largely was due to a decrease in IBNR, discussed further below, as well as the application of 2016 results to the premium deficiency reserve liability recognized in 2015 associated with our individual commercial medical products compliant with the Health Care Reform Law for the 2016 coverage year. There was no premium deficiency reserve liability at December 31, 2016. The increases in benefits payable in 2015 and 2014 largely were due to increases in IBNR as well as an increase in the amount of processed but unpaid claims due to our pharmacy benefit administrator, which fluctuates due to month-end cutoff. These items were partially offset by a decrease in amounts owed to providers under capitated and risk sharing arrangements in both 2015 and 2014, including the disbursement of a portion of our Medicare risk adjustment collections under our contractual obligations associated with our risk sharing arrangements. In addition, benefits payable in 2015 reflects the recognition of the premium deficiency reserve discussed previously. IBNR decreased during 2016 primarily due to declines in group Medicare Advantage, individual commercial medical, and fully-insured commercial group medical membership in 2016. IBNR increased during 2015 primarily as a result of individual Medicare Advantage membership growth while during 2014 IBNR also increased as a result of individual Medicare Advantage membership growth as well as significant growth in individual commercial medical and group Medicare Advantage membership. As discussed previously, our cash flows are impacted by changes in enrollment. In 2014 (the first year plans compliant with the Health Care Reform Law were effective), membership in new fully-insured individual commercial medical plans compliant with the Health Care Reform Law grew as compared with much lower growth in membership in these plans in 2015 and a decline in membership in these plans in 2016. Similarly, growth in group Medicare Advantage membership in 2014 favorably impacted the 2014 cash flows while a decline in group Medicare Advantage membership in 2015 and more significantly in 2016, negatively impacted the 2015 and 2016 cash flows. The detail of total net receivables was as follows at December 31, 2016, 2015 and 2014: As disclosed previously, on June 1, 2015, we completed the sale of our wholly owned subsidiary Concentra. Net receivables associated with Concentra were classified as held-for-sale at December 31, 2014 excluded from the table above for comparative purposes. Medicare receivables are impacted by changes in revenue associated with individual and group Medicare membership changes as well as the timing of accruals and related collections associated with the CMS risk-adjustment model. The increases in commercial and other receivables in 2016 as compared to 2015 primarily reflects an increase in our receivable associated with the commercial risk adjustment provision of the Health Care Reform Law. Similarly, excluding the effect of classifying Concentra receivables as held-for-sale at December 31, 2014, the increase in commercial and other receivables in 2014 primarily was due to the commercial risk adjustment provisions of the Health Care Reform Law which became effective in 2014. Military services receivables at December 31, 2016, 2015, and 2014 primarily consist of administrative services only fees owed from the federal government for administrative services provided under our current TRICARE South Region contract. Many provisions of the Health Care Reform Law became effective in 2014, including the commercial risk adjustment, risk corridor, and reinsurance provisions as well as the non-deductible health insurance industry fee. As discussed previously, the timing of payments and receipts associated with these provisions impact our operating cash flows as we build receivables for each coverage year that are expected to be collected in subsequent coverage years. During 2016, net collections under the 3Rs associated with prior coverage years were $383 million as compared to net collections of $417 million in 2015. There were no amounts collected in 2014, the first year of the programs. The net receivable balance associated with the 3Rs was approximately $456 million at December 31, 2016, including certain amounts recorded in receivables as noted above. In 2016, we paid the federal government $916 million for the annual health insurance industry fee compared to our payments of $867 million in 2015 and $562 million in 2014. In addition to the timing of payments of benefits expense, receipts for premiums and services revenues, and amounts due under the risk limiting and health insurance industry fee provisions of the Health Care Reform Law, other items impacting operating cash flows include income tax payments and the timing of payroll cycles resulting in one less payroll cycle in 2016 than in 2015. Cash Flow from Investing Activities Our ongoing capital expenditures primarily relate to our information technology initiatives, support of services in our provider services operations including medical and administrative facility improvements necessary for activities such as the provision of care to members, claims processing, billing and collections, wellness solutions, care coordination, regulatory compliance and customer service. Total capital expenditures, excluding acquisitions, were $527 million in 2016, $523 million in 2015, and $528 million in 2014. We reinvested a portion of our operating cash flows in investment securities, primarily investment-grade fixed income securities, totaling $828 million in 2016. Proceeds from sales and maturities of investment securities exceeded purchases by $103 million in 2015 and $411 million in 2014. These net proceeds were used to fund normal working capital needs due to an increase in receivables associated with the 3Rs in addition to the timing of payments to and receipts from CMS associated with Medicare Part D reinsurance subsidies, as discussed below. In 2015, we purchased a $284 million note receivable directly from a third-party bank syndicate related to the financing of MCCI Holdings, LLC's business as described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. The purchase of this note is included with purchases of investment securities in our consolidated statement of cash flows. On June 1, 2015, we completed the sale of Concentra for approximately $1,055 million in cash, excluding approximately $22 million of transaction costs. Cash consideration paid for acquisitions, net of cash acquired, was $7 million in 2016, $38 million in 2015, and $18 million in 2014. Acquisitions in each year included health and wellness related acquisitions. Cash Flow from Financing Activities Our financing cash flows are significantly impacted by the timing of claims payments and the related receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk. Monthly prospective payments from CMS for reinsurance and low-income cost subsidies are based on assumptions submitted with our annual bid. Settlement of the reinsurance and low-income cost subsidies is based on a reconciliation made approximately 9 months after the close of each calendar year. Receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk were $1.1 billion higher than claims payments during 2016. Conversely, claims payments were $361 million higher than receipts from CMS associated with Medicare Part D claims subsidies for which we do not assume risk during 2015 and $945 million higher during 2014. In 2014 and 2015, we experienced higher specialty prescription drug costs associated with a new treatment for Hepatitis C than were contemplated in our bids which resulted in higher subsidy receivable balances in those years that were settled in 2015 and 2016, respectively, under the terms of our contracts with CMS. Our net receivable for CMS subsidies and brand name prescription drug discounts was $0.9 billion at December 31, 2016 compared to $2.0 billion at December 31, 2015. Refer to Note 6 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Under our administrative services only TRICARE South Region contract, health care cost payments for which we do not assume risk exceeded reimbursements from the federal government by $25 million in 2016 and by $4 million in 2015. Reimbursements from the federal government equaled health care cost payments for which we do not assume risk in 2014. Claims payments associated with cost sharing provisions of the Health Care Reform Law for which we do not assume risk were higher than reimbursements from HHS by $28 million in 2016 and less than reimbursements by $69 million in 2015 and by $26 million in 2014. See Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for further description. We repurchased 1.85 million shares for $329 million in 2015 and 5.7 million shares for $730 million in 2014(excludes another $100 million held back pending final settlement of an accelerated stock repurchase plan in March 2015) under share repurchase plans authorized by the Board of Directors. We did not repurchase shares in 2016 due to restrictions under the Merger Agreement. We also acquired common shares in connection with employee stock plans for an aggregate cost of $104 million in 2016, $56 million in 2015, and $42 million in 2014. As discussed further below, we paid dividends to stockholders of $177 million in 2016 and $172 million in each of 2015 and 2014. We entered into a commercial paper program in October 2014. Net repayments of commercial paper were $2 million in 2016 and the maximum principal amount outstanding at any one time during 2016 was $475 million. Net proceeds from the issuance of commercial paper were $298 million in 2015 and the maximum principal amount outstanding at any one time during 2015 was $414 million. There were no net proceeds from the issuance of commercial paper in 2014 and the maximum principal amount outstanding at any one time during 2014 was $175 million. In September 2014, we issued $400 million of 2.625% senior notes due October 1, 2019, $600 million of 3.85% senior notes due October 1, 2024 and $750 million of 4.95% senior notes due October 1, 2044. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses, were $1.73 billion. We used a portion of the net proceeds to redeem our $500 million 6.45% senior unsecured notes. The remainder of the cash used in or provided by financing activities in 2016, 2015, and 2014 primarily resulted from proceeds from stock option exercises and the change in book overdraft. Future Sources and Uses of Liquidity Dividends For a detailed discussion of dividends to stockholders, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Stock Repurchases On February 14, 2017, we and Aetna agreed to mutually terminate the Merger Agreement, and also announced that the Board had approved a new authorization for share repurchases of up to $2.25 billion of our common stock exclusive of shares repurchased in connection with employee stock plans, expiring on December 31, 2017. Under this new authorization, we expect to complete a $1.5 billion accelerated share repurchase program in the first quarter of 2017. For a detailed discussion of stock repurchases, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Debt For a detailed discussion of our debt, including our senior notes, credit agreement and commercial paper program, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Liquidity Requirements We believe our cash balances, investment securities, operating cash flows, and funds available under our credit agreement and our commercial paper program or from other public or private financing sources, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, acquisitions, future expansion opportunities, and capital expenditures for at least the next twelve months, as well as to refinance or repay debt, and repurchase shares. Adverse changes in our credit rating may increase the rate of interest we pay and may impact the amount of credit available to us in the future. Our investment-grade credit rating at December 31, 2016 was A- according to Standard & Poor’s Rating Services, or S&P, and Baa3 according to Moody’s Investors Services, Inc., or Moody’s. A downgrade by S&P to BB+ or by Moody’s to Ba1 triggers an interest rate increase of 25 basis points with respect to $750 million of our senior notes. Successive one notch downgrades increase the interest rate an additional 25 basis points, or annual interest expense by $2 million, up to a maximum 100 basis points, or annual interest expense by $8 million. In addition, we operate as a holding company in a highly regulated industry. Humana Inc., our parent company, is dependent upon dividends and administrative expense reimbursements from our subsidiaries, most of which are subject to regulatory restrictions. We continue to maintain significant levels of aggregate excess statutory capital and surplus in our state-regulated operating subsidiaries. Cash, cash equivalents, and short-term investments at the parent company increased to $2.0 billion at December 31, 2016 from $1.6 billion at December 31, 2015. This increase primarily reflects operating cash derived from our non-insurance subsidiaries' profits partially offset by capital expenditures, payment of stockholder dividends, and common stock repurchases. Our use of operating cash derived from our non-insurance subsidiaries, such as our Healthcare Services segment, is generally not restricted by Departments of Insurance (or comparable state regulatory agencies). Our regulated subsidiaries paid dividends to the parent of $763 million in 2016, $493 million in 2015, and $927 million in 2014. Subsidiary dividends in 2015 reflect the impact of losses for our individual commercial medical business compliant with the Health Care Reform Law and the November 5, 2015 revised statutory accounting guidance requiring the exclusion of risk corridor receivables from related statutory surplus. Refer to our parent company financial statements and accompanying notes in Schedule I - Parent Company Financial Information. Excluding Puerto Rico subsidiaries, the amount of ordinary dividends that may be paid to our parent company in 2017 is approximately $850 million, in the aggregate. Actual dividends paid may vary due to consideration of excess statutory capital and surplus and expected future surplus requirements related to, for example, premium volume and product mix. Our parent company funded a subsidiary capital contribution of approximately $535 million in the first quarter of 2017 for reserve strengthening associated with our closed block of long-term care insurance policies discussed further in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. In 2016, we paid the federal government $916 million for the annual health insurance industry fee. The Consolidated Appropriations Act, 2016, enacted on December 18, 2015, included a one-time one year suspension in 2017 of the health insurer fee. Regulatory Requirements For a detailed discussion of our regulatory requirements, including aggregate statutory capital and surplus as well as dividends paid from the subsidiaries to the parent, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Contractual Obligations We are contractually obligated to make payments for years subsequent to December 31, 2016 as follows: (1) Interest includes the estimated contractual interest payments under our debt agreements. (2) We lease facilities, computer hardware, and other furniture and equipment under long-term operating leases that are noncancelable and expire on various dates through 2037. We sublease facilities or partial facilities to third party tenants for space not used in our operations which partially mitigates our operating lease commitments. An operating lease is a type of off-balance sheet arrangement. Assuming we acquired the asset, rather than leased such asset, we would have recognized a liability for the financing of these assets. See also Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. (3) Purchase obligations include agreements to purchase services, primarily information technology related services, or to make improvements to real estate, in each case that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum levels of service to be purchased; fixed, minimum or variable price provisions; and the appropriate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. (4) Includes future policy benefits payable ceded to third parties through 100% coinsurance agreements as more fully described in Note 19 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We expect the assuming reinsurance carriers to fund these obligations and reflected these amounts as reinsurance recoverables included in other long-term assets on our consolidated balance sheet. Amounts payable in less than one year are included in trade accounts payable and accrued expenses in the consolidated balance sheet. Off-Balance Sheet Arrangements As of December 31, 2016, we were not involved in any special purpose entity, or SPE, transactions. For a detailed discussion of off-balance sheet arrangements, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Guarantees and Indemnifications For a detailed discussion of our guarantees and indemnifications, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Government Contracts For a detailed discussion of our government contracts, including our Medicare, Military, and Medicaid contracts, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Other On February 14, 2017, we and Aetna agreed to mutually terminate the Merger Agreement, as our Board determined that an appeal of the Court's ruling would not be in the best interest of our stockholders. Under terms of the Merger Agreement, we are entitled to a breakup fee of $1 billion. Under state guaranty assessment laws, including those related to state cooperative failures in the industry, we may be assessed (up to prescribed limits) for certain obligations to the policyholders and claimants of insolvent insurance companies that write the same line or lines of business as we do. Penn Treaty is a financially distressed unaffiliated long-term care insurance company. A final court ruling on Penn Treaty's insolvency would trigger a guarantee fund assessment that would result in expense for us, based on current information, estimated at approximately $30 million. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and accompanying notes, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements and accompanying notes requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We continuously evaluate our estimates and those critical accounting policies primarily related to benefits expense and revenue recognition as well as accounting for impairments related to our investment securities, goodwill, and long-lived assets. These estimates are based on knowledge of current events and anticipated future events and, accordingly, actual results ultimately may differ from those estimates. We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements. Benefits Expense Recognition Benefits expense is recognized in the period in which services are provided and includes an estimate of the cost of services which have been incurred but not yet reported, or IBNR. IBNR represents a substantial portion of our benefits payable as follows: Our reserving practice is to consistently recognize the actuarial best point estimate within a level of confidence required by actuarial standards. For further discussion of our reserving methodology, including our use of completion and claims per member per month trend factors to estimate IBNR, refer to Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. The completion and claims per member per month trend factors are the most significant factors impacting the IBNR estimate. The portion of IBNR estimated using completion factors for claims incurred prior to the most recent two months is generally less variable than the portion of IBNR estimated using trend factors. The following table illustrates the sensitivity of these factors assuming moderate adverse experience and the estimated potential impact on our operating results caused by reasonably likely changes in these factors based on December 31, 2016 data: (a) Reflects estimated potential changes in benefits payable at December 31, 2016 caused by changes in completion factors for incurred months prior to the most recent two months. (b) Reflects estimated potential changes in benefits payable at December 31, 2016 caused by changes in annualized claims trend used for the estimation of per member per month incurred claims for the most recent two months. (c) The factor change indicated represents the percentage point change. The following table provides a historical perspective regarding the accrual and payment of our benefits payable, excluding military services. Components of the total incurred claims for each year include amounts accrued for current year estimated benefits expense as well as adjustments to prior year estimated accruals. Refer to Note 10 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for Retail and Group segment tables including information about incurred and paid claims development as of December 31, 2016, net of reinsurance, as well as cumulative claim frequency and the total of IBNR included within the net incurred claims amounts. The following table summarizes the changes in estimate for incurred claims related to prior years attributable to our key assumptions. As previously described, our key assumptions consist of trend and completion factors estimated using an assumption of moderately adverse conditions. The amounts below represent the difference between our original estimates and the actual benefits expense ultimately incurred as determined from subsequent claim payments. (a) The factor change indicated represents the percentage point change. As previously discussed, our reserving practice is to consistently recognize the actuarial best estimate of our ultimate liability for claims. Actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $582 million in 2016, $236 million in 2015, and $518 million in 2014. The table below details our favorable medical claims reserve development related to prior fiscal years by segment for 2016, 2015, and 2014. The favorable medical claims reserve development for 2016, 2015, and 2014 primarily reflects the consistent application of trend and completion factors estimated using an assumption of moderately adverse conditions. Our favorable development for each of the years presented above is discussed further in Note 10 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We continually adjust our historical trend and completion factor experience with our knowledge of recent events that may impact current trends and completion factors when establishing our reserves. Because our reserving practice is to consistently recognize the actuarial best point estimate using an assumption of moderately adverse conditions as required by actuarial standards, there is a reasonable possibility that variances between actual trend and completion factors and those assumed in our December 31, 2016 estimates would fall towards the middle of the ranges previously presented in our sensitivity table. Benefits expense excluded from the previous table was as follows for the years ended December 31, 2016, 2015 and 2014: In the fourth quarter of 2015, we recognized a premium deficiency reserve for our individual commercial medical business compliant with the Health Care Reform Law associated with the 2016 coverage year as discussed in more detail in Note 7 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Military services benefits expense for each year in the table above reflect expenses associated with our contracts with the Veterans Administration. The higher benefits expense associated with future policy benefits payable during 2016 primarily relates to reserve strengthening for our closed block of long-term care insurance policies acquired in connection with the 2007 KMG America Corporation, or KMG, acquisition more fully described below and in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Certain health policies sold to individuals prior to 2014 (the first year plans compliant with the Health Care Reform Law were effective) are accounted for as long-duration as more fully described below. The decrease in benefits expense associated with future policy benefits payable in 2015 primarily reflects the release of reserves as individual commercial medical members transitioned to plans compliant with the Health Care Reform Law. Future policy benefits payable of $2.8 billion and $2.2 billion at December 31, 2016 and 2015, respectively, represent liabilities for long-duration insurance policies including long-term care insurance, life insurance, annuities, and certain health and other supplemental policies sold to individuals for which some of the premium received in the earlier years is intended to pay anticipated benefits to be incurred in future years. At policy issuance, these reserves are recognized on a net level premium method based on premium rate increase, interest rate, mortality, morbidity, persistency (the percentage of policies remaining in-force), and maintenance expense assumptions. Interest rates are based on our expected net investment returns on the investment portfolio supporting the reserves for these blocks of business. Mortality, a measure of expected death, and morbidity, a measure of health status, assumptions are based on published actuarial tables, modified based upon actual experience. The assumptions used to determine the liability for future policy benefits are established and locked in at the time each contract is issued and only change if our expected future experience deteriorates to the point that the level of the liability, together with the present value of future gross premiums, are not adequate to provide for future expected policy benefits and maintenance costs (i.e. the loss recognition date). Because these policies have long-term claim payout periods, there is a greater risk of significant variability in claims costs, either positive or negative. We perform loss recognition tests at least annually in the fourth quarter, and more frequently if adverse events or changes in circumstances indicate that the level of the liability, together with the present value of future gross premiums, may not be adequate to provide for future expected policy benefits and maintenance costs. Future policy benefits payable include $2.2 billion at December 31, 2016 and $1.5 billion at December 31, 2015 associated with a non-strategic closed block of long-term care insurance policies acquired in connection with the 2007 acquisition of KMG. Approximately 30,800 policies remain in force as of December 31, 2016. No new policies have been written since 2005 under this closed block. Future policy benefits payable includes amounts charged to accumulated other comprehensive income for an additional liability that would exist on our closed-block of long-term care insurance policies if unrealized gains on the sale of the investments backing such products had been realized and the proceeds reinvested at then current yields. There was a $77 million additional liability at December 31, 2016 and no additional liability at December 31, 2015. Amounts charged to accumulated other comprehensive income are net of applicable deferred taxes. Long-term care insurance policies provide nursing home and home health coverage for which premiums are collected many years in advance of benefits paid, if any. Therefore, our actual claims experience will emerge many years after assumptions have been established. The risk of a deviation of the actual interest, morbidity, mortality, and maintenance expense assumptions from those assumed in our reserves are particularly significant to our closed block of long-term care insurance policies. A prolonged period during which interest rates remain at levels lower than those anticipated in our reserving would result in shortfalls in investment income on assets supporting our obligation under long term care policies because the long duration of the policy obligations exceeds the duration of the supporting investment assets. Further, we monitor the loss experience of these long-term care insurance policies and, when necessary, apply for premium rate increases through a regulatory filing and approval process in the jurisdictions in which such products were sold. To the extent premium rate increases, interest rates, and/or loss experience vary from our loss recognition date assumptions, future material adjustments to reserves could be required. During 2016, we recorded a loss for a premium deficiency. The premium deficiency was based on current and anticipated experience that had deteriorated from our locked-in assumptions from the previous December 31, 2013 loss recognition date, particularly as they related to emerging experience indicating longer claims duration, a prolonged lower interest rate environment, and an increase in policyholder life expectancies. Based on this deterioration, we determined that our existing future policy benefits payable, together with the present value of future gross premiums, associated with our closed block of long-term care insurance policies were not adequate to provide for future policy benefits and maintenance costs under these policies; therefore we unlocked and modified our assumptions based on current expectations. Accordingly, during 2016 we recorded $505 million of additional benefits expense, with a corresponding increase in future policy benefits payable of $659 million partially offset by a related reinsurance recoverable of $154 million included in other long-term assets. For our closed block of long-term care policies, actuarial assumptions used to estimate reserves are inherently uncertain due to the potential changes in trends in mortality, morbidity, persistency and interest rates as well as premium rate increases. As a result, our long term care reserves may be subject to material increases if these trends develop adversely to our expectations. The estimated increase in reserves and additional benefit expense from hypothetically modeling adverse variations in our actuarial assumptions, in the aggregate, could be up to $250 million, net of reinsurance. Although such hypothetical revisions are not currently appropriate, we believe they could occur based on past variances in experience and our expectation of the ranges of future experience that could reasonably occur, and any such revision could be material. Generally accepted accounting principles do not allow us to unlock our assumptions for favorable items. In addition, future policy benefits payable includes amounts of $201 million at December 31, 2016, $205 million at December 31, 2015, and $210 million at December 31, 2014 which are subject to 100% coinsurance agreements as more fully described in Note 19 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, and as such are offset by a related reinsurance recoverable included in other long-term assets. Revenue Recognition We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group on 30-day written notice. Our Medicare contracts with CMS renew annually. Our military services contracts with the federal government and our contracts with various state Medicaid programs generally are multi-year contracts subject to annual renewal provisions. Our commercial contracts establish rates on a per employee basis for each month of coverage based on the type of coverage purchased (single to family coverage options). Our Medicare and Medicaid contracts also establish monthly rates per member. However, our Medicare contracts also have additional provisions as outlined in the following separate section. Premiums revenue and administrative services only, or ASO, fees are estimated by multiplying the membership covered under the various contracts by the contractual rates. In addition, we adjust revenues for estimated changes in an employer’s enrollment and individuals that ultimately may fail to pay, and for estimated rebates under the minimum benefit ratios required under the Health Care Reform Law. Enrollment changes not yet processed or not yet reported by an employer group or the government, also known as retroactive membership adjustments, are estimated based on available data and historical trends. We routinely monitor the collectibility of specific accounts, the aging of receivables, historical retroactivity trends, estimated rebates, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in the current period’s revenue. We bill and collect premium from employer groups and members in our Medicare and other individual products monthly. We receive monthly premiums from the federal government and various states according to government specified payment rates and various contractual terms. Changes in revenues from for our Medicare and individual commercial medical products resulting from the periodic changes in risk-adjustment scores derived from medical diagnoses for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured. Medicare Risk-Adjustment Provisions CMS utilizes a risk-adjustment model which apportions premiums paid to Medicare Advantage, or MA, plans according to health severity. The risk-adjustment model, which CMS implemented pursuant to the Balanced Budget Act of 1997(BBA) and the Benefits and Improvement Protection Act of 2000 (BIPA), generally pays more for enrollees with predictably higher costs. Under the risk-adjustment methodology, all MA plans must collect and submit the necessary diagnosis code information from hospital inpatient, hospital outpatient, and physician providers to CMS within prescribed deadlines. The CMS risk-adjustment model uses this diagnosis data to calculate the risk-adjusted premium payment to MA plans. Rates paid to MA plans are established under an actuarial bid model, including a process that bases our payments on a comparison of our beneficiaries’ risk scores, derived from medical diagnoses, to those enrolled in the government’s Medicare FFS program. We generally rely on providers, including certain providers in our network who are our employees, to code their claim submissions with appropriate diagnoses, which we send to CMS as the basis for our payment received from CMS under the actuarial risk-adjustment model. We also rely on providers to appropriately document all medical data, including the diagnosis data submitted with claims. CMS is phasing-in the process of calculating risk scores using diagnoses data from the Risk Adjustment Processing System, or RAPS, to diagnosis data from the Encounter Data System, or EDS. The RAPS process requires MA plans to apply a filter logic based on CMS guidelines and only submit those claims that pass the filtering logic. For submissions through EDS, CMS requires MA plans to submit all the claims data and CMS will apply the risk adjustment filtering logic to determine the risk adjustment data used to calculate risk scores. For 2016, 10% of the risk score was calculated from claims data submitted through EDS, increasing to 25% of the risk score calculated from claims data through EDS for 2017. The phase-in from RAPS to EDS could result in different risk scores from each dataset as a result of plan processing issues, CMS processing issues, or filtering logic differences between RAPS and EDS, and could have a material adverse effect on our results of operations, financial position, or cash flows. We estimate risk-adjustment revenues based on medical diagnoses for our membership. The risk-adjustment model, including CMS changes to the submission process, is more fully described in Item 1. - Business under the section titled “Individual Medicare.” Investment Securities Investment securities totaled $9.8 billion, or 39% of total assets at December 31, 2016, and $9.1 billion, or 37% of total assets at December 31, 2015. Debt securities, detailed below, comprised this entire investment portfolio at December 31, 2016 and 2015. The fair value of debt securities were as follows at December 31, 2016 and 2015: Approximately 98% of our debt securities were investment-grade quality, with a weighted average credit rating of AA by S&P at December 31, 2016. Most of the debt securities that were below investment-grade were rated BB, the higher end of the below investment-grade rating scale. Our investment policy limits investments in a single issuer and requires diversification among various asset types. Tax-exempt municipal securities included pre-refunded bonds of $276 million at December 31, 2016 and $178 million at December 31, 2015. These pre-refunded bonds were secured by an escrow fund consisting of U.S. government obligations sufficient to pay off all amounts outstanding at maturity. The ratings of these pre-refunded bonds generally assume the rating of the government obligations at the time the fund is established. Tax-exempt municipal securities that were not pre-refunded were diversified among general obligation bonds of U.S. states and local municipalities as well as special revenue bonds. General obligation bonds, which are backed by the taxing power and full faith of the issuer, accounted for $1.4 billion of these municipals in the portfolio. Special revenue bonds, issued by a municipality to finance a specific public works project such as utilities, water and sewer, transportation, or education, and supported by the revenues of that project, accounted for $1.6 billion of these municipals. Our general obligation bonds are diversified across the U.S. with no individual state exceeding 11%. In addition, certain monoline insurers guarantee the timely repayment of bond principal and interest when a bond issuer defaults and generally provide credit enhancement for bond issues related to our tax-exempt municipal securities. We have no direct exposure to these monoline insurers. We owned $132 million and $173 million at December 31, 2016 and 2015, respectively, of tax-exempt securities guaranteed by monoline insurers. The equivalent weighted average S&P credit rating of these tax-exempt securities without the guarantee from the monoline insurer was AA. Our direct exposure to subprime mortgage lending is limited to investment in residential mortgage-backed securities and asset-backed securities backed by home equity loans. The fair value of securities backed by Alt-A and subprime loans was less than $1 million at December 31, 2016 and $1 million at December 31, 2015. There are no collateralized debt obligations or structured investment vehicles in our investment portfolio. The percentage of corporate securities associated with the financial services industry was 23% at December 31, 2016 and 25% at December 31, 2015. Gross unrealized losses and fair values aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows at December 31, 2016: Under the other-than-temporary impairment model for debt securities held, we recognize an impairment loss in income in an amount equal to the full difference between the amortized cost basis and the fair value when we have the intent to sell the debt security or it is more likely than not we will be required to sell the debt security before recovery of our amortized cost basis. However, if we do not intend to sell the debt security, we evaluate the expected cash flows to be received as compared to amortized cost and determine if a credit loss has occurred. In the event of a credit loss, only the amount of the impairment associated with the credit loss is recognized currently in income with the remainder of the loss recognized in other comprehensive income. When we do not intend to sell a security in an unrealized loss position, potential other-than-temporary impairment is considered using a variety of factors, including the length of time and extent to which the fair value has been less than cost; adverse conditions specifically related to the industry, geographic area or financial condition of the issuer or underlying collateral of a security; payment structure of the security; changes in credit rating of the security by the rating agencies; the volatility of the fair value changes; and changes in fair value of the security after the balance sheet date. For debt securities, we take into account expectations of relevant market and economic data. For example, with respect to mortgage and asset-backed securities, such data includes underlying loan level data and structural features such as seniority and other forms of credit enhancements. A decline in fair value is considered other-than-temporary when we do not expect to recover the entire amortized cost basis of the security. We estimate the amount of the credit loss component of a debt security as the difference between the amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate of future cash flows discounted at the implicit interest rate at the date of purchase. The risks inherent in assessing the impairment of an investment include the risk that market factors may differ from our expectations, facts and circumstances factored into our assessment may change with the passage of time, or we may decide to subsequently sell the investment. The determination of whether a decline in the value of an investment is other than temporary requires us to exercise significant diligence and judgment. The discovery of new information and the passage of time can significantly change these judgments. The status of the general economic environment and significant changes in the national securities markets influence the determination of fair value and the assessment of investment impairment. There is a continuing risk that declines in fair value may occur and additional material realized losses from sales or other-than-temporary impairments may be recorded in future periods. The recoverability of our non-agency residential and commercial mortgage-backed securities is supported by factors such as seniority, underlying collateral characteristics and credit enhancements. These residential and commercial mortgage-backed securities at December 31, 2016 primarily were composed of senior tranches having high credit support, with over 99% of the collateral consisting of prime loans. The weighted average credit rating of all commercial mortgage-backed securities was AA+ at December 31, 2016. All issuers of securities we own that were trading at an unrealized loss at December 31, 2016 remain current on all contractual payments. After taking into account these and other factors previously described, we believe these unrealized losses primarily were caused by an increase in market interest rates in the current markets than when the securities were purchased. At December 31, 2016, we did not intend to sell the securities with an unrealized loss position in accumulated other comprehensive income, and it is not likely that we will be required to sell these securities before recovery of their amortized cost basis. As a result, we believe that the securities with an unrealized loss were not other-than-temporarily impaired at December 31, 2016. There were no material other-than-temporary impairments in 2016, 2015, or 2014. Goodwill and Long-lived Assets At December 31, 2016, goodwill and other long-lived assets represented 20% of total assets and 47% of total stockholders’ equity, compared to 20% and 48%, respectively, at December 31, 2015. We are required to test at least annually for impairment at a level of reporting referred to as the reporting unit, and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. A reporting unit either is our operating segments or one level below the operating segments, referred to as a component, which comprise our reportable segments. A component is considered a reporting unit if the component constitutes a business for which discrete financial information is available that is regularly reviewed by management. We are required to aggregate the components of an operating segment into one reporting unit if they have similar economic characteristics. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition. The carrying amount of goodwill for our reportable segments has been retrospectively adjusted to conform to the 2015 segment change discussed in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We use a two-step process to review goodwill for impairment. The first step is a screen for potential impairment, and the second step measures the amount of impairment, if any. Our strategy, long-range business plan, and annual planning process support our goodwill impairment tests. These tests are performed, at a minimum, annually in the fourth quarter, and are based on an evaluation of future discounted cash flows. We rely on this discounted cash flow analysis to determine fair value. However outcomes from the discounted cash flow analysis are compared to other market approach valuation methodologies for reasonableness. We use discount rates that correspond to a market-based weighted-average cost of capital and terminal growth rates that correspond to long-term growth prospects, consistent with the long-term inflation rate. Key assumptions in our cash flow projections, including changes in membership, premium yields, medical and operating cost trends, and certain government contract extensions, are consistent with those utilized in our long-range business plan and annual planning process. If these assumptions differ from actual, including the impact of the Health Care Reform Law or changes in Government rates, the estimates underlying our goodwill impairment tests could be adversely affected. Goodwill impairment tests completed in each of the last three years did not result in an impairment loss. The fair value of our reporting units with significant goodwill exceeded carrying amounts by a substantial margin. A 100 basis point increase in the discount rate would not have a significant impact on the amount of margin for any of our reporting units with significant goodwill, with the exception of our provider services reporting unit in our Healthcare Services segment. The provider services reporting unit would decline to less than 10% margin after factoring in a 100 basis point increase in the discount rate. Long-lived assets consist of property and equipment and other finite-lived intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. We periodically review long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation or amortization for these assets. There were no material impairment losses in the last three years.

<s>[INST] General Humana Inc., headquartered in Louisville, Kentucky, is a leading health and wellbeing company focused on making it easy for people to achieve their best health with clinical excellence through coordinated care. Our strategy integrates care delivery, the member experience, and clinical and consumer insights to encourage engagement, behavior change, proactive clinical outreach and wellness for the millions of people we serve across the country. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, excluding depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Aetna Merger On July 2, 2015, we entered into an Agreement and Plan of Merger, which we refer to in this report as the Merger Agreement, with Aetna Inc. and certain wholly owned subsidiaries of Aetna Inc., which we refer to collectively as Aetna, which sets forth the terms and conditions under which we agreed to merge with, and become a wholly owned subsidiary of Aetna, a transaction we refer to in this report as the Merger. The Merger was subject to customary closing conditions, including, among other things, (i) the expiration or termination of the applicable waiting period under the HartScottRodino Antitrust Improvements Act of 1976, as amended, and the receipt of necessary approvals under state insurance and healthcare laws and regulations and pursuant to certain licenses of certain of Humana’s subsidiaries, and (ii) the absence of legal restraints and prohibitions on the consummation of the Merger. On December 22, 2016, in order to extend the “End Date” (as defined in the Merger Agreement), Aetna and Humana each agreed to waive until 11:59 p.m. (Eastern time) on February 15, 2017 its right to terminate the Merger Agreement due to a failure of the Mergers to have been completed on or before December 31, 2016. On July 21, 2016, the U.S. Department of Justice and the attorneys general of certain U.S. jurisdictions filed a civil antitrust complaint in the U.S. District Court for the District of Columbia against us and Aetna, alleging that the Merger would violate Section 7 of the Clayton Antitrust Act and seeking a permanent injunction to prevent the Merger from being completed. On January 23, 2017, the Court ruled in favor of the DOJ and granted a permanent injunction of the proposed transaction. On February 14, 2017, we and Aetna agreed to mutually terminate the Merger Agreement, as our Board determined that an appeal of the Court's ruling would not be in the best interest of our stockholders. Under terms of the Merger Agreement, we are entitled to a breakup fee of $1 billion. Business Segments We manage our business with three reportable segments: Retail, Group, and Healthcare Services. In addition, the Other Businesses category includes businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on wellbeing solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources. The Retail segment consists of Medicare benefits, marketed to individuals or directly via group accounts, as well as individual commercial fullyinsured medical and specialty health insurance benefits, including dental, vision, and other supplemental health and financial protection products. In addition, the Retail segment also includes our contract with CMS to administer the LINET prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and LongTerm Support Services benefits, collectively our statebased contracts. The Group segment consists of employer group commercial fullyinsured medical and specialty health insurance benefits, including dental, vision [/INST] Negative. </s>

HUMANA INC

2018-02-16

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Executive Overview General Humana Inc., headquartered in Louisville, Kentucky, is a leading health and well-being company committed to helping our millions of medical and specialty members achieve their best health. Our successful history in care delivery and health plan administration is helping us create a new kind of integrated care with the power to improve health and well-being and lower costs. Our efforts are leading to a better quality of life for people with Medicare, families, individuals, military service personnel, and communities at large. To accomplish that, we support physicians and other health care professionals as they work to deliver the right care in the right place for their patients, our members. Our range of clinical capabilities, resources and tools, such as in-home care, behavioral health, pharmacy services, data analytics and wellness solutions, combine to produce a simplified experience that makes health care easier to navigate and more effective. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, excluding depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Aetna Merger On July 2, 2015, we entered into an Agreement and Plan of Merger, which we refer to in this report as the Merger Agreement, with Aetna Inc. and certain wholly owned subsidiaries of Aetna Inc., which we refer to collectively as Aetna, which sets forth the terms and conditions under which we agreed to merge with, and become a wholly owned subsidiary of Aetna, a transaction we refer to in this report as the Merger. On February 14, 2017, we and Aetna agreed to mutually terminate the Merger Agreement, as our Board determined that an appeal of the Court's ruling would not be in the best interest of our stockholders. On February 16, 2017, under the terms of the Merger Agreement, we received a breakup fee of $1 billion from Aetna, which is included in our consolidated statement of income in the line captioned Merger termination fee and related costs, net. Prior period Merger related transaction costs, previously included in operating costs, have been reclassified to conform to the 2017 presentation. Acquisitions and Divestitures On December 19, 2017, we announced that we have entered into a definitive agreement to acquire a 40% minority interest in the Kindred at Home Division (Kindred at Home) of Kindred Healthcare, Inc. (Kindred)(NYSE: KND), the nation’s largest home health provider and second largest hospice operator, for estimated cash consideration of approximately $800 million, including our share of transaction and related expenses, to facilitate a complete separation from the Long Term Acute Care and Rehabilitation businesses (the Specialty Hospital company). On November 6, 2017, we entered into a definitive agreement to sell the stock of our wholly-owned subsidiary, KMG to CGIC, a Texas-based insurance company wholly owned by HC2 Holdings, Inc., a diversified holding company. KMG’s subsidiary, KIC, includes our closed block of non-strategic commercial long-term care insurance policies. See Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, for a discussion of our closed block of long-term care insurance policies. These transactions are more fully discussed in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Business Segments During the first quarter of 2017, we realigned certain of our businesses among our reportable segments to correspond with internal management reporting changes corresponding to those used by our chief operating decision maker to evaluate results of operations and our previously announced planned exit from the Individual Commercial medical business on January 1, 2018. Additionally, we renamed our Group segment to the Group and Specialty segment, and began presenting the Individual Commercial business results as a separate segment rather than as part of the Retail segment. Specialty health insurance benefits, including dental, vision, other supplemental health, and financial protection products, marketed to individuals are now included in the Group and Specialty segment. Specialty health insurance benefits marketed to employer groups continue to be included in the Group and Specialty segment. As a result of this realignment, our reportable segments now include Retail, Group and Specialty, Healthcare Services, and Individual Commercial. Prior period segment financial information has been recast to conform to the 2017 presentation. See Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for segment financial information. We manage our business with four reportable segments: Retail, Group and Specialty, Healthcare Services, and Individual Commercial. In addition, the Other Businesses category includes businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on well-being solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources. The Retail segment consists of Medicare benefits, marketed to individuals or directly via group accounts. In addition, the Retail segment also includes our contract with CMS to administer the Limited Income Newly Eligible Transition, or LI-NET, prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and Long-Term Support Services benefits, which we refer to collectively as our state-based contracts. The Group and Specialty segment consists of employer group commercial fully-insured medical and specialty health insurance benefits marketed to individuals and employer groups, including dental, vision, and other supplemental health and voluntary insurance benefits, and financial protection products, as well as administrative services only, or ASO products. In addition, our Group and Specialty segment includes military services business, primarily our TRICARE contract. The Healthcare Services segment includes services offered to our health plan members as well as to third parties, including pharmacy solutions, provider services, and clinical care service, such as home health and other services and capabilities to promote wellness and advance population health. The Individual Commercial segment consists of our individual commercial fully-insured medical health insurance benefits. We report under the category of Other Businesses those businesses that do not align with the reportable segments described above, primarily our closed-block long-term care insurance policies. The results of each segment are measured by income before income taxes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and clinical care services, to our Retail, Group and Specialty, and Individual Commercial segment customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often use the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at a corporate level. These corporate amounts are reported separately from our reportable segments and are included with intersegment eliminations. Seasonality One of the product offerings of our Retail segment is Medicare stand-alone prescription drug plans, or PDPs, under the Medicare Part D program. Our quarterly Retail segment earnings and operating cash flows are impacted by the Medicare Part D benefit design and changes in the composition of our membership. The Medicare Part D benefit design results in coverage that varies as a member’s cumulative out-of-pocket costs pass through successive stages of a member’s plan period, which begins annually on January 1 for renewals. These plan designs generally result in us sharing a greater portion of the responsibility for total prescription drug costs in the early stages and less in the latter stages. As a result, the PDP benefit ratio generally decreases as the year progresses. In addition, the number of low income senior members as well as year-over-year changes in the mix of membership in our stand-alone PDP products affects the quarterly benefit ratio pattern. In addition, the Retail segment also experiences seasonality in the operating cost ratio as a result of costs incurred in the second half of the year associated with the Medicare marketing season. Our Group and Specialty segment also experiences seasonality in the benefit ratio pattern. However, the effect is opposite of Medicare stand-alone PDP in the Retail segment, with the Group and Specialty segment’s benefit ratio increasing as fully-insured members progress through their annual deductible and maximum out-of-pocket expenses. Certain of our fully-insured individual commercial medical products in our Individual Commercial segment experience seasonality in the benefit ratio similar to the Group and Specialty segment, including the effect of existing previously underwritten members transitioning to policies compliant with the Health Care Reform Law with us and other carriers. As previously underwritten members transition, it results in policy lapses and the release of reserves for future policy benefits partially offset by the recognition of previously deferred acquisition costs. The recognition of a premium deficiency reserve for our Individual Commercial medical business compliant with the Health Care Reform Law in the fourth quarter of 2015, and subsequent changes in estimate, also impacted the quarterly benefit ratio pattern for this business in 2016. Highlights Consolidated • Our 2017 results reflect the continued implementation of our strategy to offer our members affordable health care combined with a positive consumer experience in growing markets. At the core of this strategy is our integrated care delivery model, which unites quality care, high member engagement, and sophisticated data analytics. Our approach to primary, physician-directed care for our members aims to provide quality care that is consistent, integrated, cost-effective, and member-focused, provided by both employed physicians and physicians with network contract arrangements. The model is designed to improve health outcomes and affordability for individuals and for the health system as a whole, while offering our members a simple, seamless healthcare experience. We believe this strategy is positioning us for long-term growth in both membership and earnings. We offer providers a continuum of opportunities to increase the integration of care and offer assistance to providers in transitioning from a fee-for-service to a value-based arrangement. These include performance bonuses, shared savings and shared risk relationships. At December 31, 2017, approximately 1,901,300 members, or 66.5%, of our individual Medicare Advantage members were in value-based relationships under our integrated care delivery model, as compared to 1,816,300 members, or 64.0%, at December 31, 2016. • Our consolidated pretax results of $4.02 billion for 2017, an increase of $2.47 billion, from $1.55 billion in 2016, primarily reflects the net gain associated with the terminated Merger Agreement, mainly the break-up fee, along with the year-over-year improvement in earnings for our Individual Commercial, Retail and Group and Specialty segments. The year-over-year comparison was also favorably impacted by the reserve strengthening for our non-strategic closed block of long-term care insurance business recorded in 2016. These items were partially offset by lower pretax earnings in the Healthcare Services segment, charges associated with voluntary and involuntary workforce reduction programs recorded during the second half of 2017, as well as the estimated guaranty fund assessment expense to support the policyholder obligations of Penn Treaty (an unaffiliated long-term care insurance company). • Year-over-year comparisons of diluted earnings per common share reflect the same factors impacting our consolidated pretax income comparisons year-over-year as well as the beneficial effect of the lower effective tax rate in light of pricing and benefit design assumptions associated with the 2017 temporary suspension of the health insurance industry fee. In addition the year-over-year comparisons were favorably impacted by lower number of shares, primarily reflecting share repurchases. • We recorded a net gain associated with the terminated Merger Agreement, consisting primarily of the breakup fee, of approximately $936 million, or $4.31 per diluted common share, during 2017. During 2016, we recorded transaction costs in connection with the Merger of approximately $104 million, or $0.64 per diluted common share. Certain costs associated with the Merger were previously not deductible for tax purposes, but became deductible, and were recorded as such, in the first quarter 2017 as a result of the termination of the Merger Agreement. • During 2017, we initiated a voluntary early retirement program and an involuntary workforce reduction program. These programs impacted approximately 3,600 associates, or 7.8% of our workforce. As a result, we recorded charges of $148 million, or $0.64 per diluted common share. This charge is included with operating costs in the consolidated statements of income for the year ended December 31, 2017 and included at the corporate level in the segment financial information. Payments under these programs are made upon termination during the early retirement or severance pay period, beginning in the first quarter of 2018. We expect this liability to be primarily paid within the next 12 months and classified it as a current liability, included in our consolidated balance sheet in the trade accounts payable and accrued expenses line. • On March 1, 2017, a court ordered the liquidation of Penn Treaty (an unaffiliated long-term care insurance company), which triggered assessments from state guaranty associations that resulted in our recording a $54 million, or $0.24 per diluted common share, charge in operating costs. • The annual health insurance industry fee has been suspended for calendar year 2017 but has resumed in calendar year 2018. Operating cost associated with the health insurer fee attributable to 2016 was $916 million. This fee is not deductible for tax purposes, which significantly increased our effective income tax rate. The one-year suspension in 2017 of the health insurer fee has significantly reduced our operating costs and effective tax rate during 2017. The Continuing Resolution bill, H.R. 195, enacted on January 22, 2018, included a one year suspension in 2019 of the health insurer fee, but the fee is scheduled to resume in calendar year 2020. • Investment income increased $16 million in 2017, primarily due to higher average invested balances and interest rates in 2017, partially offset by lower realized capital gains. • Operating cash flow provided by operations was $4.1 billion for the year ended December 31, 2017 as compared to operating cash flow provided by operations of $1.9 billion for the year ended December 31, 2016. The increase in operating cash flow primarily was due to the receipt of the merger termination fee, net of related expenses and taxes paid, higher earnings and the timing of working capital items. • We paid dividends to stockholders of $220 million in 2017 as compared to $177 million in 2016. Retail Segment • In 2017, our Retail segment pretax income increased by $288 million, or 17.0%, from 2016 primarily driven by the year-over-year improvement in our Medicare Advantage business. • On February 1, 2018, CMS issued its preliminary 2019 Medicare Advantage and Part D payment rates and proposed policy changes, which we refer to collectively as the Advance Notice. CMS has invited public comment on the Advance Notice before publishing final rates on April 2, 2018 (the Final Notice). In the Advance Notice, CMS estimates Medicare Advantage plans across the sector will, on average, experience a 1.84 percent increase in benchmark funding based on proposals included therein. As indicated by CMS, its estimate excludes the impact of fee-for-service county re-basing/re-pricing since the related impact is dependent upon finalization of certain data, which will be available with the publication of the Final Notice. CMS’ estimate includes 30 basis points of negative impact associated with the proposed Employer Group Waiver Plan Payment Policy for 2019. Excluding that item, CMS’ estimate would be a 2.14 percent increase. Based on our preliminary analysis using the same factors CMS included in its estimate, the components of which are detailed on CMS’ web site, we anticipate the proposals in the Advance Notice would result in a change to our benchmark funding relatively in line with CMS’ estimate, excluding the impact attributable to the Employer Group Waiver Plan Payment Policy. Group and Specialty Segment • Group and Specialty segment pretax income was $412 million in 2017, an increase of $68 million, or 19.8%, from $344 million in 2016 primarily reflecting the impact of higher pretax earnings associated with our fully-insured commercial medical products as well as higher earnings from our military services business resulting from higher performance incentives earned under the TRICARE contract. • On July 21, 2016, we were notified by the Defense Health Agency, or DHA, that we were awarded the contract for the new TRICARE T2017 East Region. The T2017 East Region contract is a consolidation of the former T3 North and South Regions, comprising thirty-two states and approximately six million TRICARE beneficiaries, with delivery of health care services commencing on January 1, 2018. The T2017 East contract is a 5-year contract set to expire on December 31, 2022. Healthcare Services Segment • Healthcare Services segment pretax income was $967 million in 2017, a decrease $129 million, or 11.8%, from 2016 primarily due to the impact of the optimization process associated with our chronic care management programs, as well as lower earnings in our provider services business reflecting lower Medicare rates year-over-year in geographies where our provider assets are primarily located. The reductions in pharmacy solutions intersegment revenues were offset by similar reductions in operating costs associated with the pharmacy solutions business. • At December 31, 2017, approximately 52,200 primary care providers were in value-based relationships, an increase of 3.6% from 50,400 at December 31, 2016. At December 31, 2017, 66% of our individual Medicare Advantage members were in value-based relationships compared to 64% at December 31, 2016. • Medicare Advantage and dual demonstration program membership enrolled in a Humana chronic care management program was 794,900 at December 31, 2017, a decrease of 27.7% from 1,099,200 at December 31, 2016. We have undergone an optimization process that ensures the appropriate level of member interaction with clinicians to drive quality outcomes, which has resulted in reduced segment earnings but higher returns on investment. Individual Commercial Segment • As announced on February 14, 2017, we exited our Individual Commercial medical business January 1, 2018. • In 2017, our Individual Commercial segment pretax income was $193 million, an increase of $1.1 billion, from a pretax loss of $869 million in 2016 primarily due to the exit of certain markets in 2017, and per-member premium increases, as well as the reduction of premiums related to the write-off of receivables associated with the commercial risk corridor premium stabilization program. Health Care Reform The Health Care Reform Law enacted significant reforms to various aspects of the U.S. health insurance industry. Certain significant provisions of the Health Care Reform Law include, among others, mandated coverage requirements, mandated benefits and guarantee issuance associated with commercial medical insurance, rebates to policyholders based on minimum benefit ratios, adjustments to Medicare Advantage premiums, the establishment of federally-facilitated or state-based exchanges coupled with programs designed to spread risk among insurers, and the introduction of plan designs based on set actuarial values. In addition, the Health Care Reform Law established insurance industry assessments, including an annual health insurance industry fee and a three-year $25 billion industry wide commercial reinsurance fee. The annual health insurance industry fee levied on the insurance industry is $14.3 billion in 2018 and is not deductible for income tax purposes, which significantly increases our effective income tax rate. A one year suspension in 2017 and 2019 of the health insurer fee significantly impacts our trend in key operating metrics including our operating cost and medical expense ratios, as well as our effective tax rate. In addition, the Health Care Reform Law expands federal oversight of health plan premium rates and could adversely affect our ability to appropriately adjust health plan premiums on a timely basis. Financing for these reforms comes, in part, from material additional fees and taxes on us (as discussed above) and other health plans and individuals which began in 2014, as well as reductions in certain levels of payments to us and other health plans under Medicare as described in this 2017 Form 10-K. As noted above, the Health Care Reform Law required the establishment of health insurance exchanges for individuals and small employers to purchase health insurance that became effective January 1, 2014, with an annual open enrollment period. For 2017, we offered on-exchange individual commercial medical plans in 11 states, a reduction from the 15 states in which we offered on-exchange coverage in 2016. In addition, we discontinued substantially all Health Care Reform Law compliant off-exchange individual commercial medical plans effective January 1, 2017. Effective January 1, 2018, we have exited our remaining Individual Commercial medical business. If we fail to effectively implement our operational and strategic initiatives with respect to the implementation of the Health Care Reform Law, our business may be materially adversely affected. Additionally, potential legislative changes, including activities to repeal or replace the Health Care Reform Law, creates uncertainty for our business, and we cannot predict when, or in what form, such legislative changes may occur. We may be unable to adjust our product offerings, geographic footprint, or pricing during any given year such legislative changes occur in sufficient time to mitigate any adverse effects. As discussed above, it is reasonably possible that the Health Care Reform Law and related regulations, as well as future legislative changes, including legislative restrictions on our ability to manage our provider network or otherwise operate our business, or regulatory restrictions on profitability, including by comparison of our Medicare Advantage profitability to our non-Medicare Advantage business profitability and a requirement that they remain within certain ranges of each other, in the aggregate may have a material adverse effect on our results of operations (including restricting revenue, enrollment and premium growth in certain products and market segments, restricting our ability to expand into new markets, increasing our medical and operating costs, further lowering our Medicare payment rates and increasing our expenses associated with the non-deductible health insurance industry fee and other assessments); our financial position (including our ability to maintain the value of our goodwill); and our cash flows. On November 10, 2016, the U.S. Court of Federal Claims ruled in favor of the government in one of a series of cases filed by insurers, unrelated to us, against HHS to collect risk corridor payments, rejecting all of the insurer’s statutory, contract and Constitutional claims for payment. On November 18, 2016, HHS issued a memorandum indicating a significant funding shortfall for the 2015 coverage year, the second consecutive year of significant shortfalls. Given the successful challenge of the risk corridor provisions in court, Congressional inquiries into the funding of the risk corridor program, and significant funding shortfalls under the first two years of the program, during the fourth quarter of 2016 we wrote-off $583 million in risk corridor receivables outstanding as of September 30, 2016, including $415 million associated with the 2014 and 2015 coverage years. From inception of the risk corridor program through December 31, 2017, we collected approximately $39 million from CMS for risk corridor receivables associated with the 2014 coverage year funded by HHS in accordance with previous guidance, utilizing funds HHS collected from us and other carriers under the 2014 and 2015 risk corridor program. On November 2, 2017, we filed suit against the United States of America in the United States Court of Federal Claims, on behalf of our health plans seeking recovery from the federal government of approximately $611 million in payments under the risk corridor premium stabilization program established under the Health Care Reform Law, for years 2014, 2015 and 2016. We intend for the discussion of our financial condition and results of operations that follows to assist in the understanding of our financial statements and related changes in certain key items in those financial statements from year to year, including the primary factors that accounted for those changes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and clinical care services, to our Retail, Group and Specialty, and Individual Commercial segment customers and are described in Note 17 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this 2017 Form 10-K. Comparison of Results of Operations for 2017 and 2016 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2017 and 2016: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs, excluding depreciation and amortization, as a percentage of total revenues less investment income. Summary Net income for 2017 was $2.4 billion, or $16.81 per diluted common share compared to $614 million, or $4.07 per diluted common share, in 2016. Net income in 2017 includes a net gain of $4.31 per diluted common share associated with the terminated Merger Agreement consisting primarily of the break-up fee, and the beneficial effect of the lower effective tax rate in light of pricing and benefit design assumptions with the temporary suspension of the health insurance industry fee of $2.15 per diluted common share, excluding the Individual Commercial business impact. The year-over-year comparison was also favorably impacted by a write-off of $2.43 per diluted common share in receivables associated with the commercial risk corridor premium stabilization program, and the reserve strengthening for our non-strategic closed block of long-term care insurance business of $2.11 per common diluted share recorded in 2016. These items were partially offset by the impact of the tax reform law enacted on December 22, 2017, or the Tax Reform Law, which resulted in the reduction of our net income due to the remeasurement of deferred tax assets at lower enacted corporate tax rates of $0.92 per diluted common share, $0.64 per common diluted share in charges associated with both voluntary and involuntary workforce reduction programs in 2017, as well as the estimated guaranty fund assessment expense to support the policyholder obligations of Penn Treaty (an unaffiliated long-term care insurance company) of $0.24 per diluted common share. Excluding the impacts of the items above, the increase in net income primarily was due to year-over-year improvements in earnings for our Individual Commercial, Retail, and Group and Specialty segments, partially offset by lower earnings in the Healthcare Services segment. Premiums Revenue Consolidated premiums decreased $641 million, or 1.2%, from 2016 to $52.4 billion for 2017 primarily due to lower premiums in the Individual Commercial segment, partially offset by higher premiums in the Retail segment, primarily resulting from growth in our Medicare Advantage business, and higher premiums in the Group and Specialty segment, as discussed in the detailed segment results discussion that follows. Services Revenue Consolidated services revenue increased $13 million, or 1.3%, from 2016 for 2017 primarily due to an increase in services revenue in the Healthcare Services segment, partially offset by a decrease in services revenue in the Group and Specialty segment as discussed in the detailed segment results discussion that follows. Investment Income Investment income was $405 million for 2017, increasing $16 million, or 4.1%, from 2016, primarily due higher average invested balances and interest rates in 2017, partially offset by lower realized capital gains. Benefits Expense Consolidated benefits expense was $43.5 billion for 2017, a decrease of $1.5 billion, or 3.4%, from 2016 reflecting $505 million in incremental benefits expense for the reserve strengthening in our non-strategic closed block of long-term care insurance policies recorded in 2016. Excluding the long-term care reserve strengthening in 2016, the decrease primarily was due to a decrease in the Individual Commercial segment benefits expense, partially offset by an increase in the Retail and Group and Specialty segments benefits expense as discussed in the detailed segment results discussion that follows. As more fully described herein under the section entitled “Benefits Expense Recognition”, actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $483 million in 2017 and $582 million in 2016. The consolidated benefit ratio for 2017 was 83.0%, a decrease of 190 basis points from 2016 primarily due to the incremental benefits expense in 2016 for the reserve strengthening in our non-strategic closed block of long-term care insurance policies. Excluding the impact of the above, the decrease in the consolidated benefit ratio primarily was due to the decrease in the Individual Commercial segment benefit ratio, partially offset by the increase in the Retail and Group and Specialty segment benefit ratio as discussed in the segment results of operation discussion that follows. Favorable prior-period medical claims reserve development decreased the consolidated benefit ratio by approximately 90 basis points in 2017 versus approximately 110 basis points in 2016. Operating Costs Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs decreased $606 million, or 8.4%, from 2016 to $6.6 billion in 2017 primarily due to the temporary suspension of the health insurance industry fee for the calendar year 2017 and lower Individual Commercial membership. This was partially offset by charges associated with both voluntary and involuntary workforce reduction programs, an increase in employee compensation costs resulting from the continued strong performance, increased spending associated with the Medicare Annual Election Period, or AEP, as well as the estimated guaranty fund assessment expense recorded to support the policyholder obligations of Penn Treaty (an unaffiliated long-term care insurance company). The consolidated operating cost ratio for 2017 was 12.3%, decreasing 100 basis points from 2016 primarily due to the temporary suspension of the health insurance industry fee for the calendar year 2017, the write-off of receivables associated with the commercial risk corridor premium stabilization program in 2016, as well as operating cost efficiencies, partially offset by the loss of scale efficiency from market exits in the 2017 period associated with the Individual Commercial product, the estimated charges associated with both voluntary and involuntary workforce reduction programs recorded in 2017, increased employee compensation costs resulting from the continued strong performance, as well as the impact of the estimated guaranty fund assessment expense recorded to support the policyholder obligations of Penn Treaty (an unaffiliated long-term care insurance company). The non-deductible health insurance industry fee impacted the operating cost ratio by 170 basis points in 2016. Depreciation and Amortization Depreciation and amortization for 2017 of $378 million was relatively unchanged from 2016. Interest Expense Interest expense was $242 million for 2017 compared to $189 million for 2016, an increase of $53 million, or 28.0%, due to the issuance of $1.8 billion in senior notes, a portion of the proceeds which were used to redeem $800 million of senior notes scheduled to mature in 2018. We recognized a loss on extinguishment of debt of approximately $17 million in December 2017 for the redemption of these senior notes, which is included in interest expense. Income Taxes Our effective tax rate during 2017 was 39.1% compared to the effective tax rate of 60.5% in 2016 primarily reflecting the suspension of the annual health insurance industry fee in 2017, as well as previously non-deductible transaction costs that, as a result of termination of the Merger Agreement, became deductible for tax purposes and were recorded as such in the first quarter of 2017, partially offset by the Tax Reform Law, which increased our effective tax rate due to the remeasurement of deferred tax assets at lower enacted corporate tax rates. See Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. The tax reform law enacted on December 22, 2017 significantly reduced our federal corporate tax rate. As a result, we expect our effective tax rate for 2018 to be approximately 32.5% to 33.5%. The decline in the effective tax rate for 2018 primarily is due to the enactment of tax reform, partially offset by the resumption of the annual health insurance industry fee in 2018. Retail Segment Pretax Results • Retail segment pretax income was $2.0 billion in 2017, an increase of $288 million, or 17.0%, compared to 2016 primarily driven by the year-over-year improvement in our Medicare Advantage business. Enrollment • Individual Medicare Advantage membership increased 23,200 members, or 0.8%, from December 31, 2016 to December 31, 2017 reflecting net membership additions for Medicare beneficiaries including the effect of planned market and product exits in 2017. We decided certain markets and/or products were not meeting long term strategic and financial objectives. Additionally, membership growth was muted due to competitive actions including the uncertainty associated with the then-pending Merger transaction during last year's AEP. For full year 2018, we anticipate net membership growth in our individual Medicare Advantage offerings of 180,000 to 200,000. • Group Medicare Advantage membership increased 86,000 members, or 24.2%, from December 31, 2016 to December 31, 2017 reflecting the addition of a large account in January 2017. For full year 2018, we anticipate net membership growth in our group Medicare Advantage offerings of 65,000 to 70,000. • Medicare stand-alone PDP membership increased 356,700 members, or 7.2%, from December 31, 2016 to December 31, 2017 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2017 plan year. For full year 2018, we anticipate a net membership decline in our Medicare stand-alone PDP offerings of 280,000 to 320,000, primarily attributable to the loss of auto assign members in Florida and South Carolina due to pricing over the CMS low income benchmark and continued membership declines in our Enhanced Plan offering. • State-based Medicaid membership decreased 28,000 members, or 7.2%, from December 31, 2016 to December 31, 2017, primarily driven by lower membership associated with our Florida contracts resulting from network realignments. Premiums revenue • Retail segment premiums increased $1.4 billion, or 3.2%, from 2016 to 2017 primarily due to Medicare Advantage membership growth and increased per-member premiums for certain of the segment's products. Average group and individual Medicare Advantage membership increased 3.4% in 2017. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Premiums revenue reflects changes in membership and average per-member premiums. Items impacting average per-member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership. Benefits expense • The Retail segment benefit ratio of 85.6% for 2017 increased 50 basis points from 2016 primarily due to the impact of the temporary suspension of the health insurance industry fee for calendar year 2017 which was contemplated in the pricing and benefit design of our products, margin compression associated with the competitive environment in the group Medicare Advantage business and slightly lower favorable prior-period medical claims reserve development. These increases were partially offset by the impact of planned exits from certain Medicare Advantage markets that carried a higher benefit ratio than other markets as well as lower than expected medical costs as compared to the assumptions used in the pricing of our individual Medicare Advantage business. • The Retail segment’s benefits expense for 2017 included the beneficial effect of $386 million in favorable prior-year medical claims reserve development versus $429 million in 2016. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 90 basis points in 2017 versus approximately 100 basis points in 2016. Operating costs • The Retail segment operating cost ratio of 9.6% for 2017 decreased 120 basis points from 2016 primarily due to the temporary suspension of the health insurance industry fee for calendar year 2017, partially offset by increased spending associated with AEP, investments in our integrated care delivery model, and the increase in employee compensation costs resulting from the continued strong performance. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 170 basis points in 2016. Group and Specialty Segment (a) Specialty products include dental, vision, voluntary benefit products and other supplemental health and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Group and Specialty segment pretax income was $412 million in 2017, an increase of $68 million, or 19.8%, from $344 million in 2016 primarily reflecting the impact of higher pretax earnings associated with our fully-insured commercial business as well as higher earnings from our military services business resulting from higher performance incentives earned under the TRICARE contract. Enrollment • Fully-insured commercial group medical membership decreased 38,300 members, or 3.4% from December 31, 2016 reflecting lower membership in small group accounts due in part to more small group accounts selecting ASO products in 2017. • Group ASO commercial medical membership decreased 114,500 members, or 20.0%, from December 31, 2016 to December 31, 2017 primarily due to the loss of certain large group accounts as a result of continued discipline in pricing of services for self-funded accounts amid a highly competitive environment, partially offset by more small group accounts selecting ASO products in 2017. • Specialty membership increased 24,800 members, or 0.4%, from December 31, 2016 to December 31, 2017 primarily due to strong growth in vision products marketed to employer groups. Premiums revenue • Group and Specialty segment premiums increased $76 million, or 1.1%, from 2016 to 2017 primarily due to an increase in group fully-insured commercial medical per-member premiums, partially offset by a decline in average group fully-insured commercial medical membership. Services revenue • Group and Specialty segment services revenue decreased $17 million, or 2.6%, from 2016 to 2017 primarily due to a decline in revenue in our group ASO commercial medical business mainly due to membership declines partially offset by higher revenue from our military services business resulting from higher performance incentives earned under the TRICARE contract. Benefits expense • The Group and Specialty segment benefit ratio increased 100 basis points from 78.2% in 2016 to 79.2% in 2017 primarily due to the impact of the temporary suspension of the health insurance industry fee for calendar year 2017 which was contemplated in the pricing of our products. The increase was further impacted by an increased proportion of small group members transitioning to community rated plans that carry a higher benefit ratio. These increases were partially offset by lower utilization for the fully-insured commercial medical business in 2017, primarily associated with the large group business. • The Group and Specialty segment’s benefits expense included the beneficial effect of $40 million in favorable prior-year medical claims reserve development in 2017 versus $46 million in 2016. This favorable prior-year medical claims reserve development decreased the Group and Specialty segment benefit ratio by approximately 60 basis points in 2017 versus approximately 70 basis points in 2016. Operating costs • The Group and Specialty segment operating cost ratio of 21.4% for 2017 decreased 210 basis points from 23.5% for 2016 primarily due to the temporary suspension of the health insurance industry fee for calendar year 2017 as well as operating cost efficiencies, partially offset by an increase in employee compensation costs resulting from the continued strong performance. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 150 basis points in 2016. Healthcare Services Segment Pretax results • Healthcare Services segment pretax income was $967 million in 2017, a decrease of $129 million, or 11.8%, from 2016 primarily was due to the impact of the optimization process associated with our chronic care management programs, as well as lower earnings in our provider services business reflecting lower Medicare rates year-over-year in geographies where our provider assets are primarily located. The reductions in pharmacy solutions intersegment revenues were offset by similar reductions in operating costs associated with the pharmacy solutions business. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Group and Specialty segment membership increased to approximately 433 million in 2017, up 2% versus scripts of approximately 426 million in 2016. The increase primarily reflects growth associated with higher Medicare membership for 2017 than in 2016, partially offset by the decline in Individual Commercial membership. Services revenue • Services revenue increased $28 million, or 9.0%, from 2016 to $338 million for 2017 primarily due to service revenue growth from our pharmacy solutions business. Intersegment revenues • Intersegment revenues decreased $1.4 billion, or 5.6%, from 2016 to $23.6 billion for 2017 primarily due to our pharmacy solutions business as well as the result of the optimization process associated with our chronic care management programs discussed previously, as well as lower revenue in our provider services business reflecting lower Medicare rates year-over-year in geographies where our provider assets are primarily located. Our pharmacy solutions business revenues were impacted by improvements in net pharmacy costs driven by our pharmacy benefit manager and an increase in the generic dispensing rate. These items were partially offset by higher year-over-year script volume from growth in our Medicare Advantage and standalone PDP membership, partially offset by the impact of lower Individual Commercial membership. Our generic dispensing rate improved to 91.3% during 2017 from 90.5% during 2016. The higher generic dispensing rate reduced revenues (and operating costs) for our pharmacy solutions business as generic drugs are generally priced lower than branded drugs. Operating costs • The Healthcare Services segment operating cost ratio of 95.5% for 2017 was relatively unchanged from 95.2% for 2016. Individual Commercial Segment • As announced on February 14, 2017, we exited our Individual Commercial medical business January 1, 2018. • In 2017, our Individual Commercial segment pretax income was $193 million, an increase of $1.1 billion, from a pretax loss of $869 million in 2016 primarily due to the exit of certain markets in 2017, and per-member premium increases, as well as the reduction of premiums related to the write-off of receivables associated with the commercial risk corridor premium stabilization program. • Individual commercial medical membership decreased 526,000 members, or 80.3%, from December 31, 2016 to December 31, 2017 reflecting the decline in the number of counties we offered on-exchange coverage and the discontinuance of offering off-exchange products. • The Individual Commercial segment benefit ratio of 57.4% for 2017 decreased from 107.7% in 2016 primarily due to the reduction of premiums related to the write-off of receivables associated with the commercial risk corridor premium stabilization program, as well as the planned exits in 2017 in certain markets that carried a higher benefit ratio and per-member premium increases. • The Individual Commercial segment operating cost ratio of 21.2% for 2017 increased 160 basis points from 2016 primarily due to the loss of scale efficiency from market exits in 2017, partially offset by the write-off of receivables associated with the commercial risk corridor premium stabilization program and the temporary suspension of the health insurance industry fee for calendar year 2017. Other Businesses As previously disclosed, in the fourth quarter of 2016, we increased future policy benefits expense by approximately $505 million for reserve strengthening associated with our closed block of long-term care insurance policies. This increase primarily was driven by emerging experience indicating longer claims duration, a prolonged lower interest rate environment, and an increase in policyholder life expectancies as discussed further in Note 18 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this 2017 Form 10-K. Comparison of Results of Operations for 2016 and 2015 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2016 and 2015: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs, excluding depreciation and amortization, as a percentage of total revenues less investment income. Summary Net income was $614 million, or $4.07 per diluted common share, in 2016 compared to $1.3 billion, or $8.44 per diluted common share, in 2015. Net income includes a write-off of $2.43 per diluted common share in receivables associated with the commercial risk corridor premium stabilization program and reserve strengthening for our non-strategic closed block of long-term care insurance business of $2.11 per diluted common share, as discussed below. These items were partially offset by the impact of the premium deficiency reserve of $0.74 per diluted common share recorded in the fourth quarter of 2015 for certain of our individual commercial medical products for the 2016 coverage year. In addition, the completion of the sale of Concentra on June 1, 2015 resulted in an after-tax gain of $1.57 per diluted common share in 2015. Excluding these items, the increase primarily was due to year-over-year improvement in results for our individual Medicare Advantage business and our Healthcare Services segment as well as increased profitability in our state-based Medicaid business, partially offset by an increase in the effective tax rate as discussed below. In addition, 2016 includes expenses of $0.64 per diluted common share and 2015 includes expenses of $0.14 per diluted common share for transaction and integration planning costs associated with the Merger, certain of which were not deductible for tax purposes until 2017. Premiums Revenue Consolidated premiums increased $612 million, or 1.2%, from 2015 to $53.0 billion for 2016 primarily reflecting higher premiums in the Retail segment mainly driven by average membership growth and per member premium increases for certain of our lines of business. These increases were partially offset by the write-off of $583 million of receivables associated with the commercial risk corridor premium stabilization program, the loss of premiums associated with a large group Medicare account that moved to a private exchange on January 1, 2016, and a decline in premiums revenue associated with fewer individual commercial medical members as discussed in our segment results of operations discussion that follows. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Premiums revenue reflects changes in membership and average per member premiums. Items impacting average per member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership. Services Revenue Consolidated services revenue decreased $437 million, or 31.1%, from 2015 to $1.0 billion for 2016 primarily due to the completion of the sale of Concentra on June 1, 2015. Investment Income Investment income totaled $389 million for 2016, a decrease of $85 million, or 17.9%, from 2015, primarily due to lower realized capital gains in 2016 and lower interest rates partially offset by a higher average invested balance. Benefits Expense Consolidated benefits expense was $45.0 billion for 2016, an increase of $738 million, or 1.7%, from 2015 primarily due to $505 million in incremental benefits expense for the reserve strengthening in our non-strategic closed block of long-term care insurance policies partially offset by the premium deficiency reserve recorded in the fourth quarter of 2015 for certain of our individual commercial medical products for the 2016 coverage year. Excluding the long-term care reserve strengthening and impact of the premium deficiency reserve, the increase is primarily due to an increase in the Retail segment mainly driven by higher average individual Medicare Advantage membership. As more fully described herein under the section entitled “Benefits Expense Recognition”, actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $582 million in 2016 and $236 million in 2015. The increase in prior-period medical claims reserve development year over-year primarily was due to favorable year-over-year comparisons for our Medicare Advantage and individual commercial medical businesses. The consolidated benefit ratio for 2016 was 84.9%, an increase of 40 basis points from 2015 primarily due to the incremental benefits expense for the reserve strengthening in our non-strategic closed block of long-term care insurance policies, the impact on the benefit ratio of lower consolidated premiums associated with the write-off of receivables for the commercial risk corridor premium stabilization program, and the impact of the premium deficiency reserve recorded in the fourth quarter of 2015 for certain of our individual commercial medical products for the 2016 coverage year. Excluding the impact of the write-off of the commercial risk corridor receivables and the premium deficiency reserve, these items were partially offset by year-over-year improvement in both the Retail and Group and Specialty segment benefit ratios as discussed in the segment results of operations discussion that follows. Favorable prior-period medical claims reserve development decreased the consolidated benefit ratio by approximately 110 basis points in 2016 versus approximately 50 basis points in 2015. Operating Costs Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs decreased $122 million, or 1.7%, from 2015 to $7.2 billion in 2016 primarily due to the completion of the sale of Concentra on June 1, 2015. The consolidated operating cost ratio for 2016 was 13.3%, decreasing 30 basis points from 2015 primarily due to the completion of the sale of Concentra on June 1, 2015. Concentra carried a higher operating cost ratio than our Group and Specialty and Retail segments. This was partially offset by the unfavorable year-over-year comparison associated with the temporary suspension of certain discretionary administrative costs in the latter half of 2015, along with the impact of the commercial risk corridor receivables write-off in the fourth quarter of 2016. Depreciation and Amortization Depreciation and amortization for 2016 of $354 million was relatively unchanged from 2015. Interest Expense Interest expense was $189 million for 2016 compared to $186 million for 2015, an increase of $3 million, or 1.6%. Income Taxes Our effective tax rate during 2016 was 60.5% compared to the effective tax rate of 47.5% in 2015 primarily reflecting lower pretax income year-over-year, the beneficial effect of the sale of Concentra on June 1, 2015 and the impact of non-deductible transaction costs associated with the Merger. Non-deductible transaction and integration planning costs associated with the Merger increased our effective tax rate by approximately 3.4 percentage points in 2016 versus approximately 0.4 percentage points in 2015. Conversely, the tax effect of the sale of Concentra reduced our effective tax rate by approximately 4.5 percentage points in 2015. See Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. The effective tax rate for 2016 also reflects tax benefits associated with adopting new guidance related to the accounting for employee share-based payments effective January 1, 2016 as described in Note 2 to the condensed consolidated financial statements included in this report, which decreased our effective tax rate by approximately 1.2 percentage points in 2016. Retail Segment Pretax Results • Retail segment pretax income was $1,690 million in 2016, an increase of $431 million, or 34.2%, compared to 2015 primarily driven by the year-over-year improvement in our individual Medicare Advantage and state-based Medicaid businesses. Enrollment • Individual Medicare Advantage membership increased 84,200 members, or 3.1%, from December 31, 2015 to December 31, 2016 reflecting net membership additions, particularly for our HMO offerings, for the 2016 plan year. • Group Medicare Advantage membership decreased 128,700 members, or 26.6%, from December 31, 2015 to December 31, 2016 reflecting the loss of a large account that moved to a private exchange offering on January 1, 2016. • Medicare stand-alone PDP membership increased 393,500 members, or 8.6%, from December 31, 2015 to December 31, 2016 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2016 plan year. • State-based Medicaid membership increased 14,400 members, or 3.9%, from December 31, 2015 to December 31, 2016 primarily driven by the addition of members under our Florida Medicaid contract. Premiums revenue • Retail segment premiums increased $1,618 million, or 3.9%, from 2015 to 2016 primarily due to higher average membership for our individual Medicare Advantage and state-based Medicaid businesses and per member premium increases for certain lines of business. Average individual Medicare Advantage membership increased 3.9% in 2016. Benefits expense • The Retail segment benefit ratio of 85.1% for 2016 decreased 160 basis points from 2015 primarily due to lower year-over-year Medicare Advantage utilization, and favorable comparisons of prior-year medical claims reserve development. • The Retail segment’s benefits expense for 2016 included the beneficial effect of $429 million in favorable prior-year medical claims reserve development versus $248 million in 2015. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 100 basis points in 2016 versus approximately 60 basis points in 2015. The year-over-year increase in prior-period medical claims reserve development primarily was due to favorable year-over-year comparisons for our Medicare Advantage business. Operating costs • The Retail segment operating cost ratio of 10.8% for 2016 increased 50 basis points from 2015 primarily due to the unfavorable comparison to unusually low operating expenses in 2015 resulting from the temporary suspension of certain discretionary administrative costs, and the loss of a large group Medicare Advantage account which carried a lower operating cost ratio than that for our individual Medicare Advantage business. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 170 basis points in 2016 as compared to 160 basis points in 2015. Group and Specialty Segment (a) Specialty products include dental, vision, voluntary benefit products and other supplemental health and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Pretax Results • Group and Specialty segment pretax income was $344 million in 2016, an increase of $23 million, or 7.2%, from $321 million in 2015 driven by the improvement in the benefit ratio as discussed below. Enrollment • Fully-insured commercial group medical membership decreased 42,300 members, or 3.6% from December 31, 2015 reflecting lower membership in both large and small group accounts. • Group ASO commercial medical membership decreased 137,500 members, or 19.3%, from December 31, 2015 to December 31, 2016 primarily due to the loss of certain large group accounts as a result of continued discipline in pricing of services for self-funded accounts amid a highly competitive environment. • Specialty membership decreased 260,600 members, or 3.6%, from December 31, 2015 to December 31, 2016 primarily due to the loss of several large stand-alone dental and vision accounts as well as the loss of certain fully-insured group medical accounts that also had specialty coverage. The decrease includes the loss of certain individual commercial medical members that also had specialty coverage. Premiums revenue • Group and Specialty segment premiums decreased $134 million, or 2.0%, from 2015 to 2016 primarily due to a decline in fully-insured commercial medical membership as described above, partially offset by an increase in fully-insured commercial medical per member premiums. Services revenue • Group and Specialty segment services revenue decreased $15 million, or 2.3%, from 2015 to 2016 primarily due to a decline in group ASO commercial medical membership. Benefits expense • The Group and Specialty segment benefit ratio decreased 60 basis points from 78.8% in 2015 to 78.2% in 2016 primarily reflecting the beneficial effect of higher prior-year medical claims reserve development in 2016 and lower utilization. • The Group and Specialty segment’s benefits expense included the beneficial effect of $46 million in favorable prior-year medical claims reserve development in 2016 versus $7 million in 2015. This favorable prior-year medical claims reserve development decreased the Group and Specialty segment benefit ratio by approximately 70 basis points in 2016 versus approximately 10 basis points in 2015. Operating costs • The Group and Specialty segment operating cost ratio of 23.5% for 2016 increased 10 basis points from 23.4% for 2015, primarily due to the unfavorable comparison to unusually low operating expenses in 2015 resulting from the temporary suspension of certain discretionary administrative costs. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 150 basis points in 2016 as compared to 140 basis points in 2015. Healthcare Services Segment Pretax results • Healthcare Services segment pretax income of $1,096 million for 2016 increased $74 million, or 7.2%, from 2015 primarily due to incremental earnings associated with revenue growth from our pharmacy solutions business as it increased mail-order penetration and served our growing individual Medicare membership. The increase was partially offset by lower earnings in our provider services business reflecting significantly lower Medicare rates year-over-year associated with CMS' risk coding recalibration for 2016 in geographies where our provider assets are primarily located. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Group and Specialty segment membership increased to approximately 426 million in 2016, up 7% versus scripts of approximately 398 million in 2015. The increase primarily reflects growth associated with higher average medical membership for 2016 than in 2015. Services revenue • Services revenue decreased $416 million, or 57.3%, from 2015 to $310 million for 2016 primarily due to the completion of the sale of Concentra on June 1, 2015. Intersegment revenues • Intersegment revenues increased $1.9 billion, or 8.3%, from 2015 to $25.0 billion for 2016 primarily due to increased mail order penetration and growth in our individual Medicare Advantage and Medicare stand-alone PDP membership which resulted in increased engagement of members in clinical programs and higher utilization of services across the segment. Operating costs • The Healthcare Services segment operating cost ratio of 95.2% for 2016 increased slightly from 2015 primarily due to a higher operating cost ratio for our provider services business reflecting significantly lower Medicare rates year-over-year as discussed above, partially offset by operating cost efficiencies associated with our pharmacy operations. Individual Commercial Segment • In 2016, our Individual Commercial segment pretax loss decreased by $436 million, or 100.7%, from 2015 primarily driven by the write-off of commercial risk corridor receivables, partially offset by the impact of the premium deficiency reserve recorded in the fourth quarter of 2015 associated with certain individual commercial medical policies from the 2016 coverage year. • Individual commercial medical membership decreased 244,300 members, or 27.2%, from December 31, 2015 to December 31, 2016 primarily reflecting the loss of on-exchange members due to product competitiveness, the loss of membership associated with the discontinuance of certain Health Care Reform Law compliant plans in 2016, the loss of membership associated with non-payment of premiums or termination by CMS due to lack of eligibility documentation, and the loss of members subscribing to plans that are not compliant with the Health Care Reform Law. • The Individual Commercial segment benefit ratio of 107.7% for 2016 increased from 91.1% in 2015 primarily due to the reduction of premiums related to the write-off of receivables associated with the commercial risk corridor premium stabilization program, partially offset by the impact of the premium deficiency reserve recorded in the fourth quarter of 2015 for certain of our individual commercial medical products for the 2016 coverage year. As previously disclosed, in the fourth quarter of 2015 we recorded a premium deficiency reserve associated with our 2016 individual commercial offerings compliant with the Health Care Reform Law. During 2016, we increased the premium deficiency reserve for the 2016 coverage year and recorded a change in estimate of $208 million with a corresponding increase in benefits expense primarily as a result of unfavorable current and projected claims experience. • The Individual Commercial segment operating cost ratio of 19.6% for 2016 increased 40 basis points from 2015 primarily due to the impact on premiums of the write-off of receivables associated with the commercial risk corridor premium stabilization program. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 200 basis points in 2016 as compared to 170 basis points in 2015. Other Businesses As previously disclosed, in the fourth quarter of 2016, we increased future policy benefits expense by approximately $505 million for reserve strengthening associated with our closed block of long-term care insurance policies. This increase primarily was driven by emerging experience indicating longer claims duration, a prolonged lower interest rate environment, and an increase in policyholder life expectancies as discussed further in Note 18 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this 2016 Form 10-K. Liquidity Historically, our primary sources of cash have included receipts of premiums, services revenue, and investment and other income, as well as proceeds from the sale or maturity of our investment securities, borrowings, and proceeds from sales of businesses. Our primary uses of cash historically have included disbursements for claims payments, operating costs, interest on borrowings, taxes, purchases of investment securities, acquisitions, capital expenditures, repayments on borrowings, dividends, and share repurchases. Because premiums generally are collected in advance of claim payments by a period of up to several months, our business normally should produce positive cash flows during periods of increasing premiums and enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing premiums and enrollment. From period to period, our cash flows may also be affected by the timing of working capital items including premiums receivable, benefits payable, and other receivables and payables. Our cash flows are impacted by the timing of payments to and receipts from CMS associated with Medicare Part D subsidies for which we do not assume risk. The use of cash flows may be limited by regulatory requirements of state departments of insurance (or comparable state regulators) which require, among other items, that our regulated subsidiaries maintain minimum levels of capital and seek approval before paying dividends from the subsidiaries to the parent. Our use of cash flows derived from our non-insurance subsidiaries, such as in our Healthcare Services segment, is generally not restricted by state departments of insurance (or comparable state regulators). The effect of the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform Law have impacted the timing of our operating cash flows, as we build receivables for each coverage year that are expected to be collected in subsequent coverage years. Net collections under the 3Rs associated with prior coverage years were $440 million in 2017 as compared to $383 million in 2016. As more fully described in Note 7 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, we wrote off $583 million in risk corridor receivables outstanding as of September 30, 2016, including $415 million associated with the 2014 and 2015 coverage years. From inception of the risk corridor program through December 31, 2017, we collected approximately $39 million from CMS for risk corridor receivables associated with the 2014 coverage year funded by HHS in accordance with previous guidance, utilizing funds HHS collected from us and other carriers under the 2014 and 2015 risk corridor program. On November 2, 2017, we filed suit against the United States of America in the United States Court of Federal Claims, on behalf of our health plans seeking recovery from the federal government of approximately $611 million in payments under the risk corridor premium stabilization program established under the Health Care Reform Law, for years 2014, 2015 and 2016.The remaining net receivable balance associated with the 3Rs was approximately $31 million at December 31, 2017, including the $44 million reinsurance receivable related to the 2016 coverage year, as compared to $456 million at December 31, 2016. The remaining net receivable balance is primarily related to our Individual Commercial medical business which we have exited January 1, 2018. For additional information on our liquidity risk, please refer to Item 1A. - Risk Factors in this 2017 Form 10-K. Cash and cash equivalents increased to $4.0 billion at December 31, 2017 from $3.9 billion at December 31, 2016. The change in cash and cash equivalents for the years ended December 31, 2017, 2016 and 2015 is summarized as follows: Cash Flow from Operating Activities The change in operating cash flows over the three year period primarily results from the corresponding change in the timing of working capital items, earnings, and enrollment activity as discussed below. The increase in operating cash flows in 2017 primarily was due to the receipt of the merger termination fee, net of related expenses and taxes paid, higher earnings and the timing of working capital items. The increase in operating cash flows in 2016 primarily was due to the timing of working capital items and higher earnings exclusive of the commercial risk corridor receivables write-off and the long-term care reserve strengthening in 2016, as well as the gain on sale of Concentra and the recognition of the premium deficiency reserve in 2015 discussed previously. The most significant drivers of changes in our working capital are typically the timing of payments of benefits expense and receipts for premiums. We illustrate these changes with the following summaries of benefits payable and receivables. The detail of benefits payable was as follows at December 31, 2017, 2016 and 2015: (1) IBNR represents an estimate of benefits payable for claims incurred but not reported (IBNR) at the balance sheet date and includes unprocessed claim inventories. The level of IBNR is primarily impacted by membership levels, medical claim trends and the receipt cycle time, which represents the length of time between when a claim is initially incurred and when the claim form is received (i.e. a shorter time span results in a lower IBNR). (2) Reported claims in process represents the estimated valuation of processed claims that are in the post claim adjudication process, which consists of administrative functions such as audit and check batching and handling, as well as amounts owed to our pharmacy benefit administrator which fluctuate due to bi-weekly payments and the month-end cutoff. (3) Premium deficiency reserve recognized for our individual commercial medical business compliant with the Health Care Reform Law associated with the 2016 coverage year. (4) Other benefits payable include amounts owed to providers under capitated and risk sharing arrangements. The increase in benefits payable in 2017 largely was due to an increase in amounts owed under capitated, risk sharing, and quality incentive arrangements, partially offset by a decrease in IBNR. Benefits payable decreased in 2016 primarily due to a decrease in IBNR, as well as the application of 2016 results to the premium deficiency reserve liability recognized in 2015 associated with our individual commercial medical products compliant with the Health Care Reform Law for the 2016 coverage year. There was no premium deficiency reserve liability at December 31, 2016 or 2017. The increase in benefits payable in 2015 largely was due to increases in IBNR and in the amount of processed but unpaid claims due to our pharmacy benefit administrator, which fluctuates due to month-end cutoff. These items were partially offset by a decrease in amounts owed to providers under capitated and risk sharing arrangements in 2015, including the disbursement of a portion of our Medicare risk adjustment collections under our contractual obligations associated with our risk sharing arrangements. In addition, benefits payable in 2015 reflects the recognition of the premium deficiency reserve discussed previously. IBNR decreased during 2017 and 2016 primarily due to declines in individual and fully-insured group commercial membership. The decrease in IBNR during 2016 was also impacted by declines in group Medicare Advantage. IBNR increased during 2015 primarily as a result of individual Medicare Advantage membership growth. As discussed previously, our cash flows are impacted by changes in enrollment. The decline in membership experienced in 2017 and 2016 negatively impacted operating cash flows for those years. The detail of total net receivables was as follows at December 31, 2017, 2016 and 2015: Medicare receivables are impacted by changes in revenue associated with individual and group Medicare membership changes as well as the timing of accruals and related collections associated with the CMS risk-adjustment model. The decrease in commercial and other receivables in 2017 as compared to 2016 primarily was due to a decrease in our receivable associated with the commercial risk adjustment provision of the Health Care Reform Law. The increases in commercial and other receivables in 2016 and 2015 primarily reflect increases in our receivable associated with the commercial risk adjustment provision of the Health Care Reform Law. Military services receivables at December 31, 2017, 2016, and 2015 primarily consist of administrative services only fees owed from the federal government for administrative services provided under our TRICARE South Region contract. The 2017 balance also includes transition-in receivables under our T2017 East Region contract with collection scheduled in 2018. Many provisions of the Health Care Reform Law became effective in 2014, including the commercial risk adjustment, risk corridor, and reinsurance provisions as well as the non-deductible health insurance industry fee. As discussed previously, the timing of payments and receipts associated with these provisions impacted our operating cash flows as we built receivables for each coverage year that were expected to be collected in subsequent coverage years. Net collections under the 3Rs associated with prior coverage years were $440 million as compared to net collections of $383 million in 2016. The net receivable balance associated with the 3Rs was approximately $31 million at December 31, 2017, including certain amounts recorded in receivables as noted above. The annual health insurance industry fee was suspended for the calendar year 2017, but has resumed in calendar year 2018. The annual health insurance industry fee was also suspended for the calendar year 2019 and is scheduled to resume in calendar year 2020. We paid the federal government annual health insurance industry fees of $916 million in 2016 and $867 million in 2015. We have exited our individual commercial medical business effective January 1, 2018. In addition to the timing of payments of benefits expense, receipts for premiums and services revenues, and amounts due under the risk limiting and health insurance industry fee provisions of the Health Care Reform Law, other items impacting operating cash flows include income tax payments and the timing of payroll cycles resulting in one less payroll cycle in 2016 than in 2015. Cash Flow from Investing Activities Our ongoing capital expenditures primarily relate to our information technology initiatives, support of services in our provider services operations including medical and administrative facility improvements necessary for activities such as the provision of care to members, claims processing, billing and collections, wellness solutions, care coordination, regulatory compliance and customer service. Total capital expenditures, excluding acquisitions, were $526 million in 2017, $527 million in 2016, and $523 million in 2015. We reinvested a portion of our operating cash flows in investment securities, primarily investment-grade fixed income securities, totaling $2.4 billion in 2017 and $828 million in 2016. Proceeds from sales and maturities of investment securities exceeded purchases by $103 million in 2015. These net proceeds were used to fund normal working capital needs due to an increase in receivables associated with the 3Rs in addition to the timing of payments to and receipts from CMS associated with Medicare Part D reinsurance subsidies, as discussed below. In 2015, we purchased a $284 million note receivable directly from a third-party bank syndicate related to the financing of MCCI Holdings, LLC's business as described in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. The purchase of this note is included with purchases of investment securities in our consolidated statement of cash flows. On June 1, 2015, we completed the sale of Concentra for approximately $1,055 million in cash, excluding approximately $22 million of transaction costs. Cash consideration paid for acquisitions, net of cash acquired, was $31 million in 2017, $7 million in 2016, and $38 million in 2015. Acquisitions in each year included Healthcare Services segment related acquisitions. Cash Flow from Financing Activities Our financing cash flows are significantly impacted by the timing of claims payments and the related receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk. Monthly prospective payments from CMS for reinsurance and low-income cost subsidies are based on assumptions submitted with our annual bid. Settlement of the reinsurance and low-income cost subsidies is based on a reconciliation made approximately 9 months after the close of each calendar year. Receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk were $1.9 billion higher than claims payments during 2017 and were $1.1 billion higher than claims payments during 2016. Claim payments were $361 million higher than receipts from CMS associated with Medicare Part D claims subsidies for which we do not assume risk during 2015. In 2015, we experienced higher specialty prescription drug costs associated with a new treatment for Hepatitis C than were contemplated in our bids which resulted in higher subsidy receivable balances under the terms of our contracts with CMS. Our net payable for CMS subsidies and brand name prescription drug discounts was $1.0 billion at December 31, 2017 compared to a net receivable of $0.9 billion at December 31, 2016. Refer to Note 6 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Under our administrative services only TRICARE South Region contract, reimbursements from the federal government exceeded health care cost payments for which we do not assume risk by $11 million in 2017. Health care cost payments for which we do not assume risk exceeded reimbursements from the federal government by $25 million in 2016 and $4 million in 2015. Claims payments associated with cost sharing provisions of the Health Care Reform Law for which we do not assume risk were higher than reimbursements from HHS by $44 million in 2017 and by $28 million in 2016. Claim payments were less than reimbursements by $69 million in 2015. See Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for further description. We repurchased 12.99 million shares for $3.05 billion in 2017 and 1.85 million shares for $329 million in 2015 under share repurchase plans authorized by the Board of Directors. We did not repurchase shares in 2016 due to restrictions under the Merger Agreement. We also acquired common shares in connection with employee stock plans for an aggregate cost of $115 million in 2017, $104 million in 2016, and $56 million in 2015. As discussed further below, we paid dividends to stockholders of $220 million in 2017, $177 million in 2016, and $172 million in 2015. We entered into a commercial paper program in October 2014. Net repayments of commercial paper were $153 million in 2017 and the maximum principal amount outstanding at any one time during 2017 was $500 million. Net repayments of commercial paper were $2 million in 2016 and the maximum principal amount outstanding at any one time during 2016 was $475 million. Net proceeds from the issuance of commercial paper were $298 million in 2015 and the maximum principal amount outstanding at any one time during 2015 was $414 million. In March 2017, we issued $600 million of 3.95% senior notes due March 15, 2027 and $400 million of 4.80% senior notes due March 15, 2047. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses paid as of March 31, 2017, were $991 million. The net proceeds from these issuances are being used for general corporate purposes. In December 2017, we issued $400 million of 2.50% senior notes due December 15, 2020 and $400 million of 2.90% senior notes due December 15, 2022. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses paid as of December 31, 2017, were $794 million. We used the net proceeds, together with available cash, to fund the redemption of our $300 million aggregate principal amount of 6.30% senior notes maturing in August 2018 and our $500 million aggregate principal amount of 7.20% senior notes maturing in June 2018 at 100% of the principal amount plus applicable premium for early redemption and accrued and unpaid interest to the redemption date, for cash totaling approximately $829 million. The remainder of the cash used in or provided by financing activities in 2017, 2016, and 2015 primarily resulted from proceeds from stock option exercises and the change in book overdraft. Future Sources and Uses of Liquidity Dividends For a detailed discussion of dividends to stockholders, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Stock Repurchases For a detailed discussion of stock repurchases, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Debt For a detailed discussion of our debt, including our senior notes, credit agreement and commercial paper program, please refer to Note 12 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Acquisitions & Divestitures On November 6, 2017, we entered into a definitive agreement to sell the stock of our wholly-owned subsidiary KMG to CGIC, a Texas-based insurance company wholly owned by HC2 Holdings, Inc., a diversified holding company. KMG’s subsidiary, KIC, includes our closed block of non-strategic commercial long-term care insurance policies. We will fund the transaction with approximately $203 million of parent company cash contributed into KMG, subject to customary adjustments, in addition to the transfer of approximately $150 million of statutory capital with the sale. The KMG transaction is anticipated to close by the third quarter of 2018 subject to customary closing conditions, including South Carolina Department of Insurance approval. There can be no assurance we will obtain regulatory approvals needed to sell the business or do so under terms acceptable to us. On December 19, 2017, we announced that we have entered into a definitive agreement to acquire a 40% minority interest in the Kindred at Home Division (Kindred at Home) of Kindred Healthcare, Inc. (Kindred)(NYSE: KND), the nation’s largest home health provider and second largest hospice operator, for estimated cash consideration of approximately $800 million, including our share of transaction and related expenses, to facilitate a complete separation from the Long Term Acute Care and Rehabilitation businesses (the Specialty Hospital company). The Kindred transaction, which is anticipated to close in the summer of 2018, is subject to customary state and federal regulatory approvals, including approval by the stockholders of Kindred and the expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvement Act of 1976, as amended, as well as other customary closing conditions. We expect to fund the transaction through the use of parent company cash and will account for the minority investment under the equity method. The pending transaction did not have a material impact to earnings in 2017. For a detailed discussion of the above please refer to Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Liquidity Requirements We believe our cash balances, investment securities, operating cash flows, and funds available under our credit agreement and our commercial paper program or from other public or private financing sources, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, acquisitions, future expansion opportunities, and capital expenditures for at least the next twelve months, as well as to refinance or repay debt, and repurchase shares. Adverse changes in our credit rating may increase the rate of interest we pay and may impact the amount of credit available to us in the future. Our investment-grade credit rating at December 31, 2017 was BBB+ according to Standard & Poor’s Rating Services, or S&P, and Baa3 according to Moody’s Investors Services, Inc., or Moody’s. A downgrade by S&P to BB+ or by Moody’s to Ba1 triggers an interest rate increase of 25 basis points with respect to $750 million of our senior notes. Successive one notch downgrades increase the interest rate an additional 25 basis points, or annual interest expense by $2 million, up to a maximum 100 basis points, or annual interest expense by $8 million. In addition, we operate as a holding company in a highly regulated industry. Humana Inc., our parent company, is dependent upon dividends and administrative expense reimbursements from our subsidiaries, most of which are subject to regulatory restrictions. We continue to maintain significant levels of aggregate excess statutory capital and surplus in our state-regulated operating subsidiaries. Cash, cash equivalents, and short-term investments at the parent company decreased to $688 million at December 31, 2017 from $2.0 billion at December 31, 2016. This decrease primarily reflects common stock repurchases, insurance subsidiaries' capital contributions and capital expenditures, partially offset by insurance subsidiaries dividends, non-insurance subsidiaries' profits and net proceeds from debt issuance. Our use of operating cash derived from our non-insurance subsidiaries, such as our Healthcare Services segment, is generally not restricted by Departments of Insurance (or comparable state regulatory agencies). Our regulated subsidiaries paid dividends to the parent of $1.4 billion in 2017, $763 million in 2016, and $493 million in 2015. Subsidiary dividends in 2015 reflect the impact of losses for our individual commercial medical business compliant with the Health Care Reform Law and the November 5, 2015 revised statutory accounting guidance requiring the exclusion of risk corridor receivables from related statutory surplus. Refer to our parent company financial statements and accompanying notes in Schedule I - Parent Company Financial Information. Excluding Puerto Rico subsidiaries, the amount of ordinary dividends that may be paid to our parent company in 2018 is approximately $1.1 billion, in the aggregate. Actual dividends paid may vary due to consideration of excess statutory capital and surplus and expected future surplus requirements related to, for example, premium volume and product mix. Our parent company funded a subsidiary capital contribution of approximately $535 million in the first quarter of 2017 for reserve strengthening associated with our closed block of long-term care insurance policies discussed further in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Regulatory Requirements For a detailed discussion of our regulatory requirements, including aggregate statutory capital and surplus as well as dividends paid from the subsidiaries to the parent, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Contractual Obligations We are contractually obligated to make payments for years subsequent to December 31, 2017 as follows: (1) Interest includes the estimated contractual interest payments under our debt agreements. (2) We lease facilities, computer hardware, and other furniture and equipment under long-term operating leases that are noncancelable and expire on various dates through 2046. We sublease facilities or partial facilities to third party tenants for space not used in our operations which partially mitigates our operating lease commitments. An operating lease is a type of off-balance sheet arrangement. Assuming we acquired the asset, rather than leased such asset, we would have recognized a liability for the financing of these assets. See also Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. (3) Purchase obligations include agreements to purchase services, primarily information technology related services, or to make improvements to real estate, in each case that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum levels of service to be purchased; fixed, minimum or variable price provisions; and the appropriate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. (4) Includes future policy benefits payable ceded to third parties through 100% coinsurance agreements as more fully described in Note 19 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We expect the assuming reinsurance carriers to fund these obligations and reflected these amounts as reinsurance recoverables included in other long-term assets on our consolidated balance sheet. Amounts payable in less than one year are included in trade accounts payable and accrued expenses in the consolidated balance sheet. Off-Balance Sheet Arrangements As of December 31, 2017, we were not involved in any special purpose entity, or SPE, transactions. For a detailed discussion of off-balance sheet arrangements, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Guarantees and Indemnifications For a detailed discussion of our guarantees and indemnifications, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Government Contracts For a detailed discussion of our government contracts, including our Medicare, Military, and Medicaid contracts, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Other On February 14, 2017, we and Aetna agreed to mutually terminate the Merger Agreement, as our Board determined that an appeal of the Court's ruling would not be in the best interest of our stockholders. On February 16, 2017, under the terms of the Merger Agreement, we received a breakup fee of $1 billion. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and accompanying notes, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements and accompanying notes requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We continuously evaluate our estimates and those critical accounting policies primarily related to benefits expense and revenue recognition as well as accounting for impairments related to our investment securities, goodwill, and long-lived assets. These estimates are based on knowledge of current events and anticipated future events and, accordingly, actual results ultimately may differ from those estimates. We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements. Benefits Expense Recognition Benefits expense is recognized in the period in which services are provided and includes an estimate of the cost of services which have been incurred but not yet reported, or IBNR. IBNR represents a substantial portion of our benefits payable as follows: Our reserving practice is to consistently recognize the actuarial best point estimate within a level of confidence required by actuarial standards. For further discussion of our reserving methodology, including our use of completion and claims per member per month trend factors to estimate IBNR, refer to Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. The completion and claims per member per month trend factors are the most significant factors impacting the IBNR estimate. The portion of IBNR estimated using completion factors for claims incurred prior to the most recent two months is generally less variable than the portion of IBNR estimated using trend factors. The following table illustrates the sensitivity of these factors assuming moderately adverse experience and the estimated potential impact on our operating results caused by reasonably likely changes in these factors based on December 31, 2017 data: (a) Reflects estimated potential changes in benefits payable at December 31, 2017 caused by changes in completion factors for incurred months prior to the most recent two months. (b) Reflects estimated potential changes in benefits payable at December 31, 2017 caused by changes in annualized claims trend used for the estimation of per member per month incurred claims for the most recent two months. (c) The factor change indicated represents the percentage point change. The following table provides a historical perspective regarding the accrual and payment of our benefits payable, excluding military services. Components of the total incurred claims for each year include amounts accrued for current year estimated benefits expense as well as adjustments to prior year estimated accruals. Refer to Note 10 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for Retail, Group and Specialty, and Individual Commercial segment tables including information about incurred and paid claims development as of December 31, 2017, net of reinsurance, as well as cumulative claim frequency and the total of IBNR included within the net incurred claims amounts. The following table summarizes the changes in estimate for incurred claims related to prior years attributable to our key assumptions. As previously described, our key assumptions consist of trend and completion factors estimated using an assumption of moderately adverse conditions. The amounts below represent the difference between our original estimates and the actual benefits expense ultimately incurred as determined from subsequent claim payments. (a) The factor change indicated represents the percentage point change. As previously discussed, our reserving practice is to consistently recognize the actuarial best estimate of our ultimate liability for claims. Actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $483 million in 2017, $582 million in 2016, and $236 million in 2015. The table below details our favorable medical claims reserve development related to prior fiscal years by segment for 2017, 2016, and 2015. The favorable medical claims reserve development for 2017, 2016, and 2015 primarily reflects the consistent application of trend and completion factors estimated using an assumption of moderately adverse conditions. Our favorable development for each of the years presented above is discussed further in Note 10 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We continually adjust our historical trend and completion factor experience with our knowledge of recent events that may impact current trends and completion factors when establishing our reserves. Because our reserving practice is to consistently recognize the actuarial best point estimate using an assumption of moderately adverse conditions as required by actuarial standards, there is a reasonable possibility that variances between actual trend and completion factors and those assumed in our December 31, 2017 estimates would fall towards the middle of the ranges previously presented in our sensitivity table. Benefits expense excluded from the previous table was as follows for the years ended December 31, 2017, 2016 and 2015: In the fourth quarter of 2015, we recognized a premium deficiency reserve for our individual commercial medical business compliant with the Health Care Reform Law associated with the 2016 coverage year as discussed in more detail in Note 7 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Military services benefits expense for each year in the table above reflect expenses associated with our contracts with the Veterans Administration. The higher benefits expense associated with future policy benefits payable during 2016 primarily relates to reserve strengthening for our closed block of long-term care insurance policies acquired in connection with the 2007 KMG acquisition as more fully described below and in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Certain health policies sold to individuals prior to 2014 (the first year plans compliant with the Health Care Reform Law were effective) are accounted for as long-duration as more fully described below. Benefits expense associated with future policy benefits payable in 2015 primarily reflects the release of reserves as individual commercial medical members transitioned to plans compliant with the Health Care Reform Law. Future policy benefits payable of $2.9 billion and $2.8 billion at December 31, 2017 and 2016, respectively, represent liabilities for long-duration insurance policies including long-term care insurance, life insurance, annuities, and certain health and other supplemental policies sold to individuals for which some of the premium received in the earlier years is intended to pay anticipated benefits to be incurred in future years. At policy issuance, these reserves are recognized on a net level premium method based on premium rate increase, interest rate, mortality, morbidity, persistency (the percentage of policies remaining in-force), and maintenance expense assumptions. Interest rates are based on our expected net investment returns on the investment portfolio supporting the reserves for these blocks of business. Mortality, a measure of expected death, and morbidity, a measure of health status, assumptions are based on published actuarial tables, modified based upon actual experience. The assumptions used to determine the liability for future policy benefits are established and locked in at the time each contract is issued and only change if our expected future experience deteriorates to the point that the level of the liability, together with the present value of future gross premiums, are not adequate to provide for future expected policy benefits and maintenance costs (i.e. the loss recognition date). Because these policies have long-term claim payout periods, there is a greater risk of significant variability in claims costs, either positive or negative. We perform loss recognition tests at least annually in the fourth quarter, and more frequently if adverse events or changes in circumstances indicate that the level of the liability, together with the present value of future gross premiums, may not be adequate to provide for future expected policy benefits and maintenance costs. Future policy benefits payable include $2.3 billion at December 31, 2017 and $2.2 billion at December 31, 2016 associated with a non-strategic closed block of long-term care insurance policies acquired in connection with the 2007 acquisition of KMG. Approximately 29,800 policies remain in force as of December 31, 2017. No new policies have been written since 2005 under this closed block. Future policy benefits payable includes amounts charged to accumulated other comprehensive income for an additional liability that would exist on our closed-block of long-term care insurance policies if unrealized gains on the sale of the investments backing such products had been realized and the proceeds reinvested at then current yields. There was a $168 million additional liability at December 31, 2017 and $77 million additional liability at December 31, 2016. Amounts charged to accumulated other comprehensive income are net of applicable deferred taxes. Long-term care insurance policies provide nursing home and home health coverage for which premiums are collected many years in advance of benefits paid, if any. Therefore, our actual claims experience will emerge many years after assumptions have been established. The risk of a deviation of the actual interest, morbidity, mortality, and maintenance expense assumptions from those assumed in our reserves are particularly significant to our closed block of long-term care insurance policies. A prolonged period during which interest rates remain at levels lower than those anticipated in our reserving would result in shortfalls in investment income on assets supporting our obligation under long term care policies because the long duration of the policy obligations exceeds the duration of the supporting investment assets. Further, we monitor the loss experience of these long-term care insurance policies and, when necessary, apply for premium rate increases through a regulatory filing and approval process in the jurisdictions in which such products were sold. To the extent premium rate increases, interest rates, and/or loss experience vary from our loss recognition date assumptions, future material adjustments to reserves could be required. During 2016, we recorded a loss for a premium deficiency. The premium deficiency was based on current and anticipated experience that had deteriorated from our locked-in assumptions from the previous December 31, 2013 loss recognition date, particularly as they related to emerging experience indicating longer claims duration, a prolonged lower interest rate environment, and an increase in policyholder life expectancies. Based on this deterioration, we determined that our existing future policy benefits payable, together with the present value of future gross premiums, associated with our closed block of long-term care insurance policies were not adequate to provide for future policy benefits and maintenance costs under these policies; therefore we unlocked and modified our assumptions based on current expectations. Accordingly, during 2016 we recorded $505 million of additional benefits expense, with a corresponding increase in future policy benefits payable of $659 million partially offset by a related reinsurance recoverable of $154 million included in other long-term assets. For our closed block of long-term care policies, actuarial assumptions used to estimate reserves are inherently uncertain due to the potential changes in trends in mortality, morbidity, persistency and interest rates as well as premium rate increases. As a result, our long term care reserves may be subject to material increases if these trends develop adversely to our expectations. The estimated increase in reserves and additional benefit expense from hypothetically modeling adverse variations in our actuarial assumptions, in the aggregate, could be up to $250 million, net of reinsurance. Although such hypothetical revisions are not currently appropriate, we believe they could occur based on past variances in experience and our expectation of the ranges of future experience that could reasonably occur, and any such revision could be material. Generally accepted accounting principles do not allow us to unlock our assumptions for favorable items. In addition, future policy benefits payable includes amounts of $199 million at December 31, 2017, $201 million at December 31, 2016, and $205 million at December 31, 2015 which are subject to 100% coinsurance agreements as more fully described in Note 19 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data, and as such are offset by a related reinsurance recoverable included in other long-term assets. Revenue Recognition We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group on 30-day written notice. Our Medicare contracts with CMS renew annually. Our military services contracts with the federal government and our contracts with various state Medicaid programs generally are multi-year contracts subject to annual renewal provisions. Our commercial contracts establish rates on a per employee basis for each month of coverage based on the type of coverage purchased (single to family coverage options). Our Medicare and Medicaid contracts also establish monthly rates per member. However, our Medicare contracts also have additional provisions as outlined in the following separate section. Premiums revenue and administrative services only, or ASO, fees are estimated by multiplying the membership covered under the various contracts by the contractual rates. In addition, we adjust revenues for estimated changes in an employer’s enrollment and individuals that ultimately may fail to pay, and for estimated rebates under the minimum benefit ratios required under the Health Care Reform Law. Enrollment changes not yet processed or not yet reported by an employer group or the government, also known as retroactive membership adjustments, are estimated based on available data and historical trends. We routinely monitor the collectibility of specific accounts, the aging of receivables, historical retroactivity trends, estimated rebates, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in the current period’s revenue. We bill and collect premium from employer groups and members in our Medicare and other individual products monthly. We receive monthly premiums from the federal government and various states according to government specified payment rates and various contractual terms. Changes in revenues from for our Medicare and commercial medical products resulting from the periodic changes in risk-adjustment scores derived from medical diagnoses for our membership are recognized when the amounts become determinable and the collectibility is reasonably assured. Medicare Risk-Adjustment Provisions CMS utilizes a risk-adjustment model which apportions premiums paid to Medicare Advantage, or MA, plans according to health severity. The risk-adjustment model, which CMS implemented pursuant to the Balanced Budget Act of 1997(BBA) and the Benefits Improvement and Protection Act of 2000 (BIPA), generally pays more for enrollees with predictably higher costs. Under the risk-adjustment methodology, all MA plans must collect and submit the necessary diagnosis code information from hospital inpatient, hospital outpatient, and physician providers to CMS within prescribed deadlines. The CMS risk-adjustment model uses this diagnosis data to calculate the risk-adjusted premium payment to MA plans. Rates paid to MA plans are established under an actuarial bid model, including a process that bases our payments on a comparison of our beneficiaries’ risk scores, derived from medical diagnoses, to those enrolled in the government’s Medicare FFS program. We generally rely on providers, including certain providers in our network who are our employees, to code their claim submissions with appropriate diagnoses, which we send to CMS as the basis for our payment received from CMS under the actuarial risk-adjustment model. We also rely on providers to appropriately document all medical data, including the diagnosis data submitted with claims. CMS is phasing-in the process of calculating risk scores using diagnoses data from the Risk Adjustment Processing System, or RAPS, to diagnoses data from the Encounter Data System, or EDS. The RAPS process requires MA plans to apply a filter logic based on CMS guidelines and only submit claims that satisfy those guidelines. For submissions through EDS, CMS requires MA plans to submit all the encounter data and CMS will apply the risk adjustment filtering logic to determine the risk scores. For 2016, 10% of the risk score was calculated from claims data submitted through EDS, increasing to 25% of the risk score calculated from claims data through EDS for 2017. In April 2017, CMS revised the pace of the phase-in. For 2018, 15% of the risk score will be calculated from claims data submitted through EDS. The phase-in from RAPS to EDS could result in different risk scores from each dataset as a result of plan processing issues, CMS processing issues, or filtering logic differences between RAPS and EDS, and could have a material adverse effect on our results of operations, financial position, or cash flows. We estimate risk-adjustment revenues based on medical diagnoses for our membership. The risk-adjustment model, including CMS changes to the submission process, is more fully described in Item 1. - Business under the section titled “Individual Medicare.” Investment Securities Investment securities totaled $12.3 billion, or 45% of total assets at December 31, 2017, and $9.8 billion, or 39% of total assets at December 31, 2016. Debt securities, detailed below, comprised this entire investment portfolio at December 31, 2017 and 2016. The fair value of debt securities were as follows at December 31, 2017 and 2016: Approximately 98% of our debt securities were investment-grade quality, with a weighted average credit rating of AA by S&P at December 31, 2017. Most of the debt securities that were below investment-grade were rated BB, the higher end of the below investment-grade rating scale. Our investment policy limits investments in a single issuer and requires diversification among various asset types. Tax-exempt municipal securities included pre-refunded bonds of $222 million at December 31, 2017 and $276 million at December 31, 2016. These pre-refunded bonds were secured by an escrow fund consisting of U.S. government obligations sufficient to pay off all amounts outstanding at maturity. The ratings of these pre-refunded bonds generally assume the rating of the government obligations at the time the fund is established. Tax-exempt municipal securities that were not pre-refunded were diversified among general obligation bonds of U.S. states and local municipalities as well as special revenue bonds. General obligation bonds, which are backed by the taxing power and full faith of the issuer, accounted for $1.8 billion of these municipals in the portfolio. Special revenue bonds, issued by a municipality to finance a specific public works project such as utilities, water and sewer, transportation, or education, and supported by the revenues of that project, accounted for $1.9 billion of these municipals. Our general obligation bonds are diversified across the U.S. with no individual state exceeding 9%. In addition, certain monoline insurers guarantee the timely repayment of bond principal and interest when a bond issuer defaults and generally provide credit enhancement for bond issues related to our tax-exempt municipal securities. We have no direct exposure to these monoline insurers. We owned $94 million and $132 million at December 31, 2017 and 2016, respectively, of tax-exempt securities guaranteed by monoline insurers. The equivalent weighted average S&P credit rating of these tax-exempt securities without the guarantee from the monoline insurer was AA. Our direct exposure to subprime mortgage lending is limited to investment in residential mortgage-backed securities and asset-backed securities backed by home equity loans. The fair value of securities backed by Alt-A and subprime loans was less than $1 million at December 31, 2017 and December 31, 2016. There are no collateralized debt obligations or structured investment vehicles in our investment portfolio. The percentage of corporate securities associated with the financial services industry was 30% at December 31, 2017 and 23% at December 31, 2016. Gross unrealized losses and fair values aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows at December 31, 2017: Under the other-than-temporary impairment model for debt securities held, we recognize an impairment loss in income in an amount equal to the full difference between the amortized cost basis and the fair value when we have the intent to sell the debt security or it is more likely than not we will be required to sell the debt security before recovery of our amortized cost basis. However, if we do not intend to sell the debt security, we evaluate the expected cash flows to be received as compared to amortized cost and determine if a credit loss has occurred. In the event of a credit loss, only the amount of the impairment associated with the credit loss is recognized currently in income with the remainder of the loss recognized in other comprehensive income. When we do not intend to sell a security in an unrealized loss position, potential other-than-temporary impairment is considered using a variety of factors, including the length of time and extent to which the fair value has been less than cost; adverse conditions specifically related to the industry, geographic area or financial condition of the issuer or underlying collateral of a security; payment structure of the security; changes in credit rating of the security by the rating agencies; the volatility of the fair value changes; and changes in fair value of the security after the balance sheet date. For debt securities, we take into account expectations of relevant market and economic data. For example, with respect to mortgage and asset-backed securities, such data includes underlying loan level data and structural features such as seniority and other forms of credit enhancements. A decline in fair value is considered other-than-temporary when we do not expect to recover the entire amortized cost basis of the security. We estimate the amount of the credit loss component of a debt security as the difference between the amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate of future cash flows discounted at the implicit interest rate at the date of purchase. The risks inherent in assessing the impairment of an investment include the risk that market factors may differ from our expectations, facts and circumstances factored into our assessment may change with the passage of time, or we may decide to subsequently sell the investment. The determination of whether a decline in the value of an investment is other than temporary requires us to exercise significant diligence and judgment. The discovery of new information and the passage of time can significantly change these judgments. The status of the general economic environment and significant changes in the national securities markets influence the determination of fair value and the assessment of investment impairment. There is a continuing risk that declines in fair value may occur and additional material realized losses from sales or other-than-temporary impairments may be recorded in future periods. The recoverability of our non-agency residential and commercial mortgage-backed securities is supported by factors such as seniority, underlying collateral characteristics and credit enhancements. These residential and commercial mortgage-backed securities at December 31, 2017 primarily were composed of senior tranches having high credit support, with over 99% of the collateral consisting of prime loans. The weighted average credit rating of all commercial mortgage-backed securities was AA+ at December 31, 2017. All issuers of securities we own that were trading at an unrealized loss at December 31, 2017 remain current on all contractual payments. After taking into account these and other factors previously described, we believe these unrealized losses primarily were caused by an increase in market interest rates in the current markets than when the securities were purchased. At December 31, 2017, we did not intend to sell the securities with an unrealized loss position in accumulated other comprehensive income, and it is not likely that we will be required to sell these securities before recovery of their amortized cost basis. As a result, we believe that the securities with an unrealized loss were not other-than-temporarily impaired at December 31, 2017. There were no material other-than-temporary impairments in 2017, 2016, or 2015. Goodwill and Long-lived Assets At December 31, 2017, goodwill and other long-lived assets represented 19% of total assets and 52% of total stockholders’ equity, compared to 20% and 47%, respectively, at December 31, 2016. We are required to test at least annually for impairment at a level of reporting referred to as the reporting unit, and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. A reporting unit either is our operating segments or one level below the operating segments, referred to as a component, which comprise our reportable segments. A component is considered a reporting unit if the component constitutes a business for which discrete financial information is available that is regularly reviewed by management. We are required to aggregate the components of an operating segment into one reporting unit if they have similar economic characteristics. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition. The carrying amount of goodwill for our reportable segments has been retrospectively adjusted to conform to the 2017 segment change discussed in Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We use the one-step process to review goodwill for impairment to determine both the existence and amount of goodwill impairment, if any. Our strategy, long-range business plan, and annual planning process support our goodwill impairment tests. These tests are performed, at a minimum, annually in the fourth quarter, and are based on an evaluation of future discounted cash flows. We rely on this discounted cash flow analysis to determine fair value. However outcomes from the discounted cash flow analysis are compared to other market approach valuation methodologies for reasonableness. We use discount rates that correspond to a market-based weighted-average cost of capital and terminal growth rates that correspond to long-term growth prospects, consistent with the long-term inflation rate. Key assumptions in our cash flow projections, including changes in membership, premium yields, medical and operating cost trends, and certain government contract extensions, are consistent with those utilized in our long-range business plan and annual planning process. If these assumptions differ from actual, including the impact of the Health Care Reform Law or changes in Government rates, the estimates underlying our goodwill impairment tests could be adversely affected. Goodwill impairment tests completed in each of the last three years did not result in an impairment loss. The fair value of our reporting units with significant goodwill exceeded carrying amounts by a substantial margin. A 100 basis point increase in the discount rate would not have a significant impact on the amount of margin for any of our reporting units with significant goodwill, with the exception of our provider services reporting unit in our Healthcare Services segment. The provider services reporting unit, with $590 million of goodwill, would decline to less than 10% margin after factoring in a 100 basis point increase in the discount rate. Long-lived assets consist of property and equipment and other finite-lived intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. We periodically review long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation or amortization for these assets. There were no material impairment losses in the last three years.

<s>[INST] General Humana Inc., headquartered in Louisville, Kentucky, is a leading health and wellbeing company committed to helping our millions of medical and specialty members achieve their best health. Our successful history in care delivery and health plan administration is helping us create a new kind of integrated care with the power to improve health and wellbeing and lower costs. Our efforts are leading to a better quality of life for people with Medicare, families, individuals, military service personnel, and communities at large. To accomplish that, we support physicians and other health care professionals as they work to deliver the right care in the right place for their patients, our members. Our range of clinical capabilities, resources and tools, such as inhome care, behavioral health, pharmacy services, data analytics and wellness solutions, combine to produce a simplified experience that makes health care easier to navigate and more effective. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, excluding depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Aetna Merger On July 2, 2015, we entered into an Agreement and Plan of Merger, which we refer to in this report as the Merger Agreement, with Aetna Inc. and certain wholly owned subsidiaries of Aetna Inc., which we refer to collectively as Aetna, which sets forth the terms and conditions under which we agreed to merge with, and become a wholly owned subsidiary of Aetna, a transaction we refer to in this report as the Merger. On February 14, 2017, we and Aetna agreed to mutually terminate the Merger Agreement, as our Board determined that an appeal of the Court's ruling would not be in the best interest of our stockholders. On February 16, 2017, under the terms of the Merger Agreement, we received a breakup fee of $1 billion from Aetna, which is included in our consolidated statement of income in the line captioned Merger termination fee and related costs, net. Prior period Merger related transaction costs, previously included in operating costs, have been reclassified to conform to the 2017 presentation. Acquisitions and Divestitures On December 19, 2017, we announced that we have entered into a definitive agreement to acquire a 40% minority interest in the Kindred at Home Division (Kindred at Home) of Kindred Healthcare, Inc. (Kindred)(NYSE: KND), the nation’s largest home health provider and second largest hospice operator, for estimated cash consideration of approximately $800 million, including our share of transaction and related expenses, to facilitate a complete separation from the Long Term Acute Care and Rehabilitation businesses (the Specialty Hospital company). On November 6, 2017, we entered into a definitive agreement to sell the stock of our whollyowned subsidiary, KMG to CGIC, a Texasbased insurance company wholly owned by HC2 Holdings, Inc., a diversified holding company. KMG’s subsidiary, KIC, includes our closed block of nonstrategic commercial longterm care insurance policies. See Note 18 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, for a discussion of our closed block of longterm care insurance policies. These transactions are more fully discussed in Note 2 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data. Business Segments During the first quarter of 2017, we realigned certain of our businesses among our reportable segments to correspond with internal management reporting changes corresponding to those used by our chief operating decision maker to evaluate results of operations and our previously announced planned exit from the Individual Commercial medical business on January 1, 2018. Additionally, we renamed our Group segment to the Group and Specialty segment, and began presenting the Individual Commercial business results as a separate segment rather than as part of the Retail segment. Specialty health insurance benefits, including dental, vision, other supp [/INST] Positive. </s>

HUMANA INC

2019-02-21

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Executive Overview General Humana Inc., headquartered in Louisville, Kentucky, is a leading health and well-being company committed to helping our millions of medical and specialty members achieve their best health. Our successful history in care delivery and health plan administration is helping us create a new kind of integrated care with the power to improve health and well-being and lower costs. Our efforts are leading to a better quality of life for people with Medicare, families, individuals, military service personnel, and communities at large. To accomplish that, we support physicians and other health care professionals as they work to deliver the right care in the right place for their patients, our members. Our range of clinical capabilities, resources and tools, such as in-home care, behavioral health, pharmacy services, data analytics and wellness solutions, combine to produce a simplified experience that makes health care easier to navigate and more effective. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, excluding Merger termination fee and related costs, net, and depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Business Segments We manage our business with four reportable segments: Retail, Group and Specialty, Healthcare Services, and Individual Commercial. In addition, the Other Businesses category includes businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on well-being solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources. See Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for segment financial information. The Retail segment consists of Medicare benefits, marketed to individuals or directly via group Medicare accounts. In addition, the Retail segment also includes our contract with CMS to administer the Limited Income Newly Eligible Transition, or LI-NET, prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and Long-Term Support Services benefits, which we refer to collectively as our state-based contracts. The Group and Specialty segment consists of employer group commercial fully-insured medical and specialty health insurance benefits marketed to individuals and employer groups, including dental, vision, and other supplemental health benefits, as well as administrative services only, or ASO products. In addition, our Group and Specialty segment includes military services business, primarily our TRICARE T2017 East Region contract. The Healthcare Services segment includes our services offered to our health plan members as well as to third parties, including pharmacy solutions, provider services, and clinical care service, such as home health and other services and capabilities to promote wellness and advance population health, including our investment in Kindred at Home. The Individual Commercial segment consisted of our individual commercial fully-insured medical health insurance business, which we exited beginning January 1, 2018. We report under the category of Other Businesses those businesses that do not align with the reportable segments described above, primarily our closed-block long-term care insurance policies, which were sold in 2018. The results of each segment are measured by income before income taxes and equity in net earnings from Kindred at Home, or segment earnings. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and clinical care services, to our Retail and Group and Specialty segment customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often use the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at a corporate level. These corporate amounts are reported separately from our reportable segments and are included with intersegment eliminations. Seasonality One of the product offerings of our Retail segment is Medicare stand-alone prescription drug plans, or PDPs, under the Medicare Part D program. Our quarterly Retail segment earnings and operating cash flows are impacted by the Medicare Part D benefit design and changes in the composition of our membership. The Medicare Part D benefit design results in coverage that varies as a member’s cumulative out-of-pocket costs pass through successive stages of a member’s plan period, which begins annually on January 1 for renewals. These plan designs generally result in us sharing a greater portion of the responsibility for total prescription drug costs in the early stages and less in the latter stages. As a result, the PDP benefit ratio generally decreases as the year progresses. In addition, the number of low income senior members as well as year-over-year changes in the mix of membership in our stand-alone PDP products affects the quarterly benefit ratio pattern. In addition, the Retail segment also experiences seasonality in the operating cost ratio as a result of costs incurred in the second half of the year associated with the Medicare marketing season. Our Group and Specialty segment also experiences seasonality in the benefit ratio pattern. However, the effect is opposite of Medicare stand-alone PDP in the Retail segment, with the Group and Specialty segment’s benefit ratio increasing as fully-insured members progress through their annual deductible and maximum out-of-pocket expenses. Aetna Merger On February 16, 2017, under the terms of the Agreement and Plan of Merger, or Merger Agreement, with Aetna Inc., and certain wholly owned subsidiaries of Aetna Inc., which we collectively refer to as Aetna, we received a breakup fee of $1 billion from Aetna, which is included in our consolidated statement of income in the line captioned "Merger termination fee and related costs, net." Acquisitions and Divestitures On August 9, 2018, we completed the sale of our wholly-owned subsidiary, KMG America Corporation, or KMG, to Continental General Insurance Company, or CGIC, a Texas-based insurance company wholly owned by HC2 Holdings, Inc., a diversified holding company. KMG's subsidiary, Kanawha Insurance Company, or KIC, includes our closed block of non-strategic commercial long-term care policies. Upon closing, we funded the transaction with approximately $190 million of parent company cash contributed into KMG, subject to customary adjustments, in addition to the transfer of approximately $160 million of statutory capital with the sale. In connection with the sale of KMG, we recognized a pretax loss, including transaction costs, of $786 million and a corresponding $452 million tax benefit. Prior to the sale of KMG, we entered into reinsurance contracts to transfer the risk associated with certain voluntary benefit and financial protection products previously issued primarily by KIC to a third party. We transferred approximately $245 million of cash to the third party and recorded a commensurate reinsurance recoverable as a result of these transactions. The reinsurance recoverable was included as part of the net assets disposed. There was no material impact to operating results from these reinsurance transactions. On July 2, 2018 and July 11, 2018, we along with TPG Capital, or TPG, and Welsh, Carson, Anderson & Stowe, or WCAS, collectively, the Sponsors, completed the acquisitions of Kindred and Curo, respectively, merging Curo with the hospice business of Kindred at Home. As part of these transactions, we acquired a 40% minority interest in the combined business, Kindred at Home, a for total cash consideration of approximately $1.1 billion. On April 10, 2018, we acquired Family Physicians Group, or FPG, for cash consideration of approximately $185 million, net of cash received. FPG is one of the largest at-risk providers serving Medicare Advantage and Managed Medicaid HMO patients in Greater Orlando, Florida with a footprint that includes clinics located in Lake, Orange, Osceola and Seminole counties. On March 1, 2018, we acquired the remaining equity interest in MCCI Holdings LLC, or MCCI, a privately held management service organization headquartered in Miami, Florida, that primarily coordinates medical care for Medicare Advantage beneficiaries in Florida and Texas. The purchase price consisted primarily of $169 million cash, as well as our existing investment in MCCI and a note receivable and a revolving note with an aggregate balance of $383 million. These transactions are more fully discussed in Note 3 to the consolidated financial statements. Highlights Consolidated • Our 2018 results reflect the continued implementation of our strategy to offer our members affordable health care combined with a positive consumer experience in growing markets. At the core of this strategy is our integrated care delivery model, which unites quality care, high member engagement, and sophisticated data analytics. Our approach to primary, physician-directed care for our members aims to provide quality care that is consistent, integrated, cost-effective, and member-focused, provided by both employed physicians and physicians with network contract arrangements. The model is designed to improve health outcomes and affordability for individuals and for the health system as a whole, while offering our members a simple, seamless healthcare experience. We believe this strategy is positioning us for long-term growth in both membership and earnings. We offer providers a continuum of opportunities to increase the integration of care and offer assistance to providers in transitioning from a fee-for-service to a value-based arrangement. These include performance bonuses, shared savings and shared risk relationships. At December 31, 2018, approximately 2,039,100 members, or 67%, of our individual Medicare Advantage members were in value-based relationships under our integrated care delivery model, as compared to 1,901,300 members, or 66%, at December 31, 2017. • Our consolidated pretax income was $2.06 billion for 2018 compared to $4.02 billion in 2017. A number of significant items effected our year-over-year comparisons including the following: ◦ The net gain associated with the terminated Merger Agreement, mainly the break-up fee of $936 million in 2017. ◦ The loss on sale of KMG of $786 million in 2018. ◦ Charges in 2017 of $219 million associated with voluntary and involuntary workforce reduction programs, the Penn Treaty guaranty fund assessment and costs associated with the early retirement of debt. ◦ Lower year-over-year segment earnings in our Retail, Group and Specialty and Healthcare Services segments reflects the impact of investing the benefit of a lower tax rate from the 2017 Tax Reform Law into the establishment of an annual incentive compensation program for a broader range of employees, together with additional investments in the communities of our members, technology and our integrated care delivery model to drive more affordable healthcare and better clinical outcomes. ◦ Our year-over-year pretax comparisons were also favorably impacted by strong Medicare Advantage membership growth and operating efficiencies from productivity initiatives implemented in 2017. These increases were partially offset by enhanced 2018 Medicare Advantage benefits resulting from investing the better than expected 2017 individual Medicare Advantage pretax earnings, coupled with the return of the health insurance industry fee, and a more severe flu season in 2018. • Year-over-year comparisons of diluted earnings per common share were also favorably impacted by a lower number of shares used to compute earnings per common share from share repurchases and the impact of a lower tax rate for the year ended December 31, 2018.The 2017 Tax Reform Law coupled with the tax benefit from the sale of KMG, partially offset by return of the nondeductible health insurance industry fee, drove the lower tax rate in 2018. • We returned capital to our shareholders in the form of increased shareholder dividends and significant share repurchase. In 2018, we increased our per share dividend by 25% and repurchased shares worth approximately $1.1 billion, including the accelerated share repurchase agreement, or ASR, that we entered into in November 2018. • The annual health insurance industry fee was suspended for calendar year 2017, but resumed in 2018. Operating costs associated with the health insurance industry fee attributable to 2018 were $1.04 billion paid in October 2018. This fee is not deductible for tax purposes, which increases our effective income tax rate. The one-year suspension in 2017 of the health insurance industry fee significantly reduced our operating costs and effective tax rate during 2017. The annual health insurance industry fee is also suspended for calendar year 2019, but under current law is scheduled to resume for calendar year 2020. Retail Segment • Individual and Group Medicare Advantage membership increased 259,600 members, or 7.9%, in 2018 to 3,561,800 members December 31, 2018. • On January 30, 2019, after the stock market closed, the Centers for Medicare and Medicaid Services (CMS) issued its preliminary 2020 Medicare Advantage and Part D payment rates and proposed policy changes (collectively, the Advance Notice). CMS has invited public comment on the Advance Notice before publishing final rates on April 1, 2019 (the Final Notice). In the Advance Notice, CMS estimates Medicare Advantage plans across the sector will, on average, experience a 1.59 percent increase in benchmark funding based on proposals included therein. As indicated by CMS, its estimate excludes the impact of fee-for-service county rebasing/re-pricing since the related impact is dependent upon finalization of certain data, which will be available with the publication of the Final Notice. Based on our preliminary analysis using the same factors CMS included in its estimate, the components of which are detailed on CMS’ website, we anticipate the proposals in the Advance Notice would result in a change to our benchmark funding relatively in line with CMS’ estimate. We will be drawing upon our program expertise to provide CMS formal commentary on the impact of the Advance Notice and the related impact upon Medicare beneficiaries’ quality of care and service to our members through the Medicare Advantage program. • On April 24, 2018, we received a Notice of Intent to be Awarded a Comprehensive Medicaid Contract under Florida’s Statewide Managed Medicaid Program in all 11 regions, including the South Florida, Tampa, Jacksonville, and Orlando metro areas. The comprehensive program combines the traditional Medicaid, or TANF, and Long-Term Care programs. Phase-in under the new contract began December 2018 and was fully implemented February 1, 2019. • In October 2018, CMS published its updated Star quality ratings for bonus year 2020. We received a 5-star rating on CMS' 5-star rating system for two MA contracts offered in Florida and Tennessee. In addition, we received a 4.5-star rating for two MA contracts offered in Florida, Illinois, Kentucky, Mississippi, North Carolina, and Oregon. We have 12 contracts rated 4-star or above and 3 million members in 4-star or above rated contracts to be offered in 2019, representing 84% of our MA membership as of July 2018. The achievement of a 5-star rating for two MA contracts in Florida and Tennessee provides us the ability to market for these contracts throughout the year, creating an opportunity for increased penetration in these important geographies. We cannot guarantee, however, our ability to maintain or improve our star ratings. Group and Specialty Segment • During 2018, we transitioned to the new, larger T2017 East Region contract increasing membership 2,846,800 or 92.4%.The T2017 East Region contract is a consolidation of the former T3 North and South Regions, comprising thirty-two states and approximately 6 million TRICARE beneficiaries, under which delivery of health care services commenced on January 1, 2018. The T2017 East Region contract is a 5-year contract set to expire on December 31, 2022 and is subject to renewals on January 1 of each year during its term at the government's option. Healthcare Services Segment • We continued to invest in our Healthcare Services segment necessary to drive effective care delivery and clinical outcomes with our acquisitions of MCCI and FPG and our 40% investment in Kindred at Home. • Medicare Advantage and dual demonstration program membership enrolled in a Humana chronic care management program was 716,000 at December 31, 2018, a decrease of 9.9% from 794,900 at December 31, 2017. These members may not be unique to each program since members have the ability to enroll in multiple programs. We have undergone an optimization process that ensures the appropriate level of member interaction with clinicians to drive quality outcomes, which has resulted in improved Retail segment operating results. Health Care Reform The Health Care Reform Law enacted significant reforms to various aspects of the U.S. health insurance industry. Certain significant provisions of the Health Care Reform Law include, among others, mandated coverage requirements, mandated benefits and guarantee issuance associated with commercial medical insurance, rebates to policyholders based on minimum benefit ratios, adjustments to Medicare Advantage premiums, the establishment of federally facilitated or state-based exchanges coupled with programs designed to spread risk among insurers, and the introduction of plan designs based on set actuarial values. In addition, the Health Care Reform Law established insurance industry assessments, including an annual health insurance industry fee. The annual health insurance industry fee levied on the insurance industry is $14.3 billion in 2018 and is not deductible for income tax purposes, which significantly increases our effective income tax rate. A one year suspension of the health insurance industry fee, as we experienced in 2017 and are experiencing in 2019, significantly impacts our trend in key operating metrics including our operating cost and medical expense ratios, as well as our effective tax rate. The annual health insurance industry fee is scheduled to resume for calendar year 2020 under current law. As noted above, the Health Care Reform Law required the establishment of health insurance exchanges for individuals and small employers to purchase health insurance that became effective January 1, 2014, with an annual open enrollment period. Although we previously participated in these exchanges by offering on-exchange individual commercial medical plans, effective January 1, 2018, we have exited our Individual Commercial medical business. On November 2, 2017, we filed suit against the United States of America in the United States Court of Federal Claims, on behalf of our health plans seeking recovery from the federal government of approximately $611 million in payments under the risk corridor premium stabilization program established under the Health Care Reform Law, for years 2014, 2015 and 2016. Our case has been stayed by the Court, pending resolution of similar cases filed by other insurers. It is reasonably possible that the Health Care Reform Law and related regulations, as well as future legislative, judicial or regulatory changes, including restrictions on our ability to manage our provider network or otherwise operate our business, or restrictions on profitability, including reviews by regulatory bodies that may compare our Medicare Advantage profitability to our non-Medicare Advantage business profitability, or compare the profitability of various products within our Medicare Advantage business, and require that they remain within certain ranges of each other, in the aggregate may have a material adverse effect on our results of operations (including restricting revenue, enrollment and premium growth in certain products and market segments, restricting our ability to expand into new markets, increasing our medical and operating costs, further lowering our Medicare payment rates and increasing our expenses associated with the non-deductible health insurance industry fee and other assessments); our financial position (including our ability to maintain the value of our goodwill); and our cash flows. We intend for the discussion of our financial condition and results of operations that follows to assist in the understanding of our financial statements and related changes in certain key items in those financial statements from year to year, including the primary factors that accounted for those changes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and clinical care services, to our Retail and Group and Specialty segment customers and are described in Note 17 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this 2018 Form 10-K. Comparison of Results of Operations for 2018 and 2017 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2018 and 2017: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs, excluding depreciation and amortization, as a percentage of total revenues less investment income. Summary Net income for 2018 was $1.7 billion, or $12.16 per diluted common share compared to $2.4 billion, or $16.81 per diluted common share, in 2017. This comparison was impacted by the loss on sale of KMG in 2018, the Merger Agreement break-up fee in 2017, the suspension of the health insurance industry fee for calendar year 2017, the exit out of the Individual Commercial business effective January 1, 2018, a lower tax rate due to the Tax Reform Law, charges associated with both voluntary and involuntary workforce reduction programs in 2017, and the estimated guaranty fund assessment expense to support the policyholders obligation of Penn Treaty in 2017. After consideration of these items, our earnings were favorably impacted by strong Medicare Advantage membership growth and significant operating efficiencies in 2018 driven by productivity initiatives implemented in 2017. These increases were partially offset by our offering of enhanced 2018 Medicare Advantage member benefits which resulted from the investment of the better than expected 2017 individual Medicare Advantage pretax earnings, coupled with the return of the health insurance industry fee and the more severe flu season during the first quarter of 2018.The comparison of diluted earnings per common share are also impacted by a lower number of shares from share repurchases. Premiums Revenue Consolidated premiums increased $2.6 billion, or 4.9%, from $52.4 billion for 2017 to $54.9 billion for 2018 primarily driven by higher Medicare Advantage revenues, partially offset by the impact of lower revenues from the exit of the Individual Commercial business. Services Revenue Consolidated services revenue increased $475 million, or 48.4%, from $982 million for 2017 to $1.5 billion for 2018, primarily due to an increase in services revenue in the Healthcare Services and Group and Specialty segments, as discussed in the detailed segment results discussion that follows. Investment Income Investment income was $514 million for 2018, increasing $109 million, or 26.9%, from 2017, primarily due to higher realized capital gains and higher interest rates in 2018, partially offset by lower average invested balances. Benefits Expense Consolidated benefits expense was $45.9 billion for 2018, an increase of $2.4 billion, or 5.5%, from 2017 reflecting an increase in the Retail and Group and Specialty segments benefits expense as discussed in the detailed segment results discussion that follows. These increases were partially offset by a decrease in the Individual Commercial segment benefits expense. As more fully described herein under the section entitled “Benefits Expense Recognition”, actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $503 million in 2018 and $483 million in 2017. The consolidated benefit ratio for 2018 was 83.5%, an increase of 50 basis points from 2017 primarily due to the enhanced 2018 Medicare Advantage member benefits resulting from the investment of the better than expected 2017 individual Medicare Advantage pretax earnings and a more severe flu season in the first quarter of 2018. These items were partially offset by the positive impact from the reinstatement of the health insurance industry fee in 2018, which was contemplated in the pricing and benefit design of our products and higher favorable prior-period reserve development. Favorable prior-period medical claims reserve development decreased the consolidated benefit ratio by approximately 90 basis points in both 2018 and 2017. Operating Costs Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs increased $958 million, or 14.6%, from 2017 to $7.5 billion in 2018 reflecting an increase in the Retail and Group and Specialty segments discussed in the detailed segment results discussion that follows. These increases were partially offset by a decrease in the Individual Commercial segment operating costs. The consolidated operating cost ratio for 2018 was 13.3%, increasing 100 basis points from 12.3% in 2017 primarily due to the reinstatement of the health insurance industry fee in 2018, and long term sustainability investments made in 2018 as a result of the Tax Reform Law. Our long-term sustainability investments include the continuation of investments in our associate workforce, primarily the establishment of an annual incentive program for a broader range of employees, together with additional investments in the communities of our members, technology and our integrated care delivery model to drive more affordable healthcare and better clinical outcomes, and an increase in incentive compensation costs under the expanded program noted above. The ratio was further impacted by the growth in our military services business, which carries a higher operating ratio than our other products, due to the previously disclosed transition to the T2017 East Region contract effective January 1, 2018. These items were partially offset by the favorable impact of significant operating cost efficiencies in 2018 driven by productivity initiatives implemented in 2017, the impact of the charges recorded in 2017 associated with the voluntary and involuntary workforce reduction program, and the favorable year-over-year comparison of the impact of the guaranty fund assessment expense to support policyholder obligations of Penn Treaty in 2017, as well as the exit of the Individual Commercial business effective January 1, 2018, which carried a higher operating cost ratio than our other products. The nondeductible health insurance industry fee impacted the operating cost ratio by approximately 180 basis points in 2018. Depreciation and Amortization Depreciation and amortization in 2018 totaled $405 million compared to $378 million in 2017, an increase of 7.1%, primarily due to capital expenditures, the acquisitions of MCCI and FPG, and the write-off of a trade name value reflecting the re-branding of certain provider assets. Interest Expense Interest expense was $218 million for 2018 compared to $242 million for 2017, a decrease of $24 million, or 9.9%, primarily as a result of the early redemption of higher rate debt in December 2017. Income Taxes Our effective tax rate during 2018 was 18.9% compared to the effective tax rate of 39.1% in 2017. This decrease is primarily due to the Tax Reform Law and the tax benefit resulting from the sale of KMG, partially offset by the impact of the reinstatement of the non-deductible health insurance industry fee in 2018. See Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. Retail Segment Segment Earnings • Retail segment earnings were $1.7 billion in 2018, a decrease of $245 million, or 12.4%, compared to 2017 reflecting a higher operating cost ratio in 2018, partially offset by a lower benefit ratio. Enrollment • Individual Medicare Advantage membership increased 203,200 members, or 7.1%, from December 31, 2017 to December 31, 2018 reflecting net membership additions associated with last year's Annual Election Period, or AEP, for Medicare beneficiaries. For full year 2019, we anticipate net membership growth in our individual Medicare Advantage offerings of 375,000 to 400,000. • Group Medicare Advantage membership increased 56,400 members, or 12.8%, from December 31, 2017 to December 31, 2018 reflecting increased sales to our existing group accounts during last year's AEP for Medicare beneficiaries. For full year 2019, we anticipate net membership growth in our group Medicare Advantage offerings of approximately 30,000. • Medicare stand-alone PDP membership decreased 303,800 members, or 5.7%, from December 31, 2017 to December 31, 2018 reflecting net declines during last year's AEP for Medicare beneficiaries. These declines primarily resulted from the previously disclosed loss of auto assigned members in Florida and South Carolina due to pricing over the CMS low income benchmark and continued membership declines in our Enhanced Plan. In addition, growth in our co-branded Walmart plan was significantly lower than historical levels due to the introduction of additional low-priced competitor offerings in many regions. For the full year 2019, we anticipate a net membership decline in our Medicare stand-alone PDP offerings of 700,000 to 750,000. • State-based Medicaid membership decreased 19,000 members, or 5.3%, from December 31, 2017 to December 31, 2018, primarily driven by our election not to participate in Illinois' Medicaid Integrated Care Program and the Virginia Long Term Support Services contract that replaced the state's previous stand-alone dual eligible demonstration program in December 2017. Year-over-year decline was also impacted by lower membership associated with our Florida Medicaid contract due to overall strengthening economic conditions, partially offset by the addition of members associated with the new Florida Managed Medical Assistance program from the contract phase-in for certain regions that began December 1, 2018. Premiums revenue • Retail segment premiums increased $3.5 billion, or 7.8%, from 2017 to 2018 primarily reflecting individual and group Medicare Advantage membership growth in last year's AEP as well as increased per-member premiums for certain of the segment's products, partially offset by declines in stand-alone PDP and state-based contracts revenues resulting from year-over-year membership declines discussed above. Average group and individual Medicare Advantage membership increased 7.6% in 2018. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Premiums revenue reflects changes in membership and average per-member premiums. Items impacting average per-member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership. Benefits expense • The Retail segment benefit ratio of 85.1% for 2018 decreased 50 basis points from 2017 primarily due to the reinstatement of the non-deductible health insurance industry fee in 2018 which was contemplated in the pricing and benefit design of our products, partially offset by the unfavorable impact from enhanced 2018 Medicare Advantage member benefits resulting from the investment of the better than expected 2017 individual Medicare Advantage pretax earnings. 2018 was also impacted by a more severe flu season. • The Retail segment’s benefits expense for 2018 included the beneficial effect of $398 million in favorable prior-year medical claims reserve development versus $386 million in 2017. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 80 basis points in 2018 versus approximately 90 basis points in 2017. Operating costs • The Retail segment operating cost ratio of 11.1% for 2018 increased 150 basis points from 2017 primarily due to the reinstatement of the health insurance industry fee in 2018 and increase in incentive compensation costs under the expanded program, resulting from the strategic investments made in 2018 as a result of the Tax Reform Law. These items were partially offset by significant operating cost efficiencies in 2018 driven by productivity initiatives implemented in 2017. • The non-deductible health insurance industry fee increased the operating cost ratio by approximately 190 basis points in 2018. Group and Specialty Segment (a) Specialty products include dental, vision, voluntary benefit products and other supplemental health benefits and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Segment Earnings • Group and Specialty segment earnings were $361 million in 2018, a decrease of $51 million, or 12.4%, from $412 million in 2017 primarily reflecting higher benefit and operating cost ratios in 2018, partially offset by a favorable year-over-year earnings comparison for our group ASO commercial medical business. Enrollment • Fully-insured commercial group medical membership decreased 93,000 members, or 8.5% from December 31, 2017 primarily reflecting lower membership in small group accounts due in part to more small group accounts selecting level-funded ASO products in 2018. The portion of group fully-insured commercial medical membership in small group accounts was approximately 61% at December 31, 2018 and 64% at December 31, 2017. • Group ASO commercial medical membership increased 23,200 members, or 5.1%, from December 31, 2017 to December 31, 2018 reflecting more small group accounts selecting level-funded ASO products in 2018, partially offset by the loss of certain large group accounts as a result of continued discipline in pricing of services for self-funded accounts amid a highly competitive environment. • Specialty membership decreased 913,700 members, or 13.1%, from December 31, 2017 to December 31, 2018 primarily resulted from the exit of our voluntary benefits and financial protection lines of business in connection with the sale of KMG, as well as the loss of some large group accounts offering stand-alone dental and vision products. These decreases were partially offset by an increase in individual dental and vision membership. Premiums revenue • Group and Specialty segment premiums increased $31 million, or 0.5%, from 2017 to 2018 primarily due to higher stop-loss premiums related to our level funded ASO accounts resulting from membership growth in this product, and higher per-member premiums across the commercial fully-insured business, partially offset by the exit of our voluntary benefits and financial protection lines of business in connection with the sale of KMG, as well as declines in average group fully-insured commercial medical membership. Services revenue • Group and Specialty segment services revenue increased $209 million, or 33.4%, from 2017 to 2018 as a result of the transition to the TRICARE T2017 East Region contract on January 1, 2018. Benefits expense • The Group and Specialty segment benefit ratio increased 50 basis points from 79.2% in 2017 to 79.7% in 2018 primarily due to retroactive contractual rate adjustments, membership mix, including the continued migration of healthier groups to level funded ASO products in 2018, and the impact of the exit of our voluntary benefits and financial protection lines of business in connection with the sale of KMG, which carried a very low benefit ratio. These factors were partially offset by the reinstatement of the health insurance industry fee in 2018 which was contemplated in the pricing of our products, and higher favorable prior-period reserve development. • The Group and Specialty segment’s benefits expense included the beneficial effect of $46 million in favorable prior-year medical claims reserve development in 2018 versus $40 million in 2017. This favorable prior-year medical claims reserve development decreased the Group and Specialty segment benefit ratio by approximately 70 basis points in 2018 versus approximately 60 basis points in 2017. Operating costs • The Group and Specialty segment operating cost ratio of 23.6% for 2018 increased 220 basis points from 21.4% for 2017. These increases primarily were due to the reinstatement of the health insurance industry fee in 2018, growth in our military services business, which carries a higher operating cost ratio than other products within the segment, as a result of the transition to the TRICARE T2017 East Region contract, an increase in incentive compensation costs under the expanded program resulting from the strategic investments made in 2018 as a result of the Tax Reform Law. These items were partially offset by significant operating cost efficiencies driven by productivity initiatives implemented in 2017, and the impact of the exit of our voluntary benefits and financial protection lines of business in connection with the sale of KMG. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 160 basis points in 2018. Healthcare Services Segment Segment Earnings • Healthcare Services segment earnings were $754 million in 2018, a decrease of $213 million, or 22.0%, from 2017 primarily due to the impact of the optimization process associated with our chronic care management programs and investments made in 2018 as a result of the Tax Reform Law, partially offset by the impact of Kindred at Home. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Group and Specialty segment membership increased to approximately 440 million in 2018, up 2% versus scripts of approximately 433 million in 2017. The increase primarily reflects growth associated with higher Individual Advantage Medicare membership, partially offset by the decline in stand-alone PDP and Individual Commercial membership. Services revenue • Services revenue increased $269 million, or 79.6%, from 2017 to $607 million for 2018 primarily due to service revenue growth from our provider services and pharmacy solutions business. Intersegment revenues • Intersegment revenues decreased $415 million, or 1.8%, from 2017 to $23.2 billion for 2018 primarily due to a decline in pharmacy solutions revenue due to lower stand-alone PDP membership, the loss of intersegment revenues associated with our exit from the Individual commercial business, the result of improving the effectiveness of our chronic care management programs, and the impact to our provider services business of the lower Medicare rates year-over-year in geographies where our provider assets are primarily located. These declines were partially offset by Medicare Advantage membership growth as well as higher intersegment revenues associated with our provider services business reflecting our acquisition of MCCI. Operating costs • The Healthcare Services segment operating cost ratio of 96.3% for 2018 increased from 95.5% for 2017 primarily due to an increase in incentive compensation costs under the expanded program resulting from the strategic investments made in 2018 as a result of the Tax Reform Law and the lag in operating cost reduction associated with improving the effectiveness of our chronic care management programs as compared to the timing of reduction in revenue. These items were partially offset by significant operating cost efficiencies in 2018 driven by productivity initiatives implemented in 2017. Individual Commercial Segment • In 2018, our Individual Commercial segment pretax income was $74 million, a decrease of $119 million, from a pretax income of $193 million in 2017 primarily due to the impact of favorable prior-period reserve development from the run-out of this business. We exited this business effective January 1, 2018. Other Businesses As previously disclosed, in the third quarter of 2018, we completed the sale of our wholly-owned subsidiary KMG, as discussed further in Note 3 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this 2018 Form 10-K. Comparison of Results of Operations for 2017 and 2016 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2017 and 2016: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs, excluding depreciation and amortization, as a percentage of total revenues less investment income. Summary Net income was $2.4 billion, or $16.81 per diluted common share, in 2017 compared to $614 million, or $4.07 per diluted common share, in 2016. Net income in 2017 includes a net gain of $4.31 per diluted common share associated with the terminated Merger Agreement consisting primarily of the break-up fee, and the beneficial effect of the lower effective tax rate in light of pricing and benefit design assumptions with the temporary suspension of the health insurance industry fee of $2.15 per diluted common share, excluding the Individual Commercial business impact. The year-over-year comparison was also favorably impacted by a write-off of $2.43 per diluted common share in receivables associated with the commercial risk corridor premium stabilization program, and the reserve strengthening for our non-strategic closed block of long-term care insurance business of $2.11 per common diluted share recorded in 2016. These items were partially offset by the impact of the tax reform law enacted on December 22, 2017, or the Tax Reform Law, which resulted in the reduction of our net income due to the remeasurement of deferred tax assets at lower enacted corporate tax rates of $0.92 per diluted common share, $0.64 per common diluted share in charges associated with both voluntary and involuntary workforce reduction programs in 2017, as well as the estimated guaranty fund assessment expense to support the policyholder obligations of Penn Treaty (an unaffiliated long-term care insurance company) of $0.24 per diluted common share. Excluding the impacts of the items above, the increase in net income primarily was due to year-over-year improvements in earnings for our Individual Commercial, Retail, and Group and Specialty segments, partially offset by lower earnings in the Healthcare Services segment. Premiums Revenue Consolidated premiums decreased $641 million, or 1.2%, from 2016 to $52.4 billion for 2017 primarily due to lower premiums in the Individual Commercial segment, partially offset by higher premiums in the Retail segment, primarily resulting from growth in our Medicare Advantage business, and higher premiums in the Group and Specialty segment, as discussed in the detailed segment results discussion that follows. Services Revenue Consolidated services revenue increased $13 million, or 1.3%, from 2016 for 2017 primarily due to an increase in services revenue in the Healthcare Services segment, partially offset by a decrease in services revenue in the Group and Specialty segment as discussed in the detailed segment results discussion that follows. Investment Income Investment income totaled $405 million for 2017, increasing $16 million, or 4.1%, from 2016, primarily due to higher average invested balances and interest rates in 2017, partially offset by lower realized capital gains. Benefits Expense Consolidated benefits expense was $43.5 billion for 2017, a decrease of $1.5 billion, or 3.4%, from 2016 reflecting $505 million in incremental benefits expense for the reserve strengthening in our non-strategic closed block of long-term care insurance policies recorded in 2016. Excluding the long-term care reserve strengthening in 2016, the decrease primarily was due to a decrease in the Individual Commercial segment benefits expense, partially offset by an increase in the Retail and Group and Specialty segments benefits expense as discussed in the detailed segment results discussion that follows. As more fully described herein under the section entitled “Benefits Expense Recognition”, actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $483 million in 2017 and $582 million in 2016. The consolidated benefit ratio for 2017 was 83.0%, a decrease of 190 basis points from 2016 primarily due to the incremental benefits expense in 2016 for the reserve strengthening in our non-strategic closed block of long-term care insurance policies. Excluding the impact of the above, the decrease in the consolidated benefit ratio primarily was due to the decrease in the Individual Commercial segment benefit ratio, partially offset by the increase in the Retail and Group and Specialty segment benefit ratio as discussed in the segment results of operation discussion that follows. Favorable prior-period medical claims reserve development decreased the consolidated benefit ratio by approximately 90 basis points in 2017 versus approximately 110 basis points in 2016. Operating Costs Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs decreased $606 million, or 8.4%, from 2016 to $6.6 billion in 2017 primarily due to the temporary suspension of the health insurance industry fee for the calendar year 2017 and lower Individual Commercial membership. This was partially offset by charges associated with both voluntary and involuntary workforce reduction programs, an increase in employee compensation costs resulting from the continued strong performance, increased spending associated with the Medicare Annual Election Period, or AEP, as well as the estimated guaranty fund assessment expense recorded to support the policyholder obligations of Penn Treaty (an unaffiliated long-term care insurance company). The consolidated operating cost ratio for 2017 was 12.3%, decreasing 100 basis points from 2016 primarily due to the temporary suspension of the health insurance industry fee for the calendar year 2017, the write-off of receivables associated with the commercial risk corridor premium stabilization program in 2016, as well as operating cost efficiencies, partially offset by the loss of scale efficiency from market exits in the 2017 period associated with the Individual Commercial product, the estimated charges associated with both voluntary and involuntary workforce reduction programs recorded in 2017, increased employee compensation costs resulting from the continued strong performance, as well as the impact of the estimated guaranty fund assessment expense recorded to support the policyholder obligations of Penn Treaty (an unaffiliated long-term care insurance company). The non-deductible health insurance industry fee impacted the operating cost ratio by 170 basis points in 2016. Depreciation and Amortization Depreciation and amortization for 2017 of $378 million was relatively unchanged from 2016. Interest Expense Interest expense was $242 million for 2017 compared to $189 million for 2016, an increase of $53 million, or 28.0% due to the issuance of $1.8 billion in senior notes, a portion of the proceeds which were used to redeem $800 million of senior notes scheduled to mature in 2018. We recognized a loss on extinguishment of debt of approximately $17 million in December 2017 for the redemption of these senior notes, which is included in interest expense. Income Taxes Our effective tax rate during 2017 was 39.1% compared to the effective tax rate of 60.5% in 2016 primarily reflecting the suspension of the annual health insurance industry fee in 2017, as well as previously non-deductible transaction costs that, as a result of termination of the Merger Agreement, became deductible for tax purposes and were recorded as such in the first quarter of 2017, partially offset by the Tax Reform Law, which increased our effective tax rate due to the remeasurement of deferred tax assets at lower enacted corporate tax rates. See Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. Retail Segment Segment Earnings • Retail segment earnings were $2.0 billion in 2017, an increase of $288 million, or 17.0%, compared to 2016 primarily driven by the year-over-year improvement in our Medicare Advantage business. Enrollment • Individual Medicare Advantage membership increased 23,200 members, or 0.8%, from December 31, 2016 to December 31, 2017 reflecting net membership additions for Medicare beneficiaries including the effect of planned market and product exits in 2017. We decided certain markets and/or products were not meeting long term strategic and financial objectives. Additionally, membership growth was muted due to competitive actions including the uncertainty associated with the then-pending Merger transaction during last year's AEP. • Group Medicare Advantage membership increased 86,000 members, or 24.2%, from December 31, 2016 to December 31, 2017 reflecting the addition of a large account in January 2017. • Medicare stand-alone PDP membership increased 356,700 members, or 7.2%, from December 31, 2016 to December 31, 2017 reflecting net membership additions, primarily for our Humana-Walmart plan offering, for the 2017 plan year. • State-based Medicaid membership decreased 28,000 members, or 7.2%, from December 31, 2016 to December 31, 2017 primarily driven by lower membership associated with our Florida contracts resulting from network realignments. Premiums revenue • Retail segment premiums increased $1.4 billion, or 3.2%, from 2016 to 2017 primarily due to Medicare Advantage membership growth and increased per-member premiums for certain of the segment's products. Average group and individual Medicare Advantage membership increased 3.4% in 2017. Average membership is calculated by summing the ending membership for each month in a period and dividing the result by the number of months in a period. Premiums revenue reflects changes in membership and average per-member premiums. Items impacting average per-member premiums include changes in premium rates as well as changes in the geographic mix of membership, the mix of product offerings, and the mix of benefit plans selected by our membership. Benefits expense • The Retail segment benefit ratio of 85.6% for 2017 increased 50 basis points from 2016 primarily due to the impact of the temporary suspension of the health insurance industry fee for calendar year 2017 which was contemplated in the pricing and benefit design of our products, margin compression associated with the competitive environment in the group Medicare Advantage business and slightly lower favorable prior-period medical claims reserve development. These increases were partially offset by the impact of planned exits from certain Medicare Advantage markets that carried a higher benefit ratio than other markets as well as lower than expected medical costs as compared to the assumptions used in the pricing of our individual Medicare Advantage business. • The Retail segment’s benefits expense for 2017 included the beneficial effect of $386 million in favorable prior-year medical claims reserve development versus $429 million in 2016. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 90 basis points in 2017 versus approximately 100 basis points in 2016. Operating costs • The Retail segment operating cost ratio of 9.6% for 2017 decreased 120 basis points from 2016 primarily due to the temporary suspension of the health insurance industry fee for calendar year 2017, partially offset by increased spending associated with AEP, investments in our integrated care delivery model, and the increase in employee compensation costs resulting from the continued strong performance. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 170 basis points in 2016. Group and Specialty Segment (a) Specialty products include dental, vision, voluntary benefit products and other supplemental health and financial protection products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Segment Earnings • Group and Specialty segment earnings were $412 million in 2017, an increase of $68 million, or 19.8%, from $344 million in 2016 primarily reflecting the impact of higher pretax earnings associated with our fully-insured commercial business as well as higher earnings from our military services business resulting from higher performance incentives earned under the TRICARE contract. Enrollment • Fully-insured commercial group medical membership decreased 38,300 members, or 3.4% from December 31, 2016 reflecting lower membership in small group accounts due in part to more small group accounts selecting ASO products in 2017. • Group ASO commercial medical membership decreased 114,500 members, or 20.0%, from December 31, 2016 to December 31, 2017 primarily due to the loss of certain large group accounts as a result of continued discipline in pricing of services for self-funded accounts amid a highly competitive environment, partially offset by more small group accounts selecting ASO products in 2017. • Specialty membership increased 24,800 members, or 0.4%, from December 31, 2016 to December 31, 2017 primarily due to strong growth in vision products marketed to employer groups. Premiums revenue • Group and Specialty segment premiums increased $76 million, or 1.1%, from 2016 to 2017 primarily due to an increase in group fully-insured commercial medical per-member premiums, partially offset by a decline in average group fully-insured commercial medical membership. Services revenue • Group and Specialty segment services revenue decreased $17 million, or 2.6%, from 2016 to 2017 primarily due to a decline in revenue in our group ASO commercial medical business mainly due to membership declines partially offset by higher revenue from our military services business resulting from higher performance incentives earned under the TRICARE contract. Benefits expense • The Group and Specialty segment benefit ratio increased 100 basis points from 78.2% in 2016 to 79.2% in 2017 primarily due to the impact of the temporary suspension of the health insurance industry fee for calendar year 2017 which was contemplated in the pricing of our products. The increase was further impacted by an increased proportion of small group members transitioning to community rated plans that carry a higher benefit ratio. These increases were partially offset by lower utilization for the fully-insured commercial medical business in 2017, primarily associated with the large group business. • The Group and Specialty segment’s benefits expense included the beneficial effect of $40 million in favorable prior-year medical claims reserve development in 2017 versus $46 million in 2016. This favorable prior-year medical claims reserve development decreased the Group and Specialty segment benefit ratio by approximately 60 basis points in 2017 versus approximately 70 basis points in 2016. Operating costs • The Group and Specialty segment operating cost ratio of 21.4% for 2017 decreased 210 basis points from 23.5% for 2016, primarily due to the temporary suspension of the health insurance industry fee for calendar year 2017 as well as operating cost efficiencies, partially offset by an increase in employee compensation costs resulting from the continued strong performance. The non-deductible health insurance industry fee increased the operating cost ratio by approximately 150 basis points in 2016. Healthcare Services Segment Segment Earnings • Healthcare Services segment earnings of $967 million for 2017, a decrease of $129 million, or 11.8%, from 2016 primarily due to the impact of the optimization process associated with our chronic care management programs, as well as lower earnings in our provider services business reflecting lower Medicare rates year-over-year in geographies where our provider assets are primarily located. The reductions in pharmacy solutions intersegment revenues were offset by similar reductions in operating costs associated with the pharmacy solutions business. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Group and Specialty segment membership increased to approximately 433 million in 2017, up 2% versus scripts of approximately 426 million in 2016. The increase primarily reflects growth associated with higher Medicare membership for 2017 than in 2016, partially offset by the decline in Individual Commercial membership. Services revenue • Services revenue increased $28 million, or 9.0%, from 2016 to $338 million for 2017 primarily due to service revenue growth from our pharmacy solutions business. Intersegment revenues • Intersegment revenues decreased $1.4 billion, or 5.6%, from 2016 to $23.6 billion for 2017 primarily due to care management programs discussed previously, as well as lower revenue in our provider services business reflecting lower Medicare rates year-over-year in geographies where our provider assets are primarily located. Our pharmacy solutions business revenues were impacted by improvements in net pharmacy costs driven by our pharmacy benefit manager and an increase in the generic dispensing rate. These items were partially offset by higher year-over-year script volume from growth in our Medicare Advantage and standalone PDP membership, partially offset by the impact of lower Individual Commercial membership. Our generic dispensing rate improved to 91.3% during 2017 from 90.5% during 2016. The higher generic dispensing rate reduced revenues (and operating costs) for our pharmacy solutions business as generic drugs are generally priced lower than branded drugs. Operating costs • The Healthcare Services segment operating cost ratio of 95.5% for 2017 was relatively unchanged from 95.2% for 2016. Individual Commercial Segment • As announced on February 14, 2017, we exited our Individual Commercial medical business January 1, 2018. • In 2017, our Individual Commercial segment pretax income was $193 million, an increase of $1.1 billion, from a pretax loss of $869 million in 2016 primarily due to the exit of certain markets in 2017, and per-member premium increases, as well as the reduction of premiums related to the write-off of receivables associated with the commercial risk corridor premium stabilization program. • Individual commercial medical membership decreased 526,000 members, or 80.3%, from December 31, 2016 to December 31, 2017 reflecting the decline in the number of counties we offered on-exchange coverage and the discontinuance of offering off-exchange products. • The Individual Commercial segment benefit ratio of 57.4% for 2017 decreased from 107.7% in 2016 primarily due to the reduction of premiums related to the write-off of receivables associated with the commercial risk corridor premium stabilization program, as well as the planned exits in 2017 in certain markets that carried a higher benefit ratio and per-member premium increases. • The Individual Commercial segment operating cost ratio of 21.2% for 2017 increased 160 basis points from 2016 primarily due to the loss of scale efficiency from market exits in 2017, partially offset by the write-off of receivables associated with the commercial risk corridor premium stabilization program and the temporary suspension of the health insurance industry fee for calendar year 2017. Other Businesses As previously disclosed, in the fourth quarter of 2016, we increased future policy benefits expense by approximately $505 million for reserve strengthening associated with our closed block of long-term care insurance policies. This increase primarily was driven by emerging experience indicating longer claims duration, a prolonged lower interest rate environment, and an increase in policyholder life expectancies as discussed further in Note 18 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data in this 2018 Form 10-K. Liquidity Historically, our primary sources of cash have included receipts of premiums, services revenue, and investment and other income, as well as proceeds from the sale or maturity of our investment securities, borrowings, and proceeds from sales of businesses. Our primary uses of cash historically have included disbursements for claims payments, operating costs, interest on borrowings, taxes, purchases of investment securities, acquisitions, capital expenditures, repayments on borrowings, dividends, and share repurchases. Because premiums generally are collected in advance of claim payments by a period of up to several months, our business normally should produce positive cash flows during periods of increasing premiums and enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing premiums and enrollment. From period to period, our cash flows may also be affected by the timing of working capital items including premiums receivable, benefits payable, and other receivables and payables. Our cash flows are impacted by the timing of payments to and receipts from CMS associated with Medicare Part D subsidies for which we do not assume risk. The use of cash flows may be limited by regulatory requirements of state departments of insurance (or comparable state regulators) which require, among other items, that our regulated subsidiaries maintain minimum levels of capital and seek approval before paying dividends from the subsidiaries to the parent. Our use of cash flows derived from our non-insurance subsidiaries, such as in our Healthcare Services segment, is generally not restricted by state departments of insurance (or comparable state regulators). For additional information on our liquidity risk, please refer to Item 1A. - Risk Factors in this 2018 Form 10-K. Cash and cash equivalents decreased to $2.3 billion at December 31, 2018 from $4.0 billion at December 31, 2017. The change in cash and cash equivalents for the years ended December 31, 2018, 2017 and 2016 is summarized as follows: Cash Flow from Operating Activities The change in operating cash flows over the three year period primarily results from the corresponding change in the timing of working capital items, earnings, and enrollment activity as discussed below. The decrease in operating cash flows in 2018 primarily was due to the receipt of the merger termination fee in 2017, net of related expenses and taxes paid, funding the reinsurance of certain voluntary benefit and financial protection products to a third party in connection with the sale of KMG in 2018, and the timing of working capital items. The increase in operating cash flows in 2017 primarily was due to the receipt of the merger termination fee, net of related expenses and taxes paid, higher earnings and the timing of working capital items. The most significant drivers of changes in our working capital are typically the timing of payments of benefits expense and receipts for premiums. We illustrate these changes with the following summaries of benefits payable and receivables. The detail of benefits payable was as follows at December 31, 2018, 2017 and 2016: (1) IBNR represents an estimate of benefits payable for claims incurred but not reported (IBNR) at the balance sheet date and includes unprocessed claim inventories. The level of IBNR is primarily impacted by membership levels, medical claim trends and the receipt cycle time, which represents the length of time between when a claim is initially incurred and when the claim form is received (i.e. a shorter time span results in a lower IBNR). (2) Reported claims in process represents the estimated valuation of processed claims that are in the post claim adjudication process, which consists of administrative functions such as audit and check batching and handling, as well as amounts owed to our pharmacy benefit administrator which fluctuate due to bi-weekly payments and the month-end cutoff. (3) Premium deficiency reserve recognized for our individual commercial medical business compliant with the Health Care Reform Law associated with the 2016 coverage year. (4) Other benefits payable include amounts owed to providers under capitated and risk sharing arrangements. The increase in benefits payable in 2018 was primarily due to an increase in IBNR, mainly as a result of Medicare Advantage membership growth. The increase in benefits payable from 2016 to 2017 primarily was due to an increase in the amounts owed to providers under the capitated and risk sharing arrangements. This was partially offset by a decrease in IBNR primarily driven by declines in individual commercial medical membership in the 2017 period, partially offset by an increase in group Medicare Advantage membership. Benefits payable decreased in 2016 primarily due to a decrease in IBNR, as well as the application of 2016 results to the premium deficiency reserve liability recognized in 2015 associated with our individual commercial medical products compliant with the Health Care Reform Law for the 2016 coverage year. IBNR decreased during 2017 and 2016 primarily due to declines in individual and fully-insured group commercial membership. The decrease in IBNR during 2016 was also impacted by declines in group Medicare Advantage membership. The detail of total net receivables was as follows at December 31, 2018, 2017 and 2016: Medicare receivables are impacted by changes in revenue associated with individual and group Medicare membership changes as well as the timing of accruals and related collections associated with the CMS risk-adjustment model. The decrease in commercial and other receivables in 2018 as compared to 2017, as well as the decrease in 2017 as compared to 2016, was due primarily to a decrease in our receivable associated with the commercial risk adjustment provision of the Health Care Reform Law. This decrease corresponds with our exit from the Individual Commercial business. Military services receivables at December 31, 2018, 2017, and 2016 primarily consist of administrative services only fees owed from the federal government for administrative services provided under our TRICARE contracts. The 2017 balance also includes transition-in receivables under our T2017 East Region contract collected in 2018. Many provisions of the Health Care Reform Law became effective in 2014, including the commercial risk adjustment, risk corridor, and reinsurance provisions as well as the non-deductible health insurance industry fee. The effect of the commercial risk adjustment, risk corridor, and reinsurance provisions of the Health Care Reform law, also known as the 3R's, has impacted our operating cash flows over the last three years, but more significantly in 2017 and 2016 as the temporary risk corridor and reinsurance program provisions phased out in 2016. The timing of payments and receipts associated with these provisions impacted our operating cash flows as we built receivables for each coverage year that were expected to be collected in subsequent coverage years. Net collections under the 3Rs associated with prior coverage years were $8 million in 2018, $440 million in 2017 and $383 million in 2016. The annual health insurance industry fee was suspended for the calendar year 2017, but resumed in calendar year 2018. The annual health insurance industry fee was also suspended for the calendar year 2019 and, under current law, is scheduled to resume in calendar year 2020. We paid the federal government annual health insurance industry fees of $1.04 billion in 2018 and $916 million in 2016. In addition to the timing of payments of benefits expense, receipts for premiums and services revenues, and amounts due under the risk limiting and health insurance industry fee provisions of the Health Care Reform Law, other items impacting operating cash flows include income tax payments and the timing of payroll cycles. Cash Flow from Investing Activities Our ongoing capital expenditures primarily relate to our information technology initiatives, support of services in our provider services operations including medical and administrative facility improvements necessary for activities such as the provision of care to members, claims processing, billing and collections, wellness solutions, care coordination, regulatory compliance and customer service. Total capital expenditures, excluding acquisitions, were $612 million in 2018, $524 million in 2017, and $527 million in 2016. In 2018, we completed the sale of our wholly-owned subsidiary KMG to CGIC. Upon closing, we funded the transaction with approximately $190 million of parent company cash contributed into KMG, subject to customary adjustments, in addition to the transfer of approximately $160 million of statutory capital with the sale. Total cash and cash equivalents, including parent company funding, disposed at the time of sale, was $805 million. See Note 3 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data During 2018 we paid cash consideration of approximately $1.1 billion to acquire a 40% minority interest in Kindred at Home, $169 million to acquire the remaining interest in MCCI, and $185 million to acquire all of FPG, as discussed in Note 3 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We reinvested a portion of our operating cash flows in investment securities, primarily investment-grade fixed income securities, totaling $221 million, $2.4 billion, and $828 million during 2018, 2017 and 2016 respectively. Cash Flow from Financing Activities Our financing cash flows are significantly impacted by the timing of claims payments and the related receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk. Monthly prospective payments from CMS for reinsurance and low-income cost subsidies are based on assumptions submitted with our annual bid. Settlement of the reinsurance and low-income cost subsidies is based on a reconciliation made approximately 9 months after the close of each calendar year. Claims payments were $653 million higher than receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk during 2018. Receipts from CMS associated with Medicare Part D claims subsidies for which we do not assume risk were $1.9 billion higher than claims payments during 2017 and were $1.1 billion higher than claims payments during 2016. Our net payable for CMS subsidies and brand name prescription drug discounts was $331 million at December 31, 2018 compared to a net payable of $1.0 billion at December 31, 2017. Under our administrative services only TRICARE contract, reimbursements from the federal government exceeded health care cost payments for which we do not assume risk by $38 million in 2018 and by $11 million in 2017. Health care cost payments for which we do not assume risk exceeded reimbursements from the federal government by $25 million in 2016. Claims payments associated with cost sharing provisions of the Health Care Reform Law for which we do not assume risk were $25 million in 2018. There were no reimbursements from HHS in 2018. Claims payments associated with cost sharing provisions of the Health Care Reform Law for which we do not assume risk were higher than reimbursements from HHS by $44 million in 2017 and by $28 million in 2016. We repurchased common shares for $1.09 billion in 2018 and $3.37 billion in 2017 under share repurchase plans authorized by the Board of Directors and in connection with employee stock plans. We did not repurchase shares in 2016 due to restrictions under the Merger Agreement. As discussed further below, we paid dividends to stockholders of $265 million in 2018, $220 million in 2017, and $177 million in 2016. We entered into a commercial paper program in October 2014. Net proceeds from the issuance of commercial paper were $485 million in 2018 and the maximum principal amount outstanding at any one time during 2018 was $923 million. Net repayments of commercial paper were $153 million in 2017 and the maximum principal amount outstanding at any one time during 2017 was $500 million. Net repayments of commercial paper were $2 million in 2016 and the maximum principal amount outstanding at any one time during 2016 was $475 million. In December 2017, we issued $400 million of 2.50% senior notes due December 15, 2020 and $400 million of 2.90% senior notes due December 15, 2022. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses paid as of December 31, 2017, were $794 million. We used the net proceeds, together with available cash, to fund the redemption of our $300 million aggregate principal amount of 6.30% senior notes maturing in August 2018 and our $500 million aggregate principal amount of 7.20% senior notes maturing in June 2018 at 100% of the principal amount plus applicable premium for early redemption and accrued and unpaid interest to the redemption date, for cash totaling approximately $829 million. The remainder of the cash used in or provided by financing activities in 2018, 2017, and 2016 primarily resulted from proceeds from stock option exercises and the change in book overdraft. Future Sources and Uses of Liquidity Dividends For a detailed discussion of dividends to stockholders, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Stock Repurchases For a detailed discussion of stock repurchases, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Debt For a detailed discussion of our debt, including our senior notes, credit agreement and commercial paper program, please refer to Note 12 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Liquidity Requirements We believe our cash balances, investment securities, operating cash flows, and funds available under our credit agreement and our commercial paper program or from other public or private financing sources, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, acquisitions, future expansion opportunities, and capital expenditures for at least the next twelve months, as well as to refinance or repay debt, and repurchase shares. Adverse changes in our credit rating may increase the rate of interest we pay and may impact the amount of credit available to us in the future. Our investment-grade credit rating at December 31, 2018 was BBB+ according to Standard & Poor’s Rating Services, or S&P, and Baa3 according to Moody’s Investors Services, Inc., or Moody’s. A downgrade by S&P to BB+ or by Moody’s to Ba1 triggers an interest rate increase of 25 basis points with respect to $250 million of our senior notes. Successive one notch downgrades increase the interest rate an additional 25 basis points, or annual interest expense by $1 million, up to a maximum 100 basis points, or annual interest expense by $3 million. In addition, we operate as a holding company in a highly regulated industry. Humana Inc., our parent company, is dependent upon dividends and administrative expense reimbursements from our subsidiaries, most of which are subject to regulatory restrictions. We continue to maintain significant levels of aggregate excess statutory capital and surplus in our state-regulated operating subsidiaries. Cash, cash equivalents, and short-term investments at the parent company decreased to $578 million at December 31, 2018 from $688 million at December 31, 2017. This decrease primarily reflects acquisitions, common stock repurchases, insurance subsidiaries' capital contributions and capital expenditures, partially offset by insurance subsidiaries dividends, non-insurance subsidiaries' profits and net proceeds from debt issuance. Our use of operating cash derived from our non-insurance subsidiaries, such as our Healthcare Services segment, is generally not restricted by Departments of Insurance (or comparable state regulatory agencies). Our regulated insurance subsidiaries paid dividends to the parent of $2.3 billion in 2018, $1.4 billion in 2017, and $0.8 billion in 2016. Refer to our parent company financial statements and accompanying notes in Schedule I - Parent Company Financial Information. The amount of ordinary dividends that may be paid to our parent company in 2019 is approximately $1 billion, in the aggregate. Actual dividends paid may vary due to consideration of excess statutory capital and surplus and expected future surplus requirements related to, for example, premium volume and product mix. Regulatory Requirements For a detailed discussion of our regulatory requirements, including aggregate statutory capital and surplus as well as dividends paid from the subsidiaries to the parent, please refer to Note 15 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Contractual Obligations We are contractually obligated to make payments for years subsequent to December 31, 2018 as follows: (1) Interest includes the estimated contractual interest payments under our debt agreements. (2) We lease facilities, computer hardware, and other furniture and equipment under long-term operating leases that are noncancelable and expire on various dates through 2046. We sublease facilities or partial facilities to third party tenants for space not used in our operations which partially mitigates our operating lease commitments. See also Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. (3) Purchase obligations include agreements to purchase services, primarily information technology related services, or to make improvements to real estate, in each case that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum levels of service to be purchased; fixed, minimum or variable price provisions; and the appropriate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. (4) Includes future policy benefits payable ceded to third parties through 100% coinsurance agreements as more fully described in Note 19 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We expect the assuming reinsurance carriers to fund these obligations and reflected these amounts as reinsurance recoverables included in other long-term assets on our consolidated balance sheet. Amounts payable in less than one year are included in trade accounts payable and accrued expenses in the consolidated balance sheet. Off-Balance Sheet Arrangements As of December 31, 2018, we were not involved in any special purpose entity, or SPE, transactions. For a detailed discussion of off-balance sheet arrangements, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Guarantees and Indemnifications For a detailed discussion of our guarantees and indemnifications, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Government Contracts For a detailed discussion of our government contracts, including our Medicare, Military, and Medicaid contracts, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and accompanying notes, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements and accompanying notes requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We continuously evaluate our estimates and those critical accounting policies primarily related to benefits expense and revenue recognition as well as accounting for impairments related to our investment securities, goodwill, and long-lived assets. These estimates are based on knowledge of current events and anticipated future events and, accordingly, actual results ultimately may differ from those estimates. We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements. Benefits Expense Recognition Benefits expense is recognized in the period in which services are provided and includes an estimate of the cost of services which have been incurred but not yet reported, or IBNR. IBNR represents a substantial portion of our benefits payable as follows: Our reserving practice is to consistently recognize the actuarial best point estimate within a level of confidence required by actuarial standards. For further discussion of our reserving methodology, including our use of completion and claims per member per month trend factors to estimate IBNR, refer to Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. The completion and claims per member per month trend factors are the most significant factors impacting the IBNR estimate. The portion of IBNR estimated using completion factors for claims incurred prior to the most recent two months is generally less variable than the portion of IBNR estimated using trend factors. The following table illustrates the sensitivity of these factors assuming moderately adverse experience and the estimated potential impact on our operating results caused by reasonably likely changes in these factors based on December 31, 2018 data: (a) Reflects estimated potential changes in benefits payable at December 31, 2018 caused by changes in completion factors for incurred months prior to the most recent two months. (b) Reflects estimated potential changes in benefits payable at December 31, 2018 caused by changes in annualized claims trend used for the estimation of per member per month incurred claims for the most recent two months. (c) The factor change indicated represents the percentage point change. The following table provides a historical perspective regarding the accrual and payment of our benefits payable, excluding military services. Components of the total incurred claims for each year include amounts accrued for current year estimated benefits expense as well as adjustments to prior year estimated accruals. Refer to Note 10 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for Retail, Group and Specialty, and Individual Commercial segment tables including information about incurred and paid claims development as of December 31, 2018, net of reinsurance, as well as cumulative claim frequency and the total of IBNR included within the net incurred claims amounts. The following table summarizes the changes in estimate for incurred claims related to prior years attributable to our key assumptions. As previously described, our key assumptions consist of trend and completion factors estimated using an assumption of moderately adverse conditions. The amounts below represent the difference between our original estimates and the actual benefits expense ultimately incurred as determined from subsequent claim payments. (a) The factor change indicated represents the percentage point change. As previously discussed, our reserving practice is to consistently recognize the actuarial best estimate of our ultimate liability for claims. Actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $503 million in 2018, $483 million in 2017, and $582 million in 2016. The table below details our favorable medical claims reserve development related to prior fiscal years by segment for 2018, 2017, and 2016. The favorable medical claims reserve development for 2018, 2017, and 2016 primarily reflects the consistent application of trend and completion factors estimated using an assumption of moderately adverse conditions. Our favorable development for each of the years presented above is discussed further in Note 10 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We continually adjust our historical trend and completion factor experience with our knowledge of recent events that may impact current trends and completion factors when establishing our reserves. Because our reserving practice is to consistently recognize the actuarial best point estimate using an assumption of moderately adverse conditions as required by actuarial standards, there is a reasonable possibility that variances between actual trend and completion factors and those assumed in our December 31, 2018 estimates would fall towards the middle of the ranges previously presented in our sensitivity table. Benefits expense excluded from the previous table was as follows for the years ended December 31, 2018, 2017 and 2016: In 2016, we increased our existing premium deficiency reserve, initially recorded in 2015, for our individual commercial medical business compliant with the Health Care Reform Law associated with the 2016 coverage year. The higher benefits expense associated with future policy benefits payable during 2016 primarily relates to reserve strengthening for our closed block of long-term care insurance policies, which were sold in 2018, as more fully described below and in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Revenue Recognition We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group on 30-day written notice. Our Medicare contracts with CMS renew annually. Our military services contracts with the federal government and certain contracts with various state Medicaid programs generally are multi-year contracts subject to annual renewal provisions. We receive monthly premiums from the federal government and various states according to government specified payment rates and various contractual terms. We bill and collect premium from employer groups and members in our Medicare and other individual products monthly. Changes in premium revenues resulting from the periodic changes in risk-adjustment scores derived from medical diagnoses for our membership are estimated by projecting the ultimate annual premium and recognized ratably during the year with adjustments each period to reflect changes in the ultimate premium. Premiums revenue is estimated by multiplying the membership covered under the various contracts by the contractual rates. Premiums revenue is recognized as income in the period members are entitled to receive services, and is net of estimated uncollectible amounts, retroactive membership adjustments, and adjustments to recognize rebates under the minimum benefit ratios required under the Health Care Reform Law. We estimate policyholder rebates by projecting calendar year minimum benefit ratios for the small group and large group markets, as defined by the Health Care Reform Law using a methodology prescribed by HHS, separately by state and legal entity. Medicare Advantage products are also subject to minimum benefit ratio requirements under the Health Care Reform Law. Estimated calendar year rebates recognized ratably during the year are revised each period to reflect current experience. Retroactive membership adjustments result from enrollment changes not yet processed, or not yet reported by an employer group or the government. We routinely monitor the collectibility of specific accounts, the aging of receivables, historical retroactivity trends, estimated rebates, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in current operations. Premiums received prior to the service period are recorded as unearned revenues. Medicare Risk-Adjustment Provisions CMS utilizes a risk-adjustment model which apportions premiums paid to Medicare Advantage, or MA, plans according to health severity. The risk-adjustment model, which CMS implemented pursuant to the Balanced Budget Act of 1997(BBA) and the Benefits Improvement and Protection Act of 2000 (BIPA), generally pays more for enrollees with predictably higher costs. Under the risk-adjustment methodology, all MA plans must collect and submit the necessary diagnosis code information from hospital inpatient, hospital outpatient, and physician providers to CMS within prescribed deadlines. The CMS risk-adjustment model uses this diagnosis data to calculate the risk-adjusted premium payment to MA plans. Rates paid to MA plans are established under an actuarial bid model, including a process that bases our payments on a comparison of our beneficiaries’ risk scores, derived from medical diagnoses, to those enrolled in the government’s Medicare FFS program. We generally rely on providers, including certain providers in our network who are our employees, to code their claim submissions with appropriate diagnoses, which we send to CMS as the basis for our payment received from CMS under the actuarial risk-adjustment model. We also rely on providers to appropriately document all medical data, including the diagnosis data submitted with claims. CMS is phasing-in the process of calculating risk scores using diagnoses data from the Risk Adjustment Processing System, or RAPS, to diagnoses data from the Encounter Data System, or EDS. The RAPS process requires MA plans to apply a filter logic based on CMS guidelines and only submit diagnoses that satisfy those guidelines. For submissions through EDS, CMS requires MA plans to submit all the encounter data and CMS will apply the risk adjustment filtering logic to determine the risk scores. For 2018, 15% of the risk score was calculated from claims data submitted through EDS. In 2019 and 2020 CMS will increase that percentage to 25% and 50%, respectively. The phase-in from RAPS to EDS could result in different risk scores from each dataset as a result of plan processing issues, CMS processing issues, or filtering logic differences between RAPS and EDS, and could have a material adverse effect on our results of operations, financial position, or cash flows. We estimate risk-adjustment revenues based on medical diagnoses for our membership. The risk-adjustment model, including CMS changes to the submission process, is more fully described in Item 1. - Business under the section titled “Individual Medicare,” and in Item 1A. - Risk Factors. Investment Securities Investment securities totaled $10.4 billion, or 41% of total assets at December 31, 2018, and $12.3 billion, or 45% of total assets at December 31, 2017. Debt securities, detailed below, comprised this entire investment portfolio at December 31, 2018 and 2017. The fair value of debt securities were as follows at December 31, 2018 and 2017: Approximately 97% of our debt securities were investment-grade quality, with a weighted average credit rating of AA by S&P at December 31, 2018. Most of the debt securities that were below investment-grade were rated BB, the higher end of the below investment-grade rating scale. Our investment policy limits investments in a single issuer and requires diversification among various asset types. Tax-exempt municipal securities included pre-refunded bonds of $118 million at December 31, 2018 and $222 million at December 31, 2017. These pre-refunded bonds were secured by an escrow fund consisting of U.S. government obligations sufficient to pay off all amounts outstanding at maturity. The ratings of these pre-refunded bonds generally assume the rating of the government obligations at the time the fund is established. Tax-exempt municipal securities that were not pre-refunded were diversified among general obligation bonds of U.S. states and local municipalities as well as special revenue bonds. General obligation bonds, which are backed by the taxing power and full faith of the issuer, accounted for $1.4 billion of these municipals in the portfolio. Special revenue bonds, issued by a municipality to finance a specific public works project such as utilities, water and sewer, transportation, or education, and supported by the revenues of that project, accounted for $1.3 billion of these municipals. Our general obligation bonds are diversified across the U.S. with no individual state exceeding 9%. Gross unrealized losses and fair values aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows at December 31, 2018: Under the other-than-temporary impairment model for debt securities held, we recognize an impairment loss in income in an amount equal to the full difference between the amortized cost basis and the fair value when we have the intent to sell the debt security or it is more likely than not we will be required to sell the debt security before recovery of our amortized cost basis. However, if we do not intend to sell the debt security, we evaluate the expected cash flows to be received as compared to amortized cost and determine if a credit loss has occurred. In the event of a credit loss, only the amount of the impairment associated with the credit loss is recognized currently in income with the remainder of the loss recognized in other comprehensive income. When we do not intend to sell a security in an unrealized loss position, potential other-than-temporary impairment is considered using a variety of factors, including the length of time and extent to which the fair value has been less than cost; adverse conditions specifically related to the industry, geographic area or financial condition of the issuer or underlying collateral of a security; payment structure of the security; changes in credit rating of the security by the rating agencies; the volatility of the fair value changes; and changes in fair value of the security after the balance sheet date. For debt securities, we take into account expectations of relevant market and economic data. For example, with respect to mortgage and asset-backed securities, such data includes underlying loan level data and structural features such as seniority and other forms of credit enhancements. A decline in fair value is considered other-than-temporary when we do not expect to recover the entire amortized cost basis of the security. We estimate the amount of the credit loss component of a debt security as the difference between the amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate of future cash flows discounted at the implicit interest rate at the date of purchase. The risks inherent in assessing the impairment of an investment include the risk that market factors may differ from our expectations, facts and circumstances factored into our assessment may change with the passage of time, or we may decide to subsequently sell the investment. The determination of whether a decline in the value of an investment is other than temporary requires us to exercise significant diligence and judgment. The discovery of new information and the passage of time can significantly change these judgments. The status of the general economic environment and significant changes in the national securities markets influence the determination of fair value and the assessment of investment impairment. There is a continuing risk that declines in fair value may occur and additional material realized losses from sales or other-than-temporary impairments may be recorded in future periods. All issuers of securities we own that were trading at an unrealized loss at December 31, 2018 remain current on all contractual payments. After taking into account these and other factors previously described, we believe these unrealized losses primarily were caused by an increase in market interest rates in the current markets since the time the securities were purchased. At December 31, 2018, we did not intend to sell the securities with an unrealized loss position in accumulated other comprehensive income, and it is not likely that we will be required to sell these securities before recovery of their amortized cost basis. As a result, we believe that the securities with an unrealized loss were not other-than-temporarily impaired at December 31, 2018. There were no material other-than-temporary impairments in 2018, 2017, or 2016. Goodwill and Long-lived Assets At December 31, 2018, goodwill and other long-lived assets represented 23% of total assets and 58% of total stockholders’ equity, compared to 19% and 52%, respectively, at December 31, 2017 with the increase due to our 2018 acquisitions. We are required to test at least annually for impairment at a level of reporting referred to as the reporting unit, and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. A reporting unit either is our operating segments or one level below the operating segments, referred to as a component, which comprise our reportable segments. A component is considered a reporting unit if the component constitutes a business for which discrete financial information is available that is regularly reviewed by management. We are required to aggregate the components of an operating segment into one reporting unit if they have similar economic characteristics. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition. We use the one-step process to review goodwill for impairment to determine both the existence and amount of goodwill impairment, if any. Our strategy, long-range business plan, and annual planning process support our goodwill impairment tests. These tests are performed, at a minimum, annually in the fourth quarter, and are based on an evaluation of future discounted cash flows. We rely on this discounted cash flow analysis to determine fair value. However outcomes from the discounted cash flow analysis are compared to other market approach valuation methodologies for reasonableness. We use discount rates that correspond to a market-based weighted-average cost of capital and terminal growth rates that correspond to long-term growth prospects, consistent with the long-term inflation rate. Key assumptions in our cash flow projections, including changes in membership, premium yields, medical and operating cost trends, and certain government contract extensions, are consistent with those utilized in our long-range business plan and annual planning process. If these assumptions differ from actual, including the impact of the Health Care Reform Law or changes in Government rates, the estimates underlying our goodwill impairment tests could be adversely affected. Goodwill impairment tests completed in each of the last three years did not result in an impairment loss. The fair value of our reporting units with significant goodwill exceeded carrying amounts by a substantial margin. A 100 basis point increase in the discount rate would not have a significant impact on the amount of margin for any of our reporting units with significant goodwill, with the exception of our clinical and provider reporting units in our Healthcare Services segment. The margin on the clinical reporting unit would decline to less than 10% after factoring in a 100 basis point increase in the discount rate. The provider reporting unit, while not falling beneath this threshold, was closer than any of our other reporting units. The clinical and provider reporting units account for $524 million and $730 million, respectively, of goodwill. Long-lived assets consist of property and equipment and other finite-lived intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. We periodically review long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation or amortization for these assets. There were no material impairment losses in the last three years.

<s>[INST] General Humana Inc., headquartered in Louisville, Kentucky, is a leading health and wellbeing company committed to helping our millions of medical and specialty members achieve their best health. Our successful history in care delivery and health plan administration is helping us create a new kind of integrated care with the power to improve health and wellbeing and lower costs. Our efforts are leading to a better quality of life for people with Medicare, families, individuals, military service personnel, and communities at large. To accomplish that, we support physicians and other health care professionals as they work to deliver the right care in the right place for their patients, our members. Our range of clinical capabilities, resources and tools, such as inhome care, behavioral health, pharmacy services, data analytics and wellness solutions, combine to produce a simplified experience that makes health care easier to navigate and more effective. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, excluding Merger termination fee and related costs, net, and depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Business Segments We manage our business with four reportable segments: Retail, Group and Specialty, Healthcare Services, and Individual Commercial. In addition, the Other Businesses category includes businesses that are not individually reportable because they do not meet the quantitative thresholds required by generally accepted accounting principles. These segments are based on a combination of the type of health plan customer and adjacent businesses centered on wellbeing solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer to assess performance and allocate resources. See Note 17 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data for segment financial information. The Retail segment consists of Medicare benefits, marketed to individuals or directly via group Medicare accounts. In addition, the Retail segment also includes our contract with CMS to administer the Limited Income Newly Eligible Transition, or LINET, prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and LongTerm Support Services benefits, which we refer to collectively as our statebased contracts. The Group and Specialty segment consists of employer group commercial fullyinsured medical and specialty health insurance benefits marketed to individuals and employer groups, including dental, vision, and other supplemental health benefits, as well as administrative services only, or ASO products. In addition, our Group and Specialty segment includes military services business, primarily our TRICARE T2017 East Region contract. The Healthcare Services segment includes our services offered to our health plan members as well as to third parties, including pharmacy solutions, provider services, and clinical care service, such as home health and other services and capabilities to promote wellness and advance population health, including our investment in Kindred at Home. The Individual Commercial segment consisted of our individual commercial fullyinsured medical health insurance business, which we exited beginning January 1, 2018. We report under the category of Other Businesses those businesses that do not align with the reportable segments described above, primarily our closedblock longterm care insurance policies, which were sold in 2018. The results of each segment are measured by income before income taxes and equity in net earnings from Kindred at Home, or segment earnings. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and clinical care services, to our Retail and Group and Specialty segment customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often use the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at a corporate level. These corporate amounts [/INST] Negative. </s>

HUMANA INC

2020-02-20

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For discussion of 2017 items and year-over-year comparisons between 2018 and 2017 that are not included in this 2019 Form 10-K, refer to "Item 7. - Management Discussion and Analysis of Financial Condition and Results of Operations" found in our Form 10-K for the year ended December 31, 2018, that was filed with the Securities and Exchange Commission on February 21, 2019. Executive Overview General Humana Inc., headquartered in Louisville, Kentucky, is a leading health and well-being company committed to helping our millions of medical and specialty members achieve their best health. Our successful history in care delivery and health plan administration is helping us create a new kind of integrated care with the power to improve health and well-being and lower costs. Our efforts are leading to a better quality of life for people with Medicare, families, individuals, military service personnel, and communities at large. To accomplish that, we support physicians and other health care professionals as they work to deliver the right care in the right place for their patients, our members. Our range of clinical capabilities, resources and tools, such as in-home care, behavioral health, pharmacy services, data analytics and wellness solutions, combine to produce a simplified experience that makes health care easier to navigate and more effective. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, excluding Merger termination fee and related costs, net, and depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Business Segments We manage our business with three reportable segments: Retail, Group and Specialty, and Healthcare Services. Beginning January 1, 2018, we exited the individual commercial fully-insured medical health insurance business, as well as certain other business in 2018, and therefore no longer report separately the Individual Commercial segment and the Other Businesses category in the current year. Previously, the Other Businesses category included businesses that were not individually reportable because they did not meet the quantitative thresholds required by generally accepted accounting principles, primarily our closed-block of commercial long-term care insurance policies which were sold in 2018. The reportable segments are based on a combination of the type of health plan customer and adjacent businesses centered on well-being solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer, the chief operating decision maker, to assess performance and allocate resources. See Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for segment financial information. The Retail segment consists of Medicare benefits, marketed to individuals or directly via group Medicare accounts. In addition, the Retail segment also includes our contract with CMS to administer the Limited Income Newly Eligible Transition, or LI-NET, prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and Long-Term Support Services benefits, which we refer to collectively as our state-based contracts. The Group and Specialty segment consists of employer group commercial fully-insured medical and specialty health insurance benefits marketed to individuals and employer groups, including dental, vision, and other supplemental health benefits, as well as administrative services only, or ASO products. In addition, our Group and Specialty segment includes our military services business, primarily our TRICARE T2017 East Region contract. The Healthcare Services segment includes our services offered to our health plan members as well as to third parties, including pharmacy solutions, provider services, and clinical care service, such as home health and other services and capabilities to promote wellness and advance population health, including our minority investment in Kindred at Home. The results of each segment are measured by income before income taxes and equity in net earnings from Kindred at Home, or segment earnings. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and clinical care services, to our Retail and Group and Specialty segment customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often use the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate expenses. These items are managed at a corporate level. These corporate amounts are reported separately from our reportable segments and are included with intersegment eliminations. Seasonality One of the product offerings of our Retail segment is Medicare stand-alone prescription drug plans, or PDPs, under the Medicare Part D program. Our quarterly Retail segment earnings and operating cash flows are impacted by the Medicare Part D benefit design and changes in the composition of our membership. The Medicare Part D benefit design results in coverage that varies as a member’s cumulative out-of-pocket costs pass through successive stages of a member’s plan period, which begins annually on January 1 for renewals. These plan designs generally result in us sharing a greater portion of the responsibility for total prescription drug costs in the early stages and less in the latter stages. As a result, the PDP benefit ratio generally decreases as the year progresses. In addition, the number of low income senior members as well as year-over-year changes in the mix of membership in our stand-alone PDP products affects the quarterly benefit ratio pattern. In addition, the Retail segment also experiences seasonality in the operating cost ratio as a result of costs incurred in the second half of the year associated with the Medicare marketing season. Our Group and Specialty segment also experiences seasonality in the benefit ratio pattern. However, the effect is opposite of Medicare stand-alone PDP in the Retail segment, with the Group and Specialty segment’s benefit ratio increasing as fully-insured members progress through their annual deductible and maximum out-of-pocket expenses. Aetna Merger On February 16, 2017, under the terms of the Agreement and Plan of Merger, or Merger Agreement, with Aetna Inc., and certain wholly owned subsidiaries of Aetna Inc., which we collectively refer to as Aetna, we received a breakup fee of $1 billion from Aetna, which is included in our consolidated statement of income in the line captioned "Merger termination fee and related costs, net." Acquisitions and Divestitures In the first quarter of 2020, we acquired privately held Enclara Healthcare, or Enclara, one of the nation’s largest hospice pharmacy and benefit management providers for cash consideration of approximately $707 million, net of cash received. The purchase accounting is incomplete due to the timing of the availability of information. Also in the first quarter of 2020, our Partners in Primary Care wholly-owned subsidiary entered into a strategic partnership with Welsh, Carson, Anderson & Stowe, or WCAS, to accelerate the expansion of our primary care model. The WCAS partnership is expected to open approximately 50 payor-agnostic, senior-focused primary care centers over 3 years beginning in 2020. Partners in Primary Care committed to the acquisition of a non-controlling interest in the approximately $600 million entity. In addition, the agreement includes a series of put and call options through which WCAS may require us to purchase their interest in the entity and, through which we may acquire WCAS’s interest over the next 5 - 10 years. In the third quarter of 2018, we completed the sale of our wholly-owned subsidiary KMG America Corporation, or KMG, to Continental General Insurance Company, or CGIC, a Texas-based insurance company wholly owned by HC2 Holdings, Inc., a diversified holding company. KMG's subsidiary, Kanawha Insurance Company, or KIC, included our closed block of non-strategic commercial long-term care policies. Upon closing, we funded the transaction with approximately $190 million of parent company cash contributed into KMG, subject to customary adjustments, in addition to the transfer of approximately $160 million of statutory capital with the sale. Also in the third quarter of 2018, we, along with TPG Capital, or TPG, and WCAS (together, the "Sponsors"), completed the acquisitions of Kindred and Curo, respectively, merging Curo with the hospice business of Kindred at Home. As part of these transactions, we acquired a 40% minority interest in Kindred at Home, a leading home health and hospice company, for total cash consideration of approximately $1.1 billion. In the second quarter of 2018, we acquired Family Physicians Group, or FPG, for cash consideration of approximately $185 million, net of cash received. FPG is one of the largest at-risk providers serving Medicare Advantage and Managed Medicaid HMO patients in Greater Orlando, Florida with a footprint that includes clinics located in Lake, Orange, Osceola and Seminole counties. The acquisition of FPG advances our strategy of helping physicians and clinicians evolve from treating health episodically to managing health holistically. In the first quarter of 2018, we acquired the remaining equity interest in MCCI Holdings, LLC, or MCCI, a privately held management service organization headquartered in Miami, Florida, which primarily coordinates medical care for Medicare Advantage beneficiaries in Florida and Texas. The purchase price consisted primarily of $169 million cash, as well as our existing investment in MCCI and a note receivable and a revolving note with an aggregate balance of $383 million. These transactions are more fully discussed in Note 3 and Note 4 to the consolidated financial statements. Highlights • Our 2019 results reflect the continued implementation of our strategy to offer our members affordable health care combined with a positive consumer experience in growing markets. At the core of this strategy is our integrated care delivery model, which unites quality care, high member engagement, and sophisticated data analytics. Our approach to primary, physician-directed care for our members aims to provide quality care that is consistent, integrated, cost-effective, and member-focused, provided by both employed physicians and physicians with network contract arrangements. The model is designed to improve health outcomes and affordability for individuals and for the health system as a whole, while offering our members a simple, seamless healthcare experience. We believe this strategy is positioning us for long-term growth in both membership and earnings. We offer providers a continuum of opportunities to increase the integration of care and offer assistance to providers in transitioning from a fee-for-service to a value-based arrangement. These include performance bonuses, shared savings and shared risk relationships. At December 31, 2019, approximately 2,407,000 members, or 67%, of our individual Medicare Advantage members were in value-based relationships under our integrated care delivery model, as compared to 2,039,100 members, or 67%, at December 31, 2018. Medicare Advantage and dual demonstration program membership enrolled in a Humana chronic care management program was 868,800 at December 31, 2019, an increase of 21.3% from 716,000 at December 31, 2018. These members may not be unique to each program since members have the ability to enroll in multiple programs. The increase is driven by our improved process for identifying and enrolling members in the appropriate program at the right time, coupled with growth in Special Needs Plans, or SNP, membership. • On February 5, 2020, after the stock market closed, the Centers for Medicare and Medicaid Services (“CMS”) issued Part II of the 2021 Advance Notice of Methodological Changes for Medicare Advantage Capitation Rates and Part C and Part D Payment Policies (the “Advance Notice”). CMS has invited public comment on the Advance Notice before publishing final rates on April 6, 2020 (the “Final Notice”). In the Advance Notice, CMS estimates Medicare Advantage plans across the sector will, on average, experience a 0.93 percent increase in benchmark funding based on proposals included therein. As indicated by CMS, its estimate excludes the impact of fee-for-service county rebasing/repricing because the related impact is dependent upon finalization of certain data, which will be available with the publication of the Final Notice. Based on our preliminary analysis using the same factors CMS included in its estimate, the components of which are detailed on CMS’ website, we anticipate that the proposals in the Advance Notice would result in a change to our benchmark funding relatively in line with CMS’ estimate. Also on February 5, 2020, CMS issued a proposed rule (which we refer to as the “2021 Proposed Rule”) related to the administration of the MA and Part D programs, including, among other things, the Agency’s implementation of recent legislation removing the limitation on MA eligibility for end-stage-renal-disease, or ESRD, Medicare-eligible beneficiaries beginning in 2021, allowing for Medicare Advantage plans to offer additional supplemental benefits including telehealth, and addressing opioid recovery and treatment. The 2021 Proposed Rule also recognizes the potential opportunity to create new options for beneficiaries, including ESRD beneficiaries, and their access to care through greater flexibility around current network adequacy requirements. CMS has invited public comments to the 2021 Proposed Rule on or before April 6, 2020. The Advance Notice and the 2021 Proposed Rule are subject to the required notice and comment period, and we cannot predict when or to what extent CMS will adopt the proposals in the Advance Notice or the 2021 Proposed Rule. We will be drawing upon our program expertise to provide CMS formal commentary on the impact of both the Advance Notice and the 2021 Proposed Rule and the related impact upon Medicare beneficiaries’ quality of care and service to our members through the MA and Part D programs. • Net income was $2.7 billion for 2019 compared to $1.7 billion in 2018 and earnings per diluted common share increased $7.94 from $12.16 earnings per diluted common share in 2018 to $20.10 earnings per diluted common share in 2019. This comparison was primarily impacted by higher segment earnings in our Retail and Healthcare Services segments, partially offset by lower Group and Specialty segment earnings. These changes were further favorably impacted by the put/call valuation adjustments associated with our investment in Kindred at Home and by a lower number of shares used to compute dilutive earnings per share, primarily reflecting share repurchases. In addition, year-over-year comparison to 2019 was impacted by the loss on the sale of KMG of $786 million recognized in 2018. • Contributing to our Retail segment revenue growth was our individual and group Medicare Advantage membership, which increased 550,700 members, or 15.5%, from 3,561,800 members at December 31, 2018 to 4,112,500 members at December 31, 2019. • Our operating cash flow of $5.3 billion for 2019 improved from $2.2 billion for 2018, reflecting the significant impact of increasing premiums and enrollment, as premiums generally are collected in advance of claim payments by a period of up to several months. The year-over-year comparison was further impacted by the timing of other working capital changes, higher earnings in 2019 versus 2018, and the negative impact on 2018 cash flows resulting from the funding of reinsurance transactions in connection with the sale of KMG. • In July 2019, the Board of Directors approved a $3.0 billion share repurchase authorization with an expiration date of June 30, 2022. We subsequently entered into an agreement with a third-party financial institution on July 31, 2019, to effect a $1.0 billion ASR program under the authorization. Under the terms of this program, which was completed in the fourth quarter of 2019, we repurchased approximately 3,376,200 shares at an average price, after a discount, of $296.19. Aside from the completion of the ASR program, we have not completed any open market stock repurchases. As of February 19, 2020, we had a remaining repurchase authorization of $2.0 billion. • In August 2019, we issued $500 million of 3.125% senior notes due August 15, 2029, and $500 million of 3.950% senior notes due August 15, 2049. Our net proceeds, reduced for the underwriters discount and commission and offering expenses, were $987 million. We used the net proceeds from this offering, together with available cash, to repay the $650 million outstanding amount due under our term note in August 2019, and the $400 million aggregate principal amount of our 2.625% senior notes due on its maturity date of October 1, 2019. • In 2019 we initiated an involuntary workforce optimization program that will allow us to promote operational excellence, accelerate our strategy, fund critical initiatives and advance our growth objectives. As a result we recorded estimated charges of $47 million, or $0.26 per diluted common share, on the corporate level, included with operating costs in the condensed consolidated statements of income. We expect this liability to be primarily paid within 12 months. Health Care Reform The Health Care Reform Law enacted significant reforms to various aspects of the U.S. health insurance industry. Certain significant provisions of the Health Care Reform Law include, among others, mandated coverage requirements, mandated benefits and guarantee issuance associated with commercial medical insurance, rebates to policyholders based on minimum benefit ratios, adjustments to Medicare Advantage premiums, the establishment of federally facilitated or state-based exchanges coupled with programs designed to spread risk among insurers, and the introduction of plan designs based on set actuarial values. In addition, the Health Care Reform Law established insurance industry assessments, including an annual health insurance industry fee. The annual health insurance industry fee was suspended in 2019, but will resume for calendar year 2020, not be deductible for income tax purposes, and significantly increase our effective tax rate. In 2018, the fee levied on the health insurance industry was $14.3 billion. Under current law, the health industry fee will be permanently repealed beginning in calendar year 2021. It is reasonably possible that the Health Care Reform Law and related regulations, as well as other current or future legislative, judicial or regulatory changes, including restrictions on our ability to manage our provider network or otherwise operate our business, or restrictions on profitability, including reviews by regulatory bodies that may compare our Medicare Advantage profitability to our non-Medicare Advantage business profitability, or compare the profitability of various products within our Medicare Advantage business, and require that they remain within certain ranges of each other, increases in member benefits or changes to member eligibility criteria without corresponding increases in premium payments to us, or increases in regulation of our prescription drug benefit businesses, in the aggregate may have a material adverse effect on our results of operations (including restricting revenue, enrollment and premium growth in certain products and market segments, restricting our ability to expand into new markets, increasing our medical and operating costs, further lowering our Medicare payment rates and increasing our expenses associated with assessments); our financial position (including our ability to maintain the value of our goodwill); and our cash flows. We intend for the discussion of our financial condition and results of operations that follows to assist in the understanding of our financial statements and related changes in certain key items in those financial statements from year to year, including the primary factors that accounted for those changes. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and clinical care services, to our Retail and Group and Specialty segment customers and are described in Note 18 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data in this 2019 Form 10-K. Comparison of Results of Operations for 2019 and 2018 Certain financial data on a consolidated basis and for our segments was as follows for the years ended December 31, 2019 and 2018: Consolidated (a) Represents total benefits expense as a percentage of premiums revenue. (b) Represents total operating costs, excluding depreciation and amortization, as a percentage of total revenues less investment income. Summary Net income for 2019 was $2.7 billion, or $20.10 per diluted common share, compared to $1.7 billion, or $12.16 per diluted common share, in 2018. This increase primarily was impacted by our Medicare Advantage business and Healthcare Services segment, as well as by previously implemented productivity initiatives that led to significant operating cost efficiencies in 2019. These impacts were partially offset by strategic investments in our integrated care delivery model, the impact of higher compensation accruals for the Annual Incentive Plan, or AIP, offered to employees across all levels of the company, lower Group and Specialty segment earnings, increased spending associated with the 2020 Medicare Annual Election Period, or AEP, and the impact of workforce optimization. These changes were further favorably impacted by the put/call valuation adjustments associated with our investment in Kindred at Home and by a lower number of shares used to compute dilutive earnings per share, primarily reflecting share repurchases. In addition, 2019 was impacted by the loss on the sale of KMG recognized in 2018. Premiums Revenue Consolidated premiums increased $8.0 billion, or 14.6%, from $54.9 billion for 2018 to $62.9 billion for 2019 primarily due to higher premiums in the Retail segment, driven by higher premium revenues from our Medicare Advantage business resulting from membership growth and higher per member premiums associated with individual Medicare Advantage. These increases were partially offset by the impact of declining stand-alone PDP membership, as well as lower premiums in the Group and Specialty segment as discussed in the detailed segment results discussion that follows. Services Revenue Consolidated services revenue decreased $18 million, or 1.2%, from $1.5 billion for 2018 to $1.4 billion for 2019, primarily due to a decrease in services revenue in the Group and Specialty segment, partially offset by an increase in the Healthcare Services segment as detailed in the segment results discussion that follows. Investment Income Investment income was $501 million for 2019, decreasing $13 million, or 2.5%, from 2018, primarily due to lower realized capital gains, partially offset by higher average invested balances and interest rates. Benefits Expense Consolidated benefits expense was $53.9 billion for 2019, an increase of $8.0 billion, or 17.4%, from 2018 reflecting an increase in the Retail and Group and Specialty segments benefits expense as discussed in the detailed segment results discussion that follows. As more fully described herein under the section entitled "Benefits Expense Recognition", actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $336 million in 2019 and $503 million in 2018. The consolidated benefit ratio for 2019 was 85.6%, an increase of 210 basis points from 2018 primarily due to the suspension of the health insurance industry fee in 2019, which was contemplated in the pricing and benefit design of our products, lower favorable prior-period medical claims reserve development, an increase in the Group and Specialty benefit ratio as discussed in the detailed segment results discussion that follows, and the shift in Medicare membership mix due to the loss of stand-alone PDP members and significant growth in Medicare Advantage members. These increases were partially offset by engaging our Medicare Advantage members in clinical programs, as well as ensuring they are appropriately documented under the CMS risk-adjustment model, and lower than expected medical costs as compared to the assumptions used in the pricing of our individual Medicare Advantage business for 2019. Favorable prior-period medical claims reserve development decreased the consolidated benefit ratio by approximately 50 basis points in 2019 and 90 basis points in 2018. Operating Costs Our segments incur both direct and shared indirect operating costs. We allocate the indirect costs shared by the segments primarily as a function of revenues. As a result, the profitability of each segment is interdependent. Consolidated operating costs decreased $144 million, or 1.9%, from 2018 to $7.4 billion in 2019 reflecting a decrease in operating costs in the Retail and the Group and Specialty segments as discussed in the detailed segment results discussion that follows. The consolidated operating cost ratio for 2019 was 11.5%, decreasing 180 basis points from 13.3% in 2018 primarily due to the suspension of the health insurance industry fee in 2019, scale efficiencies associated with growth in our Medicare Advantage membership, and significant operating cost efficiencies in 2019 driven by previously implemented productivity initiatives. These improvements were partially offset by strategic investments in our integrated care delivery model, the impact of higher compensation expense accruals in 2019 for the AIP offered to employees across all levels, increased spending associated with the Medicare AEP, and charges associated with workforce optimization. The higher compensation accruals resulted from our continued strong performance, including customer satisfaction as measured by the net promoter score, along with higher than anticipated individual Medicare Advantage membership growth. The nondeductible health insurance industry fee impacted the operating cost ratio by approximately 180 basis points in 2018. Depreciation and Amortization Depreciation and amortization in 2019 totaled $458 million compared to $405 million in 2018, an increase of 13.1%, primarily due to capital expenditures. Interest Expense Interest expense was $242 million for 2019 compared to $218 million for 2018, an increase of $24 million, or 11.0% The increase was primarily due to the higher average borrowings outstanding including the impact of the borrowings under the November 2018 term loan agreement and senior notes issued in August 2019. Income Taxes Our effective tax rate during 2019 was 22.0% compared to the effective tax rate of 18.9% in 2018. This change primarily reflects the impact of the suspension of the non-deductible health insurance industry fee in 2019 as well as the deferred tax benefit recognized in 2018 from the loss on sale of KMG. The effective income tax rate in 2018 reflected a $430 million deferred tax benefit, resulting from the loss on the sale of KMG attributable to its original tax basis and subsequent capital contributions to fund accumulated losses. See Note 12 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for a complete reconciliation of the federal statutory rate to the effective tax rate. Retail Segment Segment Earnings • Retail segment earnings were $2.2 billion in 2019, an increase of $502 million, or 29.0%, compared to $1.7 billion in 2018 primarily reflecting a lower operating cost ratio, partially offset by the higher benefit ratio as more fully described below. As expected, the higher-than-anticipated individual Medicare Advantage membership growth during the previous AEP had a muted impact on the segment's earnings in 2019. While new Medicare Advantage members increase revenue, on average, they have a break even impact on segment earnings in the first year as they were not previously engaged in clinical programs or appropriately documented under the CMS risk adjustment model, and accordingly, carry a higher benefit ratio. Enrollment • Individual Medicare Advantage membership increased 523,200 members, or 17.1%, from 3,064,000 members as of December 31, 2018 to 3,587,200 members as of December 31, 2019, primarily due to membership additions associated with the 2019 AEP and Open Election Period, or OEP, for Medicare beneficiaries. The OEP sales period, which ran from January 1 to March 31, added approximately 43,700 members. Since the conclusion of the OEP, enrollment continued to increase due to strong sales to age-ins and those eligible for Dual Eligible Special Need Plans, or D-SNP. Individual Medicare Advantage membership includes 288,200 D-SNP members as of December 31, 2019, a net increase of 69,600, or 31.8%, from 218,600 December 31, 2018. For the full year 2020, we anticipate a net membership increase in our Individual Medicare Advantage offerings of 270,000 members to 330,000 members. • Group Medicare Advantage membership increased 27,500 members, or 5.5%, from 497,800 members as of December 31, 2018 to 525,300 members as of December 31, 2019, primarily due to net membership additions associated with the 2019 AEP for Medicare beneficiaries. For the full year 2020, we anticipate a net membership increase in our Group Medicare Advantage offerings of approximately 90,000 members. • Medicare stand-alone PDP membership decreased 639,100 members, or 12.8%, from 5,004,300 members as of December 31, 2018 to 4,365,200 members as of December 31, 2019, primarily reflecting net declines during the 2019 AEP for Medicare beneficiaries. The anticipated decline primarily was due to the competitive nature of the industry and the pricing discipline we have employed, which resulted in us no longer being the low cost plan in any market for 2019. For the full year 2020, we anticipate a net membership decline in our Medicare stand-alone PDP offerings of approximately 550,000 members. • State-based Medicaid membership increased 127,900 members, or 37.5%, from 341,100 members as of December 31, 2018 to 469,000 members as of December 31, 2019, primarily driven by the statewide award of a comprehensive contract under the Managed Medical Assistance, or MMA, program in Florida. Our January 31, 2020 state-based contracts membership was 608,000, representing growth of 139,000, or 30%, from December 31, 2019. This growth primarily reflects the impact of terminating the reinsurance agreement with CareSource effective January 1, 2020, which ceded all risk for our Kentucky Medicaid contract. Premiums revenue • Retail segment premiums increased $8.1 billion, or 16.9%, from 2018 to 2019 period primarily due to Medicare Advantage membership growth and higher per member premiums, as well as increased state-based contracts membership. These favorable items were partially offset by the decline in membership in our stand-alone PDP offerings. Benefits expense • The Retail segment benefit ratio of 86.4% for 2019 increased 130 basis points from 85.1% in 2018 primarily due to the suspension of the health insurance industry fee in 2019 which was contemplated in the pricing and benefit design of our products, lower favorable prior-period medical claims reserve development, as well as the shift in Medicare membership mix due to the loss of stand-alone PDP members and the significant growth in Medicare Advantage members. These increases were partially offset by engaging our Medicare Advantage members in clinical programs as well as ensuring they are appropriately documented under the CMS risk adjustment model, lower than expected medical costs as compared to the assumptions used in the pricing of our individual Medicare Advantage business for 2019, and the impact of a less severe flu season experienced in the first quarter of 2019 compared to that in the first quarter of 2018. • The Retail segment’s benefits expense for 2019 included the beneficial effect of $386 million in favorable prior-year medical claims reserve development versus $398 million in 2018. This favorable prior-year medical claims reserve development decreased the Retail segment benefit ratio by approximately 70 basis points in 2019 versus approximately 80 basis points in 2018. Operating costs • The Retail segment operating cost ratio of 9.4% for 2019 decreased 170 basis points from 11.1% in 2018 primarily due to the suspension of the health insurance industry fee in 2019, as well as scale efficiencies associated with growth in our Medicare Advantage membership, and significant operating cost efficiencies in 2019 driven by previously implemented productivity initiatives. These improvements were partially offset by the strategic investments in our integrated care delivery model, the impact of higher compensation expense accruals in 2019 for the AIP as a result of our continued strong performance, and increased spending associated with the Medicare AEP. • The non-deductible health insurance industry fee increased the operating cost ratio by approximately 190 basis points in 2018. Group and Specialty Segment (a) Specialty products include dental, vision, and other supplemental health products. Members included in these products may not be unique to each product since members have the ability to enroll in multiple products. Segment Earnings • Group and Specialty segment earnings were $28 million in 2019, a decrease of $333 million, or 92.2%, from $361 million in 2018 primarily due to a higher benefit ratio, along with lower military services business earnings. Earnings comparisons related to the military services business were unfavorably impacted by the receipt of certain contractual incentives and adjustments in 2018 related to the previous TRICARE contract which did not recur in 2019. These decreases were partially offset by the improvement in the operating cost ratio as more fully described below. Enrollment • Fully-insured commercial group medical membership decreased 96,100 members, or 9.6% from 1,004,700 members as of December 31, 2018 primarily reflecting lower membership in small group accounts due in part to more small group accounts selecting level-funded ASO products in 2019, as well as the loss of certain large group accounts due to the competitive pricing environment. The portion of group fully-insured commercial medical membership in small group accounts was approximately 59% at December 31, 2019 and 61% at December 31, 2018. • Group ASO commercial medical membership increased 47,300 members, or 9.8%, from 481,900 members as of December 31, 2018 to 529,200 members as of December 31, 2019 reflecting more small group accounts selecting level-funded ASO products in 2019, partially offset by the loss of certain large group accounts as a result of continued discipline in pricing of services for self-funded accounts amid a highly competitive environment. • Military services membership increased 55,700 members, or 0.9%, from 5,928,600 members as of December 31, 2018 to 5,984,300 members as of December 31, 2019. Membership includes military service members, retirees, and their families to whom we provide healthcare services under the current T2017 TRICARE East Region contract. The current contract, which covers thirty-two states, became effective on January 1, 2018. • Specialty membership decreased 646,400 members, or 10.6%, from 6,072,300 as of December 31, 2018 to 5,425,900 members as of December 31, 2019 primarily due to the loss of certain group accounts, including one jumbo account, offering stand-alone dental and vision products. Premiums revenue • Group and Specialty segment premiums decreased $109 million, or 1.6%, from $6.8 billion in 2018 to $6.7 billion in 2019, primarily due to a decline in our fully-insured group commercial and specialty membership as well as the exit of our voluntary benefit and financial protection products in connection with the sale of KMG in 2018. These decreases were partially offset by higher stop-loss revenues related to our level-funded ASO accounts resulting from membership growth in this product and higher per member premiums across the fully-insured business. Services revenue • Group and Specialty segment services revenue decreased $45 million, or 5.4%, from 2018 to 2019 primarily due to the impact of certain contractual incentives and adjustments related to the previous TRICARE contract received in 2018, which did not recur in 2019. Benefits expense • The Group and Specialty segment benefit ratio increased 630 basis points from 79.7% in 2018 to 86.0% in 2019 primarily due to the impact of the continued migration of fully-insured group members to level-funded ASO products in 2019 resulting in a membership mix transformation, the suspension of the health insurance industry fee in 2019 which was contemplated in the pricing and benefit design of our products, and unfavorable prior-year medical claims reserve development driven by provider settlements. The benefit ratio was further negatively impacted by adjustments to dental network contracted rates resulting from dental network recontracting and expansion to position the business for the future. • The Group and Specialty segment’s benefits expense included the unfavorable effect of $50 million in prior-year medical claims reserve development in 2019 versus the beneficial effect of $46 million in favorable prior-year medical claims reserve development in 2018. This unfavorable prior-year medical claims reserve development increased the Group and Specialty segment benefit ratio by approximately 70 basis points in 2019 while the favorable prior-year medical claims reserve development decreased the Group and Specialty segment benefit ratio by approximately 70 basis points in 2018. Operating costs • The Group and Specialty segment operating cost ratio of 22.0% for 2019 decreased 160 basis points from 23.6% for 2018, primarily due to the suspension of the health insurance industry fee in 2019, significant operating cost efficiencies in 2019 driven by previously implemented productivity initiatives, as well as the exit of our voluntary benefit and financial protection products in connection with the sale of KMG in 2018, which carried a higher operating cost ratio. These improvements were offset by the higher compensation expense accruals in 2019 for the AIP as a result of our continued strong consolidated performance. • The non-deductible health insurance industry fee increased the operating cost ratio by approximately 160 basis points in 2018. Healthcare Services Segment Segment Earnings • Healthcare Services segment earnings were $789 million in 2019, an increase of $35 million, or 4.6%, from 2018. This increase primarily was due to higher earnings from our pharmacy operations and clinical operations, and higher earnings from Kindred at Home operations. These factors were partially offset by additional investments in new clinical assets associated with our provider services business. Script Volume • Humana Pharmacy Solutions® script volumes for the Retail and Group and Specialty segment membership increased to approximately 456 million in 2019, up 3.6% versus scripts of approximately 440 million in 2018. The increase primarily reflects growth associated with higher Medicare Advantage and state-based contracts membership, partially offset by the decline in stand-alone PDP membership. Services revenue • Services revenue increased $25 million, or 4.1%, from 2018 to $632 million for 2019 primarily due to revenue growth from our provider services business. Intersegment revenues • Intersegment revenues increased $1.98 billion, or 8.5%, from 2018 to $25 billion for 2019 primarily due to strong Medicare Advantage membership growth, partially offset by the loss of intersegment revenues associated with the decline in stand-alone PDP membership. Intersegment revenues in 2019 were further impacted by higher revenues associated with our provider services business reflecting the previously disclosed acquisitions of MCCI and FPG. Operating costs • The Healthcare Services segment operating cost ratio of 96.4% for 2019 was relatively unchanged from 96.3% for 2018. Liquidity Historically, our primary sources of cash have included receipts of premiums, services revenue, and investment and other income, as well as proceeds from the sale or maturity of our investment securities, and borrowings. Our primary uses of cash historically have included disbursements for claims payments, operating costs, interest on borrowings, taxes, purchases of investment securities, acquisitions, capital expenditures, repayments on borrowings, dividends, and share repurchases. Because premiums generally are collected in advance of claim payments by a period of up to several months, our business normally should produce positive cash flows during periods of increasing premiums and enrollment. Conversely, cash flows would be negatively impacted during periods of decreasing premiums and enrollment. From period to period, our cash flows may also be affected by the timing of working capital items including premiums receivable, benefits payable, and other receivables and payables. Our cash flows are impacted by the timing of payments to and receipts from CMS associated with Medicare Part D subsidies for which we do not assume risk. The use of cash flows may be limited by regulatory requirements of state departments of insurance (or comparable state regulators) which require, among other items, that our regulated subsidiaries maintain minimum levels of capital and seek approval before paying dividends from the subsidiaries to the parent. Our use of cash flows derived from our non-insurance subsidiaries, such as in our Healthcare Services segment, is generally not restricted by state departments of insurance (or comparable state regulators). For additional information on our liquidity risk, please refer to Item 1A. - Risk Factors in this 2019 Form 10-K. Cash and cash equivalents increased to $4.1 billion at December 31, 2019 from $2.3 billion at December 31, 2018. The change in cash and cash equivalents for the years ended December 31, 2019, 2018 and 2017 is summarized as follows: Cash Flow from Operating Activities The change in operating cash flows over the three year period primarily results from the corresponding change in the timing of working capital items, earnings, and enrollment activity as discussed below. The increase in operating cash flows in 2019 reflect the significant impacts of increasing premiums and enrollment, as premiums generally are collected in advance of claim payments by a period of up to several months, higher earnings, the timing of other working capital items, and the impact of an approximately $245 million payment related to reinsuring certain voluntary benefit and financial protection products to a third party in connection with the sale of KMG in 2018. The decrease in operating cash flows in 2018 primarily was due to the receipt of the merger termination fee in 2017, net of related expenses and taxes paid, funding the reinsurance of certain voluntary benefit and financial protection products to a third party in connection with the sale of KMG in 2018 and the timing of working capital items. The most significant drivers of changes in our working capital are typically the timing of payments of benefits expense and receipts for premiums. We illustrate these changes with the following summaries of benefits payable and receivables. The detail of benefits payable was as follows at December 31, 2019, 2018 and 2017: (1) IBNR represents an estimate of benefits payable for claims incurred but not reported (IBNR) at the balance sheet date and includes unprocessed claim inventories. The level of IBNR is primarily impacted by membership levels, medical claim trends and the receipt cycle time, which represents the length of time between when a claim is initially incurred and when the claim form is received and processed (i.e. a shorter time span results in a lower IBNR). IBNR includes unprocessed claims inventories. (2) Reported claims in process represents the estimated valuation of processed claims that are in the post claim adjudication process, which consists of administrative functions such as audit and check batching and handling, as well as amounts owed to our pharmacy benefit administrator which fluctuate due to bi-weekly payments and the month-end cutoff. (3) Other benefits payable include amounts owed to providers under capitated and risk sharing arrangements. The increase in benefits payable in 2019 and 2018 was primarily due to an increase in IBNR, mainly as a result of Medicare Advantage membership growth. In addition, 2019 was impacted by an increase in the amounts owed to providers under capitated and risk sharing arrangements. The detail of total net receivables was as follows at December 31, 2019, 2018 and 2017: Medicare receivables are impacted by changes in revenue associated with individual and group Medicare membership changes as well as the timing of accruals and related collections associated with the CMS risk-adjustment model. The decrease in commercial and other receivables in 2018 as compared to 2017, was due primarily to a decrease in our receivable associated with the commercial risk adjustment provision of the Health Care Reform Law. This decrease corresponds with our exit from the Individual Commercial business. Military services receivables at December 31, 2019, 2018, and 2017 primarily consist of administrative services only fees owed from the federal government for administrative services provided under our TRICARE contracts. The 2017 balance also includes transition-in receivables under our T2017 East Region contract collected in 2018. Many provisions of the Health Care Reform Law became effective in 2014, including the non-deductible health insurance industry fee. The annual health insurance industry fee was suspended for the calendar year 2017, but resumed in calendar year 2018.The annual health insurance industry fee was again suspended in 2019, but will resume for calendar year 2020, not be deductible for income tax purposes, and significantly increase our effective tax rate. Under current law, the health industry fee will be permanently repealed beginning in calendar year 2021. We paid the federal government annual health insurance industry fees of $1.04 billion in 2018. In addition to the timing of payments of benefits expense, receipts for premiums and services revenues, and amounts due under the health insurance industry fee provisions of the Health Care Reform Law, other items impacting operating cash flows include income tax payments and the timing of payroll cycles. Cash Flow from Investing Activities Our ongoing capital expenditures primarily relate to our information technology initiatives, support of services in our provider services operations including medical and administrative facility improvements necessary for activities such as the provision of care to members, claims processing, billing and collections, wellness solutions, care coordination, regulatory compliance and customer service. Total capital expenditures, excluding acquisitions, were $736 million in 2019, $612 million in 2018, and $524 million in 2017. In 2018, we completed the sale of our wholly-owned subsidiary KMG to CGIC. Upon closing, we funded the transaction with approximately $190 million of parent company cash contributed into KMG, subject to customary adjustments, in addition to the transfer of approximately $160 million of statutory capital with the sale. Total cash and cash equivalents, including parent company funding, disposed at the time of sale, was $805 million. See Note 3 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data During 2018 we paid cash consideration of approximately $1.1 billion to acquire a 40% minority interest in Kindred at Home, $169 million to acquire the remaining interest in MCCI, and $185 million to acquire all of FPG, as discussed in Notes 3 and 4 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We reinvested a portion of our operating cash flows in investment securities, primarily investment-grade fixed income securities, totaling $542 million, $221 million, and $2.4 billion, during 2019, 2018 and 2017 respectively. Cash Flow from Financing Activities Our financing cash flows are significantly impacted by the timing of claims payments and the related receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk. Monthly prospective payments from CMS for reinsurance and low-income cost subsidies are based on assumptions submitted with our annual bid. Settlement of the reinsurance and low-income cost subsidies is based on a reconciliation made approximately 9 months after the close of each calendar year. Claims payments were $560 million higher than receipts from CMS associated with Medicare Part D claim subsidies for which we do not assume risk during 2019 and $653 million higher during 2018. Receipts from CMS associated with Medicare Part D claims subsidies for which we do not assume risk were $1.9 billion higher than claims payments during 2017. Our net payable for CMS subsidies and brand name prescription drug discounts was $229 million at December 31, 2019 compared to a net payable of $331 million at December 31, 2018. Under our administrative services only TRICARE contract, health care cost payments for which we do not assume risk exceeded reimbursements from the federal government by $63 million in 2019 and reimbursements from the federal government exceeded health care cost payments for which we do not assume risk by $38 million in 2018 and $11 million in 2017. Claims payments associated with cost sharing provisions of the Health Care Reform Law for which we do not assume risk were $25 million in 2018. Claims payments associated with cost sharing provisions of the Health Care Reform Law for which we do not assume risk were higher than reimbursements from HHS by $44 million in 2017. We repurchased common shares for $1.07 billion, $1.09 billion and $3.37 billion in 2019, 2018 and 2017 under share repurchase plans authorized by the Board of Directors and in connection with employee stock plans. As discussed further below, we paid dividends to stockholders of $291 million in 2019, $265 million in 2018, and $220 million in 2017. We entered into a commercial paper program in October 2014. Net repayments of commercial paper were $360 million in 2019 and the maximum principal amount outstanding at any one time during 2019 was $801 million. Net proceeds from the issuance of commercial paper were $485 million in 2018 and the maximum principal amount outstanding at any one time during 2018 was $923 million. Net repayments of commercial paper were $153 million in 2017 and the maximum principal amount outstanding at any one time during 2017 was $500 million. In November 2018, we entered into a $1.0 billion term note agreement with a bank at a variable rate of interest due within one year. For a detailed discussion of our debt please refer to Note 13 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. In August 2019, we issued $500 million of 3.125% senior notes due August 15, 2029 and $500 million of 3.950% senior notes due August 15, 2049. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses paid were $987 million. We used the net proceeds from this offering, together with available cash, to repay the $650 million outstanding amount due under our term note in August 2019, and the $400 million aggregate principal amount of our 2.625% senior notes due on maturity at October 1, 2019. In December 2017, we issued $400 million of 2.50% senior notes due December 15, 2020 and $400 million of 2.90% senior notes due December 15, 2022. Our net proceeds, reduced for the underwriters' discount and commission and offering expenses paid as of December 31, 2017, were $794 million. We used the net proceeds, together with available cash, to fund the redemption of our $300 million aggregate principal amount of 6.30% senior notes maturing in August 2018 and our $500 million aggregate principal amount of 7.20% senior notes maturing in June 2018 at 100% of the principal amount plus applicable premium for early redemption and accrued and unpaid interest to the redemption date, for cash totaling approximately $829 million. The remainder of the cash used in or provided by financing activities in 2019, 2018, and 2017 primarily resulted from proceeds from stock option exercises and the change in book overdraft. Future Sources and Uses of Liquidity Dividends For a detailed discussion of dividends to stockholders, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Stock Repurchases For a detailed discussion of stock repurchases, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Debt In February 2020, we entered into a new $1 billion term loan commitment with a bank that allows for up to three draws with the initial draw at a minimum of $300 million that matures 1 year after the first draw, subject to a 1 year extension. Following any initial draw, any unused commitments in excess of $300 million expire on June 30, 2020, with the remaining commitments of up to $300 million available until September 30, 2020. If the initial draw has not been made by June 30, 2020, then all commitments expire on June 30, 2020. The facility fee, interest rate and financial covenants are consistent with those of our revolving credit agreement. There is no prepayment penalty. For a detailed discussion of our debt, including our senior notes, credit agreement and commercial paper program, please refer to Note 13 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Acquisitions and Divestiture For a detailed discussion of our acquisitions and divestitures, please refer to Notes 3 and 4 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data Liquidity Requirements We believe our cash balances, investment securities, operating cash flows, and funds available under our credit agreement and our commercial paper program or from other public or private financing sources, taken together, provide adequate resources to fund ongoing operating and regulatory requirements, acquisitions, future expansion opportunities, and capital expenditures for at least the next twelve months, as well as to refinance or repay debt, and repurchase shares. Adverse changes in our credit rating may increase the rate of interest we pay and may impact the amount of credit available to us in the future. Our investment-grade credit rating at December 31, 2019 was BBB+ according to Standard & Poor’s Rating Services, or S&P, and Baa3 according to Moody’s Investors Services, Inc., or Moody’s. A downgrade by S&P to BB+ or by Moody’s to Ba1 triggers an interest rate increase of 25 basis points with respect to $250 million of our senior notes. Successive one notch downgrades increase the interest rate an additional 25 basis points, or annual interest expense by $1 million, up to a maximum 100 basis points, or annual interest expense by $3 million. In addition, we operate as a holding company in a highly regulated industry. Humana Inc., our parent company, is dependent upon dividends and administrative expense reimbursements from our subsidiaries, most of which are subject to regulatory restrictions. We continue to maintain significant levels of aggregate excess statutory capital and surplus in our state-regulated operating subsidiaries. Cash, cash equivalents, and short-term investments at the parent company increased to $1.4 billion at December 31, 2019 from $578 million at December 31, 2018. This increase primarily reflects insurance subsidiaries dividends, non-insurance subsidiaries' profits and net proceeds from debt issuance, partially offset by common stock repurchases, insurance subsidiaries' capital contributions, repayment of debt and capital expenditures. Our use of operating cash derived from our non-insurance subsidiaries, such as our Healthcare Services segment, is generally not restricted by Departments of Insurance (or comparable state regulatory agencies). Our regulated insurance subsidiaries paid dividends to the parent of $1.8 billion in 2019, $2.3 billion in 2018, and $1.4 billion in 2017. Refer to our parent company financial statements and accompanying notes in Schedule I - Parent Company Financial Information. The amount of ordinary dividends that may be paid to our parent company in 2020 is approximately $1 billion, in the aggregate. Actual dividends paid may vary due to consideration of excess statutory capital and surplus and expected future surplus requirements related to, for example, premium volume and product mix. Regulatory Requirements For a detailed discussion of our regulatory requirements, including aggregate statutory capital and surplus as well as dividends paid from the subsidiaries to the parent, please refer to Note 16 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Contractual Obligations We are contractually obligated to make payments for years subsequent to December 31, 2019 as follows: (1) Interest includes the estimated contractual interest payments under our debt agreements. (2) We lease facilities, computer hardware, and other furniture and equipment under long-term operating leases that are noncancelable and expire on various dates through 2046 . We sublease facilities or partial facilities to third party tenants for space not used in our operations which partially mitigates our operating lease commitments. See also Note 10 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. (3) Purchase obligations include agreements to purchase services, primarily information technology related services, or to make improvements to real estate, in each case that are enforceable and legally binding on us and that specify all significant terms, including: fixed or minimum levels of service to be purchased; fixed, minimum or variable price provisions; and the appropriate timing of the transaction. Purchase obligations exclude agreements that are cancelable without penalty. (4) Includes future policy benefits payable ceded to third parties through 100% coinsurance agreements as more fully described in Note 19 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We expect the assuming reinsurance carriers to fund these obligations and reflected these amounts as reinsurance recoverables included in other long-term assets on our consolidated balance sheet. Amounts payable in less than one year are included in trade accounts payable and accrued expenses in the consolidated balance sheet. Off-Balance Sheet Arrangements As of December 31, 2019, we were not involved in any special purpose entity, or SPE, transactions. For a detailed discussion of off-balance sheet arrangements, please refer to Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Guarantees and Indemnifications For a detailed discussion of our guarantees and indemnifications, please refer to Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Government Contracts For a detailed discussion of our government contracts, including our Medicare, Military, and Medicaid contracts, please refer to Note 17 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements and accompanying notes, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements and accompanying notes requires us to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. We continuously evaluate our estimates and those critical accounting policies primarily related to benefits expense and revenue recognition as well as accounting for impairments related to our investment securities, goodwill, and long-lived assets. These estimates are based on knowledge of current events and anticipated future events and, accordingly, actual results ultimately may differ from those estimates. We believe the following critical accounting policies involve the most significant judgments and estimates used in the preparation of our consolidated financial statements. Benefits Expense Recognition Benefits expense is recognized in the period in which services are provided and includes an estimate of the cost of services which have been incurred but not yet reported, or IBNR. IBNR represents a substantial portion of our benefits payable as follows: Our reserving practice is to consistently recognize the actuarial best point estimate within a level of confidence required by actuarial standards. For further discussion of our reserving methodology, including our use of completion and claims per member per month trend factors to estimate IBNR, refer to Note 2 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. The completion and claims per member per month trend factors are the most significant factors impacting the IBNR estimate. The portion of IBNR estimated using completion factors for claims incurred prior to the most recent two months is generally less variable than the portion of IBNR estimated using trend factors. The following table illustrates the sensitivity of these factors assuming moderately adverse experience and the estimated potential impact on our operating results caused by reasonably likely changes in these factors based on December 31, 2019 data: (a) Reflects estimated potential changes in benefits payable at December 31, 2019 caused by changes in completion factors for incurred months prior to the most recent two months. (b) Reflects estimated potential changes in benefits payable at December 31, 2019 caused by changes in annualized claims trend used for the estimation of per member per month incurred claims for the most recent two months. (c) The factor change indicated represents the percentage point change. The following table provides a historical perspective regarding the accrual and payment of our benefits payable, excluding military services. Components of the total incurred claims for each year include amounts accrued for current year estimated benefits expense as well as adjustments to prior year estimated accruals. Refer to Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data for Retail and Group and Specialty segment tables including information about incurred and paid claims development as of December 31, 2019, net of reinsurance, as well as cumulative claim frequency and the total of IBNR included within the net incurred claims amounts. The following table summarizes the changes in estimate for incurred claims related to prior years attributable to our key assumptions. As previously described, our key assumptions consist of trend and completion factors estimated using an assumption of moderately adverse conditions. The amounts below represent the difference between our original estimates and the actual benefits expense ultimately incurred as determined from subsequent claim payments. (a) The factor change indicated represents the percentage point change. As previously discussed, our reserving practice is to consistently recognize the actuarial best estimate of our ultimate liability for claims. Actuarial standards require the use of assumptions based on moderately adverse experience, which generally results in favorable reserve development, or reserves that are considered redundant. We experienced favorable medical claims reserve development related to prior fiscal years of $336 million in 2019, $503 million in 2018, and $483 million in 2017. The table below details our favorable medical claims reserve development related to prior fiscal years by segment for 2019, 2018, and 2017. The favorable medical claims reserve development for 2019, 2018, and 2017 primarily reflects the consistent application of trend and completion factors estimated using an assumption of moderately adverse conditions. Our favorable development for each of the years presented above is discussed further in Note 11 to the consolidated financial statements included in Item 8. - Financial Statements and Supplementary Data. We continually adjust our historical trend and completion factor experience with our knowledge of recent events that may impact current trends and completion factors when establishing our reserves. Because our reserving practice is to consistently recognize the actuarial best point estimate using an assumption of moderately adverse conditions as required by actuarial standards, there is a reasonable possibility that variances between actual trend and completion factors and those assumed in our December 31, 2019 estimates would fall towards the middle of the ranges previously presented in our sensitivity table. There was no benefit expense excluded from the previous table for the years ended December 31, 2019 and 2018. Benefits expense reduced by $22 million associated with future policy benefits for the year ended December 31, 2017 was excluded from the previous table. Revenue Recognition We generally establish one-year commercial membership contracts with employer groups, subject to cancellation by the employer group on 30-day written notice. Our Medicare contracts with CMS renew annually. Our military services contracts with the federal government and certain contracts with various state Medicaid programs generally are multi-year contracts subject to annual renewal provisions. We receive monthly premiums from the federal government and various states according to government specified payment rates and various contractual terms. We bill and collect premium from employer groups and members in our Medicare and other individual products monthly. Changes in premium revenues resulting from the periodic changes in risk-adjustment scores derived from medical diagnoses for our membership are estimated by projecting the ultimate annual premium and recognized ratably during the year with adjustments each period to reflect changes in the ultimate premium. Premiums revenue is estimated by multiplying the membership covered under the various contracts by the contractual rates. Premiums revenue is recognized as income in the period members are entitled to receive services, and is net of estimated uncollectible amounts, retroactive membership adjustments, and adjustments to recognize rebates under the minimum benefit ratios required under the Health Care Reform Law. We estimate policyholder rebates by projecting calendar year minimum benefit ratios for the small group and large group markets, as defined by the Health Care Reform Law using a methodology prescribed by HHS, separately by state and legal entity. Medicare Advantage products are also subject to minimum benefit ratio requirements under the Health Care Reform Law. Estimated calendar year rebates recognized ratably during the year are revised each period to reflect current experience. Retroactive membership adjustments result from enrollment changes not yet processed, or not yet reported by an employer group or the government. We routinely monitor the collectability of specific accounts, the aging of receivables, historical retroactivity trends, estimated rebates, as well as prevailing and anticipated economic conditions, and reflect any required adjustments in current operations. Premiums received prior to the service period are recorded as unearned revenues. Medicare Risk-Adjustment Provisions CMS utilizes a risk-adjustment model which apportions premiums paid to Medicare Advantage, or MA, plans according to health severity. The risk-adjustment model, which CMS implemented pursuant to the Balanced Budget Act of 1997(BBA) and the Benefits Improvement and Protection Act of 2000 (BIPA), generally pays more for enrollees with predictably higher costs. Under the risk-adjustment methodology, all MA plans must collect and submit the necessary diagnosis code information from hospital inpatient, hospital outpatient, and physician providers to CMS within prescribed deadlines. The CMS risk-adjustment model uses this diagnosis data to calculate the risk-adjusted premium payment to MA plans. Rates paid to MA plans are established under an actuarial bid model, including a process that bases our payments on a comparison of our beneficiaries’ risk scores, derived from medical diagnoses, to those enrolled in the government’s Medicare FFS program. We generally rely on providers, including certain providers in our network who are our employees, to code their claim submissions with appropriate diagnoses, which we send to CMS as the basis for our payment received from CMS under the actuarial risk-adjustment model. We also rely on providers to appropriately document all medical data, including the diagnosis data submitted with claims. CMS is phasing-in the process of calculating risk scores using diagnoses data from the Risk Adjustment Processing System, or RAPS, to diagnoses data from the Encounter Data System, or EDS. The RAPS process requires MA plans to apply a filter logic based on CMS guidelines and only submit diagnoses that satisfy those guidelines. For submissions through EDS, CMS requires MA plans to submit all the encounter data and CMS will apply the risk adjustment filtering logic to determine the risk scores. For 2019, 25% of the risk score was calculated from claims data submitted through EDS. CMS will increase that percentage to 50% in 2020 and has proposed to increase that percentage to 75% in 2021. The phase-in from RAPS to EDS could result in different risk scores from each dataset as a result of plan processing issues, CMS processing issues, or filtering logic differences between RAPS and EDS, and could have a material adverse effect on our results of operations, financial position, or cash flows. We estimate risk-adjustment revenues based on medical diagnoses for our membership. The risk-adjustment model, including CMS changes to the submission process, is more fully described in Item 1. - Business under the section titled “Individual Medicare,” and in Item 1A. - Risk Factors. Investment Securities Investment securities totaled $11.4 billion, or 39% of total assets at December 31, 2019, and $10.4 billion, or 41% of total assets at December 31, 2018. The investment portfolio was primarily comprised of debt securities, detailed below, at December 31, 2019 and entirely at December 31, 2018. The fair value of debt securities were as follows at December 31, 2019 and 2018: Approximately 96% of our debt securities were investment-grade quality, with a weighted average credit rating of AA by S&P at December 31, 2019. Most of the debt securities that were below investment-grade were rated BB, the higher end of the below investment-grade rating scale. Tax-exempt municipal securities were diversified among general obligation bonds of states and local municipalities in the United States as well as special revenue bonds issued by municipalities to finance specific public works projects such as utilities, water and sewer, transportation, or education. Our general obligation bonds are diversified across the United States with no individual state exceeding 1% of our total debt securities. Our investment policy limits investments in a single issuer and requires diversification among various asset types. Gross unrealized losses and fair values aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows at December 31, 2019: Under the other-than-temporary impairment model for debt securities held, we recognize an impairment loss in income in an amount equal to the full difference between the amortized cost basis and the fair value when we have the intent to sell the debt security or it is more likely than not we will be required to sell the debt security before recovery of our amortized cost basis. However, if we do not intend to sell the debt security, we evaluate the expected cash flows to be received as compared to amortized cost and determine if a credit loss has occurred. In the event of a credit loss, only the amount of the impairment associated with the credit loss is recognized currently in income with the remainder of the loss recognized in other comprehensive income. When we do not intend to sell a security in an unrealized loss position, potential other-than-temporary impairment is considered using a variety of factors, including the length of time and extent to which the fair value has been less than cost; adverse conditions specifically related to the industry, geographic area or financial condition of the issuer or underlying collateral of a security; payment structure of the security; changes in credit rating of the security by the rating agencies; the volatility of the fair value changes; and changes in fair value of the security after the balance sheet date. For debt securities, we take into account expectations of relevant market and economic data. For example, with respect to mortgage and asset-backed securities, such data includes underlying loan level data and structural features such as seniority and other forms of credit enhancements. A decline in fair value is considered other-than-temporary when we do not expect to recover the entire amortized cost basis of the security. We estimate the amount of the credit loss component of a debt security as the difference between the amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate of future cash flows discounted at the implicit interest rate at the date of purchase. The risks inherent in assessing the impairment of an investment include the risk that market factors may differ from our expectations, facts and circumstances factored into our assessment may change with the passage of time, or we may decide to subsequently sell the investment. The determination of whether a decline in the value of an investment is other than temporary requires us to exercise significant diligence and judgment. The discovery of new information and the passage of time can significantly change these judgments. The status of the general economic environment and significant changes in the national securities markets influence the determination of fair value and the assessment of investment impairment. There is a continuing risk that declines in fair value may occur and additional material realized losses from sales or other-than-temporary impairments may be recorded in future periods. All issuers of securities we own that were trading at an unrealized loss at December 31, 2019 remain current on all contractual payments. After taking into account these and other factors previously described, we believe these unrealized losses primarily were caused by an increase in market interest rates in the current markets since the time the securities were purchased. At December 31, 2019, we did not intend to sell the securities with an unrealized loss position in accumulated other comprehensive income, and it is not likely that we will be required to sell these securities before recovery of their amortized cost basis. As a result, we believe that the securities with an unrealized loss were not other-than-temporarily impaired at December 31, 2019. There were no material other-than-temporary impairments in 2019, 2018, or 2017. Goodwill and Long-lived Assets At December 31, 2019, goodwill and other long-lived assets represented 21% of total assets and 50% of total stockholders’ equity, compared to 23% and 58%, respectively, at December 31, 2018. We are required to test at least annually for impairment at a level of reporting referred to as the reporting unit, and more frequently if adverse events or changes in circumstances indicate that the asset may be impaired. A reporting unit either is our operating segments or one level below the operating segments, referred to as a component, which comprise our reportable segments. A component is considered a reporting unit if the component constitutes a business for which discrete financial information is available that is regularly reviewed by management. We are required to aggregate the components of an operating segment into one reporting unit if they have similar economic characteristics. Goodwill is assigned to the reporting unit that is expected to benefit from a specific acquisition. We use the one-step process to review goodwill for impairment to determine both the existence and amount of goodwill impairment, if any. Our strategy, long-range business plan, and annual planning process support our goodwill impairment tests. These tests are performed, at a minimum, annually in the fourth quarter, and are based on an evaluation of future discounted cash flows. We rely on this discounted cash flow analysis to determine fair value. However outcomes from the discounted cash flow analysis are compared to other market approach valuation methodologies for reasonableness. We use discount rates that correspond to a market-based weighted-average cost of capital and terminal growth rates that correspond to long-term growth prospects, consistent with the long-term inflation rate. Key assumptions in our cash flow projections, including changes in membership, premium yields, medical and operating cost trends, and certain government contract extensions, are consistent with those utilized in our long-range business plan and annual planning process. If these assumptions differ from actual, including the impact of the Health Care Reform Law or changes in Government rates, the estimates underlying our goodwill impairment tests could be adversely affected. Goodwill impairment tests completed in each of the last three years did not result in an impairment loss. The fair value of our reporting units with significant goodwill exceeded carrying amounts by a substantial margin. A 100 basis point increase in the discount rate would not have a significant impact on the amount of margin for any of our reporting units with significant goodwill, with the exception of our clinical and provider reporting units in our Healthcare Services segment. Our clinical and provider reporting units primarily provide services to our Retail members. A significant increase in the discount rate, decrease in the long-term growth rate, or substantial reductions in our underlying cash flow assumptions, including revenue growth rates, medical and operating cost trends, and projected operating income, could have a negative impact on the estimated fair value of these reporting units. The clinical reporting unit had a fair value of $544 million which exceeded its carrying value of $533 million by $11 million or 2%. If the discount rate increased 100 basis points, then the clinical reporting unit would incur an impairment loss of approximately $62 million. The provider reporting unit had a fair value of $2.3 billion which exceeded its carrying value of $1.3 billion by $1.0 billion or 78%. The provider reporting unit estimate of fair value relies on multiple assumptions regarding the underlying long-term cash flows, any one of which may be significantly impacted by future changes in estimates and may negatively impact fair value. The clinical and provider reporting units account for $524 million and $761 million, respectively, of goodwill. Impairment tests completed for 2019, 2018, and 2017 did not result in an impairment loss. Long-lived assets consist of property and equipment and other finite-lived intangible assets. These assets are depreciated or amortized over their estimated useful life, and are subject to impairment reviews. We periodically review long-lived assets whenever adverse events or changes in circumstances indicate the carrying value of the asset may not be recoverable. In assessing recoverability, we must make assumptions regarding estimated future cash flows and other factors to determine if an impairment loss may exist, and, if so, estimate fair value. We also must estimate and make assumptions regarding the useful life we assign to our long-lived assets. If these estimates or their related assumptions change in the future, we may be required to record impairment losses or change the useful life, including accelerating depreciation or amortization for these assets. There were no material impairment losses in the last three years.

<s>[INST] Executive Overview General Humana Inc., headquartered in Louisville, Kentucky, is a leading health and wellbeing company committed to helping our millions of medical and specialty members achieve their best health. Our successful history in care delivery and health plan administration is helping us create a new kind of integrated care with the power to improve health and wellbeing and lower costs. Our efforts are leading to a better quality of life for people with Medicare, families, individuals, military service personnel, and communities at large. To accomplish that, we support physicians and other health care professionals as they work to deliver the right care in the right place for their patients, our members. Our range of clinical capabilities, resources and tools, such as inhome care, behavioral health, pharmacy services, data analytics and wellness solutions, combine to produce a simplified experience that makes health care easier to navigate and more effective. Our industry relies on two key statistics to measure performance. The benefit ratio, which is computed by taking total benefits expense as a percentage of premiums revenue, represents a statistic used to measure underwriting profitability. The operating cost ratio, which is computed by taking total operating costs, excluding Merger termination fee and related costs, net, and depreciation and amortization, as a percentage of total revenue less investment income, represents a statistic used to measure administrative spending efficiency. Business Segments We manage our business with three reportable segments: Retail, Group and Specialty, and Healthcare Services. Beginning January 1, 2018, we exited the individual commercial fullyinsured medical health insurance business, as well as certain other business in 2018, and therefore no longer report separately the Individual Commercial segment and the Other Businesses category in the current year. Previously, the Other Businesses category included businesses that were not individually reportable because they did not meet the quantitative thresholds required by generally accepted accounting principles, primarily our closedblock of commercial longterm care insurance policies which were sold in 2018. The reportable segments are based on a combination of the type of health plan customer and adjacent businesses centered on wellbeing solutions for our health plans and other customers, as described below. These segment groupings are consistent with information used by our Chief Executive Officer, the chief operating decision maker, to assess performance and allocate resources. See Note 18 to the consolidated financial statements included in Item 8. Financial Statements and Supplementary Data for segment financial information. The Retail segment consists of Medicare benefits, marketed to individuals or directly via group Medicare accounts. In addition, the Retail segment also includes our contract with CMS to administer the Limited Income Newly Eligible Transition, or LINET, prescription drug plan program and contracts with various states to provide Medicaid, dual eligible, and LongTerm Support Services benefits, which we refer to collectively as our statebased contracts. The Group and Specialty segment consists of employer group commercial fullyinsured medical and specialty health insurance benefits marketed to individuals and employer groups, including dental, vision, and other supplemental health benefits, as well as administrative services only, or ASO products. In addition, our Group and Specialty segment includes our military services business, primarily our TRICARE T2017 East Region contract. The Healthcare Services segment includes our services offered to our health plan members as well as to third parties, including pharmacy solutions, provider services, and clinical care service, such as home health and other services and capabilities to promote wellness and advance population health, including our minority investment in Kindred at Home. The results of each segment are measured by income before income taxes and equity in net earnings from Kindred at Home, or segment earnings. Transactions between reportable segments primarily consist of sales of services rendered by our Healthcare Services segment, primarily pharmacy, provider, and clinical care services, to our Retail and Group and Specialty segment customers. Intersegment sales and expenses are recorded at fair value and eliminated in consolidation. Members served by our segments often use the same provider networks, enabling us in some instances to obtain more favorable contract terms with providers. Our segments also share indirect costs and assets. As a result, the profitability of each segment is interdependent. We allocate most operating expenses to our segments. Assets and certain corporate income and expenses are not allocated to the segments, including the portion of investment income not supporting segment operations, interest expense on corporate debt, and certain other corporate exp [/INST] Negative. </s>

US ECOLOGY, INC.

2015-03-02

2014-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General US Ecology, Inc. is a leading North American provider of environmental services to commercial and government entities. The Company addresses the complex waste management needs of its customers, offering treatment, disposal and recycling of hazardous, non-hazardous and radioactive waste, as well as a wide range of complementary field and industrial services. US Ecology's comprehensive knowledge of the waste business, its collection of waste management facilities combined and focus on safety, environmental compliance, and customer service enables us to effectively meet the needs of our customers and to build long-lasting relationships. Headquartered in Boise, Idaho, we are one of the oldest providers of such services in North America. Prior to June 17, 2014, our operations consisted primarily of our six fixed facilities located near Beatty, Nevada; Richland, Washington; Robstown, Texas; Grand View, Idaho; Detroit, Michigan and Blainville, Québec, Canada. These facilities generate revenue from fees charged to treat and dispose of waste and from fees charged to perform various field and industrial services for our customers. On June 17, 2014, the Company acquired 100% of the outstanding shares of EQ Holdings, Inc. and its wholly-owned subsidiaries (collectively "EQ"). EQ is a fully integrated environmental services company providing waste treatment and disposal, wastewater treatment, remediation, recycling, industrial cleaning and maintenance, transportation, total waste management, technical services, and emergency response services to a variety of industries and customers in North America. As a result of our acquisition of EQ, we have made changes to the manner in which we manage our business, make operating decisions and assess our performance. Under our new structure our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental Services-This segment includes all of the legacy US Ecology operations and the legacy EQ treatment and disposal facilities. It provides a broad range of hazardous material management services including transportation, recycling, treatment and disposal of hazardous and non-hazardous waste at Company-owned landfill, wastewater and other treatment facilities. Field & Industrial Services-This segment includes all of the field and industrial service business of the legacy EQ operation. It provides packaging and collection of hazardous waste and total waste management solutions at customer sites and through our 10-day transfer facilities. Services include on-site management, waste characterization, transportation and disposal of non-hazardous and hazardous waste. This segment also provides specialty services such as high-pressure and chemical cleaning, centrifuge and materials processing, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response and other services to commercial and industrial facilities and to government entities. Prior to the acquisition of EQ, our operations were managed in two reportable segments: Operating Disposal Facilities and Non-Operating Disposal Facilities. The Operating Disposal Facility segment represented disposal facilities accepting hazardous and radioactive waste while the Non-Operating Disposal Facility segment represented facilities not accepting hazardous and/or radioactive waste or formerly proposed new facilities. All operations of both the former Operating Disposal Facilities and the Non-Operating Disposal Facilities segment are now included in the Environmental Services segment. None of the Company's operations prior to the acquisition of EQ have been assigned to the Field & Industrial Services segment. Detailed financial information for our reportable segments can be found in Note 18 to the Consolidated Financial Statements under Item 8 - Financial Statements and Supplementary Data of this Form 10-K. We divide our Environmental Services segment customers into categories to better evaluate period-to-period changes in our treatment and disposal ("T&D") revenue based on service mix and type of business (recurring customer "Base Business" or waste clean-up project "Event Business"). Each of these categories is described in the table below, along with information on the percentage of total T&D revenues by category, for the years ended December 31, 2014 and 2013. (1)Excludes all transportation service revenue (2)Excludes EQ Holdings, Inc. which was acquired on June 17, 2014 A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and unit pricing. For the year ended December 31, 2014, approximately 41% of our T&D revenue, excluding EQ, was derived from Event Business projects. The one-time nature of Event Business, diverse spectrum of waste types received and widely varying unit pricing necessarily creates variability in revenue and earnings. This variability may be influenced by general and industry-specific economic conditions, funding availability, changes in laws and regulations, government enforcement actions or court orders, public controversy, litigation, weather, commercial real estate, closed military bases and other redevelopment project timing, government appropriation and funding cycles and other factors. The types and amounts of waste received from Base Business also vary from quarter to quarter. This variability can cause significant quarter-to-quarter and year-to-year differences in revenue, gross profit, gross margin, operating income and net income. Also, while we pursue many large projects months or years in advance of work performance, both large and small clean-up project opportunities routinely arise with little or no prior notice. These market dynamics are inherent to the waste disposal business and are factored into our projections and externally communicated business outlook statements. Our projections combine historical experience with identified sales pipeline opportunities, new or expanded service line projections and prevailing market conditions. During 2014, Base Business revenue, excluding EQ, increased 5% compared to 2013. Base Business revenue was approximately 59% of total 2014 T&D revenue, down slightly from 62% in 2013. Our business is highly competitive and no assurance can be given that we will maintain these revenue levels or increase our market share. Depending on project-specific customer needs and competitive economics, transportation services may be offered at or near our cost to help secure new business. For waste transported by rail from the eastern United States and other locations distant from our Grand View, Idaho and Robstown, Texas facilities, transportation-related revenue can account for as much as 75% of total project revenue. While bundling transportation and disposal services reduces overall gross profit as a percentage of total revenue ("gross margin"), this value-added service has allowed us to win multiple projects that management believes we could not have otherwise competed for successfully. Our Company-owned fleet of gondola railcars, which is periodically supplemented with railcars obtained under operating leases, has reduced our transportation expenses by largely eliminating reliance on more costly short-term rentals. These Company-owned railcars also help us to win business during times of demand-driven railcar scarcity. The increased waste volumes resulting from projects won through this bundled service strategy further drive operating leverage benefits inherent to the disposal business, increasing profitability. While waste treatment and other variable costs are project-specific, the incremental earnings contribution from large and small projects generally increases as overall disposal volumes increase. Based on past experience, management believes that maximizing operating income, net income and earnings per share is a higher priority than maintaining or increasing gross margin. We intend to continue aggressively bidding bundled transportation and disposal services based on this proven strategy. To maximize utilization of our railcar fleet, we periodically deploy available railcars to transport waste from clean-up sites to disposal facilities operated by other companies. Such transportation services may also be bundled with for-profit logistics and field services support work. We serve oil refineries, chemical production plants, steel mills, waste brokers/aggregators serving small manufacturers and other industrial customers that are generally affected by the prevailing economic conditions and credit environment. Adverse conditions may cause our customers as well as those they serve to curtail operations, resulting in lower waste production and/or delayed spending on off-site waste shipments, maintenance, waste clean-up projects and other work. Factors that can impact general economic conditions and the level of spending by customers include, but are not limited to, consumer and industrial spending, increases in fuel and energy costs, conditions in the real estate and mortgage markets, labor and healthcare costs, access to credit, consumer confidence and other global economic factors affecting spending behavior. Market forces may also induce customers to reduce or cease operations, declare bankruptcy, liquidate or relocate to other countries, any of which could adversely affect our business. To the extent business is either government funded or driven by government regulations or enforcement actions, we believe it is less susceptible to general economic conditions. Spending by government agencies may also be reduced due to declining tax revenues resulting from a weak economy or changes in policy. Disbursement of funds appropriated by Congress may also be delayed for various reasons. Our results of operations have been affected by certain significant events during the past three fiscal years including, but not limited to: 2014 Events Acquisition of EQ Holdings, Inc.: On June 17, 2014, the Company acquired 100% of the outstanding shares of EQ Holdings, Inc. and its wholly-owned subsidiaries (collectively "EQ"). EQ is a fully integrated environmental services company providing waste treatment and disposal, wastewater treatment, remediation, recycling, industrial cleaning and maintenance, transportation, total waste management, technical services, and emergency response services to a variety of industries and customers in North America. The total purchase price was $460.9 million, net of cash acquired, and was funded through a combination of cash on hand and borrowings under a new $415.0 million term loan. The acquisition of EQ affects the comparability of 2014 with previous years, including as follows: • Revenue and operating income from the legacy EQ business for the period from June 17, 2014 to December 31, 2014 included in the Company's consolidated statements of operations for the year ended December 31, 2014 were $228.2 million and $18.5 million, respectively. • We incurred $6.4 million of business development expenses during the year ended December 31, 2014 in connection with the EQ acquisition primarily for due diligence and business integration purposes. • We recorded $252.9 million of intangible assets and $197.2 million of goodwill on our Consolidated Balance Sheet as a result of the acquisition. Acquired finite-lived intangibles will be amortized over their estimated useful life ranging from one to 45 years. Goodwill and indefinite-lived intangibles are tested for impairment at least annually. 2013 Events Full year of Dynecol, Inc. Operations: 2013 included a full year of operating results for Dynecol, Inc. ("Dynecol"), which was acquired on May 31, 2012. 2012 includes only the seven months of operating results subsequent to the acquisition. Public Common Stock Offering: In December 2013, we sold and issued 2,990,000 shares of our common stock, including 390,000 shares pursuant to the underwriters' option to purchase additional shares, at a price of $34.00 per share. We received net proceeds of $96.4 million after deducting underwriting discounts, commissions and offering expenses. $30.0 million of the net proceeds were used to repay amounts outstanding under our former credit agreement with the remainder used for general corporate purposes. 2012 Events Acquisition of Dynecol: On May 31, 2012, the Company acquired 100% of the outstanding shares of Dynecol, a chemical and industrial byproducts treatment and reuse facility located in Detroit, Michigan, for a total purchase price of $10.8 million. The acquisition of Dynecol affects the comparability of 2012 with other years as follows: • Revenue and operating loss from Dynecol included in the Company's consolidated statements of operations for the seven months of ownership in 2012 were $6.7 million and $161,000, respectively. • We incurred $348,000 of business development expense in connection with the Dynecol acquisition primarily for due diligence and business integration purposes. • We recorded $1.9 million of intangible assets and $1.3 million of goodwill on the Consolidated Balance Sheet as a result of the acquisition. Finite-lived intangibles will be amortized over their estimated useful life ranging from 1 to 15 years. Goodwill and indefinite-lived intangibles are tested for impairment at least annually. Results of Operations Our operating results and percentage of revenues for the years ended December 31, 2014, 2013 and 2012 were as follows: The primary financial measure used by management to assess segment performance is Adjusted EBITDA. Adjusted EBITDA is defined as net income before net interest expense, income tax expense, depreciation, amortization, stock based compensation, accretion of closure and post-closure liabilities, foreign currency gain/loss and other income/expense, which are not considered part of usual business operations. The reconciliation of Adjusted EBITDA to Net Income for the years ended December 31, 2014, 2013 and 2012 is as follows: Adjusted EBITDA is a complement to results provided in accordance with accounting principles generally accepted in the United States ("GAAP") and we believe that such information provides additional useful information to analysts, stockholders and other users to understand the Company's operating performance. Since Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA as presented may not be comparable to other similarly titled measures of other companies. Items excluded from Adjusted EBITDA are significant components in understanding and assessing our financial performance. Adjusted EBITDA should not be considered in isolation or as an alternative to, or substitute for, net income, cash flows generated by operations, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation or a substitute for analyzing our results as reported under GAAP. Some of the limitations are: • Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; • Adjusted EBITDA does not reflect our interest expense, or the requirements necessary to service interest or principal payments on our debt; • Adjusted EBITDA does not reflect our income tax expenses or the cash requirements to pay our taxes; • Adjusted EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; and • Although depreciation and amortization charges are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements. 2014 Compared to 2013 Revenue Total revenue increased 122% to $447.4 million in 2014, compared with $201.1 million in 2013. The acquired EQ operations contributed $228.2 million of revenue subsequent to the acquisition on June 17, 2014. Excluding EQ operations, total revenue increased 9% to $219.2 million in 2014, compared with $201.1 million in 2013. Revenue from EQ is excluded from percentages of Base and Event Business and customer category information in the following paragraphs. Environmental Services Environmental Services segment revenue increased 55% to $311.8 million in 2014, compared to $201.1 million in 2013. The acquired EQ operations contributed $90.9 million of segment revenue subsequent to the acquisition of EQ on June 17, 2014. Excluding EQ operations, segment revenue increased 9% to $219.2 million in 2014, compared with $201.1 million in 2013. T&D revenue (excluding EQ) increased 9% in 2014 compared to 2013, primarily as a result of a 16% increase in project-based Event Business. Transportation service revenue (excluding EQ) increased 12% compared to 2013, reflecting more Event Business projects utilizing the Company's transportation and logistics services. During 2014, we disposed of or processed 1.2 million tons of waste (excluding EQ), an increase of 12% compared to 1.1 million tons in 2013. Our average selling price for treatment and disposal services (excluding transportation and EQ) in 2014 was 2% lower than our average selling price in 2013. T&D revenue from recurring Base Business customers increased 5% in 2014 compared to 2013 and comprised 59% of total T&D revenue. As discussed further below, the slight increase in Base Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from our broker, "other industry" and government Base Business customer categories, partially offset by lower T&D revenue from our refinery Base Business customer category. Event Business revenue increased 16% in 2014 compared to 2013 and was 41% of T&D revenue for 2013. As discussed further below, the increase in Event Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from our private clean-up, broker and "other industry" Event Business customer categories, partially offset by lower T&D revenue from our government and refinery Event Business customer categories. The following table summarizes combined Base Business and Event Business revenue growth by customer category for 2014 as compared to 2013: T&D revenue from private clean-up projects increased 31% in 2014 compared to 2013. This increase primarily reflects revenue from an East Coast clean-up project and other smaller remedial projects. Revenues from our other industry customer category increased 17% in 2014 compared to 2013 primarily as a result of changes in shipments from this broadly diverse industrial customer category. Our broker business increased 8% in 2014 compared to 2013 primarily as a result of changes in shipments across the broad range of government and industry waste generators directly served by multiple broker customers. Rate-regulated business at our Richland, Washington LLRW disposal facility increased 1% in 2014 compared to 2013. Our Richland facility operates under a State-approved annual revenue requirement. The increases reflect the timing of revenue recognition for the rate-regulated portion of the business. Government clean-up business revenue decreased 11% in 2014 compared to 2013 due to reduced shipments from the USACE and the completion of a military base clean-up project in 2013 that that was not replaced in 2014. T&D revenue from the USACE decreased approximately 19% in 2014 compared to 2013 due to project-specific timing at multiple USACE clean-up sites and federal spending reductions. T&D revenue from our refinery customers decreased 13% in 2014 compared to 2013, primarily reflecting lower landfill disposal volumes. Field & Industrial Services Our Field & Industrial Services segment was added in 2014 as a result of our acquisition of EQ on June 17, 2014. Field & Industrial Services segment revenue was $135.6 million for the period subsequent to the acquisition. Gross Profit Total gross profit increased 85% to $145.8 million in 2014, up from $79.0 million in 2013. The acquired EQ operations contributed $57.4 million of gross profit subsequent to the acquisition on June 17, 2014. Excluding EQ operations, total gross profit increased 12.0% to $88.4 million in 2014, compared with $79.0 million in 2013. Total gross margin in 2014 was 33%. Excluding EQ operations, total gross margin was 40%. Environmental Services Environmental Services segment gross profit increased 49% to $117.5 million in 2014, up from $79.0 million in 2013. The acquired EQ operations contributed $29.1 million of segment gross profit subsequent to the acquisition on June 17, 2014. Excluding EQ operations, segment gross profit increased 12.0% to $88.4 million in 2014, compared with $79.0 million in 2013. This increase primarily reflects higher treatment and disposal volumes in 2014 compared to 2013. Total segment gross margin in 2014 was 38%. Excluding EQ operations, total segment margin was 40%. T&D gross margin (excluding EQ) was 49% in 2014. Field & Industrial Services Our Field & Industrial Services segment was added in 2014 as a result of our acquisition of EQ on June 17, 2014. Field & Industrial Services segment gross profit was $28.3 million and segment gross margin was 21% for the period subsequent to the acquisition. Selling, General and Administrative Expenses ("SG&A") Total SG&A increased 181% to $73.3 million in 2014, up from $26.1 million in 2013. The acquired EQ operations contributed $38.9 million of SG&A subsequent to the acquisition on June 17, 2014. Excluding EQ operations, total SG&A was $34.4 million, or 16% of total revenue in 2014, compared with $26.1 million, or 13% of total revenue in 2013. Environmental Services Environmental Services segment SG&A increased 64% to $19.4 million in 2014, up from $11.8 million in 2013. The acquired EQ operations contributed $7.6 million of segment SG&A subsequent to the acquisition on June 17, 2014. Excluding EQ operations, total segment SG&A was $11.8 million, or 5% of segment revenue in 2014, compared with $11.8 million, or 6% of segment revenue in 2013. Field & Industrial Services Our Field & Industrial Services segment was added in 2014 as a result of our acquisition of EQ on June 17, 2014. Field & Industrial Services segment SG&A was $13.7 million, or 10% of segment revenue, for the period subsequent to the acquisition. Corporate Corporate SG&A increased 183% to $40.2 million in 2014, up from $14.2 million in 2013. The acquired EQ operations contributed $17.6 million of corporate SG&A subsequent to the acquisition on June 17, 2014. Excluding EQ operations, total corporate SG&A was $22.6 million, or 10% of total revenue in 2014, compared with $14.2 million, or 7% of total revenue in 2013. 2014 corporate SG&A includes $6.4 million of business development expenses related to the acquisition of EQ. The remaining increase primarily reflects higher labor costs, variable incentive compensation costs and other administrative expenses supporting increased business activity. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2014 was 37.4% compared to 35.9% in 2013. The increase reflects non-deductible business development expenses associated with the acquisition of EQ, partially offset by a higher proportion of earnings from our Canadian operations, which are taxed at a lower corporate tax rate. During 2014 we reduced our unrecognized tax benefit by $480,000 due to the expiration of certain statutes of limitations, which had a favorable impact on our 2014 effective tax rate. As of December 31, 2014, we had approximately $1.3 million in federal net operating loss carry forwards ("NOLs") acquired from EQ. As of December 31, 2014, we had approximately $21.7 million in state NOLs for which we maintain nearly a full valuation allowance. These state NOLs are located in states where we currently do little or no business or where we do not expect to generate future taxable income. We consider it unlikely that we will utilize these NOLs in the future. Our gross state NOLs were decreased as a result of a change in various state laws impacting how NOLs are determined, which had no impact to our annual effective tax rate since these NOLs were entirely offset by the valuation allowance. Interest expense Interest expense was $10.7 million in 2014 compared with $828,000 in 2013. The increase is a result of higher debt levels and the related interest expense on borrowings under the Company's credit facility used to finance the acquisition of EQ. Foreign currency gain (loss) We recognized a $1.5 million non-cash foreign currency loss in 2014 compared with a $2.3 million non-cash foreign currency loss in 2013. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Stablex facility is owned by our Canadian subsidiary, whose functional currency is the Canadian dollar ("CAD"). Also, as part of our treasury management strategy we established intercompany loans between our parent company, US Ecology, and Stablex. These intercompany loans are payable by Stablex to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2014, we had $20.7 million of intercompany loans subject to currency revaluation. Depreciation and amortization of plant and equipment Depreciation and amortization expense was $24.4 million in 2014, an increase of 65% compared to 2013. The acquired EQ operations contributed $9.0 million of depreciation and amortization expense subsequent to the acquisition on June 17, 2014. Excluding EQ operations, depreciation and amortization expense was $15.4 million in 2014, compared with $14.8 million in 2013. Amortization of intangibles Intangible assets amortization expense was $8.2 million in 2014, an increase of 462% compared to 2013. Excluding $6.8 million of intangible assets amortization expense on new intangible assets recorded as a result of the acquisition of EQ, intangible assets amortization expense was $1.4 million in 2014, compared with $1.5 million in 2013. Stock-based compensation Stock-based compensation expense increased 45% to $1.3 million in 2014, compared with $865,000 in 2013 as a result of an increase in equity-based awards granted to employees. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities increased 138% to $2.7 million in 2014, compared with $1.1 million in 2013. The acquired EQ operations contributed $1.2 million of accretion and non-cash adjustment of closure and post-closure liabilities subsequent to the acquisition on June 17, 2014. Excluding EQ operations, accretion and non-cash adjustment of closure and post-closure liabilities was $1.5 million in 2014, compared with $1.1 million in 2013. 2013 Compared to 2012 All 2013 and 2012 financial results of the Company are now included in the Environmental Services segment. As such, the Field & Industrial Services segment is not applicable to the discussion of 2013 and 2012 financial results and is excluded from the explanations below. Revenue Environmental Services segment revenue increased 19% to $201.1 million in 2013, compared with $169.1 million in 2012. Dynecol, acquired on May 31, 2012, contributed $12.3 million of segment revenue in 2013 compared with $6.7 million of segment revenue during the seven months we owned the operation in 2012. Excluding Dynecol, segment revenue increased $26.5 million, or 16.0%, in 2013 compared to 2012. T&D revenue (excluding Dynecol) increased 11% in 2013 compared to 2012, primarily as a result of a 27% increase in project-based Event Business. Transportation service revenue (excluding Dynecol) increased 51% compared to 2012, reflecting more Event Business projects utilizing the Company's transportation and logistics services. Revenue from Dynecol is excluded from percentages of Base and Event Business and customer category information in the following paragraphs. During 2013, we disposed of or processed 1.1 million tons of waste, an increase of 2% compared to 2012. Our average selling price for treatment and disposal services (excluding transportation) in 2013 was 11% higher than our average selling price in 2012, reflecting a more favorable service mix in 2013. During 2013, T&D revenue from recurring Base Business customers increased 2% compared to 2012 and comprised 60% of total T&D revenue in 2013 compared with 65% of T&D revenue in 2012. As discussed further below, the slight increase in Base Business T&D revenue in 2013 compared to 2012 primarily reflects higher T&D revenue from our broker Base Business customer category, partially offset by lower T&D revenue from our "other industry" and refinery Base Business customer categories. Event Business revenue increased 27% in 2013 compared to 2012 and comprised 40% of total T&D revenue in 2013 compared with 35% of total T&D revenue in 2012. As discussed further below, the increase in Event Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from our private clean-up and refinery Event Business customer categories, partially offset by lower T&D revenue from our government Event Business customer category. The following table summarizes combined Base Business and Event Business revenue growth by customer category for 2013 as compared to 2012: T&D revenue from private clean-up projects increased 188% in 2013 compared to 2012. This increase primarily reflects revenue from a nuclear fuel fabrication facility decommissioning project and an East Coast clean-up project. T&D revenue from our refinery customers increased 33% in 2013 compared to 2012. This increase primarily reflects T&D revenue on thermal recycling projects sourced directly from refinery customers. The increase is also partially attributable to a refinery clean-up project in 2013. Our broker business increased 5% in 2013 compared to 2012. This increase was the result of shipments across the broad range of government and industry waste generators directly served by multiple broker customers, partially offset by lower volumes of brokered thermal recycling projects. Rate-regulated business at our Richland, Washington LLRW disposal facility increased 3% in 2013 compared to 2012. Our Richland facility operates under a State-approved annual revenue requirement. The increase reflects the timing of revenue recognition for the rate-regulated portion of the business. Our other industry revenue category decreased 3% in 2013 compared to 2012 as a result of reduced shipments from this broadly diverse industrial customer category. Government clean-up business revenue decreased 45% in 2013 compared to 2012 due to reduced shipments from the USACE and a military base clean-up project in 2012 that was not replaced in 2013. T&D revenue from the USACE decreased approximately 30% in 2013 compared with 2012. This decrease was due to project-specific timing at multiple USACE clean-up sites and federal spending reductions. Gross Profit Environmental Services segment gross profit increased 19% to $79.0 million in 2013, up from $66.3 million in 2012. This increase primarily reflects a higher average selling price in 2013 compared to 2012. Total segment gross margin was 39% in both 2013 and 2012. T&D gross margin was 48% in 2013, up from 46% in 2012, reflecting a more favorable service mix in 2013. The increase was also partially attributable to lower costs for chemical reagents used to treat waste prior to disposal in 2013 compared to 2012. Selling, General and Administrative Expenses Environmental Services Environmental Services segment SG&A increased to $11.8 million, or 6% of total revenue, in 2013, compared with $11.6 million, or 8% of total revenue, in 2012. The dollar increase primarily reflects a full twelve months of SG&A expenses related to Dynecol operations in 2013 and higher labor expenses, partially offset by lower variable incentive compensation. Corporate Corporate SG&A increased to $14.2 million in 2013, compared with $14.1 million in 2012. The increase was primarily attributable to an increase in professional services fees, partially offset by lower business development expenses. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2013 was 35.9% compared to 38.5% in 2012. This decrease reflects a higher proportion of earnings from our Canadian operations, which are taxed at a lower corporate tax rate, partially offset by higher U.S. state income taxes. As of December 31, 2013, we had approximately $122.1 million in state net operating loss carry forwards ("NOLs") for which we maintain nearly a full valuation allowance. These state NOLs are located in states where we currently do little or no business or where we do not expect to generate future taxable income. We consider it unlikely that we will utilize these NOLs in the future. Interest expense Interest expense for 2013 was $828,000, down from $878,000 for 2012, primarily reflecting lower average debt levels in 2013. Foreign currency gain (loss) We recognized a $2.3 million non-cash foreign currency loss in 2013 compared with a $1.2 million non-cash foreign currency gain in 2012. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Stablex facility is owned by our Canadian subsidiary, whose functional currency is the CAD. Also, as part of our treasury management strategy we established intercompany loans between our parent company, US Ecology, and Stablex. These intercompany loans are payable by Stablex to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2013, we had $35.7 million of intercompany loans subject to currency revaluation. Liquidity and Capital Resources Our primary sources of liquidity are cash and cash equivalents, cash generated from operations and borrowings under the Credit Agreement. At December 31, 2014, we had $23.0 million in cash and cash equivalents immediately available. We assess our liquidity in terms of our ability to generate cash to fund our operating, investing and financing activities. Our primary ongoing cash requirements are funding operations, capital expenditures, paying interest and required principal payments of our long-term debt, and paying declared dividends pursuant to our dividend policy. We believe future operating cash flows will be sufficient to meet our future operating, investing and dividend cash needs for the foreseeable future. Furthermore, existing cash balances and availability of additional borrowings under our Credit Agreement provide additional sources of liquidity should they be required. Operating Activities. In 2014, net cash provided by operating activities was $71.4 million. This primarily reflects net income of $38.2 million, non-cash depreciation, amortization and accretion of $35.3 million, unrealized foreign currency losses of $2.4 million, an increase in deferred revenue of $1.9 million and an increase in deferred income taxes of $2.0 million, partially offset by an increase in receivables of $4.4 million, a decrease in accounts payable and accrued liabilities of $2.9 million and an increase in income taxes receivable of $1.8 million. Impacts on net income are due to the factors discussed above under Results of Operations. Non-cash foreign currency losses reflect a weaker CAD relative to the USD in 2014. The increase in deferred revenue and receivables is primarily attributable to the timing of the treatment and disposal of waste associated with a significant east coast clean-up project. The changes in income taxes receivable are primarily attributable to the timing of income tax payments. Days sales outstanding was 77 days as of December 31, 2014, compared to 62 days as of December 31, 2013. The increase in days sales outstanding is attributable to the increase in revenue from waste management services as a result of our acquisition of EQ on June 17, 2014. Due to the higher number of smaller customers, waste management services provided by our new Field & Industrial Services segment have a longer payment cycle than waste treatment and disposal services provided by our Environmental Services segment. Field & Industrial Services segment revenue comprised 30% of total revenue in 2014. In 2013, net cash provided by operating activities was $49.6 million. This primarily reflects net income of $32.1 million, non-cash depreciation, amortization and accretion of $17.4 million, an increase in income taxes payable of $4.1 million, unrealized non-cash foreign currency losses of $2.8 million and share-based compensation expense of $865,000, partially offset by an increase in receivables of $10.4 million and a decrease in deferred income taxes of $2.6 million. Impacts on net income are due to the factors discussed above under Results of Operations. The increase in income taxes payable is primarily attributable to the timing of income tax payments. The non-cash foreign currency loss reflects a weaker CAD relative to the USD in 2013. The increase in receivables is primarily attributable to the timing of the treatment and disposal of waste associated with a large east coast clean-up project. In 2012, net cash provided by operating activities was $35.2 million. This primarily reflects net income of $25.7 million, non-cash depreciation, amortization and accretion of $16.8 million and an increase in accrued salaries and benefits of $1.9 million, partially offset by a decrease in accrued closure and post-closure obligations of $2.3 million, a decrease in accounts payable and accrued liabilities of $2.2 million, an increase in receivables of $1.9 million and unrealized non-cash foreign currency gains of $1.4 million. Impacts on 2012 net income are due to the factors discussed above under Results of Operations. The increase in accrued salaries and benefits is primarily attributable to an increase in incentive compensation. The decrease in accrued closure and post-closure liabilities is primarily attributable to cash payments during 2012 for capping filled disposal cells at our Robstown, Texas and Blainville, Québec, Canada facilities. The decrease in accrued liabilities is primarily attributable to the payment of fiscal year 2011 accrued customer refunds related to our rate-regulated business in Richland, Washington. The increase in receivables is primarily attributable to the timing of customer payments. The non-cash foreign currency gain reflects a stronger CAD relative to the USD in 2012. Investing Activities. In 2014, net cash used in investing activities was $488.5 million, primarily related to the purchase of EQ for $460.9 million, net of cash acquired, and capital expenditures of $28.4 million. Significant capital projects included construction of additional disposal capacity at our Blainville, Quebec, Canada location and equipment purchases and infrastructure upgrades at all of our corporate and operating facilities. In 2013, net cash used in investing activities was $21.2 million, primarily attributable to capital expenditures of $21.4 million. Significant capital projects included the purchase of land for future expansion of our Robstown, Texas operation, construction of additional disposal capacity at our Grand View, Idaho, Beatty, Nevada and Blainville, Quebec, Canada locations, and equipment purchases and infrastructure upgrades at all of our corporate and operating facilities. In 2012, net cash used in investing activities was $26.3 million, primarily attributable to capital expenditures of $15.8 million and the acquisition of Dynecol for $10.7 million, net of cash acquired. Significant capital projects included construction of additional disposal capacity at our Grand View, Idaho and Blainville, Québec, Canada locations and equipment purchases and infrastructure upgrades at all of our corporate and operating facilities. Financing Activities. During 2014, net cash provided by financing activities was $366.8 million, consisting primarily of $414.0 million of net proceeds from the Company's new term loan used to partially finance the acquisition of EQ, offset in part by $19.4 million of term loan repayments, $15.5 million of dividend payments to our stockholders and $14.0 million of deferred financing costs associated with the Company's new Credit Agreement. During 2013, net cash provided by financing activities was $43.7 million, consisting primarily of $96.4 million of net proceeds received from our public common stock offering (discussed further below) and $2.5 million of proceeds from stock option exercises, partially offset by $45.0 million of net repayments under the Credit Agreement and $10.0 million of dividends paid to our stockholders. During 2012, net cash used in financing activities was $11.2 million, consisting primarily of $16.4 million of dividends paid to our stockholders (including a one-time accelerated quarterly dividend payment in December 2012), partially offset by net borrowings under the Credit Agreement of $4.5 million incurred primarily to finance the Dynecol acquisition and fund working capital requirements. Credit Facility On June 17, 2014, in connection with the acquisition of EQ, the Company entered into a new $540.0 million senior secured credit agreement (the "Credit Agreement") with a syndicate of banks comprised of a $415.0 million term loan (the "Term Loan") with a maturity date of June 17, 2021 and a $125.0 million revolving line of credit (the "Revolving Credit Facility") with a maturity date of June 17, 2019. Upon entering into the Credit Agreement, the Company terminated its existing credit agreement with Wells Fargo, dated October, 29, 2010, as amended (the "Former Agreement"). Immediately prior to the termination of the Former Agreement, there were no outstanding borrowings under the Former Agreement. No early termination penalties were incurred as a result of the termination of the Former Agreement. Term Loan The Term Loan provides an initial commitment amount of $415.0 million, the proceeds of which were used to acquire 100% of the outstanding shares of EQ and pay related transaction fees and expenses. The Term Loan bears interest at a base rate (as defined in the Credit Agreement) plus 2.00% or LIBOR plus 3.00%, at the Company's option. The Term Loan is subject to amortization in equal quarterly installments in an aggregate annual amount equal to 1.00% of the original principal amount of the Term Loan. At December 31, 2014, the effective interest rate on the Term Loan was 3.75%. Interest only payments are due either monthly or on the last day of any interest period, as applicable. As set forth in the Credit Agreement, the Company is required to enter into one or more interest rate hedge agreements in amounts sufficient to fix the interest rate on at least 50% of the principal amount of the $415.0 million Term Loan. In October 2014, the Company entered into an interest rate swap agreement with Wells Fargo, effectively fixing the interest rate on $250.0 million, or 63%, of the Term Loan principal outstanding as of December 31, 2014. Revolving Credit Facility The Revolving Credit Facility provides up to $125.0 million of revolving credit loans or letters of credit with the use of proceeds restricted solely for working capital and other general corporate purposes. Under the Revolving Credit Facility, revolving loans are available based on a base rate (as defined in the Credit Agreement) or LIBOR, at the Company's option, plus an applicable margin which is determined according to a pricing grid under which the interest rate decreases or increases based on our ratio of funded debt to earnings before interest, taxes, depreciation and amortization ("EBITDA"). The Company is required to pay a commitment fee of 0.50% per annum on the unused portion of the Revolving Credit Facility, with such commitment fee to be reduced based upon the Company's total leverage ratio as defined in the Credit Agreement. The maximum letter of credit capacity under the new revolving credit facility is $50.0 million and the Credit Agreement provides for a letter of credit fee equal to the applicable margin for LIBOR loans under the Revolving Credit Facility. Interest only payments are due either monthly or on the last day of any interest period, as applicable. At December 31, 2014, there were no borrowings outstanding on the Revolving Credit Facility. The availability under the Revolving Credit Facility was $89.1 million with $35.9 million of the Revolving Credit Facility issued in the form of standby letters of credit utilized as collateral for closure and post-closure financial assurance and other assurance obligations. Except as set forth below, the Company may prepay the Term Loan or permanently reduce the Revolving Credit Facility commitment under the Credit Agreement at any time without premium or penalty (other than customary "breakage" costs with respect to the early termination of LIBOR loans). On or prior to six months after the closing of the Credit Agreement, if we prepay the initial term loans or amend the pricing terms of the initial term loans, in each case in connection with a reduction of the effective yield, we are required to pay a 1% prepayment premium (unless in connection with a change of control, sale or permitted acquisition). Subject to certain exceptions, the Credit Agreement provides for mandatory prepayment upon certain asset dispositions, casualty events and issuances of indebtedness. The Credit Agreement is also subject to mandatory annual prepayments commencing in December 2015 if our total leverage (defined as the ratio of our consolidated funded debt as of the last day of the applicable fiscal year to our adjusted EBITDA for such period) exceeds certain ratios as follows: 50% of our adjusted excess cash flow (as defined in the Credit Agreement and which takes into account certain adjustments) if our total leverage ratio is greater than 2.50 to 1.00, with step-downs to 0% if our total leverage ratio is equal to or less than 2.50 to 1.00. Pursuant to (i) an unconditional guarantee agreement (the "Guarantee") and (ii) a collateral agreement (the "Collateral Agreement"), each entered into by the Company and its domestic subsidiaries on June 17, 2014 in connection with the Credit Agreement, the Company's obligations under the Credit Agreement are jointly and severally and fully and unconditionally guaranteed on a senior basis by all of the Company's existing and certain future domestic subsidiaries and the Credit Agreement is secured by substantially all of the Company's and its domestic subsidiaries' assets except the Company's and its domestic subsidiaries' real property. The Credit Agreement contains customary restrictive covenants, subject to certain permitted amounts and exceptions, including covenants limiting the ability of the Company to incur additional indebtedness, pay dividends and make other restricted payments, repurchase shares of our outstanding stock and create certain liens. We may only declare quarterly or annual dividends if on the date of declaration, no event of default has occurred and no other event or condition has occurred that would constitute default due to the payment of the dividend. The Credit Agreement also contains a financial maintenance covenant, which is a maximum Consolidated Senior Secured Leverage Ratio, as defined in the Credit Agreement, and is only applicable to the Revolving Credit Facility. Our Consolidated Senior Secured Leverage Ratio as of the last day of any fiscal quarter, commencing with June 30, 2014, may not exceed the ratios indicated below: At December 31, 2014, we were in compliance with all of the financial covenants in the Credit Agreement. Public Common Stock Offering. In December 2013, we sold and issued 2,990,000 shares of our common stock, including 390,000 shares pursuant to the underwriters' option to purchase additional shares, at a price of $34.00 per share. We received net proceeds of $96.4 million after deducting underwriting discounts, commissions and offering expenses. $30.0 million of the net proceeds were used to repay amounts outstanding under the Credit Agreement with the remainder available for general corporate purposes, including potential future acquisitions. Contractual Obligations and Guarantees Contractual Obligations US Ecology's contractual obligations at December 31, 2014 mature as follows: (1)For the purposes of the table above, closure and post-closure obligations are shown on an undiscounted basis and inflated using an estimated annual inflation rate of 2.6%. Cash payments for closure and post-closure obligation extend to the year 2105. (2)The Term Loan portion of the Credit Agreement with Wells Fargo matures on June 17, 2021 and is subject to amortization in equal quarterly installments in an aggregate annual amount of $4.0 million beginning March 31, 2015. (3)Interest expense has been calculated using the effective interest rate of 3.75% in effect at December 31, 2014 on the unhedged variable rate portion of the outstanding principal and 5.17% on the fixed rate hedged portion of the outstanding principal beginning December 31, 2014, the effective date of the Company's interest rate swap agreement with Wells Fargo. The interest expense calculation reflects assumed principal reductions consistent with the disclosures in footnote (2) above. Guarantees We enter into a wide range of indemnification arrangements, guarantees and assurances in the ordinary course of business and have evaluated agreements that contain guarantees and indemnification clauses. These include tort indemnities, tax indemnities, indemnities against third-party claims arising out of arrangements to provide services to us and indemnities related to the sale of our securities. We also indemnify individuals made party to any suit or proceeding if that individual was acting as an officer or director of US Ecology or was serving at the request of US Ecology or any of its subsidiaries during their tenure as a director or officer. We also provide guarantees and indemnifications for the benefit of our wholly-owned subsidiaries to satisfy performance obligations, including closure and post-closure financial assurances. It is difficult to quantify the maximum potential liability under these indemnification arrangements; however, we are not currently aware of any material liabilities to the Company or any of its subsidiaries arising from these arrangements. Environmental Matters We maintain funded trusts agreements, surety bonds and insurance policies for future closure and post-closure obligations at both current and formerly operated disposal facilities. These funded trust agreements, surety bonds and insurance policies are based on management estimates of future closure and post-closure monitoring using engineering evaluations and interpretations of regulatory requirements which are periodically updated. Accounting for closure and post-closure costs includes final disposal cell capping and revegetation, soil and groundwater monitoring and routine maintenance and surveillance required after a site is closed. We estimate that our undiscounted future closure and post-closure costs for all facilities was approximately $312.2 million at December 31, 2014, with a median payment year of 2060. Our future closure and post-closure estimates are our best estimate of current costs and are updated periodically to reflect current technology, cost of materials and services, applicable laws, regulations, permit conditions or orders and other factors. These current costs are adjusted for anticipated annual inflation, which we assumed to be 2.6% as of December 31, 2014. These future closure and post-closure estimates are discounted to their present value for financial reporting purposes using our credit-adjusted risk-free interest rate, which approximates our incremental long-term borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. At December 31, 2014, our weighted-average credit-adjusted risk-free interest rate was 5.9%. For financial reporting purposes, our recorded closure and post-closure obligations were $72.9 million and $17.5 million as of December 31, 2014 and 2013, respectively. Through December 31, 2014, we have met our financial assurance requirements through insurance, surety bonds, standby letters of credit and self-funded restricted trusts. US Operating and Non-Operating Facilities We cover our closure and post-closure obligations for our U.S. operating facilities through the use of third-party insurance policies, surety bonds and standby letters of credit. Insurance policies covering our closure and post-closure obligations expire in December 2015. Our total policy limits are approximately $45.5 million. At December 31, 2014 our trust accounts had $4.1 million for our closure and post-closure obligations and are identified as Restricted cash and investments on our consolidated balance sheet. All closure and post-closure funding obligations for our Beatty, Nevada and Richland, Washington facilities revert to the state. Volume based fees are collected from our customers and remitted to state controlled trust funds to cover the estimated cost of closure and post-closure obligations. Stablex We use commercial surety bonds to cover our closure obligations for our Stablex facility located in Blainville, Québec, Canada. Our lease agreement with the Province of Québec requires that the surety bond be maintained for 25 years after the lease expires in 2023. At December 31, 2014 we had $779,000 in commercial surety bonds dedicated for closure obligations. These bonds were renewed in November 2014 and expire November 2015. Post-closure funding obligations for the Stablex landfill revert back to the Province of Québec through a dedicated trust account that is funded based on a per-metric-ton disposed fee by Stablex. We expect to renew insurance policies and commercial surety bonds in the future. If we are unable to obtain adequate closure, post-closure or environmental liability insurance and/or commercial surety bonds in future years, any partial or completely uninsured claim against us, if successful and of sufficient magnitude, could have a material adverse effect on our financial condition, results of operations or cash flows. Additionally, continued access to casualty and pollution legal liability insurance with sufficient limits, at acceptable terms, is important to obtaining new business. Failure to maintain adequate financial assurance could also result in regulatory action including early closure of facilities. While we believe we will be able to maintain the requisite financial assurance policies at a reasonable cost, premium and collateral requirements may materially increase. Operation of disposal facilities creates operational, closure and post-closure obligations that could result in unplanned monitoring and corrective action costs. We cannot predict the likelihood or effect of all such costs, new laws or regulations, litigation or other future events affecting our facilities. We do not believe that continuing to satisfy our environmental obligations will have a material adverse effect on our financial condition or results of operations. Seasonal Effects Seasonal fluctuations due to weather and budgetary cycles can influence the timing of customer spending for our services. Typically, in the first quarter of each calendar year there is less demand for our services due to reduced construction and business activities related to weather while we experience improvement in our second and third quarters of each calendar year as weather conditions and other business activity improves. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates included in our critical accounting policies discussed below and those accounting policies and use of estimates discussed in Notes 2 and 3 to the Consolidated Financial Statements. We base our estimates on historical experience and on various assumptions and other factors we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We make adjustments to judgments and estimates based on current facts and circumstances on an ongoing basis. Historically, actual results have not deviated significantly from those determined using the estimates described below or in Notes 2 and 3 to the Consolidated Financial Statements located in Item 8 - Financial Statements and Supplementary Data to this Form 10-K. However, actual amounts could differ materially from those estimated at the time the consolidated financial statements are prepared. We believe the following critical accounting policies are important to understand our financial condition and results of operations and require management's most difficult, subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, delivery and disposal have occurred or services have been rendered, the price is fixed or determinable and collection is reasonably assured. We recognize revenue from three primary sources: 1) waste treatment, recycling and disposal, 2) field and industrial waste management services and 3) waste transportation services. Waste treatment and disposal revenue results primarily from fees charged to customers for treatment and/or disposal or recycling of specified wastes. Waste treatment and disposal revenue is generally charged on a per-ton or per-yard basis based on contracted prices and is recognized when services are complete. Field and industrial waste management services revenue results primarily from specialty onsite services such as high-pressure and chemical cleaning, centrifuge and materials processing, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response at refineries, chemical plants, utilities, pulp and paper mills, automotive and other government, commercial and industrial facilities. These services are provided based on purchase orders or agreements with the customer and include prices based upon daily, hourly or job rates for equipment, materials and personnel. Revenues are recognized over the term of the agreements or as services are performed. Revenue is recognized on contracts with retainage when services have been rendered and collectability is reasonably assured. Transportation revenue results from delivering customer waste to a disposal facility for treatment and/or disposal or recycling. Transportation services are generally not provided on a stand-alone basis and instead are bundled with other Company services. However, in some instances we provide transportation and logistics services for shipment of waste from clean-up sites to disposal facilities operated by other companies. We account for our bundled arrangements as multiple deliverable arrangements and determine the amount of revenue recognized for each deliverable (unit of accounting) using the relative fair value method. Transportation revenue is recognized when the transported waste is received at the disposal facility. Waste treatment and disposal revenue under bundled arrangements is recognized when services are complete and the waste is disposed in the landfill. Burial fees collected from customers for each ton or cubic yard of waste disposed in our landfills are paid to the respective local and/or state government entity and are not included in revenue. Revenue and associated costs from waste that has been received but not yet treated and disposed of in our landfills are deferred until disposal occurs. Our Richland, Washington disposal facility is regulated by the WUTC, which approves our rates for disposal of LLRW. Annual revenue levels are established based on a six-year rate agreement with the WUTC at amounts sufficient to cover the costs of operation and provide us with a reasonable profit. Per-unit rates charged to LLRW customers during the year are based on our evaluation of disposal volume and radioactivity projections submitted to us by waste generators. Our proposed rates are then reviewed and approved by the WUTC. If annual revenue exceeds the approved levels set by the WUTC, we are required to refund excess collections to facility users on a pro-rata basis. The current rate agreement with the WUTC was extended in 2013 and is effective until January 1, 2020. Disposal Facility Accounting In general, a disposal cell development asset exists for the cost of building new disposal space and a closure liability exists for closing, maintaining and monitoring the disposal unit once this space is filled. Major assumptions and judgments used to calculate cell development assets and closure liabilities are as follows: • Personnel and equipment costs incurred to construct new disposal cells are identified and capitalized as a cell development asset. • The cell development asset is amortized as each available cubic yard, or cubic meter in the case of Stablex, of disposal space is filled. Periodic independent engineering surveys and inspection reports are used to determine the remaining volume available. These reports take into account volume, compaction rates and space reserved for capping filled disposal cells. • We record the fair value of an Asset Retirement Obligation ("ARO") as a liability in the period in which we incur a legal obligation associated with the retirement of tangible long-lived assets. We are also required to record a corresponding asset that is amortized over the life of the underlying tangible asset. After the initial measurement, the ARO is adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. The closure liability (obligation) represents the present value of current cost estimates to close, maintain and monitor disposal cells and support facilities. Cost estimates are developed using input from our technical and accounting personnel as well as independent engineers and our interpretation of current requirements, and are intended to approximate fair value. We estimate the timing of future payments based on expected annual disposal airspace consumption and then accrete the current cost estimate by an inflation rate, estimated at December 31, 2014 to be 2.6%. Inflated current costs are then discounted using our credit-adjusted risk-free interest rate, which approximates our incremental borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. Our weighted-average credit-adjusted risk-free interest rate at December 31, 2014 approximated 5.9%. Final closure and post-closure monitoring obligations are currently estimated as being paid through the year 2105. During 2014, we updated several assumptions. This included the estimated cost of closing disposal cells. These updates resulted in a net increase to our closure post-closure obligation of $7.2 million, comprised of an increase of $7.2 million in retirement assets and $77,000 recorded as a charge to other direct costs. Changes in inflation rates or the estimated costs, timing or extent of the required future activities to close, maintain and monitor disposal cells and facilities result in both: (i) a current adjustment to the recorded liability and related asset and (ii) a change in the liability and asset amounts to be recorded prospectively over the remaining life of the asset in accordance with our depreciation policy. A hypothetical 1% increase in the inflation rate would increase our closure/post-closure obligation by $15.2 million. A hypothetical 10% increase in our cost estimates would increase our closure/post-closure obligation by $7.4 million. Goodwill and Intangible Assets As of December 31, 2014, the Company's goodwill balance was $217.2 million. We assess goodwill for impairment during the fourth quarter of each year, and also if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Some of the factors that could indicate impairment include a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, or operating losses at the reporting unit. The assessment consists of comparing the fair value of the reporting unit to the carrying value of the net assets assigned to the reporting unit, including goodwill. We determine our reporting units by identifying the components of each operating segment, and then aggregate components having similar economic characteristics based on quantitative and / or qualitative factors. At December 31, 2014, we had 17 reporting units, eight of which had allocated goodwill. Fair values are determined by using both the market approach, applying a multiple of earnings based on guideline for publicly traded companies, and the income approach, discounting projected future cash flows based on our expectations of the current and future operating environment. The rates used to discount projected future cash flows reflect a weighted average cost of capital based on our industry, capital structure and risk premiums including those reflected in the current market capitalization. In the event the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill test would be performed to measure the amount of impairment loss. In the event that we determine that the value of goodwill has become impaired, we will incur an accounting charge for the amount of impairment during the period in which the determination has been made. The result of the annual assessment of goodwill undertaken in the fourth quarter of 2014 indicated no goodwill impairment charges were required for any of our reporting units. We review intangible assets with indefinite useful lives for impairment during the fourth quarter of each year. We also review both indefinite-lived and finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of an intangible asset may not be recoverable. In order to assess whether a potential impairment exists, the assets' carrying values are compared with their undiscounted expected future cash flows. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. Impairments are measured by comparing the fair value of the asset to its carrying value. Fair value is generally determined by considering: (i) the internally developed discounted projected cash flow analysis of the asset; (ii) actual third-party valuations; and/or (iii) information available regarding the current market environment for similar assets. If the fair value of an asset is determined to be less than the carrying amount of the asset, an impairment in the amount of the difference is recorded in the period in which the events or changes in circumstances that indicated the carrying value of the assets may not be recoverable occurred. No events or circumstances occurred during 2014 that would indicate that our intangible assets may be impaired, therefore no impairment tests were performed during 2014 other than the annual assessment of intangible assets with indefinite useful lives conducted in the fourth quarter of every year. The result of the annual assessment undertaken in the fourth quarter of 2014 indicated no impairment of our intangible assets with indefinite useful lives. Share Based Payments The Company's Board of Directors grants options to purchase our common stock to certain directors and employees under approved stock option plans. As of December 31, 2014 we have options outstanding under two stock option plans, the 1992 Stock Option Plan for Employees ("1992 Employee Plan") and the 2008 Stock Option Incentive Plan ("2008 Stock Option Plan"). In April 2013, the 1992 Employee Plan expired and was cancelled except for options then outstanding. The Company's Board of Directors has also granted restricted stock awards to certain directors and employees under the Amended and Restated 2005 Non-Employee Director Compensation Plan and the 2006 Restricted Stock Plan. The determination of fair value of stock option awards on the date of grant using the Black-Scholes model is affected by our stock price and subjective assumptions. These assumptions include, but are not limited to, the expected term of stock options and expected stock price volatility over the term of the awards. Refer to Note 16 to the Consolidated Financial Statements located in Item 8 - Financial Statements and Supplementary Data to this Form 10-K for a summary of the assumptions utilized in 2014, 2013 and 2012. Our stock options have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimates. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. When actual forfeitures vary from our estimates, we recognize the difference in compensation expense in the period the actual forfeitures occur or when options vest. Income Taxes Income taxes are accounted for using an asset and liability approach whereby we recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement and tax basis of assets and liabilities at the applicable tax rates. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the enactment date. Deferred tax assets are evaluated for the likelihood of use in future periods. A valuation allowance is recorded against deferred tax assets if, based on the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The determination of the need for a valuation allowance, if any, requires our judgment and the use of estimates. If we determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, we would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes. As of December 31, 2014, we have deferred tax assets totaling approximately $20.2 million, a valuation allowance of $2.7 million and deferred tax liabilities totaling approximately $120.6 million. The application of income tax law is inherently complex. Tax laws and regulations are voluminous and at times ambiguous and interpretations of guidance regarding such tax laws and regulations change over time. This requires us to make many subjective assumptions and judgments regarding the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. A liability for uncertain tax positions is recorded in our financial statements on the basis of a two-step process whereby (1) we determine whether it is more likely than not that the tax position taken will be sustained based on the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is greater than 50% likely to be realized upon ultimate settlement with the related tax authority. As facts and circumstances change, we reassess these probabilities and record any changes in the financial statements as appropriate. Changes in our assumptions and judgments can materially affect our financial position, results of operations and cash flows. We recognize interest assessed by taxing authorities or interest associated with uncertain tax positions as a component of interest expense. We recognize any penalties assessed by taxing authorities or penalties associated with uncertain tax positions as a component of selling, general and administrative expenses. Litigation We have, in the past, been involved in litigation requiring estimates of timing and loss potential whose timing and ultimate disposition is controlled by the judicial process. As of December 31, 2014, we did not have any ongoing, pending or threatened legal action that management believes, either individually or in the aggregate, would have a material adverse effect on our financial position, results of operations or cash flows. The decision to accrue costs or write off assets is based on the pertinent facts and our evaluation of present circumstances. Off Balance Sheet Arrangements We do not have any off balance sheet arrangements or interests in variable interest entities that would require consolidation. US Ecology operates through wholly-owned subsidiaries.

<s>[INST] US Ecology, Inc. is a leading North American provider of environmental services to commercial and government entities. The Company addresses the complex waste management needs of its customers, offering treatment, disposal and recycling of hazardous, nonhazardous and radioactive waste, as well as a wide range of complementary field and industrial services. US Ecology's comprehensive knowledge of the waste business, its collection of waste management facilities combined and focus on safety, environmental compliance, and customer service enables us to effectively meet the needs of our customers and to build longlasting relationships. Headquartered in Boise, Idaho, we are one of the oldest providers of such services in North America. Prior to June 17, 2014, our operations consisted primarily of our six fixed facilities located near Beatty, Nevada; Richland, Washington; Robstown, Texas; Grand View, Idaho; Detroit, Michigan and Blainville, Québec, Canada. These facilities generate revenue from fees charged to treat and dispose of waste and from fees charged to perform various field and industrial services for our customers. On June 17, 2014, the Company acquired 100% of the outstanding shares of EQ Holdings, Inc. and its whollyowned subsidiaries (collectively "EQ"). EQ is a fully integrated environmental services company providing waste treatment and disposal, wastewater treatment, remediation, recycling, industrial cleaning and maintenance, transportation, total waste management, technical services, and emergency response services to a variety of industries and customers in North America. As a result of our acquisition of EQ, we have made changes to the manner in which we manage our business, make operating decisions and assess our performance. Under our new structure our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental ServicesThis segment includes all of the legacy US Ecology operations and the legacy EQ treatment and disposal facilities. It provides a broad range of hazardous material management services including transportation, recycling, treatment and disposal of hazardous and nonhazardous waste at Companyowned landfill, wastewater and other treatment facilities. Field & Industrial ServicesThis segment includes all of the field and industrial service business of the legacy EQ operation. It provides packaging and collection of hazardous waste and total waste management solutions at customer sites and through our 10day transfer facilities. Services include onsite management, waste characterization, transportation and disposal of nonhazardous and hazardous waste. This segment also provides specialty services such as highpressure and chemical cleaning, centrifuge and materials processing, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response and other services to commercial and industrial facilities and to government entities. Prior to the acquisition of EQ, our operations were managed in two reportable segments: Operating Disposal Facilities and NonOperating Disposal Facilities. The Operating Disposal Facility segment represented disposal facilities accepting hazardous and radioactive waste while the NonOperating Disposal Facility segment represented facilities not accepting hazardous and/or radioactive waste or formerly proposed new facilities. All operations of both the former Operating Disposal Facilities and the NonOperating Disposal Facilities segment are now included in the Environmental Services segment. None of the Company's operations prior to the acquisition of EQ have been assigned to the Field & Industrial Services segment. Detailed financial information for our reportable segments can be found in Note 18 to the Consolidated Financial Statements under Item 8 Financial Statements and Supplementary Data of this Form 10K. We divide our Environmental Services segment customers into categories to better evaluate periodtoperiod changes in our treatment and disposal ("T&D") revenue based on service mix and type of business (recurring customer "Base Business" or waste cleanup project "Event Business"). Each of these categories is described in the table below, along with information on the percentage of total T&D revenues by category, for the years ended December 31, 2014 and 2013. (1)Excludes all transportation service revenue (2)Excludes EQ Holdings, Inc. which was acquired on June 17, 2014 A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and [/INST] Negative. </s>

US ECOLOGY, INC.

2016-02-29

2015-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General US Ecology, Inc. is a leading North American provider of environmental services to commercial and government entities. The Company addresses the complex waste management needs of its customers, offering treatment, disposal and recycling of hazardous, non-hazardous and radioactive waste, as well as a wide range of complementary field and industrial services. US Ecology's comprehensive knowledge of the waste business, its collection of waste management facilities and focus on safety, environmental compliance, and customer service enables us to effectively meet the needs of our customers and to build long-lasting relationships. We have fixed facilities and service centers operating in the United States, Canada and Mexico. Our fixed facilities include five RCRA subtitle C hazardous waste landfills and one LLRW landfill located near Beatty, Nevada; Richland, Washington; Robstown, Texas; Grand View, Idaho; Detroit, Michigan and Blainville, Québec, Canada. These facilities generate revenue from fees charged to treat and dispose of waste and from fees charged to perform various field and industrial services for our customers. On June 17, 2014, the Company acquired 100% of the outstanding shares of EQ Holdings, Inc. and its wholly-owned subsidiaries (collectively "EQ"). EQ is a fully integrated environmental services company providing waste treatment and disposal, wastewater treatment, remediation, recycling, industrial cleaning and maintenance, transportation, total waste management, technical services, and emergency response services to a variety of industries and customers in North America. On August 4, 2015, we entered into a definitive agreement to sell our Allstate Power Vac, Inc. ("Allstate") subsidiary to a private investor group and completed the divestiture on November 1, 2015. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information. Our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental Services-This segment provides a broad range of hazardous material management services including transportation, recycling, treatment and disposal of hazardous and non-hazardous waste at Company-owned landfill, wastewater and other treatment facilities. Field & Industrial Services-This segment provides packaging and collection of hazardous waste and total waste management solutions at customer sites and through our 10-day transfer facilities. Services include on-site management, waste characterization, transportation and disposal of non-hazardous and hazardous waste. This segment also provides specialty services such as high-pressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response and other services to commercial and industrial facilities and to government entities. As a result of our continued integration of EQ, we have modified and conformed the categories used to evaluate period-to-period changes in our T&D revenue for our Environmental Services segment. Historically, US Ecology divided T&D revenue into groups based on the industry of the customer. In order to provide better insight into the underlying drivers of our waste volumes and related T&D revenues, beginning with the third quarter of 2015, we now evaluate period-to-period changes in our T&D revenue for our Environmental Services segment based on the industry of the waste generator, based on North American Industry Classification System ("NAICS") codes. We believe the new categorizations provide better insight into our Environmental Services segment T&D revenues. Throughout this Annual Report on Form 10-K, except where noted, prior periods presented have been recast based on the new categorizations. The composition of the Environmental Services segment T&D revenues by waste generator industry for the years ended December 31, 2015 and 2014 were as follows: (1)Excludes all transportation service revenue (2)Excludes EQ Holdings, Inc. which was acquired on June 17, 2014 (3)Includes retail and wholesale trade, rate regulated, construction and other industries As a result of our continued integration of EQ, we have modified and conformed how we define "Base Business" and "Event Business." Previously, US Ecology defined Event Business as non-recurring waste cleanup projects regardless of size, with Base Business representing all recurring business. Beginning with the third quarter of 2015, we now define Event Business as non-recurring projects that are expected to equal or exceed 1,000 tons, with Base Business defined as all other business not meeting the definition of Event Business. We believe the new definitions are a better representation of Base and Event Business and provide better insight into our Environmental Services segment T&D revenues. Throughout this Annual Report on Form 10-K, except where noted, prior periods presented have been recast based on the new definitions. A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and unit pricing. For the year ended December 31, 2015, approximately 26% of our T&D revenue, excluding EQ, was derived from Event Business projects. The one-time nature of Event Business, diverse spectrum of waste types received and widely varying unit pricing necessarily creates variability in revenue and earnings. This variability may be influenced by general and industry-specific economic conditions, funding availability, changes in laws and regulations, government enforcement actions or court orders, public controversy, litigation, weather, commercial real estate, closed military bases and other redevelopment project timing, government appropriation and funding cycles and other factors. The types and amounts of waste received from Base Business also vary from quarter to quarter. This variability can also cause significant quarter-to-quarter and year-to-year differences in revenue, gross profit, gross margin, operating income and net income. While we pursue many projects months or years in advance of work performance, clean-up project opportunities routinely arise with little or no prior notice. These market dynamics are inherent to the waste disposal business and are factored into our projections and externally communicated business outlook statements. Our projections combine historical experience with identified sales pipeline opportunities, new or expanded service line projections and prevailing market conditions. During 2015, Base Business revenue growth, excluding EQ, was flat compared to 2014. Base Business revenue was approximately 74% of total 2015 T&D revenue, up from 68% in 2014. Our business is highly competitive and no assurance can be given that we will maintain these revenue levels or increase our market share. Depending on project-specific customer needs and competitive economics, transportation services may be offered at or near our cost to help secure new business. For waste transported by rail from the eastern United States and other locations distant from our Grand View, Idaho and Robstown, Texas facilities, transportation-related revenue can account for as much as 75% of total project revenue. While bundling transportation and disposal services reduces overall gross profit as a percentage of total revenue ("gross margin"), this value-added service has allowed us to win multiple projects that management believes we could not have otherwise competed for successfully. Our Company-owned fleet of gondola railcars, which is periodically supplemented with railcars obtained under operating leases, has reduced our transportation expenses by largely eliminating reliance on more costly short-term rentals. These Company-owned railcars also help us to win business during times of demand-driven railcar scarcity. The increased waste volumes resulting from projects won through this bundled service strategy further drive operating leverage benefits inherent to the disposal business, increasing profitability. While waste treatment and other variable costs are project-specific, the incremental earnings contribution from large and small projects generally increases as overall disposal volumes increase. Based on past experience, management believes that maximizing operating income, net income and earnings per share is a higher priority than maintaining or increasing gross margin. We intend to continue aggressively bidding bundled transportation and disposal services based on this proven strategy. To maximize utilization of our railcar fleet, we periodically deploy available railcars to transport waste from clean-up sites to disposal facilities operated by other companies. Such transportation services may also be bundled with for-profit logistics and field services support work. We serve oil refineries, chemical production plants, steel mills, waste brokers/aggregators serving small manufacturers and other industrial customers that are generally affected by the prevailing economic conditions and credit environment. Adverse conditions may cause our customers as well as those they serve to curtail operations, resulting in lower waste production and/or delayed spending on off-site waste shipments, maintenance, waste clean-up projects and other work. Factors that can impact general economic conditions and the level of spending by customers include, but are not limited to, consumer and industrial spending, increases in fuel and energy costs, conditions in the real estate and mortgage markets, labor and healthcare costs, access to credit, consumer confidence and other global economic factors affecting spending behavior. Market forces may also induce customers to reduce or cease operations, declare bankruptcy, liquidate or relocate to other countries, any of which could adversely affect our business. To the extent business is either government funded or driven by government regulations or enforcement actions, we believe it is less susceptible to general economic conditions. Spending by government agencies may be reduced due to declining tax revenues resulting from a weak economy or changes in policy. Disbursement of funds appropriated by Congress may also be delayed for various reasons. Our results of operations have been affected by certain significant events during the past three fiscal years including, but not limited to: 2015 Events Full Year of EQ Operations: 2015 includes a full year of operating results for EQ, which was acquired on June 17, 2014. 2014 includes only the operating results during our ownership period from June 17, 2014 to December 31, 2014. Sale of Allstate Power Vac, Inc. ("Allstate") and Goodwill Impairment: On August 4, 2015, we entered into a definitive agreement to sell our Allstate subsidiary to a private investor group. Allstate represents the majority of the industrial services business we acquired with the acquisition of EQ. As a result of this agreement and management's strategic review, we evaluated the recoverability of the assets associated with our industrial services business. Based on this analysis, we recorded a non-cash goodwill impairment charge of $6.7 million, or $0.31 per diluted share, in the second quarter of 2015. On November 1, 2015, we completed the sale of Allstate for cash proceeds of $58.8 million, subject to post-closing adjustments for working capital. We recognized a pre-tax loss on the divestiture of Allstate, including transaction-related costs, of $542,000 in the fourth quarter of 2015. Cash proceeds from the transaction were used to repay debt. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information on the sale of Allstate. 2014 Events Acquisition of EQ Holdings, Inc.: On June 17, 2014, the Company acquired 100% of the outstanding shares of EQ. EQ is a fully integrated environmental services company providing waste treatment and disposal, wastewater treatment, remediation, recycling, industrial cleaning and maintenance, transportation, total waste management, technical services, and emergency response services to a variety of industries and customers in North America. The total purchase price was $460.9 million, net of cash acquired, and was funded through a combination of cash on hand and borrowings under a new $415.0 million term loan. The acquisition of EQ affects the comparability of 2014 with other years, including as follows: • Revenue and operating income from the legacy EQ business for the period from June 17, 2014 to December 31, 2014 included in the Company's consolidated statements of operations for the year ended December 31, 2014 were $228.2 million and $18.5 million, respectively. • We incurred $6.4 million of business development expenses during the year ended December 31, 2014 in connection with the EQ acquisition primarily for due diligence and business integration purposes. • We recorded $252.9 million of intangible assets and $197.6 million of goodwill on our Consolidated Balance Sheet as a result of the acquisition. Acquired finite-lived intangibles will be amortized over their estimated useful life ranging from one to 45 years. Goodwill and indefinite-lived intangibles are tested for impairment at least annually. 2013 Events Public Common Stock Offering: In December 2013, we sold and issued 2,990,000 shares of our common stock, including 390,000 shares pursuant to the underwriters' option to purchase additional shares, at a price of $34.00 per share. We received net proceeds of $96.4 million after deducting underwriting discounts, commissions and offering expenses. $30.0 million of the net proceeds were used to repay amounts outstanding under our Former Agreement (as defined below) with the remainder used for general corporate purposes. Results of Operations Our operating results and percentage of revenues for the years ended December 31, 2015, 2014 and 2013 were as follows: The primary financial measure used by management to assess segment performance is Adjusted EBITDA. Adjusted EBITDA is defined as net income before interest expense, interest income, income tax expense, depreciation, amortization, stock based compensation, accretion of closure and post-closure liabilities, foreign currency gain/loss, non-cash impairment charges, loss on divestiture and other income/expense, which are not considered part of usual business operations. The reconciliation of Adjusted EBITDA to Net Income for the years ended December 31, 2015, 2014 and 2013 is as follows: Adjusted EBITDA is a complement to results provided in accordance with accounting principles generally accepted in the United States ("GAAP") and we believe that such information provides additional useful information to analysts, stockholders and other users to understand the Company's operating performance. Since Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA as presented may not be comparable to other similarly titled measures of other companies. Items excluded from Adjusted EBITDA are significant components in understanding and assessing our financial performance. Adjusted EBITDA should not be considered in isolation or as an alternative to, or substitute for, net income, cash flows generated by operations, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation or a substitute for analyzing our results as reported under GAAP. Some of the limitations are: • Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; • Adjusted EBITDA does not reflect our interest expense, or the requirements necessary to service interest or principal payments on our debt; • Adjusted EBITDA does not reflect our income tax expenses or the cash requirements to pay our taxes; • Adjusted EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; and • Although depreciation and amortization charges are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements. 2015 Compared to 2014 Revenue Total revenue increased 26% to $563.1 million in 2015, compared with $447.4 million in 2014. The acquired EQ operations contributed $359.0 million of revenue in 2015, compared with $228.2 million for our period of ownership in 2014. Excluding EQ operations, total revenue decreased 7% to $204.1 million in 2015, compared with $219.2 million in 2014. Revenue from EQ is excluded from percentages of Base and Event Business and waste generator industry information in the following paragraphs. Environmental Services Environmental Services segment revenue increased 18% to $375.8 million in 2015, compared to $319.8 million in 2014. The acquired EQ operations contributed $171.7 million of segment revenue in 2015 compared with $100.6 million of segment revenue for our period of ownership in 2014. Excluding EQ operations, segment revenue decreased 7% to $204.1 million in 2015, compared with $219.2 million in 2014. T&D revenue (excluding EQ) decreased 8% in 2015 compared to 2014, primarily as a result of a 23% decrease in project-based Event Business. Transportation service revenue (excluding EQ) increased 2% compared to 2014, reflecting more Event Business projects utilizing our transportation and logistics services. Tons of waste disposed of or processed increased 5% in 2015 compared to 2014. Excluding EQ, tons of waste disposed of or processed decreased 20% in 2015 compared to 2014. Growth in T&D revenue from recurring Base Business waste generators was flat compared to 2014 and comprised 74% of total T&D revenue in 2015. During 2015, increases in Base Business T&D revenue from the refining and broker/TSDF industries were offset by decreases in T&D revenue from Base Business in the chemical manufacturing, utilities, and mining, exploration and production industries. T&D revenue from Event Business waste generators decreased 23% in 2015 compared to 2014 and comprised 26% of total T&D revenue in 2015. The decrease in Event Business T&D revenue compared to the prior year primarily reflects lower T&D revenue from the chemical and metal manufacturing, transportation, broker/TSDF, and mining, exploration and production industries, partially offset by higher T&D revenue from the utilities, government and refining industries. The decrease in T&D revenue from the chemical manufacturing industry is primarily attributable to reductions in volume from a large East Coast remedial cleanup project and lower overall industry activity in 2015. The decrease in T&D revenue from the metal manufacturing industry is primarily attributable to lower domestic production of metal related products and services. The decrease in T&D revenue from the mining, exploration and production industry primarily reflects lower industry activity due to lower commodity prices. The following table summarizes combined Base Business and Event Business T&D revenue growth by waste generator industry for 2015 compared to 2014: (1)Excludes EQ Holdings, Inc. which was acquired on June 17, 2014 Field & Industrial Services Our Field & Industrial Services segment was added subsequent to, and as a result of, our acquisition of EQ on June 17, 2014. This segment includes all of the field and industrial service business of the legacy EQ operations and none of the legacy US Ecology operations. Field & Industrial Services segment revenue was $187.2 million in 2015 compared with $127.6 million for our period of ownership in 2014. The Allstate business, which was divested on November 1, 2015, contributed segment revenue of $59.1 million for our period of ownership in 2015 compared with $37.0 million for our period of ownership in 2014. Gross Profit Total gross profit increased 18% to $171.4 million in 2015, up from $145.8 million in 2014. The acquired EQ operations contributed $91.7 million of gross profit in 2015, compared with $57.4 million for our period of ownership in 2014. Excluding EQ operations, total gross profit decreased 10% to $79.7 million in 2015, compared with $88.4 million in 2014. Total gross margin in 2015 was 30%. Excluding EQ operations, total gross margin was 39%. Environmental Services Environmental Services segment gross profit increased 12% to $141.1 million in 2015, up from $125.6 million in 2014. The acquired EQ operations contributed $61.4 million of segment gross profit in 2015 compared with $37.2 million of segment gross profit for our period of ownership in 2014. Excluding EQ operations, segment gross profit decreased 10% to $79.7 million in 2015, compared with $88.4 million in 2014. This decrease primarily reflects lower T&D volumes in 2015 compared to 2014. Total segment gross margin in 2015 was 38%. Excluding EQ operations, total segment margin was 39%. Excluding EQ operations, T&D gross margin was 48% in 2015 compared to 49% in 2014. Field & Industrial Services Our Field & Industrial Services segment was added in 2014 as a result of our acquisition of EQ on June 17, 2014. This segment includes all of the field and industrial service business of the legacy EQ operations and none of the legacy US Ecology operations. Field & Industrial Services segment gross profit and gross margin were $30.3 million and 16%, respectively, in 2015 compared with $20.2 million and 16%, respectively, for our period of ownership in 2014. The Allstate business, which was divested on November 1, 2015, contributed segment gross profit of $12.4 million for our period of ownership in 2015 compared with $8.2 million for our period of ownership in 2014. Selling, General and Administrative Expenses ("SG&A") Total SG&A increased 27% to $93.1 million in 2015, up from $73.3 million in 2014. The acquired EQ operations contributed $56.6 million of SG&A in 2015, compared with $38.9 million for our period of ownership in 2014. Excluding EQ operations, total SG&A was $36.5 million, or 18% of total revenue in 2015, compared with $34.4 million, or 16% of total revenue, in 2014. Environmental Services Environmental Services segment SG&A increased 22% to $23.6 million, or 6% of segment revenue, in 2015, up from $19.4 million, or 6% of segment revenue, in 2014. The acquired EQ operations contributed $12.5 million of segment SG&A in 2015 compared with $7.6 million of segment SG&A for our period of ownership in 2014. Excluding EQ operations, total segment SG&A was $11.1 million, or 5% of segment revenue, in 2015 compared with $11.8 million, or 5% of segment revenue, in 2014. Field & Industrial Services Our Field & Industrial Services segment was added in 2014 as a result of our acquisition of EQ on June 17, 2014. This segment includes all of the field and industrial service business of the legacy EQ operations and none of the legacy US Ecology operations. Field & Industrial Services segment SG&A was $21.1 million in 2015 compared with $13.7 million for our period of ownership in 2014. The Allstate business, which was divested on November 1, 2015, contributed segment SG&A of $10.9 million for our period of ownership in 2015 compared with $6.6 million for our period of ownership in 2014. Corporate Corporate SG&A increased 20% to $48.4 million in 2015, up from $40.2 million in 2014. The acquired EQ operations contributed $23.0 million of corporate SG&A in 2015 compared with $17.6 million of corporate SG&A for our period of ownership in 2014. Excluding EQ operations, total corporate SG&A was $25.4 million, or 12% of total revenue in 2015, compared with $22.6 million, or 10% of total revenue in 2014, primarily reflecting higher labor costs and professional fees and expenses, partially offset by lower business development expenses in 2015 compared to 2014. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2015 was 45.3% compared to 37.4% in 2014. The increase reflects non-deductible goodwill impairment charges, a non-deductible loss on the sale of the Allstate business recorded during 2015 and an increase in our U.S. effective tax rate, primarily driven by a higher overall effective state tax rate. The higher effective state tax rate was driven by changes in apportionment of income and deferred taxes between the various states in which we operate. The increase in the effective tax rate was also partially attributable to a lower proportion of earnings from our Canadian operations in 2015, which are taxed at a lower corporate tax rate. As of December 31, 2015, we had approximately $161,000 in federal net operating loss carry forwards ("NOLs") acquired from EQ. As of December 31, 2015, we had approximately $34.2 million in state and local NOLs for which we maintain a substantial valuation allowance. We maintain a valuation allowance on state and local NOLs when we no longer do business within a state or locality or determine it is unlikely that we will utilize these NOLs in the future. We consider it unlikely that we will utilize the majority of these NOLs in the future. Interest expense Interest expense was $23.4 million in 2015 compared with $10.7 million in 2014. The increase is a result of higher outstanding debt levels and the related interest expense on borrowings under our Revolving Credit Facility used to finance the acquisition of EQ in June 2014. Additionally, we recorded $2.4 million of incremental non-cash amortization of deferred financing fees in 2015 primarily as a result of significant debt principal payments during the year. Foreign currency gain (loss) We recognized a $2.2 million non-cash foreign currency loss in 2015 compared with a $1.5 million non-cash foreign currency loss in 2014. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Stablex facility is located in Blainville, Québec, Canada and uses the Canadian dollar ("CAD") as its functional currency. Also, as part of our treasury management strategy we established intercompany loans between our parent company, US Ecology, and Stablex. These intercompany loans are payable by Stablex to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2015, we had $15.0 million of intercompany loans subject to currency revaluation. Loss on divestiture On November 1, 2015, we completed the divestiture of Allstate for cash proceeds of $58.8 million, subject to post-closing adjustments. We recognized a pre-tax loss on the divestiture of Allstate, including transaction-related costs, of $542,000 during the fourth quarter of 2015. Impairment charges On August 4, 2015, we entered into a definitive agreement to sell Allstate to a private investor group. Allstate represents the majority of the industrial services business we acquired with the acquisition of EQ. As a result of this agreement and management's strategic review, we evaluated the recoverability of the assets associated with our industrial services business. Based on this analysis, we recorded a non-cash goodwill impairment charge of $6.7 million in the second quarter of 2015. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information on the sale of Allstate. Depreciation and amortization of plant and equipment Depreciation and amortization expense was $27.9 million in 2015, an increase of 14% compared to 2014. The acquired EQ operations contributed $13.9 million of depreciation and amortization expense in 2015 compared with $9.0 million of depreciation and amortization expense for our period of ownership in 2014. Excluding EQ operations, depreciation and amortization expense was $14.0 million in 2015, compared with $15.4 million in 2014. Amortization of intangibles Intangible assets amortization expense was $12.3 million in 2015, an increase of 50% compared to 2014. Excluding intangible assets amortization expense of $11.1 million and $6.8 million recorded in 2015 and 2014, respectively, on new intangible assets recorded as a result of the acquisition of EQ, intangible assets amortization expense was $1.2 million in 2015, compared with $1.4 million in 2014. Stock-based compensation Stock-based compensation expense increased 84% to $2.3 million in 2015, compared with $1.3 million 2014 as a result of an increase in equity-based awards granted to employees. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities increased 73% to $4.6 million in 2015, compared with $2.7 million in 2014. The acquired EQ operations contributed $2.5 million of accretion and non-cash adjustment of closure and post-closure liabilities in 2015 compared with $1.2 million of accretion and non-cash adjustment of closure and post-closure liabilities for our period of ownership in 2014. Excluding EQ operations, accretion and non-cash adjustment of closure and post-closure liabilities was $2.1 million in 2015, compared with $1.5 million in 2014. 2014 Compared to 2013 In the following discussion of 2014 compared to 2013, neither 2014 results nor 2013 results have been recast to reflect the new definitions of Base and Event Business or the new categorization of Environmental Services segment T&D revenue by the NAICS code of the waste generator, as to recast 2013 results would be impracticable. Although 2014 results have been recast in the previous discussion of 2015 compared to 2014, 2014 results have not been recast in the following paragraphs in order to maintain the comparability of 2014 with 2013. Revenue Total revenue increased 122% to $447.4 million in 2014, compared with $201.1 million in 2013. The acquired EQ operations contributed $228.2 million of revenue subsequent to the acquisition on June 17, 2014. Excluding EQ operations, total revenue increased 9% to $219.2 million in 2014, compared with $201.1 million in 2013. Revenue from EQ is excluded from percentages of Base and Event Business and customer category information in the following paragraphs. Environmental Services Environmental Services segment revenue increased 59% to $319.8 million in 2014, compared to $201.1 million in 2013. The acquired EQ operations contributed $100.6 million of segment revenue subsequent to the acquisition of EQ on June 17, 2014. Excluding EQ operations, segment revenue increased 9% to $219.2 million in 2014, compared with $201.1 million in 2013. T&D revenue (excluding EQ) increased 9% in 2014 compared to 2013, primarily as a result of a 16% increase in project-based Event Business. Transportation service revenue (excluding EQ) increased 12% compared to 2013, reflecting more Event Business projects utilizing our transportation and logistics services. During 2014, we disposed of or processed 1.2 million tons of waste (excluding EQ), an increase of 12% compared to 1.1 million tons in 2013. Our average selling price for treatment and disposal services (excluding transportation and EQ) in 2014 was 2% lower than our average selling price in 2013. T&D revenue from recurring Base Business customers increased 5% in 2014 compared to 2013 and comprised 59% of total T&D revenue. As discussed further below, the slight increase in Base Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from our broker, "other industry" and government Base Business customer categories, partially offset by lower T&D revenue from our refinery Base Business customer category. Event Business revenue increased 16% in 2014 compared to 2013 and was 41% of T&D revenue for 2013. As discussed further below, the increase in Event Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from our private clean-up, broker and "other industry" Event Business customer categories, partially offset by lower T&D revenue from our government and refinery Event Business customer categories. The following table summarizes combined Base Business and Event Business revenue growth by customer category for 2014 as compared to 2013: T&D revenue from private clean-up projects increased 31% in 2014 compared to 2013. This increase primarily reflects revenue from an East Coast clean-up project and other smaller remedial projects. Revenues from our other industry customer category increased 17% in 2014 compared to 2013 primarily as a result of changes in shipments from this broadly diverse industrial customer category. Our broker business increased 8% in 2014 compared to 2013 primarily as a result of changes in shipments across the broad range of government and industry waste generators directly served by multiple broker customers. Rate-regulated business at our Richland, Washington LLRW disposal facility increased 1% in 2014 compared to 2013. Our Richland facility operates under a State-approved annual revenue requirement. The increases reflect the timing of revenue recognition for the rate-regulated portion of the business. Government clean-up business revenue decreased 11% in 2014 compared to 2013 due to reduced shipments from the USACE and the completion of a military base clean-up project in 2013 that that was not replaced in 2014. T&D revenue from the USACE decreased approximately 19% in 2014 compared to 2013 due to project-specific timing at multiple USACE clean-up sites and federal spending reductions. T&D revenue from our refinery customers decreased 13% in 2014 compared to 2013, primarily reflecting lower landfill disposal volumes. Field & Industrial Services Our Field & Industrial Services segment was added in 2014 as a result of our acquisition of EQ on June 17, 2014. Field & Industrial Services segment revenue was $127.6 million for the period subsequent to the acquisition. Gross Profit Total gross profit increased 85% to $145.8 million in 2014, up from $79.0 million in 2013. The acquired EQ operations contributed $57.4 million of gross profit subsequent to the acquisition on June 17, 2014. Excluding EQ operations, total gross profit increased 12.0% to $88.4 million in 2014, compared with $79.0 million in 2013. Total gross margin in 2014 was 33%. Excluding EQ operations, total gross margin was 40%. Environmental Services Environmental Services segment gross profit increased 59% to $125.6 million in 2014, up from $79.0 million in 2013. The acquired EQ operations contributed $37.2 million of segment gross profit subsequent to the acquisition on June 17, 2014. Excluding EQ operations, segment gross profit increased 12.0% to $88.4 million in 2014, compared with $79.0 million in 2013. This increase primarily reflects higher T&D volumes in 2014 compared to 2013. Total segment gross margin in 2014 was 39%. Excluding EQ operations, total segment margin was 40%. T&D gross margin (excluding EQ) was 49% in 2014. Field & Industrial Services Our Field & Industrial Services segment was added in 2014 as a result of our acquisition of EQ on June 17, 2014. Field & Industrial Services segment gross profit was $20.2 million and segment gross margin was 16% for the period subsequent to the acquisition. Selling, General and Administrative Expenses Total SG&A increased 181% to $73.3 million in 2014, up from $26.1 million in 2013. The acquired EQ operations contributed $38.9 million of SG&A subsequent to the acquisition on June 17, 2014. Excluding EQ operations, total SG&A was $34.4 million, or 16% of total revenue in 2014, compared with $26.1 million, or 13% of total revenue in 2013. Environmental Services Environmental Services segment SG&A increased 64% to $19.4 million in 2014, up from $11.8 million in 2013. The acquired EQ operations contributed $7.6 million of segment SG&A subsequent to the acquisition on June 17, 2014. Excluding EQ operations, total segment SG&A was $11.8 million, or 5% of segment revenue in 2014, compared with $11.8 million, or 6% of segment revenue in 2013. Field & Industrial Services Our Field & Industrial Services segment was added in 2014 as a result of our acquisition of EQ on June 17, 2014. Field & Industrial Services segment SG&A was $13.7 million, or 11% of segment revenue, for the period subsequent to the acquisition. Corporate Corporate SG&A increased 183% to $40.2 million in 2014, up from $14.2 million in 2013. The acquired EQ operations contributed $17.6 million of corporate SG&A subsequent to the acquisition on June 17, 2014. Excluding EQ operations, total corporate SG&A was $22.6 million, or 10% of total revenue in 2014, compared with $14.2 million, or 7% of total revenue in 2013. 2014 corporate SG&A includes $6.4 million of business development expenses related to the acquisition of EQ. The remaining increase primarily reflects higher labor costs, variable incentive compensation costs and other administrative expenses supporting increased business activity. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2014 was 37.4% compared to 35.9% in 2013. The increase reflects non-deductible business development expenses associated with the acquisition of EQ, partially offset by a higher proportion of earnings from our Canadian operations, which are taxed at a lower corporate tax rate. During 2014 we reduced our unrecognized tax benefit by $480,000 due to the expiration of certain statutes of limitations, which had a favorable impact on our 2014 effective tax rate. As of December 31, 2014, we had approximately $1.3 million in federal NOLs acquired from EQ. As of December 31, 2014, we had approximately $21.7 million in state NOLs for which we maintain nearly a full valuation allowance. These state NOLs are located in states where we currently do little or no business or where we do not expect to generate future taxable income. We consider it unlikely that we will utilize these NOLs in the future. Our gross state NOLs were decreased as a result of a change in various state laws impacting how NOLs are determined, which had no impact to our annual effective tax rate since these NOLs were entirely offset by the valuation allowance. Interest expense Interest expense was $10.7 million in 2014 compared with $828,000 in 2013. The increase is a result of higher debt levels and the related interest expense on borrowings under our Revolving Credit Facility used to finance the acquisition of EQ. Foreign currency gain (loss) We recognized a $1.5 million non-cash foreign currency loss in 2014 compared with a $2.3 million non-cash foreign currency loss in 2013. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Stablex facility is located in Blainville, Québec, Canada and uses CAD as its functional currency. Also, as part of our treasury management strategy we established intercompany loans between our parent company, US Ecology, and Stablex. These intercompany loans are payable by Stablex to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2014, we had $20.7 million of intercompany loans subject to currency revaluation. Depreciation and amortization of plant and equipment Depreciation and amortization expense was $24.4 million in 2014, an increase of 65% compared to 2013. The acquired EQ operations contributed $9.0 million of depreciation and amortization expense subsequent to the acquisition on June 17, 2014. Excluding EQ operations, depreciation and amortization expense was $15.4 million in 2014, compared with $14.8 million in 2013. Amortization of intangibles Intangible assets amortization expense was $8.2 million in 2014, an increase of 462% compared to 2013. Excluding $6.8 million of intangible assets amortization expense on new intangible assets recorded as a result of the acquisition of EQ, intangible assets amortization expense was $1.4 million in 2014, compared with $1.5 million in 2013. Stock-based compensation Stock-based compensation expense increased 45% to $1.3 million in 2014, compared with $865,000 in 2013 as a result of an increase in equity-based awards granted to employees. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities increased 138% to $2.7 million in 2014, compared with $1.1 million in 2013. The acquired EQ operations contributed $1.2 million of accretion and non-cash adjustment of closure and post-closure liabilities subsequent to the acquisition on June 17, 2014. Excluding EQ operations, accretion and non-cash adjustment of closure and post-closure liabilities was $1.5 million in 2014, compared with $1.1 million in 2013. Liquidity and Capital Resources Our primary sources of liquidity are cash and cash equivalents, cash generated from operations and borrowings under the Credit Agreement. At December 31, 2015, we had $6.0 million in cash and cash equivalents immediately available and $117.3 million of borrowing capacity available under our Revolving Credit Facility. We assess our liquidity in terms of our ability to generate cash to fund our operating, investing and financing activities. Our primary ongoing cash requirements are funding operations, capital expenditures, paying interest and required principal payments of our long-term debt, and paying declared dividends pursuant to our dividend policy. We believe future operating cash flows will be sufficient to meet our future operating, investing and dividend cash needs for the foreseeable future. Furthermore, existing cash balances and availability of additional borrowings under our Credit Agreement provide additional sources of liquidity should they be required. Operating Activities. In 2015, net cash provided by operating activities was $71.5 million. This primarily reflects net income of $25.6 million, non-cash depreciation, amortization and accretion of $44.8 million, non-cash impairment charges of $6.7 million, a decrease in income taxes receivable of $4.8 million, non-cash amortization of debt issuance costs of $4.4 million, unrealized foreign currency losses of $3.3 million, share-based compensation expense of $2.3 million and a decrease in accounts receivable of $1.6 million, partially offset by a decrease in accounts payable and accrued liabilities of $6.5 million, a decrease in closure and post-closure obligations of $5.7 million, a decrease in deferred revenue of $4.4 million, a decrease in income taxes payable of $3.9 million and a decrease in deferred income taxes of $2.7 million. Impacts on net income are due to the factors discussed above under Results of Operations. The decrease in receivables and deferred revenue is primarily attributable to the timing of the treatment and disposal of waste associated with a significant East Coast clean-up project. The changes in income taxes receivable and payable are primarily attributable to the timing of income tax payments. The decrease in closure and post-closure obligations is primarily attributable to payments made for closure and post-closure activities primarily at our closed landfills. Days sales outstanding was 68 days as of December 31, 2015, compared to 77 days as of December 31, 2014. The decrease in days sales outstanding is attributable to a decrease in outstanding accounts receivable primarily as a result of the divestiture of Allstate, a significant component of our Field & Industrial Services segment, on November 1, 2015. Due to the higher number of smaller customers as well as a number of state and municipal government customers, Allstate had a longer payment cycle than waste treatment and disposal services provided by our Environmental Services segment. In 2014, net cash provided by operating activities was $71.4 million. This primarily reflects net income of $38.2 million, non-cash depreciation, amortization and accretion of $35.3 million, unrealized foreign currency losses of $2.4 million, an increase in deferred revenue of $1.9 million and an increase in deferred income taxes of $2.0 million, partially offset by an increase in receivables of $4.4 million, a decrease in accounts payable and accrued liabilities of $2.9 million and an increase in income taxes receivable of $1.8 million. Impacts on net income are due to the factors discussed above under Results of Operations. Non-cash foreign currency losses reflect a weaker CAD relative to the USD in 2014. The increase in deferred revenue and receivables is primarily attributable to the timing of the treatment and disposal of waste associated with a significant east coast clean-up project. The changes in income taxes receivable are primarily attributable to the timing of income tax payments. In 2013, net cash provided by operating activities was $49.6 million. This primarily reflects net income of $32.1 million, non-cash depreciation, amortization and accretion of $17.4 million, an increase in income taxes payable of $4.1 million, unrealized non-cash foreign currency losses of $2.8 million and share-based compensation expense of $865,000, partially offset by an increase in receivables of $10.4 million and a decrease in deferred income taxes of $2.6 million. Impacts on net income are due to the factors discussed above under Results of Operations. The increase in income taxes payable is primarily attributable to the timing of income tax payments. The non-cash foreign currency loss reflects a weaker CAD relative to the USD in 2013. The increase in receivables is primarily attributable to the timing of the treatment and disposal of waste associated with a large east coast clean-up project. Investing Activities. In 2015, net cash provided by investing activities was $20.3 million, primarily related to the divestiture of Allstate for $58.7 million, net of cash divested, partially offset by capital expenditures of $39.4 million. Significant capital projects included construction of additional disposal capacity at our Blainville, Quebec, Canada and Robstown, Texas locations and equipment purchases and infrastructure upgrades at all of our corporate and operating facilities. In 2014, net cash used in investing activities was $488.5 million, primarily related to the purchase of EQ for $460.9 million, net of cash acquired, and capital expenditures of $28.4 million. Significant capital projects included construction of additional disposal capacity at our Blainville, Quebec, Canada location and equipment purchases and infrastructure upgrades at all of our corporate and operating facilities. In 2013, net cash used in investing activities was $21.2 million, primarily attributable to capital expenditures of $21.4 million. Significant capital projects included the purchase of land for future expansion of our Robstown, Texas operation, construction of additional disposal capacity at our Grand View, Idaho, Beatty, Nevada and Blainville, Quebec, Canada locations, and equipment purchases and infrastructure upgrades at all of our corporate and operating facilities. Financing Activities. During 2015, net cash used in financing activities was $108.4 million, consisting primarily of $94.6 million of payments on our term loan and $15.6 million of dividend payments to our stockholders. During 2014, net cash provided by financing activities was $366.8 million, consisting primarily of $414.0 million of net proceeds from our new term loan used to partially finance the acquisition of EQ, offset in part by $19.4 million of term loan repayments, $15.5 million of dividend payments to our stockholders and $14.0 million of deferred financing costs associated with our Credit Agreement. During 2013, net cash provided by financing activities was $43.7 million, consisting primarily of $96.4 million of net proceeds received from our public common stock offering (discussed further below) and $2.5 million of proceeds from stock option exercises, partially offset by $45.0 million of net repayments under our Former Agreement (defined below) and $10.0 million of dividends paid to our stockholders. Credit Facility On June 17, 2014, in connection with the acquisition of EQ, the Company entered into a new $540.0 million senior secured credit agreement (the "Credit Agreement") with a syndicate of banks comprised of a $415.0 million term loan (the "Term Loan") with a maturity date of June 17, 2021 and a $125.0 million revolving line of credit (the "Revolving Credit Facility") with a maturity date of June 17, 2019. Upon entering into the Credit Agreement, the Company terminated its existing credit agreement with Wells Fargo, dated October, 29, 2010, as amended (the "Former Agreement"). Immediately prior to the termination of the Former Agreement, there were no outstanding borrowings under the Former Agreement. No early termination penalties were incurred as a result of the termination of the Former Agreement. Term Loan The Term Loan provides an initial commitment amount of $415.0 million, the proceeds of which were used to acquire 100% of the outstanding shares of EQ and pay related transaction fees and expenses. The Term Loan bears interest at a base rate (as defined in the Credit Agreement) plus 2.00% or LIBOR plus 3.00%, at the Company's option. The Term Loan is subject to amortization in equal quarterly installments in an aggregate annual amount equal to 1.00% of the original principal amount of the Term Loan. At December 31, 2015, the effective interest rate on the Term Loan, including the impact of our interest rate swap, was 4.70%. Interest only payments are due either monthly or on the last day of any interest period, as applicable. As set forth in the Credit Agreement, the Company is required to enter into one or more interest rate hedge agreements in amounts sufficient to fix the interest rate on at least 50% of the principal amount of the $415.0 million Term Loan. In October 2014, the Company entered into an interest rate swap agreement with Wells Fargo, effectively fixing the interest rate on $230.0 million, or 76%, of the Term Loan principal outstanding as of December 31, 2015. Revolving Credit Facility The Revolving Credit Facility provides up to $125.0 million of revolving credit loans or letters of credit with the use of proceeds restricted solely for working capital and other general corporate purposes. Under the Revolving Credit Facility, revolving loans are available based on a base rate (as defined in the Credit Agreement) or LIBOR, at the Company's option, plus an applicable margin which is determined according to a pricing grid under which the interest rate decreases or increases based on our ratio of funded debt to earnings before interest, taxes, depreciation and amortization ("EBITDA"). The Company is required to pay a commitment fee of 0.50% per annum on the unused portion of the Revolving Credit Facility, with such commitment fee to be reduced based upon the Company's total leverage ratio as defined in the Credit Agreement. The maximum letter of credit capacity under the new revolving credit facility is $50.0 million and the Credit Agreement provides for a letter of credit fee equal to the applicable margin for LIBOR loans under the Revolving Credit Facility. Interest only payments are due either monthly or on the last day of any interest period, as applicable. At December 31, 2015, there were no borrowings outstanding on the Revolving Credit Facility. The availability under the Revolving Credit Facility was $117.3 million with $7.7 million of the Revolving Credit Facility issued in the form of standby letters of credit utilized as collateral for closure and post-closure financial assurance and other assurance obligations. See Note 15 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information on the Company's debt. Public Common Stock Offering In December 2013, we sold and issued 2,990,000 shares of our common stock, including 390,000 shares pursuant to the underwriters' option to purchase additional shares, at a price of $34.00 per share. We received net proceeds of $96.4 million after deducting underwriting discounts, commissions and offering expenses. $30.0 million of the net proceeds were used to repay amounts outstanding under the Former Agreement with the remainder available for general corporate purposes, including potential future acquisitions. Contractual Obligations and Guarantees Contractual Obligations US Ecology's contractual obligations at December 31, 2015 mature as follows: (1)For the purposes of the table above, closure and post-closure obligations are shown on an undiscounted basis and inflated using an estimated annual inflation rate of 2.6%. Cash payments for closure and post-closure obligation extend to the year 2105. (2)The Term Loan portion of the Credit Agreement with Wells Fargo matures on June 17, 2021 and is subject to amortization in equal quarterly installments in an aggregate annual amount of $3.0 million beginning March 31, 2016. (3)Interest expense has been calculated using the effective interest rate of 3.75% in effect at December 31, 2015 on the unhedged variable rate portion of the outstanding principal and 5.17% on the fixed rate hedged portion of the outstanding principal beginning December 31, 2014, the effective date of the Company's interest rate swap agreement with Wells Fargo. The interest expense calculation reflects assumed principal reductions consistent with the disclosures in footnote (2) above. Guarantees We enter into a wide range of indemnification arrangements, guarantees and assurances in the ordinary course of business and have evaluated agreements that contain guarantees and indemnification clauses. These include tort indemnities, tax indemnities, indemnities against third-party claims arising out of arrangements to provide services to us and indemnities related to the sale of our securities. We also indemnify individuals made party to any suit or proceeding if that individual was acting as an officer or director of US Ecology or was serving at the request of US Ecology or any of its subsidiaries during their tenure as a director or officer. We also provide guarantees and indemnifications for the benefit of our wholly-owned subsidiaries to satisfy performance obligations, including closure and post-closure financial assurances. It is difficult to quantify the maximum potential liability under these indemnification arrangements; however, we are not currently aware of any material liabilities to the Company or any of its subsidiaries arising from these arrangements. Environmental Matters We maintain funded trusts agreements, surety bonds and insurance policies for future closure and post-closure obligations at both current and formerly operated disposal facilities. These funded trust agreements, surety bonds and insurance policies are based on management estimates of future closure and post-closure monitoring using engineering evaluations and interpretations of regulatory requirements which are periodically updated. Accounting for closure and post-closure costs includes final disposal cell capping and revegetation, soil and groundwater monitoring and routine maintenance and surveillance required after a site is closed. We estimate that our undiscounted future closure and post-closure costs for all facilities was approximately $309.7 million at December 31, 2015, with a median payment year of 2060. Our future closure and post-closure estimates are our best estimate of current costs and are updated periodically to reflect current technology, cost of materials and services, applicable laws, regulations, permit conditions or orders and other factors. These current costs are adjusted for anticipated annual inflation, which we assumed to be 2.6% as of December 31, 2015. These future closure and post-closure estimates are discounted to their present value for financial reporting purposes using our credit-adjusted risk-free interest rate, which approximates our incremental long-term borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. At December 31, 2015, our weighted-average credit-adjusted risk-free interest rate was 5.9%. For financial reporting purposes, our recorded closure and post-closure obligations were $71.2 million and $72.9 million as of December 31, 2015 and 2014, respectively. Through December 31, 2015, we have met our financial assurance requirements through insurance, surety bonds, standby letters of credit and self-funded restricted trusts. US Operating and Non-Operating Facilities We cover our closure and post-closure obligations for our U.S. operating facilities through the use of third-party insurance policies, surety bonds and standby letters of credit. Insurance policies covering our closure and post-closure obligations expire in December 2016. Our total policy limits are approximately $74.1 million. At December 31, 2015 our trust accounts had $5.7 million for our closure and post-closure obligations and are identified as Restricted cash and investments on our consolidated balance sheet. All closure and post-closure funding obligations for our Beatty, Nevada and Richland, Washington facilities revert to the respective State. Volume based fees are collected from our customers and remitted to state controlled trust funds to cover the estimated cost of closure and post-closure obligations. Stablex We use commercial surety bonds to cover our closure obligations for our Stablex facility located in Blainville, Québec, Canada. Our lease agreement with the Province of Québec requires that the surety bond be maintained for 25 years after the lease expires in 2023. At December 31, 2015 we had $657,000 in commercial surety bonds dedicated for closure obligations. These bonds were renewed in November and December 2015 and expire in November and December 2016. Post-closure funding obligations for the Stablex landfill revert back to the Province of Québec through a dedicated trust account that is funded based on a per-metric-ton disposed fee by Stablex. We expect to renew insurance policies and commercial surety bonds in the future. If we are unable to obtain adequate closure, post-closure or environmental liability insurance and/or commercial surety bonds in future years, any partial or completely uninsured claim against us, if successful and of sufficient magnitude, could have a material adverse effect on our financial condition, results of operations or cash flows. Additionally, continued access to casualty and pollution legal liability insurance with sufficient limits, at acceptable terms, is important to obtaining new business. Failure to maintain adequate financial assurance could also result in regulatory action including early closure of facilities. While we believe we will be able to maintain the requisite financial assurance policies at a reasonable cost, premium and collateral requirements may materially increase. Operation of disposal facilities creates operational, closure and post-closure obligations that could result in unplanned monitoring and corrective action costs. We cannot predict the likelihood or effect of all such costs, new laws or regulations, litigation or other future events affecting our facilities. We do not believe that continuing to satisfy our environmental obligations will have a material adverse effect on our financial condition or results of operations. Seasonal Effects Seasonal fluctuations due to weather and budgetary cycles can influence the timing of customer spending for our services. Typically, in the first quarter of each calendar year there is less demand for our services due to reduced construction and business activities related to weather while we experience improvement in our second and third quarters of each calendar year as weather conditions and other business activity improves. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates included in our critical accounting policies discussed below and those accounting policies and use of estimates discussed in Notes 2 and 3 to the Consolidated Financial Statements located in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. We base our estimates on historical experience and on various assumptions and other factors we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We make adjustments to judgments and estimates based on current facts and circumstances on an ongoing basis. Historically, actual results have not deviated significantly from those determined using the estimates described below or in Notes 2 and 3 to the Consolidated Financial Statements located in "Part II, Item 8. Financial Statements and Supplementary Data" to this Annual Report on Form 10-K. However, actual amounts could differ materially from those estimated at the time the consolidated financial statements are prepared. We believe the following critical accounting policies are important to understand our financial condition and results of operations and require management's most difficult, subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, delivery and disposal have occurred or services have been rendered, the price is fixed or determinable and collection is reasonably assured. We recognize revenue from three primary sources: 1) waste treatment, recycling and disposal, 2) field and industrial waste management services and 3) waste transportation services. Waste treatment and disposal revenue results primarily from fees charged to customers for treatment and/or disposal or recycling of specified wastes. Waste treatment and disposal revenue is generally charged on a per-ton or per-yard basis based on contracted prices and is recognized when services are complete. Field and industrial waste management services revenue results primarily from specialty onsite services such as high-pressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response at refineries, chemical plants, steel and automotive plants, and other government, commercial and industrial facilities. These services are provided based on purchase orders or agreements with the customer and include prices based upon daily, hourly or job rates for equipment, materials and personnel. Revenues are recognized over the term of the agreements or as services are performed. Revenue is recognized on contracts with retainage when services have been rendered and collectability is reasonably assured. Transportation revenue results from delivering customer waste to a disposal facility for treatment and/or disposal or recycling. Transportation services are generally not provided on a stand-alone basis and instead are bundled with other Company services. However, in some instances we provide transportation and logistics services for shipment of waste from clean-up sites to disposal facilities operated by other companies. We account for our bundled arrangements as multiple deliverable arrangements and determine the amount of revenue recognized for each deliverable (unit of accounting) using the relative fair value method. Transportation revenue is recognized when the transported waste is received at the disposal facility. Waste treatment and disposal revenue under bundled arrangements is recognized when services are complete and the waste is disposed in the landfill. Burial fees collected from customers for each ton or cubic yard of waste disposed in our landfills are paid to the respective local and/or state government entity and are not included in revenue. Revenue and associated costs from waste that has been received but not yet treated and disposed of in our landfills are deferred until disposal occurs. Our Richland, Washington disposal facility is regulated by the WUTC, which approves our rates for disposal of LLRW. Annual revenue levels are established based on a six-year rate agreement with the WUTC at amounts sufficient to cover the costs of operation and provide us with a reasonable profit. Per-unit rates charged to LLRW customers during the year are based on our evaluation of disposal volume and radioactivity projections submitted to us by waste generators. Our proposed rates are then reviewed and approved by the WUTC. If annual revenue exceeds the approved levels set by the WUTC, we are required to refund excess collections to facility users on a pro-rata basis. The current rate agreement with the WUTC was extended in 2013 and is effective until January 1, 2020. Disposal Facility Accounting We amortize landfill and disposal assets and certain related permits over their estimated useful lives. The units-of-consumption method is used to amortize landfill cell construction and development costs and asset retirement costs. Under the units-of-consumption method, we include costs incurred to date as well as future estimated construction costs in the amortization base of the landfill assets. Additionally, where appropriate, as discussed below, we also include probable expansion airspace that has yet to be permitted in the calculation of the total remaining useful life of the landfill asset. If we determine that expansion capacity should no longer be considered in calculating the total remaining useful life of a landfill asset, we may be required to recognize an asset impairment or incur significantly higher amortization expense over the remaining estimated useful life of the landfill asset. If at any time we make the decision to abandon the expansion effort, the capitalized costs related to the expansion effort would be expensed in the period of abandonment. Our landfill assets and liabilities fall into the following two categories, each of which require accounting judgments and estimates: • Landfill assets comprised of capitalized landfill development costs. • Disposal facility retirement obligations relating to our capping, closure and post-closure liabilities that result in corresponding retirement assets. Landfill Assets Landfill assets include the costs of landfill site acquisition, permits and cell design and construction incurred to date. Landfill cells represent individual disposal areas within the overall treatment and disposal site and may be subject to specific permit requirements in addition to the general permit requirements associated with the overall site. To develop, construct and operate a landfill cell, we must obtain permits from various regulatory agencies at the local, state and federal levels. The permitting process requires an initial site study to determine whether the location is feasible for landfill operations. The initial studies are reviewed by our environmental management group and then submitted to the regulatory agencies for approval. During the development stage we capitalize certain costs that we incur after site selection but before the receipt of all required permits if we believe that it is probable that the landfill cell will be permitted. Upon receipt of regulatory approval, technical landfill cell designs are prepared. The technical designs, which include the detailed specifications to develop and construct all components of the landfill cell including the types and quantities of materials that will be required, are reviewed by our environmental management group. The technical designs are submitted to the regulatory agencies for approval. Upon approval of the technical designs, the regulatory agencies issue permits to develop and operate the landfill cell. The types of costs that are detailed in the technical design specifications generally include excavation, natural and synthetic liners, construction of leachate collection systems, installation of groundwater monitoring wells, construction of leachate management facilities and other costs associated with the development of the site. We review the adequacy of our cost estimates at least annually. These development costs, together with any costs incurred to acquire, design and permit the landfill cell, including personnel costs of employees directly associated with the landfill cell design, are recorded to the landfill asset on the balance sheet as incurred. To match the expense related to the landfill asset with the revenue generated by the landfill operations, we amortize the landfill asset on a units-of-consumption basis over its operating life, typically on a cubic yard or cubic meter of disposal space consumed. The landfill asset is fully amortized at the end of a landfill cell's operating life. The per-unit amortization rate is calculated by dividing the sum of the landfill asset net book value plus estimated future development costs (as described above) for the landfill cell, by the landfill cell's estimated remaining disposal capacity. Amortization rates are influenced by the original cost basis of the landfill cell, including acquisition costs, which in turn is determined by geographic location and market values. We have secured significant landfill assets through business acquisitions and valued them at the time of acquisition based on fair value. Included in the technical designs are factors that determine the ultimate disposal capacity of the landfill cell. These factors include the area over which the landfill cell will be developed, such as the depth of excavation, the height of the landfill cell elevation and the angle of the side-slope construction. Landfill cell capacity used in the determination of amortization rates of our landfill assets includes both permitted and unpermitted disposal capacity. Unpermitted disposal capacity is included when management believes achieving final regulatory approval is probable based on our analysis of site conditions and interactions with applicable regulatory agencies. We review the estimates of future development costs and remaining disposal capacity for each landfill cell at least annually. These costs and disposal capacity estimates are developed using input from independent engineers and internal technical and accounting managers and are reviewed and approved by our environmental management group. Any changes in future estimated costs or estimated disposal capacity are reflected prospectively in the landfill cell amortization rates. We assess our long-lived landfill assets for impairment when an event occurs or circumstances change that indicate the carrying amount may not be recoverable. Examples of events or circumstances that may indicate impairment of any of our landfill assets include, but are not limited to, the following: • Changes in legislative or regulatory requirements impacting the landfill site permitting process making it more difficult and costly to obtain and/or maintain a landfill permit; • Actions by neighboring parties, private citizen groups or others to oppose our efforts to obtain, maintain or expand permits, which could result in denial, revocation or suspension of a permit and adversely impact the economic viability of the landfill. As a result of opposition to our obtaining a permit, improved technical information as a project progresses, or changes in the anticipated economics associated with a project, we may decide to reduce the scope of, or abandon, a project, which could result in an asset impairment; and • Unexpected significant increases in estimated costs, significant reductions in prices we are able to charge our customers or reductions in disposal capacity that affect the ongoing economic viability of the landfill. Disposal Facility Retirement Obligations Disposal facility retirement obligations include the cost to close, maintain and monitor landfill cells and support facilities. As individual landfill cells reach capacity, we must cap and close the cells in accordance with the landfill cell permits. These capping and closure requirements are detailed in the technical design of each landfill cell and included as part of our approved regulatory permit. After the entire landfill cell has reached capacity and is certified closed, we must continue to maintain and monitor the landfill cell for a post-closure period, which generally extends for 30 years. Costs associated with closure and post-closure requirements generally include maintenance of the landfill cell and groundwater systems, and other activities that occur after the landfill cell has ceased accepting waste. Costs associated with post-closure monitoring generally include groundwater sampling, analysis and statistical reports, transportation and disposal of landfill leachate, and erosion control costs related to the final cap. We have a legally enforceable obligation to operate our landfill cells in accordance with the specific requirements, regulations and criteria set forth in our permits. This includes executing the approved closure/post-closure plan and closing/capping the entire landfill cell in accordance with the established requirements, design and criteria contained in the permit. As a result, we record the fair value of our disposal facility retirement obligations as a liability in the period in which the regulatory obligation to retire a specific asset is triggered. For our individual landfill cells, the required closure and post-closure obligations under the terms of our permits and our intended operation of the landfill cell are triggered and recorded when the cell is placed into service and waste is initially disposed in the landfill cell. The fair value is based on the total estimated costs to close the landfill cell and perform post-closure activities once the landfill cell has reached capacity and is no longer accepting waste, discounted using a credit-adjusted risk-free rate. Retirement obligations are increased each year to reflect the passage of time by accreting the balance at the weighted average credit-adjusted risk-free rate that is used to calculate the recorded liability, with accretion charged to direct operating costs. Actual cash expenditures to perform closure and post-closure activities reduce the retirement obligation liabilities as incurred. After initial measurement, asset retirement obligations are adjusted at the end of each period to reflect changes, if any, in the estimated future cash flows underlying the obligation. Disposal facility retirement assets are capitalized as the related disposal facility retirement obligations are incurred. Disposal facility retirement assets are amortized on a units-of-consumption basis as the disposal capacity is consumed. Our disposal facility retirement obligations represent the present value of current cost estimates to close, maintain and monitor landfills and support facilities as described above. Cost estimates are developed using input from independent engineers, internal technical and accounting managers, as well as our environmental management group's interpretation of current legal and regulatory requirements, and are intended to approximate fair value. We estimate the timing of future payments based on expected annual disposal airspace consumption and then inflate the current cost estimate by an inflation rate, estimated at December 31, 2015 to be 2.6%. Inflated current costs are then discounted using our credit-adjusted risk-free interest rate, which approximates our incremental borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. Our weighted-average credit-adjusted risk-free interest rate at December 31, 2015 was approximately 5.9%. Final closure and post-closure obligations are currently estimated as being paid through the year 2105. During 2015, we updated several assumptions, including the estimated costs and timing of closing our disposal cells. These updates resulted in a net decrease to our closure/post-closure obligation of $349,000. We update our estimates of future capping, closure and post-closure costs and of future disposal capacity for each landfill cell on an annual basis. Changes in inflation rates or the estimated costs, timing or extent of the required future activities to close, maintain and monitor landfills and facilities result in both: (i) a current adjustment to the recorded liability and related asset and (ii) a change in accretion and amortization rates which are applied prospectively over the remaining life of the asset. A hypothetical 1% increase in the inflation rate would increase our closure/post-closure obligation by $15.4 million. A hypothetical 10% increase in our cost estimates would increase our closure/post-closure obligation by $7.1 million. Goodwill and Intangible Assets As of December 31, 2015, the Company's goodwill balance was $191.8 million. We assess goodwill for impairment during the fourth quarter as of October 1 of each year, and also if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The assessment consists of comparing the fair value of the reporting unit to the carrying value of the net assets assigned to the reporting unit, including goodwill. Some of the factors that could indicate impairment include a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, or failure to generate sufficient cash flows at the reporting unit. For example, field and industrial services represents an emerging business for the Company and has been the focus of a shift in strategy since the acquisition of EQ. Failure to execute on planned growth initiatives within this business could lead to the impairment of goodwill and intangible assets in future periods. We determine our reporting units by identifying the components of each operating segment, and then aggregate components having similar economic characteristics based on quantitative and / or qualitative factors. At December 31, 2015, we had 17 reporting units, eight of which had allocated goodwill. Fair values are generally determined by using both the market approach, applying a multiple of earnings based on guideline for publicly traded companies, and the income approach, discounting projected future cash flows based on our expectations of the current and future operating environment. The rates used to discount projected future cash flows reflect a weighted average cost of capital based on our industry, capital structure and risk premiums including those reflected in the current market capitalization. In the event the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill test would be performed to measure the amount of impairment loss. In the event that we determine that the value of goodwill has become impaired, we will incur an accounting charge for the amount of impairment during the period in which the determination has been made. The result of the annual assessment of goodwill undertaken in the fourth quarter of 2015 indicated no goodwill impairment charges were required for any of our reporting units. We review intangible assets with indefinite useful lives for impairment during the fourth quarter as of October 1 of each year. Fair value is generally determined by considering: (i) the internally developed discounted projected cash flow analysis; (ii) a third-party valuation; and/or (iii) information available regarding the current market environment for similar assets. If the fair value of an asset is determined to be less than the carrying amount of the intangible asset, an impairment in the amount of the difference is recorded in the period in which the annual assessment occurs. The result of the annual assessment of intangible assets with indefinite useful lives undertaken in the fourth quarter of 2015 indicated no impairment charges were required. We also review finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of an intangible asset may not be recoverable. In order to assess whether a potential impairment exists, the assets' carrying values are compared with their undiscounted expected future cash flows. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. Impairments are measured by comparing the fair value of the asset to its carrying value. Fair value is generally determined by considering: (i) the internally developed discounted projected cash flow analysis; (ii) a third-party valuation; and/or (iii) information available regarding the current market environment for similar assets. If the fair value of an intangible asset is determined to be less than the carrying amount of the intangible asset, an impairment in the amount of the difference is recorded in the period in which the events or changes in circumstances that indicated the carrying value of the intangible assets may not be recoverable occurred. The result of the assessment of finite-lived intangible assets undertaken in 2015 indicated no impairment charges were required. On August 4, 2015, we entered into a definitive agreement to sell Allstate to a private investor group. Allstate represents the majority of the industrial services business we acquired with the acquisition of EQ. As a result of this agreement and management's strategic review, we evaluated the recoverability of the assets associated with our industrial services business. Our interim goodwill impairment test which included both Step I and Step II analysis was performed and resulted in a non-cash goodwill impairment charge of $6.7 million being recognized in the second quarter of 2015. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information on the sale of Allstate. Other than the impairment charge discussed above, no events or circumstances occurred during 2015 that would indicate that our intangible assets may be impaired, therefore no other impairment tests were performed during 2015 other than the annual assessment of intangible assets with indefinite useful lives conducted in the fourth quarter of every year. Our acquired permits and licenses generally have renewal terms of approximately 5-10 years. We have a history of renewing these permits and licenses as demonstrated by the fact that each of the sites' treatment permits and licenses have been renewed regularly since the facility began operations. We intend to continue to renew our permits and licenses as they come up for renewal for the foreseeable future. Costs incurred to renew or extend the term of our permits and licenses are recorded in Selling, general and administrative expenses in our consolidated statements of operations. Share Based Payments On May 27, 2015, our stockholders approved the Omnibus Incentive Plan ("Omnibus Plan"), which was approved by our Board of Directors on April 7, 2015. The Omnibus Plan was developed to provide additional incentives through equity ownership in US Ecology and, as a result, encourage employees and directors to contribute to our success. The Omnibus Plan provides, among other things, the ability for the Company to grant restricted stock, performance stock, options, stock appreciation rights, restricted stock units, performance stock units ("PSUs") and other stock-based awards or cash awards to officers, employees, consultants and non-employee directors. Subsequent to the approval of the Omnibus Plan in May 2015, we stopped granting equity awards under our 2008 Stock Option Incentive Plan and our 2006 Restricted Stock Plan ("Previous Plans"), and the Previous Plans will remain in effect solely for the settlement of awards granted under the Previous Plans. No shares that are reserved but unissued under the Previous Plans or that are outstanding under the Previous Plans and reacquired by the Company for any reason will be available for issuance under the Omnibus Plan. The Omnibus Plan expires on April 7, 2025 and authorizes 1,500,000 shares of common stock for grant over the life of the Omnibus Plan. As of December 31, 2015, we have PSUs outstanding under the Omnibus Plan. Each PSU represents the right to receive, on the settlement date, one share of the Company's common stock. The total number of PSUs each participant is eligible to earn ranges from 0% to 200% of the target number of PSUs granted. The actual number of PSUs that will vest and be settled in shares is determined at the end of a three-year performance period beginning January 1, 2015, based on total stockholder return relative to a set of peer companies and the S&P 600. The fair value of the PSUs is determined using a Monte Carlo simulation. Refer to Note 18 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for a summary of the assumptions utilized in the Monte Carlo valuation of awards granted during 2015. As of December 31, 2015, we have stock option awards outstanding under the 1992 Stock Option Plan for Employees ("1992 Employee Plan") and the 2008 Stock Option Incentive Plan ("2008 Stock Option Plan"). Subsequent to the approval of the Omnibus Plan in May 2015, we stopped granting equity awards under the 2008 Stock Option Plan. The 2008 Stock Option Plan will remain in effect solely for the settlement of awards previously granted. In April 2013, the 1992 Employee Plan expired and was cancelled except for options then outstanding. The determination of fair value of stock option awards on the date of grant using the Black-Scholes model is affected by our stock price and subjective assumptions. These assumptions include, but are not limited to, the expected term of stock options and expected stock price volatility over the term of the awards. Refer to Note 18 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for a summary of the assumptions utilized in 2015, 2014 and 2013. Our stock options have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimates. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. When actual forfeitures vary from our estimates, we recognize the difference in compensation expense in the period the actual forfeitures occur or when options vest. Income Taxes Income taxes are accounted for using an asset and liability approach whereby we recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement and tax basis of assets and liabilities at the applicable tax rates. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the enactment date. Deferred tax assets are evaluated for the likelihood of use in future periods. A valuation allowance is recorded against deferred tax assets if, based on the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The determination of the need for a valuation allowance, if any, requires our judgment and the use of estimates. If we determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, we would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes. As of December 31, 2015, we have deferred tax assets totaling approximately $19.6 million, a valuation allowance of $4.6 million and deferred tax liabilities totaling approximately $97.6 million. The application of income tax law is inherently complex. Tax laws and regulations are voluminous and at times ambiguous and interpretations of guidance regarding such tax laws and regulations change over time. This requires us to make many subjective assumptions and judgments regarding the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. A liability for uncertain tax positions is recorded in our financial statements on the basis of a two-step process whereby (1) we determine whether it is more likely than not that the tax position taken will be sustained based on the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is greater than 50% likely to be realized upon ultimate settlement with the related tax authority. As facts and circumstances change, we reassess these probabilities and record any changes in the financial statements as appropriate. Changes in our assumptions and judgments can materially affect our financial position, results of operations and cash flows. We recognize interest assessed by taxing authorities or interest associated with uncertain tax positions as a component of interest expense. We recognize any penalties assessed by taxing authorities or penalties associated with uncertain tax positions as a component of selling, general and administrative expenses. Litigation We have, in the past, been involved in litigation requiring estimates of timing and loss potential whose timing and ultimate disposition is controlled by the judicial process. As of December 31, 2015, we did not have any ongoing, pending or threatened legal action that management believes, either individually or in the aggregate, would have a material adverse effect on our financial position, results of operations or cash flows. The decision to accrue costs or write off assets is based on the pertinent facts and our evaluation of present circumstances. Off Balance Sheet Arrangements We do not have any off balance sheet arrangements or interests in variable interest entities that would require consolidation. US Ecology operates through wholly-owned subsidiaries.

<s>[INST] US Ecology, Inc. is a leading North American provider of environmental services to commercial and government entities. The Company addresses the complex waste management needs of its customers, offering treatment, disposal and recycling of hazardous, nonhazardous and radioactive waste, as well as a wide range of complementary field and industrial services. US Ecology's comprehensive knowledge of the waste business, its collection of waste management facilities and focus on safety, environmental compliance, and customer service enables us to effectively meet the needs of our customers and to build longlasting relationships. We have fixed facilities and service centers operating in the United States, Canada and Mexico. Our fixed facilities include five RCRA subtitle C hazardous waste landfills and one LLRW landfill located near Beatty, Nevada; Richland, Washington; Robstown, Texas; Grand View, Idaho; Detroit, Michigan and Blainville, Québec, Canada. These facilities generate revenue from fees charged to treat and dispose of waste and from fees charged to perform various field and industrial services for our customers. On June 17, 2014, the Company acquired 100% of the outstanding shares of EQ Holdings, Inc. and its whollyowned subsidiaries (collectively "EQ"). EQ is a fully integrated environmental services company providing waste treatment and disposal, wastewater treatment, remediation, recycling, industrial cleaning and maintenance, transportation, total waste management, technical services, and emergency response services to a variety of industries and customers in North America. On August 4, 2015, we entered into a definitive agreement to sell our Allstate Power Vac, Inc. ("Allstate") subsidiary to a private investor group and completed the divestiture on November 1, 2015. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10K for additional information. Our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental ServicesThis segment provides a broad range of hazardous material management services including transportation, recycling, treatment and disposal of hazardous and nonhazardous waste at Companyowned landfill, wastewater and other treatment facilities. Field & Industrial ServicesThis segment provides packaging and collection of hazardous waste and total waste management solutions at customer sites and through our 10day transfer facilities. Services include onsite management, waste characterization, transportation and disposal of nonhazardous and hazardous waste. This segment also provides specialty services such as highpressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response and other services to commercial and industrial facilities and to government entities. As a result of our continued integration of EQ, we have modified and conformed the categories used to evaluate periodtoperiod changes in our T&D revenue for our Environmental Services segment. Historically, US Ecology divided T&D revenue into groups based on the industry of the customer. In order to provide better insight into the underlying drivers of our waste volumes and related T&D revenues, beginning with the third quarter of 2015, we now evaluate periodtoperiod changes in our T&D revenue for our Environmental Services segment based on the industry of the waste generator, based on North American Industry Classification System ("NAICS") codes. We believe the new categorizations provide better insight into our Environmental Services segment T&D revenues. Throughout this Annual Report on Form 10K, except where noted, prior periods presented have been recast based on the new categorizations. The composition of the Environmental Services segment T&D revenues by waste generator industry for the years ended December 31, 2015 and 2014 were as follows: (1)Excludes all transportation service revenue (2)Excludes EQ Holdings, Inc. which was acquired on June 17, 2014 (3)Includes retail and wholesale trade, rate regulated, construction and other industries As a result of our continued integration of EQ, we have modified and conformed how we define "Base Business" and "Event Business." Previously, US Ecology defined Event Business as nonrecurring waste cleanup projects regardless of size, with Base Business representing all [/INST] Positive. </s>

US ECOLOGY, INC.

2017-02-27

2016-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General US Ecology, Inc. is a leading North American provider of environmental services to commercial and government entities. The Company addresses the complex waste management needs of its customers, offering treatment, disposal and recycling of hazardous, non-hazardous and radioactive waste, as well as a wide range of complementary field and industrial services. US Ecology's comprehensive knowledge of the waste business, its collection of waste management facilities and focus on safety, environmental compliance, and customer service enables us to effectively meet the needs of our customers and to build long-lasting relationships. We have fixed facilities and service centers operating in the United States, Canada and Mexico. Our fixed facilities include five RCRA subtitle C hazardous waste landfills and one LLRW landfill located near Beatty, Nevada; Richland, Washington; Robstown, Texas; Grand View, Idaho; Detroit, Michigan and Blainville, Québec, Canada. These facilities generate revenue from fees charged to treat and dispose of waste and from fees charged to perform various field and industrial services for our customers. On June 17, 2014, the Company acquired 100% of the outstanding shares of EQ Holdings, Inc. and its wholly-owned subsidiaries (collectively "EQ"). EQ is a fully integrated environmental services company providing waste treatment and disposal, wastewater treatment, remediation, recycling, industrial cleaning and maintenance, transportation, total waste management, technical services, and emergency response services to a variety of industries and customers in North America. On November 1, 2015, we sold our Allstate Power Vac, Inc. ("Allstate") subsidiary to a private investor group. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information. Our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental Services-This segment provides a broad range of hazardous material management services including transportation, recycling, treatment and disposal of hazardous and non-hazardous waste at Company-owned landfill, wastewater and other treatment facilities. Field & Industrial Services-This segment provides packaging and collection of hazardous waste and total waste management solutions at customer sites and through our 10-day transfer facilities. Services include on-site management, waste characterization, transportation and disposal of non-hazardous and hazardous waste. This segment also provides specialty services such as high-pressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response and other services to commercial and industrial facilities and to government entities. Effective January 1, 2016, we changed our internal reporting structure by moving the financial results of our Sulligent, Alabama and Tampa, Florida facilities from our Environmental Services segment to our Field & Industrial Services segment. The purpose of this change is to align our internal reporting structure with how we manage our business based on the primary service offering of each facility. Throughout this Annual Report on Form 10-K, our segment results for all periods presented have been recast to reflect this change. In order to provide insight into the underlying drivers of our waste volumes and related treatment and disposal ("T&D") revenues, we evaluate period-to-period changes in our T&D revenue for our Environmental Services segment based on the industry of the waste generator, based on North American Industry Classification System ("NAICS") codes. The composition of the Environmental Services segment T&D revenues by waste generator industry for the years ended December 31, 2016 and 2015 were as follows: (1)Excludes all transportation service revenue (2)Includes retail and wholesale trade, rate regulated, construction and other industries We also categorize our Environmental Services T&D revenue as either "Base Business" or "Event Business" based on the underlying nature of the revenue source. We define Event Business as non-recurring projects that are expected to equal or exceed 1,000 tons, with Base Business defined as all other business not meeting the definition of Event Business. A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and unit pricing. For the year ended December 31, 2016, approximately 18% of our T&D revenue was derived from Event Business projects. The one-time nature of Event Business, diverse spectrum of waste types received and widely varying unit pricing necessarily creates variability in revenue and earnings. This variability may be influenced by general and industry-specific economic conditions, funding availability, changes in laws and regulations, government enforcement actions or court orders, public controversy, litigation, weather, commercial real estate, closed military bases and other project timing, government appropriation and funding cycles and other factors. The types and amounts of waste received from Base Business also vary from quarter to quarter. This variability can also cause significant quarter-to-quarter and year-to-year differences in revenue, gross profit, gross margin, operating income and net income. While we pursue many projects months or years in advance of work performance, cleanup project opportunities routinely arise with little or no prior notice. These market dynamics are inherent to the waste disposal business and are factored into our projections and externally communicated business outlook statements. Our projections combine historical experience with identified sales pipeline opportunities, new or expanded service line projections and prevailing market conditions. During 2016, Base Business revenue growth was up 2% compared to 2015. Base Business revenue was approximately 82% of total 2016 T&D revenue, up from 75% in 2015. Our business is highly competitive and no assurance can be given that we will maintain these revenue levels or increase our market share. Depending on project-specific customer needs and competitive economics, transportation services may be offered at or near our cost to help secure new business. For waste transported by rail from the eastern United States and other locations distant from our Grand View, Idaho and Robstown, Texas facilities, transportation-related revenue can account for as much as 75% of total project revenue. While bundling transportation and disposal services reduces overall gross profit as a percentage of total revenue ("gross margin"), this value-added service has allowed us to win multiple projects that management believes we could not have otherwise competed for successfully. Our Company-owned fleet of gondola railcars, which is periodically supplemented with railcars obtained under operating leases, has reduced our transportation expenses by largely eliminating reliance on more costly short-term rentals. These Company-owned railcars also help us to win business during times of demand-driven railcar scarcity. The increased waste volumes resulting from projects won through this bundled service strategy further drive operating leverage benefits inherent to the disposal business, increasing profitability. While waste treatment and other variable costs are project-specific, the incremental earnings contribution from large and small projects generally increases as overall disposal volumes increase. Based on past experience, management believes that maximizing operating income, net income and earnings per share is a higher priority than maintaining or increasing gross margin. We intend to continue aggressively bidding bundled transportation and disposal services based on this proven strategy. We serve oil refineries, chemical production plants, steel mills, waste brokers/aggregators serving small manufacturers and other industrial customers that are generally affected by the prevailing economic conditions and credit environment. Adverse conditions may cause our customers as well as those they serve to curtail operations, resulting in lower waste production and/or delayed spending on off-site waste shipments, maintenance, waste cleanup projects and other work. Factors that can impact general economic conditions and the level of spending by customers include, but are not limited to, consumer and industrial spending, increases in fuel and energy costs, conditions in the real estate and mortgage markets, labor and healthcare costs, access to credit, consumer confidence and other global economic factors affecting spending behavior. Market forces may also induce customers to reduce or cease operations, declare bankruptcy, liquidate or relocate to other countries, any of which could adversely affect our business. To the extent business is either government funded or driven by government regulations or enforcement actions, we believe it is less susceptible to general economic conditions. Spending by government agencies may be reduced due to declining tax revenues resulting from a weak economy or changes in policy. Disbursement of funds appropriated by Congress may also be delayed for various reasons. Our results of operations have been affected by certain significant events during the past three fiscal years including, but not limited to: 2016 Events Divestiture of Augusta, Georgia Facility: On April 5, 2016, we completed the divestiture of our Augusta, Georgia facility for cash proceeds of $1.9 million. The Augusta, Georgia facility was reported as part of our Environmental Services segment. Sales, net income and total assets of the Augusta, Georgia facility are not material to our consolidated financial position or results of operations in any period presented. We recognized a $1.9 million pre-tax gain on the divestiture of the Augusta, Georgia facility, which is included in Other income (expense) in our consolidated statements of operations for the year ended December 31, 2016. Acquisition of Environmental Services Inc.: On May 2, 2016, the Company acquired 100% of the outstanding shares of Environmental Services Inc., ("ESI"), an environmental services company based in Tilbury, Ontario, Canada. The total purchase price was $4.9 million, net of cash acquired, and was funded with cash on hand. Revenues and total assets of ESI are not material to our consolidated financial position or results of operations. We recorded $1.5 million of intangible assets and $1.0 million of goodwill on the consolidated balance sheets as a result of the acquisition. Definite-lived intangibles will be amortized over a weighted average life of approximately 14 years. Goodwill and indefinite-lived intangibles are tested for impairment at least annually. Acquisition of Vernon, California Facility: On October 1, 2016, the Company acquired the Vernon, California based RCRA Part B, liquids and solids waste treatment and storage facility of Evoqua Water Technologies LLC. The total purchase price was $5.0 million and was funded with cash on hand. Revenues and total assets of the Vernon, California facility are not material to our consolidated financial position or results of operations. We recorded $3.2 million of intangible assets and $354,000 of goodwill on the consolidated balance sheets as a result of the acquisition. Definite-lived intangibles will be amortized over a weighted average life of approximately 20 years. Goodwill and indefinite-lived intangibles are tested for impairment at least annually. 2015 Events Full Year of EQ Operations: 2015 includes a full year of operating results for EQ, which was acquired on June 17, 2014. Sale of Allstate Power Vac, Inc. ("Allstate") and Goodwill Impairment: On November 1, 2015, we sold our Allstate subsidiary to a private investor group for cash proceeds of $58.8 million. Allstate represented the majority of the industrial services business we acquired with the acquisition of EQ. As a result of this divestiture and management's strategic review, we evaluated the recoverability of the assets associated with our industrial services business. Based on this analysis, we recorded a non-cash goodwill impairment charge of $6.7 million, or $0.31 per diluted share, in the second quarter of 2015. We recognized a pre-tax loss on the divestiture of Allstate, including transaction-related costs, of $542,000 in the fourth quarter of 2015. In the second quarter of 2016, we received additional cash proceeds of $827,000 in settlement of final post-closing adjustments and recognized an additional $178,000 pre-tax gain. Gains and losses related to the sale of Allstate are included in Other income (expense) in our consolidated statements of operations. Cash proceeds from the transaction were used to repay debt. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information on the sale of Allstate. 2014 Events Acquisition of EQ Holdings, Inc.: On June 17, 2014, the Company acquired 100% of the outstanding shares of EQ. EQ is a fully integrated environmental services company providing waste treatment and disposal, wastewater treatment, remediation, recycling, industrial cleaning and maintenance, transportation, total waste management, technical services, and emergency response services to a variety of industries and customers in North America. The total purchase price was $460.9 million, net of cash acquired, and was funded through a combination of cash on hand and borrowings under a new $415.0 million term loan. The acquisition of EQ affects the comparability of 2014 with other years, including as follows: • Revenue and operating income from the legacy EQ business for the period from June 17, 2014 to December 31, 2014 included in the Company's consolidated statements of operations for the year ended December 31, 2014 were $228.2 million and $18.5 million, respectively. • We incurred $6.4 million of business development expenses during the year ended December 31, 2014 in connection with the EQ acquisition primarily for due diligence and business integration purposes. • We recorded $252.9 million of intangible assets and $197.6 million of goodwill on our Consolidated Balance Sheet as a result of the acquisition. Acquired finite-lived intangibles will be amortized over their estimated useful life ranging from one to 45 years. Goodwill and indefinite-lived intangibles are tested for impairment at least annually. Results of Operations Our operating results and percentage of revenues for the years ended December 31, 2016, 2015 and 2014 were as follows: The primary financial measure used by management to assess segment performance is Adjusted EBITDA. Adjusted EBITDA is defined as net income before interest expense, interest income, income tax expense, depreciation, amortization, stock based compensation, accretion of closure and post-closure liabilities, foreign currency gain/loss, non-cash impairment charges, loss on divestiture and other income/expense. The reconciliation of Net Income to Adjusted EBITDA for the years ended December 31, 2016, 2015 and 2014 is as follows: Adjusted EBITDA is a complement to results provided in accordance with accounting principles generally accepted in the United States ("GAAP") and we believe that such information provides additional useful information to analysts, stockholders and other users to understand the Company's operating performance. Since Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA as presented may not be comparable to other similarly titled measures of other companies. Items excluded from Adjusted EBITDA are significant components in understanding and assessing our financial performance. Adjusted EBITDA should not be considered in isolation or as an alternative to, or substitute for, net income, cash flows generated by operations, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation or a substitute for analyzing our results as reported under GAAP. Some of the limitations are: • Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; • Adjusted EBITDA does not reflect our interest expense, or the requirements necessary to service interest or principal payments on our debt; • Adjusted EBITDA does not reflect our income tax expenses or the cash requirements to pay our taxes; • Adjusted EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; and • Although depreciation and amortization charges are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements. 2016 Compared to 2015 Revenue Total revenue decreased 15% to $477.7 million in 2016, compared with $563.1 million in 2015. Environmental Services Environmental Services segment revenue decreased 6% to $337.8 million in 2016, compared to $359.0 million in 2015. T&D revenue decreased 5% in 2016, primarily as a result of a 30% decrease in project-based Event Business. Transportation and logistics service revenue decreased 8% in 2016 compared to 2015, reflecting fewer Event Business projects utilizing the Company's transportation and logistics services. Tons of waste disposed of or processed decreased 14% in 2016 compared to 2015. T&D revenue from recurring Base Business waste generators increased 2% in 2016 compared to 2015 and comprised 82% of total T&D revenue. During 2016, increases in Base Business T&D revenue from the refining, "Other", utilities and general manufacturing industry groups were partially offset by decreases in T&D revenue from Base Business in the chemical manufacturing and broker/TSDF industry groups. T&D revenue from Event Business waste generators decreased 30% in 2016 compared to 2015 and comprised 18% of total T&D revenue. The decrease in Event Business T&D revenue compared to the prior year primarily reflects lower T&D revenue from the chemical manufacturing, refining and government industry groups, partially offset by higher T&D revenue from the general manufacturing and "Other" industry groups. The decrease in revenue from the chemical manufacturing industry group is primarily attributable to the completion of a large East Coast remedial cleanup project in the third quarter of 2015 and the completion of a nuclear fuels fabrication plant decommissioning in the first quarter of 2016. The decrease in revenue from the refining and government industry groups is primarily attributable to lower Event Business volumes. The following table summarizes combined Base Business and Event Business T&D revenue growth, within the Environmental Services segment, by waste generator industry for 2016 compared to 2015: Field & Industrial Services Field & Industrial Services segment revenue decreased 31% to $139.9 million in 2016 compared with $204.0 million in 2015. The decrease is primarily attributable to the divested Allstate business which contributed segment revenue of $59.1 million for our period of ownership in 2015. Gross Profit Total gross profit decreased 14% to $147.6 million in 2016, down from $171.4 million in 2015. Total gross margin was 31% for 2016 compared with 30% for 2015. Environmental Services Environmental Services segment gross profit decreased 8% to $126.8 million in 2016, down from $137.6 million in 2015. This decrease primarily reflects lower T&D volumes in 2016 compared to 2015. Total segment gross margin was 38% for both 2016 and 2015. T&D gross margin was 42% for 2016 compared with 43% for 2015. Field & Industrial Services Field & Industrial Services segment gross profit decreased 38% to $20.8 million in 2016, down from $33.8 million in 2015. Total segment gross margin was 15% for 2016 compared with 17% for 2015. The divested Allstate business contributed segment gross profit of $12.4 million for our period of ownership in 2015. Selling, General and Administrative Expenses ("SG&A") Total SG&A decreased to $77.6 million, or 16% of total revenue, in 2016 compared with $93.1 million, or 17% of total revenue, in 2015. Environmental Services Environmental Services segment SG&A decreased 6% to $21.4 million, or 6% of segment revenue, in 2016 compared with $22.8 million, or 6% of segment revenue, in 2015, primarily reflecting higher gains on sales of assets in 2016 compared to 2015. Field & Industrial Services Field & Industrial Services segment SG&A decreased 54% to $10.1 million, or 7% of segment revenue, in 2016 compared with $22.0 million, or 11% of segment revenue, in 2015. The divested Allstate business contributed segment SG&A of $10.9 million for our period of ownership in 2015. The remaining decrease in segment SG&A primarily reflects lower employee labor costs in 2016 compared to 2015. Corporate Corporate SG&A was $46.0 million, or 10% of total revenue, in 2016 compared with $48.4 million, or 9% of total revenue, in 2015, primarily reflecting lower business development expenses and lower professional services expenses in 2016 compared to 2015. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2016 was 38.1% compared with 45.3% in 2015. The decrease reflects nonrecurring non-deductible goodwill impairment charges incurred in 2015, a nondeductible loss on the sale of the Allstate business recorded during 2015 and a decrease in our U.S. effective tax rate, driven by a lower overall effective state tax rate. The lower effective state tax rate was driven by changes in apportionment of income and deferred taxes between the various states in which we operate. The decrease in the effective tax rate was partially offset by a lower proportion of earnings from our Canadian operations in 2016, which are taxed at a lower corporate tax rate. As of December 31, 2016, we had approximately $12.7 million in state and local net operating loss carry forwards ("NOLs") for which we maintain a valuation allowance on the majority of the balance. We maintain a valuation allowance on state and local NOLs when we no longer do business within a state or locality or determine it is unlikely that we will utilize these NOLs in the future. We consider it more likely than not that we will not utilize the majority of these NOLs in the future. Interest expense Interest expense was $17.3 million in 2016 compared with $23.4 million in 2015. The decrease is primarily due to $291,000 of incremental non-cash amortization of deferred financing fees associated with debt principal payments in 2016 compared with $2.4 million of incremental amortization in 2015. The remaining decrease is attributable to lower debt levels in 2016 compared with 2015. Foreign currency gain (loss) We recognized a $138,000 non-cash foreign currency loss in 2016 compared with a $2.2 million non-cash foreign currency loss in 2015. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Canadian subsidiaries' facilities are located in Blainville, Québec and Tilbury, Ontario, Canada and use the Canadian dollar ("CAD") as their functional currency. Additionally, we established intercompany loans between our Canadian subsidiaries, whose functional currency is the CAD, and our parent company, US Ecology, as part of a tax and treasury management strategy allowing for repayment of third-party bank debt. These intercompany loans are payable by our Canadian subsidiaries to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2016, we had $20.8 million of intercompany loans subject to currency revaluation. Gain on divestiture Other income in 2016 includes approximately $2.0 million related to the gain on sale of the Augusta, Georgia facility in April 2016 and final closing adjustments on the Allstate divestiture. Depreciation and amortization of plant and equipment Depreciation and amortization expense was $25.3 million in 2016 compared with $27.9 million in 2015. The divested Allstate business contributed depreciation and amortization expense of $2.2 million for our period of ownership in 2015. Amortization of intangibles Intangible assets amortization expense was $10.6 million in 2016 compared with $12.3 million in 2015. The divested Allstate business contributed intangible assets amortization expense of $1.4 million for our period of ownership in 2015. Stock-based compensation Stock-based compensation expense increased 27% to $2.9 million in 2016, compared with $2.3 million 2015 as a result of an increase in equity-based awards granted to employees. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities was $4.0 million in 2016 compared with $4.6 million in 2015. Impairment charges On August 4, 2015, we entered into a definitive agreement to sell Allstate to a private investor group. Allstate represented the majority of the industrial services business we acquired with the acquisition of EQ. As a result of this agreement and management's strategic review, we evaluated the recoverability of the assets associated with our industrial services business. Based on this analysis, we recorded a non-cash goodwill impairment charge of $6.7 million in the second quarter of 2015. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information on the sale of Allstate. 2015 Compared to 2014 Revenue Total revenue increased 26% to $563.1 million in 2015, compared with $447.4 million in 2014. The acquired EQ operations contributed $359.0 million of revenue in 2015, compared with $228.2 million for our period of ownership in 2014. Excluding EQ operations, total revenue decreased 7% to $204.1 million in 2015, compared with $219.2 million in 2014. Revenue from EQ is excluded from percentages of Base and Event Business and waste generator industry information in the following paragraphs. Environmental Services Environmental Services segment revenue increased 15% to $359.0 million in 2015, compared to $311.5 million in 2014. The acquired EQ operations contributed $154.9 million of segment revenue in 2015 compared with $92.3 million of segment revenue for our period of ownership in 2014. Excluding EQ operations, segment revenue decreased 7% to $204.1 million in 2015, compared with $219.2 million in 2014. T&D revenue (excluding EQ) decreased 8% in 2015 compared to 2014, primarily as a result of a 23% decrease in project-based Event Business. Transportation service revenue (excluding EQ) increased 2% compared to 2014, reflecting more Event Business projects utilizing our transportation and logistics services. Tons of waste disposed of or processed increased 5% in 2015 compared to 2014. Excluding EQ, tons of waste disposed of or processed decreased 20% in 2015 compared to 2014. Growth in T&D revenue from recurring Base Business waste generators was flat compared to 2014 and comprised 74% of total T&D revenue in 2015. During 2015, increases in Base Business T&D revenue from the refining and broker/TSDF industries were offset by decreases in T&D revenue from Base Business in the chemical manufacturing, utilities, and mining, exploration and production industries. T&D revenue from Event Business waste generators decreased 23% in 2015 compared to 2014 and comprised 26% of total T&D revenue in 2015. The decrease in Event Business T&D revenue compared to the prior year primarily reflects lower T&D revenue from the chemical and metal manufacturing, transportation, broker/TSDF, and mining, exploration and production industries, partially offset by higher T&D revenue from the utilities, government and refining industries. The decrease in T&D revenue from the chemical manufacturing industry is primarily attributable to reductions in volume from a large East Coast remedial cleanup project and lower overall industry activity in 2015. The decrease in T&D revenue from the metal manufacturing industry is primarily attributable to lower domestic production of metal related products and services. The decrease in T&D revenue from the mining, exploration and production industry primarily reflects lower industry activity due to lower commodity prices. The following table summarizes combined Base Business and Event Business T&D revenue growth by waste generator industry for 2015 compared to 2014: (1)Excludes EQ Holdings, Inc. which was acquired on June 17, 2014 Field & Industrial Services Our Field & Industrial Services segment was added subsequent to, and as a result of, our acquisition of EQ on June 17, 2014. This segment includes all of the field and industrial service business of the legacy EQ operations and none of the legacy US Ecology operations. Field & Industrial Services segment revenue was $204.0 million in 2015 compared with $135.9 million for our period of ownership in 2014. The divested Allstate business contributed segment revenue of $59.1 million for our period of ownership in 2015 compared with $37.0 million for our period of ownership in 2014. Gross Profit Total gross profit increased 18% to $171.4 million in 2015, up from $145.8 million in 2014. The acquired EQ operations contributed $91.7 million of gross profit in 2015, compared with $57.4 million for our period of ownership in 2014. Excluding EQ operations, total gross profit decreased 10% to $79.7 million in 2015, compared with $88.4 million in 2014. Total gross margin in 2015 was 30%. Excluding EQ operations, total gross margin was 39%. Environmental Services Environmental Services segment gross profit increased 11% to $137.6 million in 2015, up from $123.8 million in 2014. The acquired EQ operations contributed $57.9 million of segment gross profit in 2015 compared with $35.4 million of segment gross profit for our period of ownership in 2014. Excluding EQ operations, segment gross profit decreased 10% to $79.7 million in 2015, compared with $88.4 million in 2014. This decrease primarily reflects lower T&D volumes in 2015 compared to 2014. Total segment gross margin in 2015 was 38%. Excluding EQ operations, total segment margin was 39%. Excluding EQ operations, T&D gross margin was 48% in 2015 compared to 49% in 2014. Field & Industrial Services Our Field & Industrial Services segment was added in 2014 as a result of our acquisition of EQ on June 17, 2014. This segment includes all of the field and industrial service business of the legacy EQ operations and none of the legacy US Ecology operations. Field & Industrial Services segment gross profit and gross margin were $33.8 million and 17%, respectively, in 2015 compared with $22.0 million and 16%, respectively, for our period of ownership in 2014. The divested Allstate business contributed segment gross profit of $12.4 million for our period of ownership in 2015 compared with $8.2 million for our period of ownership in 2014. Selling, General and Administrative Expenses ("SG&A") Total SG&A increased 27% to $93.1 million in 2015, up from $73.3 million in 2014. The acquired EQ operations contributed $56.6 million of SG&A in 2015, compared with $38.9 million for our period of ownership in 2014. Excluding EQ operations, total SG&A was $36.5 million, or 18% of total revenue in 2015, compared with $34.4 million, or 16% of total revenue, in 2014. Environmental Services Environmental Services segment SG&A increased 22% to $22.8 million, or 6% of segment revenue, in 2015, up from $18.6 million, or 6% of segment revenue, in 2014. The acquired EQ operations contributed $11.6 million of segment SG&A in 2015 compared with $6.8 million of segment SG&A for our period of ownership in 2014. Excluding EQ operations, total segment SG&A was $11.1 million, or 5% of segment revenue, in 2015 compared with $11.8 million, or 5% of segment revenue, in 2014. Field & Industrial Services Our Field & Industrial Services segment was added in 2014 as a result of our acquisition of EQ on June 17, 2014. This segment includes all of the field and industrial service business of the legacy EQ operations and none of the legacy US Ecology operations. Field & Industrial Services segment SG&A was $22.0 million in 2015 compared with $14.5 million for our period of ownership in 2014. The divested Allstate business contributed segment SG&A of $10.9 million for our period of ownership in 2015 compared with $6.6 million for our period of ownership in 2014. Corporate Corporate SG&A increased 20% to $48.4 million in 2015, up from $40.2 million in 2014. The acquired EQ operations contributed $23.0 million of corporate SG&A in 2015 compared with $17.6 million of corporate SG&A for our period of ownership in 2014. Excluding EQ operations, total corporate SG&A was $25.4 million, or 12% of total revenue in 2015, compared with $22.6 million, or 10% of total revenue in 2014, primarily reflecting higher labor costs and professional fees and expenses, partially offset by lower business development expenses in 2015 compared to 2014. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2015 was 45.3% compared to 37.4% in 2014. The increase reflects non-deductible goodwill impairment charges, a non-deductible loss on the sale of the Allstate business recorded during 2015 and an increase in our U.S. effective tax rate, primarily driven by a higher overall effective state tax rate. The higher effective state tax rate was driven by changes in apportionment of income and deferred taxes between the various states in which we operate. The increase in the effective tax rate was also partially attributable to a lower proportion of earnings from our Canadian operations in 2015, which are taxed at a lower corporate tax rate. As of December 31, 2015, we had approximately $161,000 in federal NOLs acquired from EQ. As of December 31, 2015, we had approximately $34.2 million in state and local NOLs for which we maintain a substantial valuation allowance. We maintain a valuation allowance on state and local NOLs when we no longer do business within a state or locality or determine it is unlikely that we will utilize these NOLs in the future. We consider it unlikely that we will utilize the majority of these NOLs in the future. Interest expense Interest expense was $23.4 million in 2015 compared with $10.7 million in 2014. The increase is a result of higher outstanding debt levels and the related interest expense on borrowings under our Revolving Credit Facility used to finance the acquisition of EQ in June 2014. Additionally, we recorded $2.4 million of incremental non-cash amortization of deferred financing fees in 2015 primarily as a result of significant debt principal payments during the year. Foreign currency gain (loss) We recognized a $2.2 million non-cash foreign currency loss in 2015 compared with a $1.5 million non-cash foreign currency loss in 2014. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Stablex facility is located in Blainville, Québec, Canada and uses the CAD as its functional currency. Also, as part of our treasury management strategy we established intercompany loans between our parent company, US Ecology and Stablex. These intercompany loans are payable by Stablex to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2015, we had $15.0 million of intercompany loans subject to currency revaluation. Loss on divestiture On November 1, 2015, we completed the divestiture of Allstate for cash proceeds of $58.8 million, subject to post-closing adjustments. We recognized a pre-tax loss on the divestiture of Allstate, including transaction-related costs, of $542,000 during the fourth quarter of 2015. Impairment charges On August 4, 2015, we entered into a definitive agreement to sell Allstate to a private investor group. Allstate represented the majority of the industrial services business we acquired with the acquisition of EQ. As a result of this agreement and management's strategic review, we evaluated the recoverability of the assets associated with our industrial services business. Based on this analysis, we recorded a non-cash goodwill impairment charge of $6.7 million in the second quarter of 2015. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information on the sale of Allstate. Depreciation and amortization of plant and equipment Depreciation and amortization expense was $27.9 million in 2015, an increase of 14% compared to 2014. The acquired EQ operations contributed $13.9 million of depreciation and amortization expense in 2015 compared with $9.0 million of depreciation and amortization expense for our period of ownership in 2014. Excluding EQ operations, depreciation and amortization expense was $14.0 million in 2015, compared with $15.4 million in 2014. Amortization of intangibles Intangible assets amortization expense was $12.3 million in 2015, an increase of 50% compared to 2014. Excluding intangible assets amortization expense of $11.1 million and $6.8 million recorded in 2015 and 2014, respectively, on new intangible assets recorded as a result of the acquisition of EQ, intangible assets amortization expense was $1.2 million in 2015, compared with $1.4 million in 2014. Stock-based compensation Stock-based compensation expense increased 84% to $2.3 million in 2015, compared with $1.3 million 2014 as a result of an increase in equity-based awards granted to employees. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities increased 73% to $4.6 million in 2015, compared with $2.7 million in 2014. The acquired EQ operations contributed $2.5 million of accretion and non-cash adjustment of closure and post-closure liabilities in 2015 compared with $1.2 million of accretion and non-cash adjustment of closure and post-closure liabilities for our period of ownership in 2014. Excluding EQ operations, accretion and non-cash adjustment of closure and post-closure liabilities was $2.1 million in 2015, compared with $1.5 million in 2014. Liquidity and Capital Resources Our primary sources of liquidity are cash and cash equivalents, cash generated from operations and borrowings under the Credit Agreement. At December 31, 2016, we had $7.0 million in cash and cash equivalents immediately available and $116.8 million of borrowing capacity available under our Revolving Credit Facility. We assess our liquidity in terms of our ability to generate cash to fund our operating, investing and financing activities. Our primary ongoing cash requirements are funding operations, capital expenditures, paying interest and required principal payments of our long-term debt, and paying declared dividends pursuant to our dividend policy. We believe future operating cash flows will be sufficient to meet our future operating, investing and dividend cash needs for the foreseeable future. Furthermore, existing cash balances and availability of additional borrowings under our Credit Agreement provide additional sources of liquidity should they be required. Operating Activities. In 2016, net cash provided by operating activities was $74.6 million. This primarily reflects net income of $34.3 million, non-cash depreciation, amortization and accretion of $39.8 million, a decrease in accounts receivable of $10.9 million, share-based compensation expense of $2.9 million, non-cash amortization of debt issuance costs of $2.0 million, and a decrease in other assets of $1.2 million, partially offset by a decrease in accounts payable and accrued liabilities of $7.7 million, a decrease in deferred income taxes of $2.7 million, the gain recognized on the divestiture of the Augusta, Georgia facility in April 2016, final closing adjustments on the Allstate divestiture of $2.0 million, and a decrease in income taxes receivable of $2.0 million. Impacts on net income are due to the factors discussed above under "Results of Operations." The decrease in receivables is primarily attributable to the timing of customer payments. Changes in income taxes receivable and payable are primarily attributable to the timing of income tax payments. Days sales outstanding were 73 days as of December 31, 2016, compared to 68 days as of December 31, 2015. The increase in days sales outstanding compared to December 31, 2015 is primarily attributable to a decrease in revenue in 2016, compared to 2015, which resulted in a higher proportion of accounts receivable as a percentage of revenues. In 2015, net cash provided by operating activities was $71.5 million. This primarily reflects net income of $25.6 million, non-cash depreciation, amortization and accretion of $44.8 million, non-cash impairment charges of $6.7 million, a decrease in income taxes receivable of $4.8 million, non-cash amortization of debt issuance costs of $4.4 million, unrealized foreign currency losses of $3.3 million, share-based compensation expense of $2.3 million and a decrease in accounts receivable of $1.6 million, partially offset by a decrease in accounts payable and accrued liabilities of $6.5 million, a decrease in closure and post-closure obligations of $5.7 million, a decrease in deferred revenue of $4.4 million, a decrease in income taxes payable of $3.9 million and a decrease in deferred income taxes of $2.7 million. Impacts on net income are due to the factors discussed above under Results of Operations. The decrease in receivables and deferred revenue is primarily attributable to the timing of the treatment and disposal of waste associated with a significant East Coast remedial cleanup project. The changes in income taxes receivable and payable are primarily attributable to the timing of income tax payments. The decrease in closure and post-closure obligations is primarily attributable to payments made for closure and post-closure activities primarily at our closed landfills. In 2014, net cash provided by operating activities was $71.4 million. This primarily reflects net income of $38.2 million, non-cash depreciation, amortization and accretion of $35.3 million, unrealized foreign currency losses of $2.4 million, an increase in deferred revenue of $1.9 million and an increase in deferred income taxes of $2.0 million, partially offset by an increase in receivables of $4.4 million, a decrease in accounts payable and accrued liabilities of $2.9 million and an increase in income taxes receivable of $1.8 million. Impacts on net income are due to the factors discussed above under Results of Operations. Non-cash foreign currency losses reflect a weaker CAD relative to the USD in 2014. The increase in deferred revenue and receivables is primarily attributable to the timing of the treatment and disposal of waste associated with a significant East Coast remedial cleanup project. The changes in income taxes receivable are primarily attributable to the timing of income tax payments. Investing Activities. In 2016, net cash used in investing activities was $42.0 million, primarily related to capital expenditures of $35.7 million, the purchase of the Vernon, California based RCRA Part B, liquids and solids waste treatment and storage facility of Evoqua Water Technologies LLC for $5.0 million and the purchase of Environmental Services Inc., ("ESI"), for $4.9 million, net of cash acquired, partially offset by proceeds from the divestiture of our Augusta, Georgia facility for $2.7 million, net of cash divested. Significant capital projects included construction of additional disposal capacity at our Blainville, Québec, Canada, Beatty, Nevada and Robstown, Texas facilities and equipment purchases and infrastructure upgrades at our corporate and operating facilities. In 2015, net cash provided by investing activities was $20.3 million, primarily related to the divestiture of Allstate for $58.7 million, net of cash divested, partially offset by capital expenditures of $39.4 million. Significant capital projects included construction of additional disposal capacity at our Blainville, Québec, Canada and Robstown, Texas locations and equipment purchases and infrastructure upgrades at all of our corporate and operating facilities. In 2014, net cash used in investing activities was $488.5 million, primarily related to the purchase of EQ for $460.9 million, net of cash acquired, and capital expenditures of $28.4 million. Significant capital projects included construction of additional disposal capacity at our Blainville, Québec, Canada location and equipment purchases and infrastructure upgrades at all of our corporate and operating facilities. Financing Activities. During 2016, net cash used in financing activities was $31.6 million, consisting primarily of $18.0 million of payments on our Term Loan and $15.7 million of dividend payments to our stockholders, partially offset by $2.2 million of net proceeds on our Revolving Credit Facility to fund working capital requirements. During 2015, net cash used in financing activities was $108.4 million, consisting primarily of $94.6 million of payments on our Term Loan and $15.6 million of dividend payments to our stockholders. During 2014, net cash provided by financing activities was $366.8 million, consisting primarily of $414.0 million of net proceeds from our new Term Loan used to partially finance the acquisition of EQ, offset in part by $19.4 million of term loan repayments, $15.5 million of dividend payments to our stockholders and $14.0 million of deferred financing costs associated with our Credit Agreement. Credit Facility On June 17, 2014, in connection with the acquisition of EQ, the Company entered into a new $540.0 million senior secured credit agreement (the "Credit Agreement") with a syndicate of banks comprised of a $415.0 million term loan (the "Term Loan") with a maturity date of June 17, 2021 and a $125.0 million revolving line of credit (the "Revolving Credit Facility") with a maturity date of June 17, 2019. Upon entering into the Credit Agreement, the Company terminated its existing credit agreement with Wells Fargo, dated October, 29, 2010, as amended (the "Former Agreement"). Immediately prior to the termination of the Former Agreement, there were no outstanding borrowings under the Former Agreement. No early termination penalties were incurred as a result of the termination of the Former Agreement. Term Loan The Term Loan provides an initial commitment amount of $415.0 million, the proceeds of which were used to acquire 100% of the outstanding shares of EQ and pay related transaction fees and expenses. The Term Loan bears interest at a base rate (as defined in the Credit Agreement) plus 2.00% or LIBOR plus 3.00%, at the Company's option. The Term Loan is subject to amortization in equal quarterly installments in an aggregate annual amount equal to 1.00% of the original principal amount of the Term Loan. At December 31, 2016, the effective interest rate on the Term Loan, including the impact of our interest rate swap, was 4.76%. Interest only payments are due either monthly or on the last day of any interest period, as applicable. As set forth in the Credit Agreement, the Company is required to enter into one or more interest rate hedge agreements in amounts sufficient to fix the interest rate on at least 50% of the principal amount of the $415.0 million Term Loan. In October 2014, the Company entered into an interest rate swap agreement with Wells Fargo, effectively fixing the interest rate on $210.0 million, or 74%, of the Term Loan principal outstanding as of December 31, 2016. Revolving Credit Facility The Revolving Credit Facility provides up to $125.0 million of revolving credit loans or letters of credit with the use of proceeds restricted solely for working capital and other general corporate purposes. Under the Revolving Credit Facility, revolving loans are available based on a base rate (as defined in the Credit Agreement) or LIBOR, at the Company's option, plus an applicable margin which is determined according to a pricing grid under which the interest rate decreases or increases based on our ratio of funded debt to consolidated earnings before interest, taxes, depreciation and amortization (as defined in the Credit Agreement). The Company is required to pay a commitment fee of 0.50% per annum on the unused portion of the Revolving Credit Facility, with such commitment fee to be reduced based upon the Company's total leverage ratio (as defined in the Credit Agreement). The maximum letter of credit capacity under the Revolving Credit Facility is $50.0 million and the Credit Agreement provides for a letter of credit fee equal to the applicable margin for LIBOR loans under the Revolving Credit Facility. Interest payments are due either monthly or on the last day of any interest period, as applicable. At December 31, 2016, there were $2.2 million of working capital borrowings outstanding on the Revolving Credit Facility. These borrowings are due "on demand" and presented as short-term debt in the consolidated balance sheets. The availability under the Revolving Credit Facility was $116.8 million with $6.0 million of the Revolving Credit Facility issued in the form of standby letters of credit utilized as collateral for closure and post-closure financial assurance and other assurance obligations. See Note 15 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information on the Company's debt. Contractual Obligations and Guarantees Contractual Obligations US Ecology's contractual obligations at December 31, 2016 become due as follows: (1)For the purposes of the table above, closure and post-closure obligations are shown on an undiscounted basis and inflated using an estimated annual inflation rate of 2.6%. Cash payments for closure and post-closure obligation extend to the year 2105. (2)The Term Loan portion of the Credit Agreement with Wells Fargo matures on June 17, 2021 and is subject to amortization in equal quarterly installments in an aggregate annual amount of $2.9 million beginning March 31, 2017, with a final payment for the remaining principal balance due upon maturity. (3)Interest expense has been calculated using the effective interest rate of 3.75% in effect at December 31, 2016 on the unhedged variable rate portion of the outstanding principal and 5.17% on the fixed rate hedged portion of the outstanding principal beginning December 31, 2014, the effective date of the Company's interest rate swap agreement with Wells Fargo. The interest expense calculation reflects assumed principal reductions consistent with the disclosures in footnote (2) above. Guarantees We enter into a wide range of indemnification arrangements, guarantees and assurances in the ordinary course of business and have evaluated agreements that contain guarantees and indemnification clauses. These include tort indemnities, tax indemnities, indemnities against third-party claims arising out of arrangements to provide services to us and indemnities related to the sale of our securities. We also indemnify individuals made party to any suit or proceeding if that individual was acting as an officer or director of US Ecology or was serving at the request of US Ecology or any of its subsidiaries during their tenure as a director or officer. We also provide guarantees and indemnifications for the benefit of our wholly-owned subsidiaries to satisfy performance obligations, including closure and post-closure financial assurances. It is difficult to quantify the maximum potential liability under these indemnification arrangements; however, we are not currently aware of any material liabilities to the Company or any of its subsidiaries arising from these arrangements. Environmental Matters We maintain funded trusts agreements, surety bonds and insurance policies for future closure and post-closure obligations at both current and formerly operated disposal facilities. These funded trust agreements, surety bonds and insurance policies are based on management estimates of future closure and post-closure monitoring using engineering evaluations and interpretations of regulatory requirements which are periodically updated. Accounting for closure and post-closure costs includes final disposal cell capping and revegetation, soil and groundwater monitoring and routine maintenance and surveillance required after a site is closed. We estimate that our undiscounted future closure and post-closure costs for all facilities was approximately $310.6 million at December 31, 2016, with a median payment year of 2061. Our future closure and post-closure estimates are our best estimate of current costs and are updated periodically to reflect current technology, cost of materials and services, applicable laws, regulations, permit conditions or orders and other factors. These current costs are adjusted for anticipated annual inflation, which we assumed to be 2.6% as of December 31, 2016. These future closure and post-closure estimates are discounted to their present value for financial reporting purposes using our credit-adjusted risk-free interest rate, which approximates our incremental long-term borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. At December 31, 2016, our weighted-average credit-adjusted risk-free interest rate was 5.9%. For financial reporting purposes, our recorded closure and post-closure obligations were $75.1 million and $71.2 million as of December 31, 2016 and 2015, respectively. Through December 31, 2016, we have met our financial assurance requirements through insurance, surety bonds, standby letters of credit and self-funded restricted trusts. US Operating and Non-Operating Facilities We cover our closure and post-closure obligations for our U.S. operating facilities through the use of third-party insurance policies, surety bonds and standby letters of credit. Insurance policies covering our closure and post-closure obligations expire in December 2017. Our total policy limits are approximately $81.6 million. At December 31, 2016 our trust accounts had $5.8 million for our closure and post-closure obligations and are identified as Restricted cash and investments on our consolidated balance sheets. All closure and post-closure funding obligations for our Beatty, Nevada and Richland, Washington facilities revert to the respective State. Volume based fees are collected from our customers and remitted to state controlled trust funds to cover the estimated cost of closure and post-closure obligations. Stablex We use commercial surety bonds to cover our closure obligations for our Stablex facility located in Blainville, Québec, Canada. Our lease agreement with the Province of Québec requires that the surety bond be maintained for 25 years after the lease expires in 2023. At December 31, 2016 we had $686,000 in commercial surety bonds dedicated for closure obligations. These bonds were renewed in November and December 2016 and expire in November and December 2017. Post-closure funding obligations for the Stablex landfill revert back to the Province of Québec through a dedicated trust account that is funded based on a per-metric-ton disposed fee by Stablex. We expect to renew insurance policies and commercial surety bonds in the future. If we are unable to obtain adequate closure, post-closure or environmental liability insurance and/or commercial surety bonds in future years, any partial or completely uninsured claim against us, if successful and of sufficient magnitude, could have a material adverse effect on our financial condition, results of operations or cash flows. Additionally, continued access to casualty and pollution legal liability insurance with sufficient limits, at acceptable terms, is important to obtaining new business. Failure to maintain adequate financial assurance could also result in regulatory action including early closure of facilities. While we believe we will be able to maintain the requisite financial assurance policies at a reasonable cost, premium and collateral requirements may materially increase. Operation of disposal facilities creates operational, closure and post-closure obligations that could result in unplanned monitoring and corrective action costs. We cannot predict the likelihood or effect of all such costs, new laws or regulations, litigation or other future events affecting our facilities. We do not believe that continuing to satisfy our environmental obligations will have a material adverse effect on our financial condition or results of operations. Seasonal Effects Seasonal fluctuations due to weather and budgetary cycles can influence the timing of customer spending for our services. Typically, in the first quarter of each calendar year there is less demand for our services due to reduced construction and business activities related to weather while we experience improvement in our second and third quarters of each calendar year as weather conditions and other business activity improves. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates included in our critical accounting policies discussed below and those accounting policies and use of estimates discussed in Notes 2 and 3 to the Consolidated Financial Statements located in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. We base our estimates on historical experience and on various assumptions and other factors we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We make adjustments to judgments and estimates based on current facts and circumstances on an ongoing basis. Historically, actual results have not deviated significantly from those determined using the estimates described below or in Notes 2 and 3 to the Consolidated Financial Statements located in "Part II, Item 8. Financial Statements and Supplementary Data" to this Annual Report on Form 10-K. However, actual amounts could differ materially from those estimated at the time the consolidated financial statements are prepared. We believe the following critical accounting policies are important to understand our financial condition and results of operations and require management's most difficult, subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, delivery and disposal have occurred or services have been rendered, the price is fixed or determinable and collection is reasonably assured. We recognize revenue from three primary sources: 1) waste treatment, recycling and disposal, 2) field and industrial waste management services and 3) waste transportation services. Waste treatment and disposal revenue results primarily from fees charged to customers for treatment and/or disposal or recycling of specified wastes. Waste treatment and disposal revenue is generally charged on a per-ton or per-yard basis based on contracted prices and is recognized when services are complete. Field and industrial waste management services revenue results primarily from specialty onsite services such as high-pressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response at refineries, chemical plants, steel and automotive plants, and other government, commercial and industrial facilities. These services are provided based on purchase orders or agreements with the customer and include prices based upon daily, hourly or job rates for equipment, materials and personnel. Revenues are recognized over the term of the agreements or as services are performed. Revenue is recognized on contracts with retainage when services have been rendered and collectability is reasonably assured. Transportation revenue results from delivering customer waste to a disposal facility for treatment and/or disposal or recycling. Transportation services are generally not provided on a stand-alone basis and instead are bundled with other Company services. However, in some instances we provide transportation and logistics services for shipment of waste from cleanup sites to disposal facilities operated by other companies. We account for our bundled arrangements as multiple deliverable arrangements and determine the amount of revenue recognized for each deliverable (unit of accounting) using the relative fair value method. Transportation revenue is recognized when the transported waste is received at the disposal facility. Waste treatment and disposal revenue under bundled arrangements is recognized when services are complete and the waste is disposed in the landfill. Burial fees collected from customers for each ton or cubic yard of waste disposed in our landfills are paid to the respective local and/or state government entity and are not included in revenue. Revenue and associated costs from waste that has been received but not yet treated and disposed of in our landfills are deferred until disposal occurs. Our Richland, Washington disposal facility is regulated by the WUTC, which approves our rates for disposal of LLRW. Annual revenue levels are established based on a six-year rate agreement with the WUTC at amounts sufficient to cover the costs of operation and provide us with a reasonable profit. Per-unit rates charged to LLRW customers during the year are based on our evaluation of disposal volume and radioactivity projections submitted to us by waste generators. Our proposed rates are then reviewed and approved by the WUTC. If annual revenue exceeds the approved levels set by the WUTC, we are required to refund excess collections to facility users on a pro-rata basis. The current rate agreement with the WUTC was extended in 2013 and is effective until January 1, 2020. Disposal Facility Accounting We amortize landfill and disposal assets and certain related permits over their estimated useful lives. The units-of-consumption method is used to amortize landfill cell construction and development costs and asset retirement costs. Under the units-of-consumption method, we include costs incurred to date as well as future estimated construction costs in the amortization base of the landfill assets. Additionally, where appropriate, as discussed below, we also include probable expansion airspace that has yet to be permitted in the calculation of the total remaining useful life of the landfill asset. If we determine that expansion capacity should no longer be considered in calculating the total remaining useful life of a landfill asset, we may be required to recognize an asset impairment or incur significantly higher amortization expense over the remaining estimated useful life of the landfill asset. If at any time we make the decision to abandon the expansion effort, the capitalized costs related to the expansion effort would be expensed in the period of abandonment. Our landfill assets and liabilities fall into the following two categories, each of which require accounting judgments and estimates: • Landfill assets comprised of capitalized landfill development costs. • Disposal facility retirement obligations relating to our capping, closure and post-closure liabilities that result in corresponding retirement assets. Landfill Assets Landfill assets include the costs of landfill site acquisition, permits and cell design and construction incurred to date. Landfill cells represent individual disposal areas within the overall treatment and disposal site and may be subject to specific permit requirements in addition to the general permit requirements associated with the overall site. To develop, construct and operate a landfill cell, we must obtain permits from various regulatory agencies at the local, state and federal levels. The permitting process requires an initial site study to determine whether the location is feasible for landfill operations. The initial studies are reviewed by our environmental management group and then submitted to the regulatory agencies for approval. During the development stage we capitalize certain costs that we incur after site selection but before the receipt of all required permits if we believe that it is probable that the landfill cell will be permitted. Upon receipt of regulatory approval, technical landfill cell designs are prepared. The technical designs, which include the detailed specifications to develop and construct all components of the landfill cell including the types and quantities of materials that will be required, are reviewed by our environmental management group. The technical designs are submitted to the regulatory agencies for approval. Upon approval of the technical designs, the regulatory agencies issue permits to develop and operate the landfill cell. The types of costs that are detailed in the technical design specifications generally include excavation, natural and synthetic liners, construction of leachate collection systems, installation of groundwater monitoring wells, construction of leachate management facilities and other costs associated with the development of the site. We review the adequacy of our cost estimates at least annually. These development costs, together with any costs incurred to acquire, design and permit the landfill cell, including personnel costs of employees directly associated with the landfill cell design, are recorded to the landfill asset on the balance sheet as incurred. To match the expense related to the landfill asset with the revenue generated by the landfill operations, we amortize the landfill asset on a units-of-consumption basis over its operating life, typically on a cubic yard or cubic meter of disposal space consumed. The landfill asset is fully amortized at the end of a landfill cell's operating life. The per-unit amortization rate is calculated by dividing the sum of the landfill asset net book value plus estimated future development costs (as described above) for the landfill cell, by the landfill cell's estimated remaining disposal capacity. Amortization rates are influenced by the original cost basis of the landfill cell, including acquisition costs, which in turn is determined by geographic location and market values. We have secured significant landfill assets through business acquisitions and valued them at the time of acquisition based on fair value. Included in the technical designs are factors that determine the ultimate disposal capacity of the landfill cell. These factors include the area over which the landfill cell will be developed, such as the depth of excavation, the height of the landfill cell elevation and the angle of the side-slope construction. Landfill cell capacity used in the determination of amortization rates of our landfill assets includes both permitted and unpermitted disposal capacity. Unpermitted disposal capacity is included when management believes achieving final regulatory approval is probable based on our analysis of site conditions and interactions with applicable regulatory agencies. We review the estimates of future development costs and remaining disposal capacity for each landfill cell at least annually. These costs and disposal capacity estimates are developed using input from independent engineers and internal technical and accounting managers and are reviewed and approved by our environmental management group. Any changes in future estimated costs or estimated disposal capacity are reflected prospectively in the landfill cell amortization rates. We assess our long-lived landfill assets for impairment when an event occurs or circumstances change that indicate the carrying amount may not be recoverable. Examples of events or circumstances that may indicate impairment of any of our landfill assets include, but are not limited to, the following: • Changes in legislative or regulatory requirements impacting the landfill site permitting process making it more difficult and costly to obtain and/or maintain a landfill permit; • Actions by neighboring parties, private citizen groups or others to oppose our efforts to obtain, maintain or expand permits, which could result in denial, revocation or suspension of a permit and adversely impact the economic viability of the landfill. As a result of opposition to our obtaining a permit, improved technical information as a project progresses, or changes in the anticipated economics associated with a project, we may decide to reduce the scope of, or abandon, a project, which could result in an asset impairment; and • Unexpected significant increases in estimated costs, significant reductions in prices we are able to charge our customers or reductions in disposal capacity that affect the ongoing economic viability of the landfill. Disposal Facility Retirement Obligations Disposal facility retirement obligations include the cost to close, maintain and monitor landfill cells and support facilities. As individual landfill cells reach capacity, we must cap and close the cells in accordance with the landfill cell permits. These capping and closure requirements are detailed in the technical design of each landfill cell and included as part of our approved regulatory permit. After the entire landfill cell has reached capacity and is certified closed, we must continue to maintain and monitor the landfill cell for a post-closure period, which generally extends for 30 years. Costs associated with closure and post-closure requirements generally include maintenance of the landfill cell and groundwater systems, and other activities that occur after the landfill cell has ceased accepting waste. Costs associated with post-closure monitoring generally include groundwater sampling, analysis and statistical reports, transportation and disposal of landfill leachate, and erosion control costs related to the final cap. We have a legally enforceable obligation to operate our landfill cells in accordance with the specific requirements, regulations and criteria set forth in our permits. This includes executing the approved closure/post-closure plan and closing/capping the entire landfill cell in accordance with the established requirements, design and criteria contained in the permit. As a result, we record the fair value of our disposal facility retirement obligations as a liability in the period in which the regulatory obligation to retire a specific asset is triggered. For our individual landfill cells, the required closure and post-closure obligations under the terms of our permits and our intended operation of the landfill cell are triggered and recorded when the cell is placed into service and waste is initially disposed in the landfill cell. The fair value is based on the total estimated costs to close the landfill cell and perform post-closure activities once the landfill cell has reached capacity and is no longer accepting waste, discounted using a credit-adjusted risk-free rate. Retirement obligations are increased each year to reflect the passage of time by accreting the balance at the weighted average credit-adjusted risk-free rate that is used to calculate the recorded liability, with accretion charged to direct operating costs. Actual cash expenditures to perform closure and post-closure activities reduce the retirement obligation liabilities as incurred. After initial measurement, asset retirement obligations are adjusted at the end of each period to reflect changes, if any, in the estimated future cash flows underlying the obligation. Disposal facility retirement assets are capitalized as the related disposal facility retirement obligations are incurred. Disposal facility retirement assets are amortized on a units-of-consumption basis as the disposal capacity is consumed. Our disposal facility retirement obligations represent the present value of current cost estimates to close, maintain and monitor landfills and support facilities as described above. Cost estimates are developed using input from independent engineers, internal technical and accounting managers, as well as our environmental management group's interpretation of current legal and regulatory requirements, and are intended to approximate fair value. We estimate the timing of future payments based on expected annual disposal airspace consumption and then inflate the current cost estimate by an inflation rate, estimated at December 31, 2016 to be 2.6%. Inflated current costs are then discounted using our credit-adjusted risk-free interest rate, which approximates our incremental borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. Our weighted-average credit-adjusted risk-free interest rate at December 31, 2016 was approximately 5.9%. Final closure and post-closure obligations are currently estimated as being paid through the year 2105. During 2016 we updated several assumptions, including estimated costs and timing of closing our disposal cells. These updates resulted in a net increase to our post-closure obligations of $1.7 million. We update our estimates of future capping, closure and post-closure costs and of future disposal capacity for each landfill cell on an annual basis. Changes in inflation rates or the estimated costs, timing or extent of the required future activities to close, maintain and monitor landfills and facilities result in both: (i) a current adjustment to the recorded liability and related asset and (ii) a change in accretion and amortization rates which are applied prospectively over the remaining life of the asset. A hypothetical 1% increase in the inflation rate would increase our closure/post-closure obligation by $18.0 million. A hypothetical 10% increase in our cost estimates would increase our closure/post-closure obligation by $8.1 million. Goodwill and Intangible Assets As of December 31, 2016, the Company's goodwill balance was $193.6 million. We assess goodwill for impairment during the fourth quarter as of October 1 of each year, and also if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The assessment consists of comparing the fair value of the reporting unit to the carrying value of the net assets assigned to the reporting unit, including goodwill. Some of the factors that could indicate impairment include a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, or failure to generate sufficient cash flows at the reporting unit. For example, field and industrial services represents an emerging business for the Company and has been the focus of a shift in strategy since the acquisition of EQ. Failure to execute on planned growth initiatives within this business could lead to the impairment of goodwill and intangible assets in future periods. We determine our reporting units by identifying the components of each operating segment, and then aggregate components having similar economic characteristics based on quantitative and/or qualitative factors. At December 31, 2016, we had 15 reporting units, 10 of which had allocated goodwill. Fair values are generally determined by using both the market approach, applying a multiple of earnings based on guideline for publicly traded companies, and the income approach, discounting projected future cash flows based on our expectations of the current and future operating environment. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. The rates used to discount projected future cash flows reflect a weighted average cost of capital based on our industry, capital structure and risk premiums including those reflected in the current market capitalization. In the event the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill test would be performed to measure the amount of impairment loss. In the event that we determine that the value of goodwill has become impaired, we will incur an accounting charge for the amount of impairment during the period in which the determination has been made. The result of the annual assessment of goodwill undertaken in the fourth quarter of 2016 indicated that the fair value of each of our reporting units was substantially in excess of its respective carrying value. We review intangible assets with indefinite useful lives for impairment during the fourth quarter as of October 1 of each year. Fair value is generally determined by considering an internally developed discounted projected cash flow analysis. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. If the fair value of an asset is determined to be less than the carrying amount of the intangible asset, an impairment in the amount of the difference is recorded in the period in which the annual assessment occurs. The result of the annual assessment of intangible assets with indefinite useful lives undertaken in the fourth quarter of 2016 indicated no impairment charges were required. We also review finite-lived intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of an intangible asset may not be recoverable. In order to assess whether a potential impairment exists, the assets' carrying values are compared with their undiscounted expected future cash flows. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. Impairments are measured by comparing the fair value of the asset to its carrying value. Fair value is generally determined by considering: (i) the internally developed discounted projected cash flow analysis; (ii) a third-party valuation; and/or (iii) information available regarding the current market environment for similar assets. If the fair value of an intangible asset is determined to be less than the carrying amount of the intangible asset, an impairment in the amount of the difference is recorded in the period in which the events or changes in circumstances that indicated the carrying value of the intangible assets may not be recoverable occurred. The result of the assessment of finite-lived intangible assets undertaken in 2016 indicated no impairment charges were required. On August 4, 2015, we entered into a definitive agreement to sell Allstate to a private investor group. Allstate represents the majority of the industrial services business we acquired with the acquisition of EQ. As a result of this agreement and management's strategic review, we evaluated the recoverability of the assets associated with our industrial services business. Our interim goodwill impairment test which included both Step I and Step II analysis was performed and resulted in a non-cash goodwill impairment charge of $6.7 million being recognized in the second quarter of 2015. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information on the sale of Allstate. No events or circumstances occurred during 2016 that would indicate that our intangible assets may be impaired, therefore no other impairment tests were performed during 2016 other than the annual assessment of goodwill and intangible assets with indefinite useful lives conducted in the fourth quarter of every year. Our acquired permits and licenses generally have renewal terms of approximately 5-10 years. We have a history of renewing these permits and licenses as demonstrated by the fact that each of the sites' treatment permits and licenses have been renewed regularly since the facility began operations. We intend to continue to renew our permits and licenses as they come up for renewal for the foreseeable future. Costs incurred to renew or extend the term of our permits and licenses are recorded in Selling, general and administrative expenses in our consolidated statements of operations. Share Based Payments On May 27, 2015, our stockholders approved the Omnibus Incentive Plan ("Omnibus Plan"), which was approved by our Board of Directors on April 7, 2015. The Omnibus Plan was developed to provide additional incentives through equity ownership in US Ecology and, as a result, encourage employees and directors to contribute to our success. The Omnibus Plan provides, among other things, the ability for the Company to grant restricted stock, performance stock, options, stock appreciation rights, restricted stock units, performance stock units ("PSUs") and other stock-based awards or cash awards to officers, employees, consultants and non-employee directors. Subsequent to the approval of the Omnibus Plan in May 2015, we stopped granting equity awards under our 2008 Stock Option Incentive Plan and our 2006 Restricted Stock Plan ("Previous Plans"), and the Previous Plans will remain in effect solely for the settlement of awards granted under the Previous Plans. No shares that are reserved but unissued under the Previous Plans or that are outstanding under the Previous Plans and reacquired by the Company for any reason will be available for issuance under the Omnibus Plan. The Omnibus Plan expires on April 7, 2025 and authorizes 1,500,000 shares of common stock for grant over the life of the Omnibus Plan. As of December 31, 2016, we have PSUs outstanding under the Omnibus Plan. Each PSU represents the right to receive, on the settlement date, one share of the Company's common stock. The total number of PSUs each participant is eligible to earn ranges from 0% to 200% of the target number of PSUs granted. The actual number of PSUs that will vest and be settled in shares is determined at the end of a three-year performance period, based on total stockholder return relative to a set of peer companies and the S&P 600. The fair value of the PSUs is determined using a Monte Carlo simulation. Refer to Note 18 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for a summary of the assumptions utilized in the Monte Carlo valuation of awards granted during 2016 and 2015. As of December 31, 2016, we have stock option awards outstanding under the 1992 Stock Option Plan for Employees ("1992 Employee Plan") and the 2008 Stock Option Incentive Plan ("2008 Stock Option Plan"). Subsequent to the approval of the Omnibus Plan in May 2015, we stopped granting equity awards under the 2008 Stock Option Plan. The 2008 Stock Option Plan will remain in effect solely for the settlement of awards previously granted. In April 2013, the 1992 Employee Plan expired and was cancelled except for options then outstanding. The determination of fair value of stock option awards on the date of grant using the Black-Scholes model is affected by our stock price and subjective assumptions. These assumptions include, but are not limited to, the expected term of stock options and expected stock price volatility over the term of the awards. Refer to Note 18 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for a summary of the assumptions utilized in 2016, 2015 and 2014. Our stock options have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimates. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. When actual forfeitures vary from our estimates, we recognize the difference in compensation expense in the period the actual forfeitures occur or when options vest. Income Taxes Income taxes are accounted for using an asset and liability approach whereby we recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement and tax basis of assets and liabilities at the applicable tax rates. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the enactment date. Deferred tax assets are evaluated for the likelihood of use in future periods. A valuation allowance is recorded against deferred tax assets if, based on the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The determination of the need for a valuation allowance, if any, requires our judgment and the use of estimates. If we determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, we would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes. As of December 31, 2016, we have deferred tax assets totaling approximately $24.3 million, a valuation allowance of $3.1 million and deferred tax liabilities totaling approximately $102.6 million. The application of income tax law is inherently complex. Tax laws and regulations are voluminous and at times ambiguous and interpretations of guidance regarding such tax laws and regulations change over time. This requires us to make many subjective assumptions and judgments regarding the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. A liability for uncertain tax positions is recorded in our financial statements on the basis of a two-step process whereby (1) we determine whether it is more likely than not that the tax position taken will be sustained based on the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is greater than 50% likely to be realized upon ultimate settlement with the related tax authority. As facts and circumstances change, we reassess these probabilities and record any changes in the financial statements as appropriate. Changes in our assumptions and judgments can materially affect our financial position, results of operations and cash flows. We recognize interest assessed by taxing authorities or interest associated with uncertain tax positions as a component of interest expense. We recognize any penalties assessed by taxing authorities or penalties associated with uncertain tax positions as a component of selling, general and administrative expenses. Litigation We have, in the past, been involved in litigation requiring estimates of timing and loss potential whose timing and ultimate disposition is controlled by the judicial process. As of December 31, 2016, we did not have any ongoing, pending or threatened legal action that management believes, either individually or in the aggregate, would have a material adverse effect on our financial position, results of operations or cash flows. The decision to accrue costs or write off assets is based on the pertinent facts and our evaluation of present circumstances. Off Balance Sheet Arrangements We do not have any off balance sheet arrangements or interests in variable interest entities that would require consolidation. US Ecology operates through wholly-owned subsidiaries.

<s>[INST] US Ecology, Inc. is a leading North American provider of environmental services to commercial and government entities. The Company addresses the complex waste management needs of its customers, offering treatment, disposal and recycling of hazardous, nonhazardous and radioactive waste, as well as a wide range of complementary field and industrial services. US Ecology's comprehensive knowledge of the waste business, its collection of waste management facilities and focus on safety, environmental compliance, and customer service enables us to effectively meet the needs of our customers and to build longlasting relationships. We have fixed facilities and service centers operating in the United States, Canada and Mexico. Our fixed facilities include five RCRA subtitle C hazardous waste landfills and one LLRW landfill located near Beatty, Nevada; Richland, Washington; Robstown, Texas; Grand View, Idaho; Detroit, Michigan and Blainville, Québec, Canada. These facilities generate revenue from fees charged to treat and dispose of waste and from fees charged to perform various field and industrial services for our customers. On June 17, 2014, the Company acquired 100% of the outstanding shares of EQ Holdings, Inc. and its whollyowned subsidiaries (collectively "EQ"). EQ is a fully integrated environmental services company providing waste treatment and disposal, wastewater treatment, remediation, recycling, industrial cleaning and maintenance, transportation, total waste management, technical services, and emergency response services to a variety of industries and customers in North America. On November 1, 2015, we sold our Allstate Power Vac, Inc. ("Allstate") subsidiary to a private investor group. See Note 5 to the Consolidated Financial Statements in "Part II, Item 8. Financial Statements and Supplementary Data" of this Annual Report on Form 10K for additional information. Our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental ServicesThis segment provides a broad range of hazardous material management services including transportation, recycling, treatment and disposal of hazardous and nonhazardous waste at Companyowned landfill, wastewater and other treatment facilities. Field & Industrial ServicesThis segment provides packaging and collection of hazardous waste and total waste management solutions at customer sites and through our 10day transfer facilities. Services include onsite management, waste characterization, transportation and disposal of nonhazardous and hazardous waste. This segment also provides specialty services such as highpressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response and other services to commercial and industrial facilities and to government entities. Effective January 1, 2016, we changed our internal reporting structure by moving the financial results of our Sulligent, Alabama and Tampa, Florida facilities from our Environmental Services segment to our Field & Industrial Services segment. The purpose of this change is to align our internal reporting structure with how we manage our business based on the primary service offering of each facility. Throughout this Annual Report on Form 10K, our segment results for all periods presented have been recast to reflect this change. In order to provide insight into the underlying drivers of our waste volumes and related treatment and disposal ("T&D") revenues, we evaluate periodtoperiod changes in our T&D revenue for our Environmental Services segment based on the industry of the waste generator, based on North American Industry Classification System ("NAICS") codes. The composition of the Environmental Services segment T&D revenues by waste generator industry for the years ended December 31, 2016 and 2015 were as follows: (1)Excludes all transportation service revenue (2)Includes retail and wholesale trade, rate regulated, construction and other industries We also categorize our Environmental Services T&D revenue as either "Base Business" or "Event Business" based on the underlying nature of the revenue source. We define Event Business as nonrecurring projects that are expected to equal or exceed 1,000 tons, with Base Business defined as all other business not meeting the definition of Event Business. A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and unit pricing. For the year ended December 31, 2016 [/INST] Negative. </s>

US ECOLOGY, INC.

2018-02-26

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General US Ecology, Inc. is a leading North American provider of environmental services to commercial and government entities. The Company addresses the complex waste management needs of its customers, offering treatment, disposal and recycling of hazardous, non-hazardous and radioactive waste, as well as a wide range of complementary field and industrial services. US Ecology’s comprehensive knowledge of the waste business, its collection of waste management facilities and focus on safety, environmental compliance, and customer service enables us to effectively meet the needs of our customers and to build long-lasting relationships. We have fixed facilities and service centers operating in the United States, Canada and Mexico. Our fixed facilities include five RCRA subtitle C hazardous waste landfills and one LLRW landfill located near Beatty, Nevada; Richland, Washington; Robstown, Texas; Grand View, Idaho; Detroit, Michigan and Blainville, Québec, Canada. These facilities generate revenue from fees charged to treat and dispose of waste and from fees charged to perform various field and industrial services for our customers. On November 1, 2015, we sold our Allstate Power Vac, Inc. (“Allstate”) subsidiary to a private investor group. See Note 5 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. Our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental Services-This segment provides a broad range of hazardous material management services including transportation, recycling, treatment and disposal of hazardous and non-hazardous waste at Company-owned landfill, wastewater and other treatment facilities. Field & Industrial Services-This segment provides packaging and collection of hazardous waste and total waste management solutions at customer sites and through our 10-day transfer facilities. Services include on-site management, waste characterization, transportation and disposal of non-hazardous and hazardous waste. This segment also provides specialty services such as high-pressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response and other services to commercial and industrial facilities and to government entities. In order to provide insight into the underlying drivers of our waste volumes and related treatment and disposal (“T&D”) revenues, we evaluate period-to-period changes in our T&D revenue for our Environmental Services segment based on the industry of the waste generator, based on North American Industry Classification System (“NAICS”) codes. The composition of the Environmental Services segment T&D revenues by waste generator industry for the years ended December 31, 2017 and 2016 were as follows: (1) Excludes all transportation service revenue (2) Includes retail and wholesale trade, rate regulated, construction and other industries We also categorize our Environmental Services T&D revenue as either “Base Business” or “Event Business” based on the underlying nature of the revenue source. Base Business consists of waste streams from ongoing industrial activities and tends to be reoccurring in nature. We define Event Business as non-recurring projects that are expected to equal or exceed 1,000 tons, with Base Business defined as all other business not meeting the definition of Event Business. The duration of Event Business projects can last from a several-week cleanup of a contaminated site to a multiple year cleanup project. During 2017, Base Business revenue growth was up 5% compared to 2016. Base Business revenue was approximately 78% of total 2017 T&D revenue, down from 82% in 2016. Our business is highly competitive and no assurance can be given that we will maintain these revenue levels or increase our market share. A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and unit pricing. For the year ended December 31, 2017, approximately 22% of our T&D revenue was derived from Event Business projects. The one-time nature of Event Business, diverse spectrum of waste types received and widely varying unit pricing necessarily creates variability in revenue and earnings. This variability may be influenced by general and industry-specific economic conditions, funding availability, changes in laws and regulations, government enforcement actions or court orders, public controversy, litigation, weather, commercial real estate, closed military bases and other project timing, government appropriation and funding cycles and other factors. The types and amounts of waste received from Base Business also vary from quarter to quarter. This variability can also cause significant quarter-to-quarter and year-to-year differences in revenue, gross profit, gross margin, operating income and net income. While we pursue many projects months or years in advance of work performance, cleanup project opportunities routinely arise with little or no prior notice. These market dynamics are inherent to the waste disposal business and are factored into our projections and externally communicated business outlook statements. Our projections combine historical experience with identified sales pipeline opportunities, new or expanded service line projections and prevailing market conditions. Depending on project-specific customer needs and competitive economics, transportation services may be offered at or near our cost to help secure new business. For waste transported by rail from the eastern United States and other locations distant from our Grand View, Idaho and Robstown, Texas facilities, transportation-related revenue can account for as much as 75% of total project revenue. While bundling transportation and disposal services reduces overall gross profit as a percentage of total revenue (“gross margin”), this value-added service has allowed us to win multiple projects that management believes we could not have otherwise competed for successfully. Our Company-owned fleet of gondola railcars, which is periodically supplemented with railcars obtained under operating leases, has reduced our transportation expenses by largely eliminating reliance on more costly short-term rentals. These Company-owned railcars also help us to win business during times of demand-driven railcar scarcity. The increased waste volumes resulting from projects won through this bundled service strategy further drive operating leverage benefits inherent to the disposal business, increasing profitability. While waste treatment and other variable costs are project-specific, the incremental earnings contribution from large and small projects generally increases as overall disposal volumes increase. Based on past experience, management believes that maximizing operating income, net income and earnings per share is a higher priority than maintaining or increasing gross margin. We intend to continue aggressively bidding bundled transportation and disposal services based on this proven strategy. We serve oil refineries, chemical production plants, steel mills, waste brokers/aggregators serving small manufacturers and other industrial customers that are generally affected by the prevailing economic conditions and credit environment. Adverse conditions may cause our customers as well as those they serve to curtail operations, resulting in lower waste production and/or delayed spending on off-site waste shipments, maintenance, waste cleanup projects and other work. Factors that can impact general economic conditions and the level of spending by customers include, but are not limited to, consumer and industrial spending, increases in fuel and energy costs, conditions in the real estate and mortgage markets, labor and healthcare costs, access to credit, consumer confidence and other global economic factors affecting spending behavior. Market forces may also induce customers to reduce or cease operations, declare bankruptcy, liquidate or relocate to other countries, any of which could adversely affect our business. To the extent business is either government funded or driven by government regulations or enforcement actions, we believe it is less susceptible to general economic conditions. Spending by government agencies may be reduced due to declining tax revenues resulting from a weak economy or changes in policy. Disbursement of funds appropriated by Congress may also be delayed for various reasons. Our results of operations have been affected by certain significant events during the past three fiscal years including, but not limited to: 2017 Events Goodwill and Nonamortizing Intangible Asset Impairment Charges: Based on the results of the Company’s annual assessment of goodwill and indefinite-lived intangible assets, during the fourth quarter we recorded a $5.5 million goodwill impairment charge in our Resource Recovery reporting unit and a $3.4 million impairment charge on the indefinite-lived intangible waste collection, recycling and resale permit associated with our Resource Recovery business. See Note 12 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. Tax Cuts and Jobs Act of 2017: On December 22, 2017, the Tax Act was signed into law making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings as of December 31, 2017. The Company calculated a provisional amount of the impact of the Tax Act in its year end income tax provision in accordance with its understanding of the Tax Act and guidance available as of the date of this Annual Report on Form 10-K and, as a result, recorded a $23.8 million net income tax benefit in the fourth quarter of 2017, the period in which the legislation was enacted. See Note 16 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. Write-off of Deferred Financing Costs: In connection with the refinancing of the Company’s outstanding debt, we wrote off certain unamortized deferred financing costs and original issue discount that were to be amortized to interest expense in future periods through a one-time charge of $5.5 million to interest expense in the second quarter of 2017. See Note 15 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. 2016 Events Divestiture of Augusta, Georgia Facility: On April 5, 2016, we completed the divestiture of our Augusta, Georgia facility for cash proceeds of $1.9 million. The Augusta, Georgia facility was reported as part of our Environmental Services segment. Sales, net income and total assets of the Augusta, Georgia facility are not material to our consolidated financial position or results of operations in any period presented. We recognized a $1.9 million pre-tax gain on the divestiture of the Augusta, Georgia facility, which is included in Other income (expense) in our consolidated statements of operations for the year ended December 31, 2016. Acquisition of Environmental Services Inc.: On May 2, 2016, the Company acquired 100% of the outstanding shares of Environmental Services Inc., (“ESI”), an environmental services company based in Tilbury, Ontario, Canada. The total purchase price was $4.9 million, net of cash acquired, and was funded with cash on hand. Revenues and total assets of ESI are not material to our consolidated financial position or results of operations. We recorded $1.5 million of intangible assets and $1.0 million of goodwill on the consolidated balance sheets as a result of the acquisition. Definite-lived intangibles will be amortized over a weighted average life of approximately 14 years. Goodwill and indefinite-lived intangibles are tested for impairment at least annually. Acquisition of Vernon, California Facility: On October 1, 2016, the Company acquired the Vernon, California based RCRA Part B, liquids and solids waste treatment and storage facility of Evoqua Water Technologies LLC. The total purchase price was $5.0 million and was funded with cash on hand. Revenues and total assets of the Vernon, California facility are not material to our consolidated financial position or results of operations. We recorded $3.2 million of intangible assets and $354,000 of goodwill on the consolidated balance sheets as a result of the acquisition. Definite-lived intangibles will be amortized over a weighted average life of approximately 20 years. Goodwill and indefinite-lived intangibles are tested for impairment at least annually. 2015 Events Sale of Allstate Power Vac, Inc. (“Allstate”) and Goodwill Impairment: On November 1, 2015, we sold our Allstate subsidiary to a private investor group for cash proceeds of $58.8 million. Allstate represented the majority of the industrial services business we acquired with the acquisition of EQ. As a result of this divestiture and management’s strategic review, we evaluated the recoverability of the assets associated with our industrial services business. Based on this analysis, we recorded a non-cash goodwill impairment charge of $6.7 million, or $0.31 per diluted share, in the second quarter of 2015. We recognized a pre-tax loss on the divestiture of Allstate, including transaction-related costs, of $542,000 in the fourth quarter of 2015. In the second quarter of 2016, we received additional cash proceeds of $827,000 in settlement of final post-closing adjustments and recognized an additional $178,000 pre-tax gain. Gains and losses related to the sale of Allstate are included in Other income (expense) in our consolidated statements of operations. Cash proceeds from the transaction were used to repay debt. See Note 5 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information on the sale of Allstate. Results of Operations Our operating results and percentage of revenues for the years ended December 31, 2017, 2016 and 2015 were as follows: The primary financial measure used by management to assess segment performance is Adjusted EBITDA. Adjusted EBITDA is defined as net income before interest expense, interest income, income tax expense, depreciation, amortization, stock based compensation, accretion of closure and post-closure liabilities, foreign currency gain/loss, non-cash impairment charges, gain/loss on divestiture and other income/expense. The reconciliation of Net Income to Adjusted EBITDA for the years ended December 31, 2017, 2016 and 2015 is as follows: Adjusted EBITDA is a complement to results provided in accordance with accounting principles generally accepted in the United States (“GAAP”) and we believe that such information provides additional useful information to analysts, stockholders and other users to understand the Company’s operating performance. Since Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA as presented may not be comparable to other similarly titled measures of other companies. Items excluded from Adjusted EBITDA are significant components in understanding and assessing our financial performance. Adjusted EBITDA should not be considered in isolation or as an alternative to, or substitute for, net income, cash flows generated by operations, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation or a substitute for analyzing our results as reported under GAAP. Some of the limitations are: · Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; · Adjusted EBITDA does not reflect our interest expense, or the requirements necessary to service interest or principal payments on our debt; · Adjusted EBITDA does not reflect our income tax expenses or the cash requirements to pay our taxes; · Adjusted EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; and · Although depreciation and amortization charges are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements. 2017 Compared to 2016 Revenue Total revenue increased 6% to $504.0 million in 2017, compared with $477.7 million in 2016. Environmental Services Environmental Services segment revenue increased 8% to $366.3 million in 2017, compared to $337.8 million in 2016. T&D revenue increased 8% in 2017, primarily as a result of a 23% increase in project-based Event Business revenue and a 5% increase in Base Business revenue. Transportation and logistics service revenue increased 8% in 2017 compared to 2016, reflecting more Event Business projects utilizing the Company’s transportation and logistics services. Tons of waste disposed of or processed increased 7% in 2017 compared to 2016. T&D revenue from recurring Base Business waste generators increased 5% in 2017 compared to 2016 and comprised 78% of total T&D revenue. During 2017, increases in Base Business T&D revenue from the chemical manufacturing, refining, general manufacturing, and “Other” industry groups were partially offset by decreases in T&D revenue from Base Business in the broker/TSDF industry group. T&D revenue from Event Business waste generators increased 23% in 2017 compared to 2016 and comprised 22% of total T&D revenue. The increase in Event Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from the chemical manufacturing, metal manufacturing, government and “Other” industry groups, partially offset by lower T&D revenue from the general manufacturing industry group. The increase in revenue from the chemical manufacturing industry group is primarily attributable to a large East Coast remedial cleanup project. The decrease in revenue from the general manufacturing industry group is primarily attributable to lower Event Business volume. The following table summarizes combined Base Business and Event Business T&D revenue growth, within the Environmental Services segment, by waste generator industry for 2017 compared to 2016: Field & Industrial Services Field & Industrial Services segment revenue decreased 2% to $137.7 million in 2017 compared with $139.9 million in 2016. The decrease in Field & Industrial Services segment revenue is primarily attributable to the expiration of a contract that was not renewed or replaced and softer overall market conditions for industrial and remediation services. Gross Profit Total gross profit increased 4% to $153.1 million in 2017, up from $147.6 million in 2016. Total gross margin was 30% for 2017 compared with 31% for 2016. Environmental Services Environmental Services segment gross profit increased 6% to $135.0 million in 2017, up from $126.8 million in 2016. This increase primarily reflects higher T&D volumes in 2017 compared to 2016. Total segment gross margin was 37% for 2017 compared with 38% for 2016. T&D gross margin was 40% for 2017 compared with 42% for 2016. The decrease in T&D gross margin is primarily attributable to the impact of the temporary closure of one of our treatment facilities due to wind damage and incremental costs associated with the hurricanes in the Gulf Coast and Florida that impacted our operations in 2017. Field & Industrial Services Field & Industrial Services segment gross profit decreased 13% to $18.2 million in 2017, down from $20.8 million in 2016. Total segment gross margin was 13% for 2017 compared with 15% for 2016. The decrease in segment gross margin is attributable to lower route density in our small quantity generation services due to a contract that was not renewed in late 2016 and a less favorable service mix for our industrial and remediation services in 2017 compared to 2016. Selling, General and Administrative Expenses (“SG&A”) Total SG&A increased to $84.5 million, or 17% of total revenue, in 2017 compared with $77.6 million, or 16% of total revenue, in 2016. Environmental Services Environmental Services segment SG&A increased 13% to $24.2 million, or 7% of segment revenue, in 2017 compared with $21.4 million, or 6% of segment revenue, in 2016, primarily reflecting higher labor and incentive compensation costs, higher property tax expenses and lower gains on sale of assets, partially offset by lower bad debt expense and higher insurance proceeds in 2017 compared to 2016. Field & Industrial Services Field & Industrial Services segment SG&A decreased 8% to $9.3 million, or 7% of segment revenue, in 2017 compared with $10.1 million, or 7% of segment revenue, in 2016. The decrease in segment SG&A primarily reflects lower bad debt expense and higher insurance proceeds, partially offset by higher labor and incentive compensation costs in 2017 compared to 2016. Corporate Corporate SG&A was $51.0 million, or 10% of total revenue, in 2017 compared with $46.0 million, or 10% of total revenue, in 2016, primarily reflecting higher labor and incentive compensation costs in 2017 compared to 2016. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2017 was -14.9% compared to 38.1% in 2016. The decrease was primarily the result of the impact of the Tax Act, enacted on December 22, 2017 by the U.S. government. Among other provisions, the Tax Act reduces the federal corporate tax rate to 21% from the existing maximum rate of 35%, effective for tax years beginning after December 31, 2017, and imposes a deemed repatriation tax on previously untaxed accumulated earnings and profits of foreign subsidiaries. We re-measured our net deferred tax assets and liabilities and recorded a provisional benefit of $25.2 million to our income tax expense. We also recorded a provisional charge of $1.4 million to our income tax expense for the deemed repatriation transition tax. While we are able to make reasonable estimates of the impact of the reduction in the corporate income tax rate and the deemed repatriation transition tax, the final impact of the Tax Act may differ from these estimates, due to, among other things, changes in our interpretations and assumptions, additional guidance that may be issued by the Internal Revenue Service (“IRS”), and actions we may take. We are continuing to gather additional information to determine the final impact. The decrease in the effective income tax rate was also attributable to a higher proportion of earnings from our Canadian operations in 2017 which are taxed at a lower corporate tax rate, partially offset by non-recurring non-deductible impairment charges as well as a higher effective state tax rate driven by changes in apportionment of income between the various states in which we operate. As of December 31, 2017, we have exhausted all of our federal net operating loss carry forwards (“NOLs”) and have approximately $8.9 million in state and local NOLs for which we maintain a substantial valuation allowance. We maintain a valuation allowance on state and local NOLs when we no longer do business within a state or locality or determine it is unlikely that we will utilize these NOLs in the future. We consider it more likely than not that we will not utilize the majority of these NOLs in the future. Interest expense Interest expense was $18.2 million in 2017 compared with $17.3 million in 2016. The Company wrote off certain unamortized deferred financing costs and original issue discount associated with the Former Credit Agreement that were to be amortized to interest expense in future periods through a one-time non-cash charge of $5.5 million to interest expense in the second quarter of 2017. This increase is partially offset by a lower effective interest rate under the New Credit Agreement compared to the Former Credit Agreement and reduced debt levels in 2017 compared to 2016. Foreign currency gain (loss) We recognized a $516,000 non-cash foreign currency gain in 2017 compared with a $138,000 non-cash foreign currency loss in 2016. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Canadian subsidiaries’ facilities are located in Blainville, Québec and Tilbury, Ontario, Canada and use the Canadian dollar (“CAD”) as their functional currency. Additionally, we established intercompany loans between our Canadian subsidiaries, whose functional currency is the CAD, and our parent company, US Ecology, as part of a tax and treasury management strategy allowing for repayment of third-party bank debt. These intercompany loans are payable by our Canadian subsidiaries to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2017, we had $21.4 million of intercompany loans subject to currency revaluation. Gain on divestiture Other income in 2016 includes approximately $2.0 million related to the gain on sale of the Augusta, Georgia facility in April 2016 and final closing adjustments on the Allstate divestiture. Depreciation and amortization of plant and equipment Depreciation and amortization expense increased to $28.3 million in 2017 compared with $25.3 million in 2016, primarily reflecting additional depreciation expense on assets placed in service in 2017. Amortization of intangibles Intangible assets amortization expense was $9.9 million in 2017 compared with $10.6 million in 2016. Stock-based compensation Stock-based compensation expense increased 34% to $3.9 million in 2017, compared with $2.9 million 2016 as a result of an increase in equity-based awards granted to employees. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities decreased to $3.0 million in 2017 compared with $4.0 million in 2016, primarily reflecting non-cash adjustments to post-closure liabilities recorded in 2017 due to changes in cost estimates associated with closed sites. Impairment charges Based on the results of our annual assessment of goodwill and indefinite-lived intangible assets, we recorded a $5.5 million goodwill impairment charge in our Resource Recovery reporting unit and a $3.4 million impairment charge on the indefinite-lived intangible waste collection, recycling and resale permit of our Resource Recovery business. See Note 12 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. 2016 Compared to 2015 Revenue Total revenue decreased 15% to $477.7 million in 2016, compared with $563.1 million in 2015. Environmental Services Environmental Services segment revenue decreased 6% to $337.8 million in 2016, compared to $359.0 million in 2015. T&D revenue decreased 5% in 2016, primarily as a result of a 30% decrease in project-based Event Business. Transportation and logistics service revenue decreased 8% in 2016 compared to 2015, reflecting fewer Event Business projects utilizing the Company’s transportation and logistics services. Tons of waste disposed of or processed decreased 14% in 2016 compared to 2015. T&D revenue from recurring Base Business waste generators increased 2% in 2016 compared to 2015 and comprised 82% of total T&D revenue. During 2016, increases in Base Business T&D revenue from the refining, “Other”, utilities and general manufacturing industry groups were partially offset by decreases in T&D revenue from Base Business in the chemical manufacturing and broker/TSDF industry groups. T&D revenue from Event Business waste generators decreased 30% in 2016 compared to 2015 and comprised 18% of total T&D revenue. The decrease in Event Business T&D revenue compared to the prior year primarily reflects lower T&D revenue from the chemical manufacturing, refining and government industry groups, partially offset by higher T&D revenue from the general manufacturing and “Other” industry groups. The decrease in revenue from the chemical manufacturing industry group is primarily attributable to the completion of a large East Coast remedial cleanup project in the third quarter of 2015 and the completion of a nuclear fuels fabrication plant decommissioning in the first quarter of 2016. The decrease in revenue from the refining and government industry groups is primarily attributable to lower Event Business volumes. The following table summarizes combined Base Business and Event Business T&D revenue growth, within the Environmental Services segment, by waste generator industry for 2016 compared to 2015: Field & Industrial Services Field & Industrial Services segment revenue decreased 31% to $139.9 million in 2016 compared with $204.0 million in 2015. The decrease is primarily attributable to the divested Allstate business which contributed segment revenue of $59.1 million for our period of ownership in 2015. Gross Profit Total gross profit decreased 14% to $147.6 million in 2016, down from $171.4 million in 2015. Total gross margin was 31% for 2016 compared with 30% for 2015. Environmental Services Environmental Services segment gross profit decreased 8% to $126.8 million in 2016, down from $137.6 million in 2015. This decrease primarily reflects lower T&D volumes in 2016 compared to 2015. Total segment gross margin was 38% for both 2016 and 2015. T&D gross margin was 42% for 2016 compared with 43% for 2015. Field & Industrial Services Field & Industrial Services segment gross profit decreased 38% to $20.8 million in 2016, down from $33.8 million in 2015. Total segment gross margin was 15% for 2016 compared with 17% for 2015. The divested Allstate business contributed segment gross profit of $12.4 million for our period of ownership in 2015. Selling, General and Administrative Expenses (“SG&A”) Total SG&A decreased to $77.6 million, or 16% of total revenue, in 2016 compared with $93.1 million, or 17% of total revenue, in 2015. Environmental Services Environmental Services segment SG&A decreased 6% to $21.4 million, or 6% of segment revenue, in 2016 compared with $22.8 million, or 6% of segment revenue, in 2015, primarily reflecting higher gains on sales of assets in 2016 compared to 2015. Field & Industrial Services Field & Industrial Services segment SG&A decreased 54% to $10.1 million, or 7% of segment revenue, in 2016 compared with $22.0 million, or 11% of segment revenue, in 2015. The divested Allstate business contributed segment SG&A of $10.9 million for our period of ownership in 2015. The remaining decrease in segment SG&A primarily reflects lower employee labor costs in 2016 compared to 2015. Corporate Corporate SG&A was $46.0 million, or 10% of total revenue, in 2016 compared with $48.4 million, or 9% of total revenue, in 2015, primarily reflecting lower business development expenses and lower professional services expenses in 2016 compared to 2015. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2016 was 38.1% compared to 45.3% in 2015. The decrease reflects nonrecurring non-deductible goodwill impairment charges incurred in 2015, a nondeductible loss on the sale of the Allstate business recorded during 2015 and a decrease in our U.S. effective tax rate, driven by a lower overall effective state tax rate. The lower effective state tax rate was driven by changes in apportionment of income and deferred taxes between the various states in which we operate. The decrease in the effective tax rate was partially offset by a lower proportion of earnings from our Canadian operations in 2016, which are taxed at a lower corporate tax rate. As of December 31, 2016, we had approximately $17,000 in federal NOLs acquired from EQ. As of December 31, 2016, we had approximately $12.7 million in state and local NOLs for which we maintain a substantial valuation allowance. We maintain a valuation allowance on state and local NOLs when we no longer do business within a state or locality or determine it is unlikely that we will utilize these NOLs in the future. We consider it more likely than not that we will not utilize the majority of these NOLs in the future. Interest expense Interest expense was $17.3 million in 2016 compared with $23.4 million in 2015. The decrease is primarily due to $291,000 of incremental non-cash amortization of deferred financing fees associated with debt principal payments in 2016 compared with $2.4 million of incremental amortization in 2015. The remaining decrease is attributable to lower debt levels in 2016 compared with 2015. Foreign currency gain (loss) We recognized a $138,000 non-cash foreign currency loss in 2016 compared with a $2.2 million non-cash foreign currency loss in 2015. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Canadian subsidiaries’ facilities are located in Blainville, Québec and Tilbury, Ontario, Canada and use the Canadian dollar (“CAD”) as their functional currency. Additionally, we established intercompany loans between our Canadian subsidiaries, whose functional currency is the CAD, and our parent company, US Ecology, as part of a tax and treasury management strategy allowing for repayment of third-party bank debt. These intercompany loans are payable by our Canadian subsidiaries to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2016, we had $20.8 million of intercompany loans subject to currency revaluation. Gain on divestiture Other income in 2016 includes approximately $2.0 million related to the gain on sale of the Augusta, Georgia facility in April 2016 and final closing adjustments on the Allstate divestiture. Depreciation and amortization of plant and equipment Depreciation and amortization expense was $25.3 million in 2016 compared with $27.9 million in 2015. The divested Allstate business contributed depreciation and amortization expense of $2.2 million for our period of ownership in 2015. Amortization of intangibles Intangible assets amortization expense was $10.6 million in 2016 compared with $12.3 million in 2015. The divested Allstate business contributed intangible assets amortization expense of $1.4 million for our period of ownership in 2015. Stock-based compensation Stock-based compensation expense increased 27% to $2.9 million in 2016, compared with $2.3 million 2015 as a result of an increase in equity-based awards granted to employees. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities was $4.0 million in 2016 compared with $4.6 million in 2015. Impairment charges On August 4, 2015, we entered into a definitive agreement to sell Allstate to a private investor group. Allstate represented the majority of the industrial services business we acquired with the acquisition of EQ. As a result of this agreement and management’s strategic review, we evaluated the recoverability of the assets associated with our industrial services business. Based on this analysis, we recorded a non-cash goodwill impairment charge of $6.7 million in the second quarter of 2015. See Note 5 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information on the sale of Allstate. Liquidity and Capital Resources Our primary sources of liquidity are cash and cash equivalents, cash generated from operations and borrowings under the new senior secured credit agreement (the “New Credit Agreement”). At December 31, 2017, we had $27.0 million in cash and cash equivalents immediately available and $216.7 million of borrowing capacity available under the New Credit Agreement. We assess our liquidity in terms of our ability to generate cash to fund our operating, investing and financing activities. Our primary ongoing cash requirements are funding operations, capital expenditures, paying principal and interest on our long-term debt, and paying declared dividends pursuant to our dividend policy. We believe future operating cash flows will be sufficient to meet our future operating, investing and dividend cash needs for the foreseeable future. Furthermore, existing cash balances and availability of additional borrowings under the New Credit Agreement provide additional sources of liquidity should they be required. Operating Activities. In 2017, net cash provided by operating activities was $81.0 million. This primarily reflects net income of $49.4 million, non-cash depreciation, amortization and accretion of $41.2 million, non-cash impairment charges of $8.9 million, amortization and write-off of debt issuance costs of $6.0 million, a decrease in income taxes receivable of $4.1 million, share-based compensation expense of $3.9 million, an increase in income taxes payable of $3.9 and an increase in accrued salaries and benefits of $3.4 million, partially offset by a decrease in deferred income taxes of $25.3 million, an increase in accounts receivable of $13.9 million, and a decrease in closure and post-closure obligations of $1.8 million. Impacts on net income are due to the factors discussed above under “Results of Operations.” The increase in receivables is primarily attributable to the timing of customer payments. Changes in income taxes receivable and payable are primarily attributable to the timing of income tax payments. Changes in deferred income taxes are primarily attributable to the re-measurement of our deferred tax assets and liabilities based on the provisions of the Tax Act. Days sales outstanding were 77 days as of December 31, 2017, compared to 73 days as of December 31, 2016. In 2016, net cash provided by operating activities was $74.6 million. This primarily reflects net income of $34.3 million, non-cash depreciation, amortization and accretion of $39.8 million, a decrease in accounts receivable of $10.9 million, share-based compensation expense of $2.9 million, non-cash amortization of debt issuance costs of $2.0 million, and a decrease in other assets of $1.2 million, partially offset by a decrease in accounts payable and accrued liabilities of $7.7 million, a decrease in deferred income taxes of $2.7 million, the gain recognized on the divestiture of the Augusta, Georgia facility in April 2016, final closing adjustments on the Allstate divestiture of $2.0 million, and an increase in income taxes receivable of $2.0 million. Impacts on net income are due to the factors discussed above under “Results of Operations.” The decrease in receivables is primarily attributable to the timing of customer payments. Changes in income taxes receivable and payable are primarily attributable to the timing of income tax payments. In 2015, net cash provided by operating activities was $71.5 million. This primarily reflects net income of $25.6 million, non-cash depreciation, amortization and accretion of $44.8 million, non-cash impairment charges of $6.7 million, a decrease in income taxes receivable of $4.8 million, non-cash amortization of debt issuance costs of $4.4 million, unrealized foreign currency losses of $3.3 million, share-based compensation expense of $2.3 million and a decrease in accounts receivable of $1.6 million, partially offset by a decrease in accounts payable and accrued liabilities of $6.5 million, a decrease in closure and post-closure obligations of $5.7 million, a decrease in deferred revenue of $4.4 million, a decrease in income taxes payable of $3.9 million and a decrease in deferred income taxes of $2.7 million. Impacts on net income are due to the factors discussed above under “Results of Operations.” The decrease in receivables and deferred revenue is primarily attributable to the timing of the treatment and disposal of waste associated with a significant East Coast remedial cleanup project. The changes in income taxes receivable and payable are primarily attributable to the timing of income tax payments. The decrease in closure and post-closure obligations is primarily attributable to payments made for closure and post-closure activities primarily at our closed landfills. Investing Activities. In 2017, net cash used in investing activities was $35.3 million, primarily related to capital expenditures. Significant capital projects included construction of additional disposal capacity at our Beatty, Nevada and Blainville, Québec, Canada locations and equipment purchases and infrastructure upgrades at our corporate and operating facilities. In 2016, net cash used in investing activities was $42.0 million, primarily related to capital expenditures of $35.7 million, the purchase of the Vernon, California based RCRA Part B, liquids and solids waste treatment and storage facility of Evoqua Water Technologies LLC for $5.0 million and the purchase of Environmental Services Inc., (“ESI”), for $4.9 million, net of cash acquired, partially offset by proceeds from the divestiture of our Augusta, Georgia facility for $2.7 million, net of cash divested. Significant capital projects included construction of additional disposal capacity at our Blainville, Québec, Canada, Beatty, Nevada and Robstown, Texas facilities and equipment purchases and infrastructure upgrades at our corporate and operating facilities. In 2015, net cash provided by investing activities was $20.3 million, primarily related to the divestiture of Allstate for $58.7 million, net of cash divested, partially offset by capital expenditures of $39.4 million. Significant capital projects included construction of additional disposal capacity at our Blainville, Québec, Canada and Robstown, Texas locations and equipment purchases and infrastructure upgrades at all of our corporate and operating facilities. Financing Activities. During 2017, net cash used in financing activities was $26.3 million, consisting primarily of $283.0 million of repayment of the Company’s long-term debt under the Former Credit Agreement, $281.0 million of initial proceeds from the borrowing of long-term debt under the New Credit Agreement, $4.0 million of subsequent repayments of long-term debt under the New Credit Agreement, $15.7 million of dividend payments to our stockholders, $3.0 million of deferred financing costs associated with the New Credit Agreement and net payment activity on the Company’s short-term borrowings of $2.2 million. During 2016, net cash used in financing activities was $31.6 million, consisting primarily of $18.0 million of payments on our Term Loan and $15.7 million of dividend payments to our stockholders, partially offset by $2.2 million of net proceeds on our Revolving Credit Facility to fund working capital requirements. During 2015, net cash used in financing activities was $108.4 million, consisting primarily of $94.6 million of payments on our Term Loan and $15.6 million of dividend payments to our stockholders. Credit Facility On April 18, 2017, the Company entered into the New Credit Agreement with Wells Fargo Bank, National Association, as administrative agent for the lenders, swingline lender and issuing lender, and Bank of America, N.A., as an issuing lender, which provides for a $500.0 million, five-year revolving credit facility (the “Revolving Credit Facility”), including a $75.0 million sublimit for the issuance of standby letters of credit and a $25.0 million sublimit for the issuance of swingline loans used to fund short-term working capital requirements. The New Credit Agreement also contains an accordion feature whereby the Company may request up to $200.0 million of additional funds through an increase to the Revolving Credit Facility, through incremental term loans, or some combination thereof. Proceeds from the Revolving Credit Facility are restricted solely for working capital and other general corporate purposes (including acquisitions and capital expenditures). Under the Revolving Credit Facility, revolving credit loans are available based on a base rate (as defined in the New Credit Agreement) or LIBOR, at the Company’s option, plus an applicable margin which is determined according to a pricing grid under which the interest rate decreases or increases based on our ratio of funded debt to consolidated earnings before interest, taxes, depreciation and amortization (as defined in the New Credit Agreement). The Company wrote off certain unamortized deferred financing costs and original issue discount associated with the Former Credit Agreement that were to be amortized to interest expense in future periods through a one-time charge of $5.5 million to interest expense in the second quarter of 2017. At December 31, 2017, the effective interest rate on the Revolving Credit Facility, including the impact of our interest rate swap, was 3.39%. Interest only payments are due either quarterly or on the last day of any interest period, as applicable. In October 2014, the Company entered into an interest rate swap agreement, effectively fixing the interest rate on $190.0 million, or 69%, of the Revolving Credit Facility borrowings as of December 31, 2017. The interest rate swap agreement continued to be effective following the termination of the Former Credit Agreement. The Company is required to pay a commitment fee ranging from 0.175% to 0.35% on the average daily unused portion of the Revolving Credit Facility, with such commitment fee to be reduced based upon the Company’s total net leverage ratio (as defined in the New Credit Agreement). The maximum letter of credit capacity under the Revolving Credit Facility is $75.0 million and the New Credit Agreement provides for a letter of credit fee equal to the applicable margin for LIBOR loans under the Revolving Credit Facility. At December 31, 2017, there were $277.0 million of borrowings outstanding on the Revolving Credit Facility. These borrowings are due on the revolving credit maturity date (as defined in the New Credit Agreement) and presented as long-term debt in the consolidated balance sheets. The Company has entered into a sweep arrangement whereby day-to-day cash requirements in excess of available cash balances are advanced to the Company on an as-needed basis with repayments of these advances automatically made from subsequent deposits to our cash operating accounts (the “Sweep Arrangement”). Total advances outstanding under the Sweep Arrangement are subject to the $25.0 million swingline loan sublimit under the Revolving Credit Facility. The Company’s revolving credit loans outstanding under the Revolving Credit Facility are not subject to repayment through the Sweep Arrangement. As of December 31, 2017, there were no amounts outstanding subject to the Sweep Arrangement. As of December 31, 2017, the availability under the Revolving Credit Facility was $216.7 million with $6.3 million of the Revolving Credit Facility issued in the form of standby letters of credit utilized as collateral for closure and post-closure financial assurance and other assurance obligations. See Note 15 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information on the Company’s debt. Contractual Obligations and Guarantees Contractual Obligations US Ecology’s contractual obligations at December 31, 2017 become due as follows: (1) For the purposes of the table above, closure and post-closure obligations are shown on an undiscounted basis and inflated using an estimated annual inflation rate of 2.6%. Cash payments for closure and post-closure obligation extend to the year 2105. (2) At December 31, 2017, there were $277.0 million of revolving credit loans outstanding on the Revolving Credit Facility. These revolving credit loans are due upon the earliest to occur of (a) April 18, 2022 (or, with respect to any lender, such later date as requested by us and accepted by such lender), (b) the date of termination of the entire revolving credit commitment (as defined in the New Credit Agreement) by us, and (c) the date of termination of the revolving credit commitment. (3) Interest expense has been calculated using the effective interest rate of 3.06% in effect at December 31, 2017 on the unhedged variable rate portion of the Revolving Credit Facility borrowings and 3.67% on the fixed rate hedged portion of the Revolving Credit Facility borrowings. The interest expense calculation reflects assumed payments on the Revolving Credit Facility borrowings consistent with the disclosures in footnote (2) above. Guarantees We enter into a wide range of indemnification arrangements, guarantees and assurances in the ordinary course of business and have evaluated agreements that contain guarantees and indemnification clauses. These include tort indemnities, tax indemnities, indemnities against third-party claims arising out of arrangements to provide services to us and indemnities related to the sale of our securities. We also indemnify individuals made party to any suit or proceeding if that individual was acting as an officer or director of US Ecology or was serving at the request of US Ecology or any of its subsidiaries during their tenure as a director or officer. We also provide guarantees and indemnifications for the benefit of our wholly-owned subsidiaries to satisfy performance obligations, including closure and post-closure financial assurances. It is difficult to quantify the maximum potential liability under these indemnification arrangements; however, we are not currently aware of any material liabilities to the Company or any of its subsidiaries arising from these arrangements. Environmental Matters We maintain funded trusts agreements, surety bonds and insurance policies for future closure and post-closure obligations at both current and formerly operated disposal facilities. These funded trust agreements, surety bonds and insurance policies are based on management estimates of future closure and post-closure monitoring using engineering evaluations and interpretations of regulatory requirements which are periodically updated. Accounting for closure and post-closure costs includes final disposal cell capping and revegetation, soil and groundwater monitoring and routine maintenance and surveillance required after a site is closed. We estimate that our undiscounted future closure and post-closure costs for all facilities was approximately $308.5 million at December 31, 2017, with a median payment year of 2061. Our future closure and post-closure estimates are our best estimate of current costs and are updated periodically to reflect current technology, cost of materials and services, applicable laws, regulations, permit conditions or orders and other factors. These current costs are adjusted for anticipated annual inflation, which we assumed to be 2.6% as of December 31, 2017. These future closure and post-closure estimates are discounted to their present value for financial reporting purposes using our credit-adjusted risk-free interest rate, which approximates our incremental long-term borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. At December 31, 2017, our weighted-average credit-adjusted risk-free interest rate was 5.9%. For financial reporting purposes, our recorded closure and post-closure obligations were $76.1 million and $75.1 million as of December 31, 2017 and 2016, respectively. Through December 31, 2017, we have met our financial assurance requirements through insurance, surety bonds, standby letters of credit and self-funded restricted trusts. U.S. Operating and Non-Operating Facilities We cover our closure and post-closure obligations for our U.S. operating facilities through the use of third-party insurance policies, surety bonds and standby letters of credit. Insurance policies covering our closure and post-closure obligations expire in April 2018 and December 2018. Our total policy limits are approximately $87.4 million. At December 31, 2017 our trust accounts had $5.8 million for our closure and post-closure obligations and are identified as Restricted cash and investments on our consolidated balance sheets. All closure and post-closure funding obligations for our Beatty, Nevada and Richland, Washington facilities revert to the respective State. Volume based fees are collected from our customers and remitted to state controlled trust funds to cover the estimated cost of closure and post-closure obligations. Stablex We use commercial surety bonds to cover our closure obligations for our Stablex facility located in Blainville, Québec, Canada. Our lease agreement with the Province of Québec requires that the surety bond be maintained for 25 years after the lease expires in 2023. At December 31, 2017 we had $752,000 in commercial surety bonds dedicated for closure obligations. These bonds were renewed in November and December 2017 and expire in November and December 2018. Post-closure funding obligations for the Stablex landfill revert back to the Province of Québec through a dedicated trust account that is funded based on a per-metric-ton disposed fee by Stablex. We expect to renew insurance policies and commercial surety bonds in the future. If we are unable to obtain adequate closure, post-closure or environmental liability insurance and/or commercial surety bonds in future years, any partial or completely uninsured claim against us, if successful and of sufficient magnitude, could have a material adverse effect on our financial condition, results of operations or cash flows. Additionally, continued access to casualty and pollution legal liability insurance with sufficient limits, at acceptable terms, is important to obtaining new business. Failure to maintain adequate financial assurance could also result in regulatory action including early closure of facilities. While we believe we will be able to maintain the requisite financial assurance policies at a reasonable cost, premium and collateral requirements may materially increase. Operation of disposal facilities creates operational, closure and post-closure obligations that could result in unplanned monitoring and corrective action costs. We cannot predict the likelihood or effect of all such costs, new laws or regulations, litigation or other future events affecting our facilities. We do not believe that continuing to satisfy our environmental obligations will have a material adverse effect on our financial condition or results of operations. Seasonal Effects Seasonal fluctuations due to weather and budgetary cycles can influence the timing of customer spending for our services. Typically, in the first quarter of each calendar year there is less demand for our services due to reduced construction and business activities related to weather while we experience improvement in our second and third quarters of each calendar year as weather conditions and other business activity improves. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates included in our critical accounting policies discussed below and those accounting policies and use of estimates discussed in Notes 2 and 3 to the Consolidated Financial Statements located in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. We base our estimates on historical experience and on various assumptions and other factors we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We make adjustments to judgments and estimates based on current facts and circumstances on an ongoing basis. Historically, actual results have not deviated significantly from those determined using the estimates described below or in Notes 2 and 3 to the Consolidated Financial Statements located in “Part II, Item 8. Financial Statements and Supplementary Data” to this Annual Report on Form 10-K. However, actual amounts could differ materially from those estimated at the time the consolidated financial statements are prepared. We believe the following critical accounting policies are important to understand our financial condition and results of operations and require management’s most difficult, subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, delivery and disposal have occurred or services have been rendered, the price is fixed or determinable and collection is reasonably assured. We recognize revenue from three primary sources: 1) waste treatment, recycling and disposal, 2) field and industrial waste management services and 3) waste transportation services. Waste treatment and disposal revenue results primarily from fees charged to customers for treatment and/or disposal or recycling of specified wastes. Waste treatment and disposal revenue is generally charged on a per-ton or per-yard basis based on contracted prices and is recognized when services are complete. Field and industrial waste management services revenue results primarily from specialty onsite services such as high-pressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response at refineries, chemical plants, steel and automotive plants, and other government, commercial and industrial facilities. These services are provided based on purchase orders or agreements with the customer and include prices based upon daily, hourly or job rates for equipment, materials and personnel. Revenues are recognized over the term of the agreements or as services are performed. Revenue is recognized on contracts with retainage when services have been rendered and collectability is reasonably assured. Transportation revenue results from delivering customer waste to a disposal facility for treatment and/or disposal or recycling. Transportation services are generally not provided on a stand-alone basis and instead are bundled with other Company services. However, in some instances we provide transportation and logistics services for shipment of waste from cleanup sites to disposal facilities operated by other companies. We account for our bundled arrangements as multiple deliverable arrangements and determine the amount of revenue recognized for each deliverable (unit of accounting) using the relative fair value method. Transportation revenue is recognized when the transported waste is received at the disposal facility. Waste treatment and disposal revenue under bundled arrangements is recognized when services are complete and the waste is disposed in the landfill. Burial fees collected from customers for each ton or cubic yard of waste disposed in our landfills are paid to the respective local and/or state government entity and are not included in revenue. Revenue and associated costs from waste that has been received but not yet treated and disposed of in our landfills are deferred until disposal occurs. Our Richland, Washington disposal facility is regulated by the WUTC, which approves our rates for disposal of LLRW. Annual revenue levels are established based on a six-year rate agreement with the WUTC at amounts sufficient to cover the costs of operation and provide us with a reasonable profit. Per-unit rates charged to LLRW customers during the year are based on our evaluation of disposal volume and radioactivity projections submitted to us by waste generators. Our proposed rates are then reviewed and approved by the WUTC. If annual revenue exceeds the approved levels set by the WUTC, we are required to refund excess collections to facility users on a pro-rata basis. The current rate agreement with the WUTC was extended in 2013 and is effective until January 1, 2020. Disposal Facility Accounting We amortize landfill and disposal assets and certain related permits over their estimated useful lives. The units-of-consumption method is used to amortize landfill cell construction and development costs and asset retirement costs. Under the units-of-consumption method, we include costs incurred to date as well as future estimated construction costs in the amortization base of the landfill assets. Additionally, where appropriate, as discussed below, we also include probable expansion airspace that has yet to be permitted in the calculation of the total remaining useful life of the landfill asset. If we determine that expansion capacity should no longer be considered in calculating the total remaining useful life of a landfill asset, we may be required to recognize an asset impairment or incur significantly higher amortization expense over the remaining estimated useful life of the landfill asset. If at any time we make the decision to abandon the expansion effort, the capitalized costs related to the expansion effort would be expensed in the period of abandonment. Our landfill assets and liabilities fall into the following two categories, each of which require accounting judgments and estimates: · Landfill assets comprised of capitalized landfill development costs. · Disposal facility retirement obligations relating to our capping, closure and post-closure liabilities that result in corresponding retirement assets. Landfill Assets Landfill assets include the costs of landfill site acquisition, permits and cell design and construction incurred to date. Landfill cells represent individual disposal areas within the overall treatment and disposal site and may be subject to specific permit requirements in addition to the general permit requirements associated with the overall site. To develop, construct and operate a landfill cell, we must obtain permits from various regulatory agencies at the local, state and federal levels. The permitting process requires an initial site study to determine whether the location is feasible for landfill operations. The initial studies are reviewed by our environmental management group and then submitted to the regulatory agencies for approval. During the development stage we capitalize certain costs that we incur after site selection but before the receipt of all required permits if we believe that it is probable that the landfill cell will be permitted. Upon receipt of regulatory approval, technical landfill cell designs are prepared. The technical designs, which include the detailed specifications to develop and construct all components of the landfill cell including the types and quantities of materials that will be required, are reviewed by our environmental management group. The technical designs are submitted to the regulatory agencies for approval. Upon approval of the technical designs, the regulatory agencies issue permits to develop and operate the landfill cell. The types of costs that are detailed in the technical design specifications generally include excavation, natural and synthetic liners, construction of leachate collection systems, installation of groundwater monitoring wells, construction of leachate management facilities and other costs associated with the development of the site. We review the adequacy of our cost estimates at least annually. These development costs, together with any costs incurred to acquire, design and permit the landfill cell, including personnel costs of employees directly associated with the landfill cell design, are recorded to the landfill asset on the balance sheet as incurred. To match the expense related to the landfill asset with the revenue generated by the landfill operations, we amortize the landfill asset on a units-of-consumption basis over its operating life, typically on a cubic yard or cubic meter of disposal space consumed. The landfill asset is fully amortized at the end of a landfill cell’s operating life. The per-unit amortization rate is calculated by dividing the sum of the landfill asset net book value plus estimated future development costs (as described above) for the landfill cell, by the landfill cell’s estimated remaining disposal capacity. Amortization rates are influenced by the original cost basis of the landfill cell, including acquisition costs, which in turn is determined by geographic location and market values. We have secured significant landfill assets through business acquisitions and valued them at the time of acquisition based on fair value. Included in the technical designs are factors that determine the ultimate disposal capacity of the landfill cell. These factors include the area over which the landfill cell will be developed, such as the depth of excavation, the height of the landfill cell elevation and the angle of the side-slope construction. Landfill cell capacity used in the determination of amortization rates of our landfill assets includes both permitted and unpermitted disposal capacity. Unpermitted disposal capacity is included when management believes achieving final regulatory approval is probable based on our analysis of site conditions and interactions with applicable regulatory agencies. We review the estimates of future development costs and remaining disposal capacity for each landfill cell at least annually. These costs and disposal capacity estimates are developed using input from independent engineers and internal technical and accounting managers and are reviewed and approved by our environmental management group. Any changes in future estimated costs or estimated disposal capacity are reflected prospectively in the landfill cell amortization rates. We assess our long-lived landfill assets for impairment when an event occurs or circumstances change that indicate the carrying amount may not be recoverable. Examples of events or circumstances that may indicate impairment of any of our landfill assets include, but are not limited to, the following: · Changes in legislative or regulatory requirements impacting the landfill site permitting process making it more difficult and costly to obtain and/or maintain a landfill permit; · Actions by neighboring parties, private citizen groups or others to oppose our efforts to obtain, maintain or expand permits, which could result in denial, revocation or suspension of a permit and adversely impact the economic viability of the landfill. As a result of opposition to our obtaining a permit, improved technical information as a project progresses, or changes in the anticipated economics associated with a project, we may decide to reduce the scope of, or abandon, a project, which could result in an asset impairment; and · Unexpected significant increases in estimated costs, significant reductions in prices we are able to charge our customers or reductions in disposal capacity that affect the ongoing economic viability of the landfill. Disposal Facility Retirement Obligations Disposal facility retirement obligations include the cost to close, maintain and monitor landfill cells and support facilities. As individual landfill cells reach capacity, we must cap and close the cells in accordance with the landfill cell permits. These capping and closure requirements are detailed in the technical design of each landfill cell and included as part of our approved regulatory permit. After the entire landfill cell has reached capacity and is certified closed, we must continue to maintain and monitor the landfill cell for a post-closure period, which generally extends for 30 years. Costs associated with closure and post-closure requirements generally include maintenance of the landfill cell and groundwater systems, and other activities that occur after the landfill cell has ceased accepting waste. Costs associated with post-closure monitoring generally include groundwater sampling, analysis and statistical reports, transportation and disposal of landfill leachate, and erosion control costs related to the final cap. We have a legally enforceable obligation to operate our landfill cells in accordance with the specific requirements, regulations and criteria set forth in our permits. This includes executing the approved closure/post-closure plan and closing/capping the entire landfill cell in accordance with the established requirements, design and criteria contained in the permit. As a result, we record the fair value of our disposal facility retirement obligations as a liability in the period in which the regulatory obligation to retire a specific asset is triggered. For our individual landfill cells, the required closure and post-closure obligations under the terms of our permits and our intended operation of the landfill cell are triggered and recorded when the cell is placed into service and waste is initially disposed in the landfill cell. The fair value is based on the total estimated costs to close the landfill cell and perform post-closure activities once the landfill cell has reached capacity and is no longer accepting waste, discounted using a credit-adjusted risk-free rate. Retirement obligations are increased each year to reflect the passage of time by accreting the balance at the weighted average credit-adjusted risk-free rate that is used to calculate the recorded liability, with accretion charged to direct operating costs. Actual cash expenditures to perform closure and post-closure activities reduce the retirement obligation liabilities as incurred. After initial measurement, asset retirement obligations are adjusted at the end of each period to reflect changes, if any, in the estimated future cash flows underlying the obligation. Disposal facility retirement assets are capitalized as the related disposal facility retirement obligations are incurred. Disposal facility retirement assets are amortized on a units-of-consumption basis as the disposal capacity is consumed. Our disposal facility retirement obligations represent the present value of current cost estimates to close, maintain and monitor landfills and support facilities as described above. Cost estimates are developed using input from independent engineers, internal technical and accounting managers, as well as our environmental management group’s interpretation of current legal and regulatory requirements, and are intended to approximate fair value. We estimate the timing of future payments based on expected annual disposal airspace consumption and then inflate the current cost estimate by an inflation rate, estimated at December 31, 2017 to be 2.6%. Inflated current costs are then discounted using our credit-adjusted risk-free interest rate, which approximates our incremental borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. Our weighted-average credit-adjusted risk-free interest rate at December 31, 2017 was approximately 5.9%. Final closure and post-closure obligations are currently estimated as being paid through the year 2105. During 2017 we updated several assumptions, including estimated costs and timing of closing our disposal cells. These updates resulted in a net decrease to our post-closure obligations of $352,000. We update our estimates of future capping, closure and post-closure costs and of future disposal capacity for each landfill cell on an annual basis. Changes in inflation rates or the estimated costs, timing or extent of the required future activities to close, maintain and monitor landfills and facilities result in both: (i) a current adjustment to the recorded liability and related asset and (ii) a change in accretion and amortization rates which are applied prospectively over the remaining life of the asset. A hypothetical 1% increase in the inflation rate would increase our closure/post-closure obligation by $16.9 million. A hypothetical 10% increase in our cost estimates would increase our closure/post-closure obligation by $7.6 million. Goodwill and Intangible Assets As of December 31, 2017, the Company’s goodwill balance was $189.4 million. We assess goodwill for impairment during the fourth quarter as of October 1 of each year, and also if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The assessment consists of comparing the fair value of the reporting unit to the carrying value of the net assets assigned to the reporting unit, including goodwill. Some of the factors that could indicate impairment include a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, or failure to generate sufficient cash flows at the reporting unit. For example, field and industrial services represents an emerging business for the Company and has been the focus of a shift in strategy since the acquisition of EQ. Failure to execute on planned growth initiatives within this business could lead to the impairment of goodwill and intangible assets in future periods. We determine our reporting units by identifying the components of each operating segment, and then aggregate components having similar economic characteristics based on quantitative and/or qualitative factors. At December 31, 2017, we had 14 reporting units, 8 of which had allocated goodwill. Fair values are generally determined by using a market approach, applying a multiple of earnings based on guideline for publicly traded companies, an income approach, discounting projected future cash flows based on our expectations of the current and future operating environment, or a combination thereof. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. The rates used to discount projected future cash flows reflect a weighted average cost of capital based on our industry, capital structure and risk premiums including those reflected in the current market capitalization. In the event the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, goodwill of the reporting unit is considered impaired, and an impairment charge would be recognized during the period in which the determination has been made for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The result of the annual assessment of goodwill undertaken in the fourth quarter of 2017 indicated that the fair value of each of our reporting units was in excess of its respective carrying value, with the exception of the Resource Recovery reporting unit. Our Resource Recovery reporting unit offers full-service storm water management and propylene glycol (“PG”) deicing fluid recovery at major airports. Recovered fluids are transported to our recycling facility in Romulus, Michigan where they are distilled and resold to industrial users. The Resource Recovery reporting unit also generates revenues from brokered PG sales and services revenues for PG collection at the airports we service. Weak PG commodity prices and reduced PG collection volumes at the airports we service negatively impacted the reporting unit’s prospective financial information in its discounted cash flow model and the reporting unit's estimated fair value. A longer-than-expected recovery in PG commodity pricing and PG collection volumes became evident during the fourth quarter of 2017 as management completed its 2018 budgeting cycle and updated the long-term projections for the reporting unit which, as a result, decreased the reporting unit’s anticipated future cash flows as compared to those estimated previously. The estimated fair value of the Resource Recovery reporting unit was determined under an income approach using discounted projected future cash flows and then compared to the reporting unit’s carrying amount as of October 1, 2017. Based on the results of that comparison, the carrying amount of the Resource Recovery reporting unit, including $5.5 million of goodwill, exceeded the estimated fair value of the reporting unit by more than $5.5 million and, as a result, we recognized a $5.5 million impairment charge, representing the reporting unit’s entire goodwill balance, in the fourth quarter of 2017. We review intangible assets with indefinite useful lives for impairment during the fourth quarter as of October 1 of each year. Fair value is generally determined by considering an internally developed discounted projected cash flow analysis. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. If the fair value of an asset is determined to be less than the carrying amount of the intangible asset, an impairment in the amount of the difference is recorded in the period in which the annual assessment occurs. The result of the annual assessment of intangible assets with indefinite useful lives undertaken in the fourth quarter of 2017 indicated no impairment charges were required, with the exception of the indefinite-lived intangible waste collection, recycling and resale permit associated with our Resource Recovery business. In performing the annual indefinite-lived intangible assets impairment test, the estimated fair value of the Resource Recovery business’ waste collection, recycling and resale permit was determined under an income approach using discounted projected future cash flows associated with the permit and then compared to the $3.7 million carrying amount of the permit as of October 1, 2017. Based on the results of that evaluation, the carrying amount of the permit exceeded the estimated fair value of the permit and, as a result, we recognized a $3.4 million impairment charge in the fourth quarter of 2017. The factors and timing contributing to the nonamortizing permit impairment charge were the same as the factors and timing described above with regards to the Resource Recovery reporting unit goodwill impairment charge. We also review finite-lived tangible and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In order to assess whether a potential impairment exists, the assets’ carrying values are compared with their undiscounted expected future cash flows. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. Impairments are measured by comparing the fair value of the asset to its carrying value. Fair value is generally determined by considering: (i) the internally developed discounted projected cash flow analysis; (ii) a third-party valuation; and/or (iii) information available regarding the current market environment for similar assets. If the fair value of an asset is determined to be less than the carrying amount of the asset, an impairment in the amount of the difference is recorded in the period in which the events or changes in circumstances that indicated the carrying value of the asset may not be recoverable occurred. In the fourth quarter of 2017, we performed an assessment of the Resource Recovery business’ finite-lived tangible and intangible assets, as events indicated their carrying values may not be recoverable. The result of the assessment indicated no impairment charges were required. Otherwise, no events or circumstances occurred during 2017 that would indicate that our finite-lived tangible and intangible assets may be impaired, therefore no other impairment tests were performed during 2017 other than the annual assessment of goodwill and intangible assets with indefinite useful lives conducted in the fourth quarter of every year. On August 4, 2015, we entered into a definitive agreement to sell Allstate to a private investor group. Allstate represents the majority of the industrial services business we acquired with the acquisition of EQ. As a result of this agreement and management’s strategic review, we evaluated the recoverability of the assets associated with our industrial services business. Our interim goodwill impairment test which included both Step I and Step II analysis was performed and resulted in a non-cash goodwill impairment charge of $6.7 million being recognized in the second quarter of 2015. See Note 5 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information on the sale of Allstate. Our acquired permits and licenses generally have renewal terms of approximately 5-10 years. We have a history of renewing these permits and licenses as demonstrated by the fact that each of the sites’ treatment permits and licenses have been renewed regularly since the facility began operations. We intend to continue to renew our permits and licenses as they come up for renewal for the foreseeable future. Costs incurred to renew or extend the term of our permits and licenses are recorded in Selling, general and administrative expenses in our consolidated statements of operations. Share Based Payments On May 27, 2015, our stockholders approved the Omnibus Incentive Plan (“Omnibus Plan”), which was approved by our Board of Directors on April 7, 2015. The Omnibus Plan was developed to provide additional incentives through equity ownership in US Ecology and, as a result, encourage employees and directors to contribute to our success. The Omnibus Plan provides, among other things, the ability for the Company to grant restricted stock, performance stock, options, stock appreciation rights, restricted stock units, performance stock units (“PSUs”) and other stock-based awards or cash awards to officers, employees, consultants and non-employee directors. Subsequent to the approval of the Omnibus Plan in May 2015, we stopped granting equity awards under our 2008 Stock Option Incentive Plan and our 2006 Restricted Stock Plan (“Previous Plans”), and the Previous Plans will remain in effect solely for the settlement of awards granted under the Previous Plans. No shares that are reserved but unissued under the Previous Plans or that are outstanding under the Previous Plans and reacquired by the Company for any reason will be available for issuance under the Omnibus Plan. The Omnibus Plan expires on April 7, 2025 and authorizes 1,500,000 shares of common stock for grant over the life of the Omnibus Plan. As of December 31, 2017, we have PSUs outstanding under the Omnibus Plan. Each PSU represents the right to receive, on the settlement date, one share of the Company’s common stock. The total number of PSUs each participant is eligible to earn ranges from 0% to 200% of the target number of PSUs granted. The actual number of PSUs that will vest and be settled in shares is determined at the end of a three-year performance period, based on total stockholder return relative to a set of peer companies and the S&P 600. The fair value of the PSUs is determined using a Monte Carlo simulation. Refer to Note 18 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for a summary of the assumptions utilized in the Monte Carlo valuation of awards granted during 2017, 2016 and 2015. As of December 31, 2017, we have stock option awards outstanding under the 1992 Stock Option Plan for Employees (“1992 Employee Plan”) and the 2008 Stock Option Incentive Plan (“2008 Stock Option Plan”). Subsequent to the approval of the Omnibus Plan in May 2015, we stopped granting equity awards under the 2008 Stock Option Plan. The 2008 Stock Option Plan will remain in effect solely for the settlement of awards previously granted. In April 2013, the 1992 Employee Plan expired and was cancelled except for options then outstanding. The determination of fair value of stock option awards on the date of grant using the Black-Scholes model is affected by our stock price and subjective assumptions. These assumptions include, but are not limited to, the expected term of stock options and expected stock price volatility over the term of the awards. Refer to Note 18 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for a summary of the assumptions utilized in 2017, 2016 and 2015. Our stock options have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimates. The Company has elected to account for forfeitures as they occur, rather than estimate expected forfeitures. Income Taxes Income taxes are accounted for using an asset and liability approach whereby we recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement and tax basis of assets and liabilities at the applicable tax rates. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the enactment date. Deferred tax assets are evaluated for the likelihood of use in future periods. A valuation allowance is recorded against deferred tax assets if, based on the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The determination of the need for a valuation allowance, if any, requires our judgment and the use of estimates. If we determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, we would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes. As of December 31, 2017, we have deferred tax assets totaling approximately $15.9 million, a valuation allowance of $2.2 million and deferred tax liabilities totaling approximately $71.2 million. The application of income tax law is inherently complex. Tax laws and regulations are voluminous and at times ambiguous and interpretations of guidance regarding such tax laws and regulations change over time. This requires us to make many subjective assumptions and judgments regarding the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. A liability for uncertain tax positions is recorded in our financial statements on the basis of a two-step process whereby (1) we determine whether it is more likely than not that the tax position taken will be sustained based on the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is greater than 50% likely to be realized upon ultimate settlement with the related tax authority. As facts and circumstances change, we reassess these probabilities and record any changes in the financial statements as appropriate. Changes in our assumptions and judgments can materially affect our financial position, results of operations and cash flows. We recognize interest assessed by taxing authorities or interest associated with uncertain tax positions as a component of interest expense. We recognize any penalties assessed by taxing authorities or penalties associated with uncertain tax positions as a component of selling, general and administrative expenses. On December 22, 2017, the Tax Act was signed into law making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings as of December 31, 2017. The Company has calculated a provisional amount of the impact of the Tax Act in its year end income tax provision in accordance with its understanding of the Tax Act and guidance available as of the date of this Annual Report on Form 10-K and as a result has recorded $23.8 million as a net income tax benefit in the fourth quarter of 2017, the period in which the legislation was enacted. The provisional benefit amount related to the re-measurement of certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in the future was $25.2 million. The provisional expense amount related to the one-time transition tax on the mandatory deemed repatriation of foreign earnings was $1.4 million based on cumulative foreign earnings of $26.7 million. In connection with the Tax Act being signed into law on December 22, 2017, the SEC staff issued Staff Accounting Bulletin No. 118 ("SAB 118") to address the application of GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Act. In accordance with SAB 118, we have determined that the $25.2 million of the deferred tax benefit recorded in connection with the re-measurement of certain deferred tax assets and liabilities and the $1.4 million of current tax expense recorded in connection with the transition tax on the mandatory deemed repatriation of foreign earnings are provisional amounts estimated based on information available as of December 31, 2017. These amounts are subject to change as we obtain information necessary to complete the calculations. Any subsequent adjustment to these provisional amounts will be recorded to current tax expense in 2018, when the analysis is complete. We expect to complete our analysis of the provisional items during the second half of 2018. The effects of other provisions of the Tax Act are being analyzed and are subject to change as additional information, guidance, and regulation becomes available. See Note 16 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information regarding income taxes. Litigation We have, in the past, been involved in litigation requiring estimates of timing and loss potential whose timing and ultimate disposition is controlled by the judicial process. As of December 31, 2017, we did not have any ongoing, pending or threatened legal action that management believes, either individually or in the aggregate, would have a material adverse effect on our financial position, results of operations or cash flows. The decision to accrue costs or write off assets is based on the pertinent facts and our evaluation of present circumstances. Off Balance Sheet Arrangements We do not have any off balance sheet arrangements or interests in variable interest entities that would require consolidation. US Ecology operates through wholly-owned subsidiaries.

<s>[INST] US Ecology, Inc. is a leading North American provider of environmental services to commercial and government entities. The Company addresses the complex waste management needs of its customers, offering treatment, disposal and recycling of hazardous, nonhazardous and radioactive waste, as well as a wide range of complementary field and industrial services. US Ecology’s comprehensive knowledge of the waste business, its collection of waste management facilities and focus on safety, environmental compliance, and customer service enables us to effectively meet the needs of our customers and to build longlasting relationships. We have fixed facilities and service centers operating in the United States, Canada and Mexico. Our fixed facilities include five RCRA subtitle C hazardous waste landfills and one LLRW landfill located near Beatty, Nevada; Richland, Washington; Robstown, Texas; Grand View, Idaho; Detroit, Michigan and Blainville, Québec, Canada. These facilities generate revenue from fees charged to treat and dispose of waste and from fees charged to perform various field and industrial services for our customers. On November 1, 2015, we sold our Allstate Power Vac, Inc. (“Allstate”) subsidiary to a private investor group. See Note 5 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10K for additional information. Our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental ServicesThis segment provides a broad range of hazardous material management services including transportation, recycling, treatment and disposal of hazardous and nonhazardous waste at Companyowned landfill, wastewater and other treatment facilities. Field & Industrial ServicesThis segment provides packaging and collection of hazardous waste and total waste management solutions at customer sites and through our 10day transfer facilities. Services include onsite management, waste characterization, transportation and disposal of nonhazardous and hazardous waste. This segment also provides specialty services such as highpressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response and other services to commercial and industrial facilities and to government entities. In order to provide insight into the underlying drivers of our waste volumes and related treatment and disposal (“T&D”) revenues, we evaluate periodtoperiod changes in our T&D revenue for our Environmental Services segment based on the industry of the waste generator, based on North American Industry Classification System (“NAICS”) codes. The composition of the Environmental Services segment T&D revenues by waste generator industry for the years ended December 31, 2017 and 2016 were as follows: (1) Excludes all transportation service revenue (2) Includes retail and wholesale trade, rate regulated, construction and other industries We also categorize our Environmental Services T&D revenue as either “Base Business” or “Event Business” based on the underlying nature of the revenue source. Base Business consists of waste streams from ongoing industrial activities and tends to be reoccurring in nature. We define Event Business as nonrecurring projects that are expected to equal or exceed 1,000 tons, with Base Business defined as all other business not meeting the definition of Event Business. The duration of Event Business projects can last from a severalweek cleanup of a contaminated site to a multiple year cleanup project. During 2017, Base Business revenue growth was up 5% compared to 2016. Base Business revenue was approximately 78% of total 2017 T&D revenue, down from 82% in 2016. Our business is highly competitive and no assurance can be given that we will maintain these revenue levels or increase our market share. A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and unit pricing. For the year ended December 31, 2017, approximately 22% of our T&D revenue was derived from Event Business projects. The onetime nature of Event Business, diverse spectrum of waste types received and widely varying unit pricing necessarily creates variability in revenue and earnings. This variability may be influenced by general and industryspecific economic conditions, funding availability [/INST] Negative. </s>

US ECOLOGY, INC.

2019-02-28

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General US Ecology, Inc. is a leading North American provider of environmental services to commercial and government entities. The Company addresses the complex waste management needs of its customers, offering treatment, disposal and recycling of hazardous, non-hazardous and radioactive waste, as well as a wide range of complementary field and industrial services. US Ecology’s comprehensive knowledge of the waste business, its collection of waste management facilities and focus on safety, environmental compliance, and customer service enables us to effectively meet the needs of our customers and to build long-lasting relationships. We have fixed facilities and service centers operating in the United States, Canada and Mexico. Our fixed facilities include five RCRA subtitle C hazardous waste landfills and one LLRW landfill located near Beatty, Nevada; Richland, Washington; Robstown, Texas; Grand View, Idaho; Detroit, Michigan and Blainville, Québec, Canada. These facilities generate revenue from fees charged to transport, recycle, treat and dispose of waste and to perform various field and industrial services for our customers. Our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental Services-This segment provides a broad range of hazardous material management services including transportation, recycling, treatment and disposal of hazardous, non-hazardous and radioactive waste at Company-owned landfill, wastewater, deep-well injection and other treatment facilities. Field & Industrial Services-This segment provides packaging and collection of hazardous waste and total waste management solutions at customer sites and through our 10-day transfer facilities. Services include on-site management, waste characterization, transportation and disposal of non-hazardous and hazardous waste. This segment also provides specialty field services such as industrial cleaning and maintenance, remediation, lab packs, retail services, transportation, emergency response and other services to commercial and industrial facilities and to government entities. In order to provide insight into the underlying drivers of our waste volumes and related treatment and disposal (“T&D”) revenues, we evaluate period-to-period changes in our T&D revenue for our Environmental Services segment based on the industry of the waste generator, based on North American Industry Classification System (“NAICS”) codes. The composition of the Environmental Services segment T&D revenues by waste generator industry for the years ended December 31, 2018 and 2017 were as follows: (1) Excludes all transportation service revenue (2) Includes retail and wholesale trade, rate regulated, construction and other industries We also categorize our Environmental Services T&D revenue as either “Base Business” or “Event Business” based on the underlying nature of the revenue source. Base Business consists of waste streams from ongoing industrial activities and tends to be reoccurring in nature. We define Event Business as non-recurring projects that are expected to equal or exceed 1,000 tons, with Base Business defined as all other business not meeting the definition of Event Business. The duration of Event Business projects can last from a several-week cleanup of a contaminated site to a multiple year cleanup project. During 2018, Base Business revenue growth was up 7% compared to 2017. Base Business revenue was approximately 80% of total 2018 T&D revenue, up from 78% in 2017. Our business is highly competitive and no assurance can be given that we will maintain these revenue levels or increase our market share. A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and unit pricing. For the year ended December 31, 2018, approximately 20% of our T&D revenue was derived from Event Business projects. The one-time nature of Event Business, diverse spectrum of waste types received and widely varying unit pricing necessarily creates variability in revenue and earnings. This variability may be influenced by general and industry-specific economic conditions, funding availability, changes in laws and regulations, government enforcement actions or court orders, public controversy, litigation, weather, commercial real estate, closed military bases and other project timing, government appropriation and funding cycles and other factors. The types and amounts of waste received from Base Business also vary from quarter to quarter. This variability can also cause significant quarter-to-quarter and year-to-year differences in revenue, gross profit, gross margin, operating income and net income. While we pursue many projects months or years in advance of work performance, cleanup project opportunities routinely arise with little or no prior notice. These market dynamics are inherent to the waste disposal business and are factored into our projections and externally communicated business outlook statements. Our projections combine historical experience with identified sales pipeline opportunities, new or expanded service line projections and prevailing market conditions. Depending on project-specific customer needs and competitive economics, transportation services may be offered at or near our cost to help secure new business. For waste transported by rail from the eastern United States and other locations distant from our Grand View, Idaho and Robstown, Texas facilities, transportation-related revenue can account for as much as 75% of total project revenue. While bundling transportation and disposal services reduces overall gross profit as a percentage of total revenue (“gross margin”), this value-added service has allowed us to win multiple projects that management believes we could not have otherwise competed for successfully. Our Company-owned fleet of gondola railcars, which is periodically supplemented with railcars obtained under operating leases, has reduced our transportation expenses by largely eliminating reliance on more costly short-term rentals. These Company-owned railcars also help us to win business during times of demand-driven railcar scarcity. The increased waste volumes resulting from projects won through this bundled service strategy further drive operating leverage benefits inherent to the disposal business, increasing profitability. While waste treatment and other variable costs are project-specific, the incremental earnings contribution from large and small projects generally increases as overall disposal volumes increase. Based on past experience, management believes that maximizing operating income, net income and earnings per share is a higher priority than maintaining or increasing gross margin. We intend to continue aggressively bidding bundled transportation and disposal services based on this proven strategy. We serve oil refineries, chemical production plants, steel mills, waste brokers/aggregators serving small manufacturers and other industrial customers that are generally affected by the prevailing economic conditions and credit environment. Adverse conditions may cause our customers as well as those they serve to curtail operations, resulting in lower waste production and/or delayed spending on off-site waste shipments, maintenance, waste cleanup projects and other work. Factors that can impact general economic conditions and the level of spending by customers include, but are not limited to, consumer and industrial spending, increases in fuel and energy costs, conditions in the real estate and mortgage markets, labor and healthcare costs, access to credit, consumer confidence and other global economic factors affecting spending behavior. Market forces may also induce customers to reduce or cease operations, declare bankruptcy, liquidate or relocate to other countries, any of which could adversely affect our business. To the extent business is either government funded or driven by government regulations or enforcement actions, we believe it is less susceptible to general economic conditions. Spending by government agencies may be reduced due to declining tax revenues resulting from a weak economy or changes in policy. Disbursement of funds appropriated by Congress may also be delayed for various reasons. Geographical Information For the year ended December 31, 2018, we derived $495.2 million or 87% of our revenue in the United States and $70.8 million or 13% of our revenue in Canada. For the year ended December 31, 2017, we derived $434.5 million or 86% of our revenue in the United States and $69.5 million or 14% of our revenue in Canada. For the year ended December 31, 2016, we derived $428.8 million or 90% of our revenue in the United States and $48.9 million or 10% of our revenue in Canada. Additional information about the geographical areas in which our revenues are derived and in which our assets are located is presented in Note 4 and Note 21 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Significant Events Our results of operations have been affected by certain significant events during the past three fiscal years including, but not limited to: 2018 Events Explosion at Grand View, Idaho Facility: On November 17, 2018, an explosion occurred at our Grand View, Idaho facility, resulting in one employee fatality and injuries to other employees. The incident severely damaged the facility’s primary waste-treatment building as well as surrounding waste handling, waste storage, maintenance and administrative support structures, resulting in the closure of the entire facility that remained in effect through January 2019. On February 8, 2019, we resumed direct landfill disposal operations at our Grand View, Idaho facility after receiving a temporary authorization from IDEQ. Waste treatment activities at the facility remain closed pending the completion of the various investigations, reconstruction of damaged facilities and authorization from IDEQ. In addition to initiating and conducting our own investigation into the incident, we are fully cooperating with the IDEQ, the USEPA and OSHA to support their comprehensive and independent investigations of the incident. As we continue to investigate the cause of the incident, we are evaluating its impact, but, at this time, we are unable to predict the timing and outcome of the investigation. As such, we cannot presently estimate the potential liability, if any, related to the incident therefore no amounts related to such claims have been recorded in our financial statements as of December 31, 2018. We believe that any potential third-party claims associated with the explosion, in excess of our deductibles, are expected to be resolved primarily through our insurance policies. Although we carry business interruption insurance, a disruption of our business caused by a casualty event, including the full and partial closure of our Grand View, Idaho facility, may result in the loss of business, profits or customers during the time of such closure. Accordingly, our insurance policies may not fully compensate us for these losses during our facility closures. Acquisition of Ecoserv Industrial Disposal, LLC: On November 14, 2018, the Company acquired Ecoserv Industrial Disposal, LLC (“Winnie”), which provides non-hazardous industrial wastewater disposal solutions and employs deep-well injection technology in the southern United States. The total purchase price was $87.1 million and was funded with borrowings under the 2017 Credit Agreement of $87.0 million and cash on hand. The purchase price is subject to post-closing adjustments based on agreed upon working capital requirements. Post-closing adjustments are expected to be finalized and settled in 2019. We recorded $66.6 million of intangible assets and $13.6 million of goodwill on the consolidated balance sheets as a result of the acquisition. Amortizing intangible assets will be amortized over a weighted average life of approximately 52 years. The acquisition of Winnie was not material to our consolidated financial position or results of operations either individually or when aggregated with other acquisitions completed in 2018. Acquisition of ES&H of Dallas, LLC: On August 31, 2018, the Company acquired ES&H of Dallas, LLC (“ES&H Dallas”), which provides emergency and spill response, light industrial services and transportation and logistics for waste disposal and recycling from locations in Dallas and Midland, Texas. The total purchase price was $21.3 million and was funded with cash on hand. We recorded $4.2 million of intangible assets and $7.1 million of goodwill on the consolidated balance sheets as a result of the acquisition. Amortizing intangible assets will be amortized over a weighted average life of approximately 16 years. The acquisition of ES&H Dallas was not material to our consolidated financial position or results of operations either individually or when aggregated with other acquisitions completed in 2018. Goodwill and Intangible Asset Impairment Charges: Based on the results of the Company’s interim assessment of the goodwill and intangible assets of our Mobile Recycling reporting unit, we recorded a $1.4 million goodwill impairment charge and impairment charges of $1.8 million and $454,000 on non-amortizing intangible assets and amortizing intangible assets, respectively, associated with our Mobile Recycling business in the third quarter of 2018. See Note 13 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. 2017 Events Goodwill and Intangible Asset Impairment Charges: Based on the results of the Company’s annual assessment of goodwill and intangible assets, during the fourth quarter we recorded a $5.5 million goodwill impairment charge in our Resource Recovery reporting unit and a $3.4 million impairment charge on the non-amortizing intangible waste collection, recycling and resale permit associated with our Resource Recovery business. See Note 13 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. Tax Cuts and Jobs Act of 2017: On December 22, 2017, the Tax Act was signed into law making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings as of December 31, 2017. In accordance with the Tax Act, we recorded $23.8 million as additional income tax benefit in the fourth quarter of 2017, the period in which the legislation was enacted. The total benefit included $25.2 million related to the re-measurement of certain deferred tax assets and liabilities partially offset by $1.4 million of provisional expense related to one-time transition tax on the mandatory deemed repatriation of foreign earnings. Additionally, Staff Accounting Bulletin No. 118 ("SAB 118") was issued to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Act. December 22, 2018 marked the end of the measurement period for purposes of SAB 118. As such, we have completed our analysis based on legislative updates relating to the Tax Act currently available, which resulted in a net benefit for measurement period adjustments of $193,000 for the year ended December 31, 2018. The total tax provision benefit included a $2.2 million benefit related to the re-measurement of certain deferred tax assets and liabilities offset by $2.0 million of expense related to adjustments to the transition tax. Write-off of Deferred Financing Costs: In connection with the refinancing of the Company’s outstanding debt, we wrote off certain unamortized deferred financing costs and original issue discount that were to be amortized to interest expense in future periods through a one-time charge of $5.5 million to interest expense in the second quarter of 2017. See Note 16 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. 2016 Events Divestiture of Augusta, Georgia Facility: On April 5, 2016, we completed the divestiture of our Augusta, Georgia facility for cash proceeds of $1.9 million. The Augusta, Georgia facility was reported as part of our Environmental Services segment. Sales, net income and total assets of the Augusta, Georgia facility are not material to our consolidated financial position or results of operations in any period presented. We recognized a $1.9 million pre-tax gain on the divestiture of the Augusta, Georgia facility, which is included in Other income (expense) in our consolidated statements of operations for the year ended December 31, 2016. Acquisition of Environmental Services Inc.: On May 2, 2016, the Company acquired 100% of the outstanding shares of Environmental Services Inc., (“ESI”), an environmental services company based in Tilbury, Ontario, Canada. The total purchase price was $4.9 million, net of cash acquired, and was funded with cash on hand. Revenues and total assets of ESI are not material to our consolidated financial position or results of operations. We recorded $1.5 million of intangible assets and $1.0 million of goodwill on the consolidated balance sheets as a result of the acquisition. Amortizing intangible assets will be amortized over a weighted average life of approximately 14 years. Acquisition of Vernon, California Facility: On October 1, 2016, the Company acquired the Vernon, California based RCRA Part B, liquids and solids waste treatment and storage facility of Evoqua Water Technologies LLC. The total purchase price was $5.0 million and was funded with cash on hand. Revenues and total assets of the Vernon, California facility are not material to our consolidated financial position or results of operations. We recorded $3.2 million of intangible assets and $354,000 of goodwill on the consolidated balance sheets as a result of the acquisition. Amortizing intangible assets will be amortized over a weighted average life of approximately 20 years. Results of Operations Our operating results and percentage of revenues for the years ended December 31, 2018, 2017 and 2016 were as follows: Management uses Adjusted EBITDA as a financial measure to assess segment performance. Adjusted EBITDA is defined as net income before interest expense, interest income, income tax expense, depreciation, amortization, share-based compensation, accretion of closure and post-closure liabilities, foreign currency gain/loss, non-cash impairment charges, gain/loss on divestiture and other income/expense. The reconciliation of Net income to Adjusted EBITDA for the years ended December 31, 2018, 2017 and 2016 is as follows: Adjusted EBITDA is a complement to results provided in accordance with accounting principles generally accepted in the United States (“GAAP”) and we believe that such information provides additional useful information to analysts, stockholders and other users to understand the Company’s operating performance. Since Adjusted EBITDA is not a measurement determined in accordance with GAAP and is thus susceptible to varying calculations, Adjusted EBITDA as presented may not be comparable to other similarly titled measures of other companies. Items excluded from Adjusted EBITDA are significant components in understanding and assessing our financial performance. Adjusted EBITDA should not be considered in isolation or as an alternative to, or substitute for, net income, cash flows generated by operations, investing or financing activities, or other financial statement data presented in the consolidated financial statements as indicators of financial performance or liquidity. Adjusted EBITDA has limitations as an analytical tool and should not be considered in isolation or a substitute for analyzing our results as reported under GAAP. Some of the limitations are: · Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs; · Adjusted EBITDA does not reflect our interest expense, or the requirements necessary to service interest or principal payments on our debt; · Adjusted EBITDA does not reflect our income tax expenses or the cash requirements to pay our taxes; · Adjusted EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments; and · Although depreciation and amortization charges are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements. 2018 Compared to 2017 Revenue Total revenue increased 12% to $565.9 million in 2018, compared with $504.0 million in 2017. Environmental Services Environmental Services segment revenue increased 9% to $400.7 million in 2018, compared to $366.3 million in 2017. T&D revenue increased 7% in 2018 compared to 2017, primarily as a result of a 7% increase in Base Business revenue, partially offset by a 3% decrease in project-based Event Business revenue. Transportation and logistics service revenue increased 18% in 2018 compared to 2017, reflecting more Event Business projects utilizing the Company’s transportation and logistics services. Tons of waste disposed of or processed increased 2% in 2018 compared to 2017. T&D revenue from recurring Base Business waste generators increased 7% in 2018 compared to 2017 and comprised 80% of total T&D revenue. The increase in Base Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from the chemical manufacturing, broker/TSDF, “Other,” metal manufacturing and refining industry groups. T&D revenue from Event Business waste generators decreased 3% in 2018 compared to 2017 and comprised 20% of total T&D revenue. The decrease in Event Business T&D revenue compared to the prior year primarily reflects lower T&D revenue from the general manufacturing, mining, exploration and production and refining industry groups, partially offset by higher T&D revenue from the government and “Other” industry groups. The following table summarizes combined Base Business and Event Business T&D revenue growth, within the Environmental Services segment, by waste generator industry for 2018 compared to 2017: Field & Industrial Services Field & Industrial Services segment revenue increased 20% to $165.3 million in 2018 compared with $137.7 million in 2017. The increase in Field & Industrial Services segment revenue is primarily attributable to revenue from new facilities in 2018 and stronger overall market conditions. Gross Profit Total gross profit increased 11% to $170.1 million in 2018, up from $153.1 million in 2017. Total gross margin was 30% for both 2018 and 2017. Environmental Services Environmental Services segment gross profit increased 9% to $147.5 million in 2018, up from $135.0 million in 2017. This increase primarily reflects higher T&D volumes in 2018 compared to 2017. Total segment gross margin was 37% for both 2018 and 2017. T&D gross margin was 42% for 2018 compared with 40% for 2017. 2017 T&D gross margin reflects the impact of the temporary closure of one of our treatment facilities due to wind damage and incremental costs associated with the hurricanes in the Gulf Coast and Florida that impacted our operations in 2017. Field & Industrial Services Field & Industrial Services segment gross profit increased 25% to $22.6 million in 2018, up from $18.2 million in 2017. Total segment gross margin was 14% for 2018 compared with 13% for 2017. The increase in segment gross margin is primarily attributable to contract wins and associated revenue in our small quantity generation services and total waste management businesses, stronger market conditions in our remediation business and the contribution from new facilities in 2018. Selling, General and Administrative Expenses (“SG&A”) Total SG&A increased to $92.3 million, or 16% of total revenue, in 2018 compared with $84.5 million, or 17% of total revenue, in 2017. Environmental Services Environmental Services segment SG&A decreased 7% to $22.5 million, or 6% of segment revenue, in 2018 compared with $24.2 million, or 7% of segment revenue, in 2017, primarily reflecting lower property tax expense and lower amortization expense. The decrease in property tax expense in 2018 was the result of a settlement in the second quarter of 2018 on a dispute related to a $1.1 million property tax assessment for tax years 2015 through 2017 associated with our 2014 acquisition of EQ Holdings, Inc. recorded in the third quarter of 2017. Field & Industrial Services Field & Industrial Services segment SG&A increased 16% to $10.7 million, or 7% of segment revenue, in 2018 compared with $9.3 million, or 7% of segment revenue, in 2017. The increase in segment SG&A primarily reflects incremental costs associated with new facilities in 2018. Corporate Corporate SG&A was $59.1 million, or 10% of total revenue, in 2018 compared with $51.0 million, or 10% of total revenue, in 2017, primarily reflecting higher employee labor costs and higher consulting and professional services expenses in 2018 compared to 2017. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2018 was 23.5% compared to -14.9% in 2017. The increase was primarily the result of the impact that the Tax Act, enacted on December 22, 2017, had on our 2017 effective tax rate. Among other provisions, the Tax Act reduces the federal corporate tax rate to 21% from the existing maximum rate of 35%, effective for tax years beginning after December 31, 2017, and imposes a deemed repatriation tax on previously untaxed accumulated earnings and profits of foreign subsidiaries. As required, in the period of enactment, we re-measured our net deferred tax assets and liabilities and recorded a provisional benefit of $25.2 million to our income tax expense. We also recorded a provisional charge of $1.4 million to our income tax expense for the deemed repatriation transition tax. Interest expense Interest expense was $12.1 million in 2018 compared with $18.2 million in 2017. The decrease in interest expense in 2018 was primarily the result of a one-time non-cash charge of $5.5 million to interest expense in 2017 related to the refinancing of our 2014 Credit Agreement. The remaining decrease is attributable to a lower effective interest rate under our 2017 Credit Agreement, partially offset by additional interest expense on borrowings used to finance the Winnie acquisition. Foreign currency gain (loss) We recognized a $55,000 non-cash foreign currency gain in 2018 compared with a $516,000 non-cash foreign currency gain in 2017. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Canadian subsidiaries’ facilities are located in Blainville, Québec and Tilbury, Ontario, Canada and use the Canadian dollar (“CAD”) as their functional currency. Additionally, we established intercompany loans between our Canadian subsidiaries, whose functional currency is the CAD, and our parent company, US Ecology, as part of a tax and treasury management strategy allowing for repayment of third-party bank debt. These intercompany loans are payable by our Canadian subsidiaries to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2018, we had $20.3 million of intercompany loans subject to currency revaluation. Other income Other income was $2.6 million in 2018 compared with other income of $791,000 in 2017, primarily reflecting a $2.0 million gain in 2018 on the issuance of a property easement on a portion of unutilized Company-owned land at one of our operating facilities. Depreciation and amortization of plant and equipment Depreciation and amortization expense increased to $29.2 million in 2018 compared with $28.3 million in 2017, primarily reflecting additional depreciation expense on assets placed in service in 2018, including assets associated with the ES&H Dallas and Winnie acquisitions. Amortization of intangibles Intangible assets amortization expense was $9.6 million in 2018 compared with $9.9 million in 2017, primarily reflecting the full amortization of certain intangible assets in 2017, partially offset by additional amortization of intangible assets recorded as a result of the ES&H Dallas and Winnie acquisitions. Share-based compensation Share-based compensation expense increased 11% to $4.4 million in 2018, compared with $3.9 million 2017 as a result of an increase in equity-based awards granted to employees. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities increased to $3.7 million in 2018 compared with $3.0 million in 2017, primarily reflecting higher non-cash adjustments to post-closure liabilities recorded in 2017 due to changes in cost estimates and timing associated with closed sites. Impairment charges Based on the results of our 2018 interim assessment of the goodwill and intangible assets of our Mobile Recycling reporting unit, which is part of our Environmental Services segment, we recorded impairment charges of $3.7 million in the third quarter of 2018. Based on the results of our 2017 annual assessment of goodwill and intangible assets, we recorded impairment charges of $8.9 million in our Resource Recovery reporting unit, which is part of our Environmental Services segment, in the fourth quarter of 2017. See Note 13 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. 2017 Compared to 2016 Revenue Total revenue increased 6% to $504.0 million in 2017, compared with $477.7 million in 2016. Environmental Services Environmental Services segment revenue increased 8% to $366.3 million in 2017, compared to $337.8 million in 2016. T&D revenue increased 8% in 2017 compared to 2016, primarily as a result of a 23% increase in project-based Event Business revenue and a 5% increase in Base Business revenue. Transportation and logistics service revenue increased 8% in 2017 compared to 2016, reflecting more Event Business projects utilizing the Company’s transportation and logistics services. Tons of waste disposed of or processed increased 7% in 2017 compared to 2016. T&D revenue from recurring Base Business waste generators increased 5% in 2017 compared to 2016 and comprised 78% of total T&D revenue. During 2017, increases in Base Business T&D revenue from the chemical manufacturing, refining, general manufacturing, and “Other” industry groups were partially offset by decreases in T&D revenue from Base Business in the broker/TSDF industry group. T&D revenue from Event Business waste generators increased 23% in 2017 compared to 2016 and comprised 22% of total T&D revenue. The increase in Event Business T&D revenue compared to the prior year primarily reflects higher T&D revenue from the chemical manufacturing, metal manufacturing, government and “Other” industry groups, partially offset by lower T&D revenue from the general manufacturing industry group. The increase in revenue from the chemical manufacturing industry group is primarily attributable to a large East Coast remedial cleanup project. The following table summarizes combined Base Business and Event Business T&D revenue growth, within the Environmental Services segment, by waste generator industry for 2017 compared to 2016: Field & Industrial Services Field & Industrial Services segment revenue decreased 2% to $137.7 million in 2017 compared with $139.9 million in 2016. The decrease in Field & Industrial Services segment revenue is primarily attributable to the expiration of a contract that was not renewed or replaced and softer overall market conditions for industrial and remediation services. Gross Profit Total gross profit increased 4% to $153.1 million in 2017, up from $147.6 million in 2016. Total gross margin was 30% for 2017 compared with 31% for 2016. Environmental Services Environmental Services segment gross profit increased 6% to $135.0 million in 2017, up from $126.8 million in 2016. This increase primarily reflects higher T&D volumes in 2017 compared to 2016. Total segment gross margin was 37% for 2017 compared with 38% for 2016. T&D gross margin was 40% for 2017 compared with 42% for 2016. The decrease in T&D gross margin is primarily attributable to the impact of the temporary closure of one of our treatment facilities due to wind damage and incremental costs associated with the hurricanes in the Gulf Coast and Florida that impacted our operations in 2017. Field & Industrial Services Field & Industrial Services segment gross profit decreased 13% to $18.2 million in 2017, down from $20.8 million in 2016. Total segment gross margin was 13% for 2017 compared with 15% for 2016. The decrease in segment gross margin is attributable to lower route density in our small quantity generation services due to a contract that was not renewed in late 2016 and a less favorable service mix for our industrial and remediation services in 2017 compared to 2016. Selling, General and Administrative Expenses (“SG&A”) Total SG&A increased to $84.5 million, or 17% of total revenue, in 2017 compared with $77.6 million, or 16% of total revenue, in 2016. Environmental Services Environmental Services segment SG&A increased 13% to $24.2 million, or 7% of segment revenue, in 2017 compared with $21.4 million, or 6% of segment revenue, in 2016, primarily reflecting higher labor and incentive compensation costs, higher property tax expenses and lower gains on sale of assets, partially offset by lower bad debt expense and higher insurance proceeds in 2017 compared to 2016. Field & Industrial Services Field & Industrial Services segment SG&A decreased 8% to $9.3 million, or 7% of segment revenue, in 2017 compared with $10.1 million, or 7% of segment revenue, in 2016. The decrease in segment SG&A primarily reflects lower bad debt expense and higher insurance proceeds, partially offset by higher labor and incentive compensation costs in 2017 compared to 2016. Corporate Corporate SG&A was $51.0 million, or 10% of total revenue, in 2017 compared with $46.0 million, or 10% of total revenue, in 2016, primarily reflecting higher labor and incentive compensation costs in 2017 compared to 2016. Components of Adjusted EBITDA Income tax expense Our effective income tax rate for 2017 was -14.9% compared to 38.1% in 2016. The decrease was primarily the result of the impact of the Tax Act, enacted on December 22, 2017 by the U.S. government. Among other provisions, the Tax Act reduced the federal corporate tax rate to 21% from the existing maximum rate of 35%, effective for tax years beginning after December 31, 2017, and imposed a deemed repatriation tax on previously untaxed accumulated earnings and profits of foreign subsidiaries. We re-measured our net deferred tax assets and liabilities and recorded a provisional benefit of $25.2 million to our income tax expense in 2017. We also recorded a provisional charge of $1.4 million to our income tax expense for the deemed repatriation transition tax. The decrease in the effective income tax rate was also attributable to a higher proportion of earnings from our Canadian operations in 2017 which are taxed at a lower corporate tax rate, partially offset by non-recurring non-deductible impairment charges as well as a higher effective state tax rate driven by changes in apportionment of income between the various states in which we operate. Interest expense Interest expense was $18.2 million in 2017 compared with $17.3 million in 2016. The Company wrote off certain unamortized deferred financing costs and original issue discount associated with the 2014 Credit Agreement that were to be amortized to interest expense in future periods through a one-time non-cash charge of $5.5 million to interest expense in the second quarter of 2017. This increase is partially offset by a lower effective interest rate under the 2017 Credit Agreement compared to the 2014 Credit Agreement and reduced debt levels in 2017 compared to 2016. Foreign currency gain (loss) We recognized a $516,000 non-cash foreign currency gain in 2017 compared with a $138,000 non-cash foreign currency loss in 2016. Foreign currency gains and losses reflect changes in business activity conducted in a currency other than the USD, our functional currency. Our Canadian subsidiaries’ facilities are located in Blainville, Québec and Tilbury, Ontario, Canada and use the Canadian dollar (“CAD”) as their functional currency. Additionally, we established intercompany loans between our Canadian subsidiaries, whose functional currency is the CAD, and our parent company, US Ecology, as part of a tax and treasury management strategy allowing for repayment of third-party bank debt. These intercompany loans are payable by our Canadian subsidiaries to US Ecology in CAD requiring us to revalue the outstanding loan balance through our statements of operations based on USD/CAD currency movements from period to period. At December 31, 2017, we had $21.4 million of intercompany loans subject to currency revaluation. Gain on divestiture Other income in 2016 includes approximately $2.0 million related to the gain on sale of the Augusta, Georgia facility in April 2016 and final closing adjustments on the Allstate divestiture. Depreciation and amortization of plant and equipment Depreciation and amortization expense increased to $28.3 million in 2017 compared with $25.3 million in 2016, primarily reflecting additional depreciation expense on assets placed in service in 2017. Amortization of intangibles Intangible assets amortization expense was $9.9 million in 2017 compared with $10.6 million in 2016. Share-based compensation Share-based compensation expense increased 34% to $3.9 million in 2017, compared with $2.9 million 2016 as a result of an increase in equity-based awards granted to employees. Accretion and non-cash adjustment of closure and post-closure liabilities Accretion and non-cash adjustment of closure and post-closure liabilities decreased to $3.0 million in 2017 compared with $4.0 million in 2016, primarily reflecting non-cash adjustments to post-closure liabilities recorded in 2017 due to changes in cost estimates associated with closed sites. Impairment charges Based on the results of our 2017 annual assessment of goodwill and intangible assets, we recorded impairment charges of $8.9 million in our Resource Recovery reporting unit, which is part of our Environmental Services segment, in the fourth quarter of 2017. See Note 13 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information. Liquidity and Capital Resources Our primary sources of liquidity are cash and cash equivalents, cash generated from operations and borrowings under the new senior secured credit agreement (the “2017 Credit Agreement”). At December 31, 2018, we had $32.0 million in cash and cash equivalents immediately available and $130.3 million of borrowing capacity available under the 2017 Credit Agreement. We assess our liquidity in terms of our ability to generate cash to fund our operating, investing and financing activities. Our primary ongoing cash requirements are funding operations, capital expenditures, paying principal and interest on our long-term debt, and paying declared dividends pursuant to our dividend policy. We believe future operating cash flows will be sufficient to meet our future operating, investing and dividend cash needs for the foreseeable future. Furthermore, existing cash balances and availability of additional borrowings under the 2017 Credit Agreement provide additional sources of liquidity should they be required. Operating Activities. In 2018, net cash provided by operating activities was $81.5 million. This primarily reflects net income of $49.6 million, non-cash depreciation, amortization and accretion of $42.6 million, an increase in accounts payable and accrued liabilities of $14.3 million, deferred income taxes of $5.9 million, share-based compensation expense of $4.4 million and non-cash impairment charges of $3.7 million, partially offset by an increase in accounts receivable of $32.3 million and an increase in income taxes receivable of $7.1 million. Impacts on net income are due to the factors discussed above under “Results of Operations.” The decrease in accounts payable and accrued liabilities is primarily attributable to the timing of payments to vendors for products and services. The increase in receivables is primarily attributable to the timing of customer payments. Changes in income taxes receivable are primarily attributable to the timing of income tax payments. Days sales outstanding were 77 days as of December 31, 2018 and 2017. In 2017, net cash provided by operating activities was $79.7 million. This primarily reflects net income of $49.4 million, non-cash depreciation, amortization and accretion of $41.2 million, non-cash impairment charges of $8.9 million, amortization and write-off of debt issuance costs of $6.0 million, a decrease in income taxes receivable of $4.1 million, share-based compensation expense of $3.9 million, an increase in income taxes payable of $3.9 and an increase in accrued salaries and benefits of $3.4 million, partially offset by a decrease in deferred income taxes of $25.3 million, an increase in accounts receivable of $13.9 million, and a decrease in closure and post-closure obligations of $1.8 million. Impacts on net income are due to the factors discussed above under “Results of Operations.” The increase in receivables is primarily attributable to the timing of customer payments. Changes in income taxes receivable and payable are primarily attributable to the timing of income tax payments. Changes in deferred income taxes are primarily attributable to the re-measurement of our deferred tax assets and liabilities based on the provisions of the Tax Act. In 2016, net cash provided by operating activities was $74.0 million. This primarily reflects net income of $34.3 million, non-cash depreciation, amortization and accretion of $39.8 million, a decrease in accounts receivable of $10.9 million, share-based compensation expense of $2.9 million, non-cash amortization of debt issuance costs of $2.0 million, and a decrease in other assets of $1.2 million, partially offset by a decrease in accounts payable and accrued liabilities of $7.7 million, a decrease in deferred income taxes of $2.7 million, the gain recognized on the divestiture of the Augusta, Georgia facility in April 2016, final closing adjustments on the Allstate divestiture of $2.0 million, and an increase in income taxes receivable of $2.0 million. Impacts on net income are due to the factors discussed above under “Results of Operations.” The decrease in receivables is primarily attributable to the timing of customer payments. Changes in income taxes receivable and payable are primarily attributable to the timing of income tax payments. Investing Activities. In 2018, net cash used in investing activities was $148.8 million, primarily related the acquisition of Winnie for $87.1 million, the acquisition of ES&H Dallas for $21.3 million, and capital expenditures of $40.8 million. Significant capital projects included continuing construction of additional disposal capacity and railway expansions at our Blainville, Québec, Canada location and infrastructure upgrades at our corporate and operating facilities. In 2017, net cash used in investing activities was $33.9 million, primarily related to capital expenditures. Significant capital projects included construction of additional disposal capacity at our Beatty, Nevada and Blainville, Québec, Canada locations and equipment purchases and infrastructure upgrades at our corporate and operating facilities. In 2016, net cash used in investing activities was $41.4 million, primarily related to capital expenditures of $35.7 million, the purchase of the Vernon, California based RCRA Part B, liquids and solids waste treatment and storage facility of Evoqua Water Technologies LLC for $5.0 million and the purchase of Environmental Services Inc., (“ESI”), for $4.9 million, net of cash acquired, partially offset by proceeds from the divestiture of our Augusta, Georgia facility for $2.7 million, net of cash divested. Significant capital projects included construction of additional disposal capacity at our Blainville, Québec, Canada, Beatty, Nevada and Robstown, Texas facilities and equipment purchases and infrastructure upgrades at our corporate and operating facilities. Financing Activities. During 2018, net cash provided by financing activities was $72.9 million, consisting primarily of $87.0 million in proceeds under the 2017 Credit Agreement to fund the acquisition of Winnie and $2.4 million in proceeds received from the exercise of stock options, partially offset by $15.8 million of dividend payments to our stockholders. During 2017, net cash used in financing activities was $26.3 million, consisting primarily of $283.0 million of repayment of the Company’s long-term debt under the 2014 Credit Agreement, $281.0 million of initial proceeds from the borrowing of long-term debt under the 2017 Credit Agreement, $4.0 million of subsequent repayments of long-term debt under the 2017 Credit Agreement, $15.7 million of dividend payments to our stockholders, $3.0 million of deferred financing costs associated with the 2017 Credit Agreement and net payment activity on the Company’s short-term borrowings of $2.2 million. During 2016, net cash used in financing activities was $31.6 million, consisting primarily of $18.0 million of payments on our Term Loan and $15.7 million of dividend payments to our stockholders, partially offset by $2.2 million of net proceeds on our Revolving Credit Facility to fund working capital requirements. Credit Facility On April 18, 2017, the Company entered into the 2017 Credit Agreement with Wells Fargo Bank, National Association, as administrative agent for the lenders, swingline lender and issuing lender, and Bank of America, N.A., as an issuing lender, which provides for a $500.0 million, five-year revolving credit facility (the “Revolving Credit Facility”), including a $75.0 million sublimit for the issuance of standby letters of credit and a $25.0 million sublimit for the issuance of swingline loans used to fund short-term working capital requirements. The 2017 Credit Agreement also contains an accordion feature whereby the Company may request up to $200.0 million of additional funds through an increase to the Revolving Credit Facility, through incremental term loans, or some combination thereof. Proceeds from the Revolving Credit Facility are restricted solely for working capital and other general corporate purposes (including acquisitions and capital expenditures). Under the Revolving Credit Facility, revolving credit loans are available based on a base rate (as defined in the 2017 Credit Agreement) or LIBOR, at the Company’s option, plus an applicable margin which is determined according to a pricing grid under which the interest rate decreases or increases based on our ratio of funded debt to consolidated earnings before interest, taxes, depreciation and amortization (as defined in the 2017 Credit Agreement). The Company wrote off certain unamortized deferred financing costs and original issue discount associated with the 2014 Credit Agreement that were to be amortized to interest expense in future periods through a one-time charge of $5.5 million to interest expense in the second quarter of 2017. At December 31, 2018, the effective interest rate on the Revolving Credit Facility, including the impact of our interest rate swap, was 3.53%. Interest only payments are due either quarterly or on the last day of any interest period, as applicable. In October 2014, the Company entered into an interest rate swap agreement, effectively fixing the interest rate on $170.0 million, or 47%, of the Revolving Credit Facility borrowings as of December 31, 2018. The Company is required to pay a commitment fee ranging from 0.175% to 0.35% on the average daily unused portion of the Revolving Credit Facility, with such commitment fee to be reduced based upon the Company’s total net leverage ratio (as defined in the 2017 Credit Agreement). The maximum letter of credit capacity under the Revolving Credit Facility is $75.0 million and the 2017 Credit Agreement provides for a letter of credit fee equal to the applicable margin for LIBOR loans under the Revolving Credit Facility. At December 31, 2018, there were $364.0 million of borrowings outstanding on the Revolving Credit Facility. These borrowings are due on the revolving credit maturity date (as defined in the 2017 Credit Agreement) and presented as long-term debt in the consolidated balance sheets. The Company has entered into a sweep arrangement whereby day-to-day cash requirements in excess of available cash balances are advanced to the Company on an as-needed basis with repayments of these advances automatically made from subsequent deposits to our cash operating accounts (the “Sweep Arrangement”). Total advances outstanding under the Sweep Arrangement are subject to the $25.0 million swingline loan sublimit under the Revolving Credit Facility. The Company’s revolving credit loans outstanding under the Revolving Credit Facility are not subject to repayment through the Sweep Arrangement. As of December 31, 2018, there were no amounts outstanding subject to the Sweep Arrangement. As of December 31, 2018, the availability under the Revolving Credit Facility was $130.3 million with $5.7 million of the Revolving Credit Facility issued in the form of standby letters of credit utilized as collateral for closure and post-closure financial assurance and other assurance obligations. See Note 16 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information on the Company’s debt. Contractual Obligations and Guarantees Contractual Obligations US Ecology’s contractual obligations at December 31, 2018 become due as follows: (1) For the purposes of the table above, closure and post-closure obligations are shown on an undiscounted basis and inflated using an estimated annual inflation rate of 2.6%. Cash payments for closure and post-closure obligation extend to the year 2105. (2) At December 31, 2018, there were $364.0 million of revolving credit loans outstanding on the Revolving Credit Facility. These revolving credit loans are due upon the earliest to occur of (a) April 18, 2022 (or, with respect to any lender, such later date as requested by us and accepted by such lender), (b) the date of termination of the entire revolving credit commitment (as defined in the 2017 Credit Agreement) by us, and (c) the date of termination of the revolving credit commitment. (3) Interest expense has been calculated using the effective interest rate of 3.85% in effect at December 31, 2018 on the unhedged variable rate portion of the Revolving Credit Facility borrowings and 3.67% on the fixed rate hedged portion of the Revolving Credit Facility borrowings. The interest expense calculation reflects assumed payments on the Revolving Credit Facility borrowings consistent with the disclosures in footnote (2) above. (4) As we are not able to reasonably estimate when we would make any cash payments to settle unrecognized tax benefits of $555,000, such amounts have not been included in the table above. In addition, we have recorded a liability for interest of $15,000 relating to such unrecognized tax benefits but have not included such amounts in the table above. Guarantees We enter into a wide range of indemnification arrangements, guarantees and assurances in the ordinary course of business and have evaluated agreements that contain guarantees and indemnification clauses. These include tort indemnities, tax indemnities, indemnities against third-party claims arising out of arrangements to provide services to us and indemnities related to the sale of our securities. We also indemnify individuals made party to any suit or proceeding if that individual was acting as an officer or director of US Ecology or was serving at the request of US Ecology or any of its subsidiaries during their tenure as a director or officer. We also provide guarantees and indemnifications for the benefit of our wholly-owned subsidiaries to satisfy performance obligations, including closure and post-closure financial assurances. It is difficult to quantify the maximum potential liability under these indemnification arrangements; however, we are not currently aware of any material liabilities to the Company or any of its subsidiaries arising from these arrangements. Environmental Matters We maintain funded trusts agreements, surety bonds and insurance policies for future closure and post-closure obligations at both current and formerly operated disposal facilities. These funded trust agreements, surety bonds and insurance policies are based on management estimates of future closure and post-closure monitoring using engineering evaluations and interpretations of regulatory requirements which are periodically updated. Accounting for closure and post-closure costs includes final disposal cell capping and revegetation, soil and groundwater monitoring and routine maintenance and surveillance required after a site is closed. We estimate that our undiscounted future closure and post-closure costs for all facilities was approximately $283.1 million at December 31, 2018, with a median payment year of 2063. Our future closure and post-closure estimates are our best estimate of current costs and are updated periodically to reflect current technology, cost of materials and services, applicable laws, regulations, permit conditions or orders and other factors. These current costs are adjusted for anticipated annual inflation, which we assumed to be 2.6% as of December 31, 2018. These future closure and post-closure estimates are discounted to their present value for financial reporting purposes using our credit-adjusted risk-free interest rate, which approximates our incremental long-term borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. At December 31, 2018, our weighted-average credit-adjusted risk-free interest rate was 6.0%. For financial reporting purposes, our recorded closure and post-closure obligations were $78.4 million and $76.1 million as of December 31, 2018 and 2017, respectively. Through December 31, 2018, we have met our financial assurance requirements through insurance, surety bonds, standby letters of credit and self-funded restricted trusts. U.S. Operating and Non-Operating Facilities We cover our closure and post-closure obligations for our U.S. operating facilities through the use of third-party insurance policies, surety bonds and standby letters of credit. Insurance policies covering our closure and post-closure obligations expire in April 2019 and December 2019. Our total policy limits are approximately $87.5 million. At December 31, 2018 our trust accounts had $4.9 million for our closure and post-closure obligations and are identified as Restricted cash and investments on our consolidated balance sheets. All closure and post-closure funding obligations for our Beatty, Nevada and Richland, Washington facilities revert to the respective State. Volume based fees are collected from our customers and remitted to state controlled trust funds to cover the estimated cost of closure and post-closure obligations. Stablex We use commercial surety bonds to cover our closure obligations for our Stablex facility located in Blainville, Québec, Canada. Our lease agreement with the Province of Québec requires that the surety bond be maintained for 25 years after the lease expires in 2023. At December 31, 2018 we had $715,000 in commercial surety bonds dedicated for closure obligations. These bonds were renewed in November and December 2018 and expire in November and December 2019. Post-closure funding obligations for the Stablex landfill revert back to the Province of Québec through a dedicated trust account that is funded based on a per-metric-ton disposed fee by Stablex. We expect to renew insurance policies and commercial surety bonds in the future. If we are unable to obtain adequate closure, post-closure or environmental liability insurance and/or commercial surety bonds in future years, any partial or completely uninsured claim against us, if successful and of sufficient magnitude, could have a material adverse effect on our financial condition, results of operations or cash flows. Additionally, continued access to casualty and pollution legal liability insurance with sufficient limits, at acceptable terms, is important to obtaining new business. Failure to maintain adequate financial assurance could also result in regulatory action including early closure of facilities. While we believe we will be able to maintain the requisite financial assurance policies at a reasonable cost, premium and collateral requirements may materially increase. Operation of disposal facilities creates operational, closure and post-closure obligations that could result in unplanned monitoring and corrective action costs. We cannot predict the likelihood or effect of all such costs, new laws or regulations, litigation or other future events affecting our facilities. We do not believe that continuing to satisfy our environmental obligations will have a material adverse effect on our financial condition or results of operations. Seasonal Effects Seasonal fluctuations due to weather and budgetary cycles can influence the timing of customer spending for our services. Typically, in the first quarter of each calendar year there is less demand for our services due to reduced construction and business activities related to weather while we experience improvement in our second and third quarters of each calendar year as weather conditions and other business activity improves. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements require us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates included in our critical accounting policies discussed below and those accounting policies and use of estimates discussed in Notes 2 and 3 to the Consolidated Financial Statements located in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. We base our estimates on historical experience and on various assumptions and other factors we believe to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. We make adjustments to judgments and estimates based on current facts and circumstances on an ongoing basis. Historically, actual results have not deviated significantly from those determined using the estimates described below or in Notes 2 and 3 to the Consolidated Financial Statements located in “Part II, Item 8. Financial Statements and Supplementary Data” to this Annual Report on Form 10-K. However, actual amounts could differ materially from those estimated at the time the consolidated financial statements are prepared. We believe the following critical accounting policies are important to understand our financial condition and results of operations and require management’s most difficult, subjective or complex judgments, often as a result of the need to estimate the effect of matters that are inherently uncertain. Revenue Recognition Revenues are recognized when control of the promised services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those services. We recognize revenue from three primary sources: 1) waste treatment, recycling and disposal services, 2) field and industrial waste management services, and 3) waste transportation services. Our waste treatment and disposal customers are legally obligated to properly treat and dispose of their waste in accordance with local, state, and federal laws and regulations. As our customers do not possess the resources to properly treat and dispose of their waste independently, they contract with the Company to perform the services. Waste treatment, recycling, and disposal revenue results primarily from fixed fees charged to customers for treatment and/or disposal or recycling of specified wastes. Waste treatment, recycling, and disposal revenue is generally charged on a per-ton or per-yard basis at contracted prices and is recognized over time as the services are performed. Our treatment and disposal services are generally performed as the waste is received and considered complete upon final disposal. Field and industrial waste management services revenue results primarily from specialty onsite services such as high-pressure cleaning, tank cleaning, decontamination, remediation, transportation, spill cleanup and emergency response at refineries, chemical plants, steel and automotive plants, and other government, commercial and industrial facilities. We also provide hazardous waste packaging and collection services and total waste management solutions at customer sites and through our 10-day transfer facilities. These services are provided based on purchase orders or agreements with the customer and include prices based upon daily, hourly or job rates for equipment, materials and personnel. Generally, the pricing in these types of contracts is fixed, but the quantity of services to be provided during the contract term is variable and revenues are recognized over the term of the agreements or as services are performed. As we have a right to consideration from our customers in an amount that corresponds directly with the value to the customer of the Company’s performance completed to date, we have applied the practical expedient to recognize revenue in the amount to which we have the right to invoice. Revenue is recognized on contracts with retainage when services have been performed and it is probable that a significant reversal in the amount of cumulative revenue recognized on the contracts will not occur. Transportation and logistics revenue results from delivering customer waste to a disposal facility for treatment and/or disposal or recycling. Transportation services are generally not provided on a stand-alone basis and instead are bundled with other Company services. However, in some instances we provide transportation and logistics services for shipment of waste from cleanup sites to disposal facilities operated by other companies. For such arrangements, we allocate revenue to each performance obligation based on its relative standalone selling price. We generally determine standalone selling prices based on the prices charged to customer or using expected cost plus margin. Transportation revenue is recognized over time as the waste is transported. Taxes and fees collected from customers concurrent with revenue-producing transactions to be remitted to governmental authorities are excluded from revenue. Our Richland, Washington disposal facility is regulated by the Washington Utilities and Transportation Commission (“WUTC”), which approves our rates for disposal of low-level radioactive waste (“LLRW”). Annual revenue levels are established based on a rate agreement with the WUTC at amounts sufficient to cover our costs of operation, including facility maintenance, equipment replacement and related costs, and provide us with a reasonable profit. Per-unit rates charged to LLRW customers during the year are based on our evaluation of disposal volume and radioactivity projections submitted to us by waste generators. Our proposed rates are then reviewed and approved by the WUTC. If annual revenue exceeds the approved levels set by the WUTC, we are required to refund excess collections to facility users on a pro-rata basis. Refundable excess collections, if any,are recorded in Accrued liabilities in the consolidated balance sheets. The current rate agreement with the WUTC was extended in 2013 and is effective until January 1, 2020. Disposal Facility Accounting We amortize landfill and disposal assets and certain related permits over their estimated useful lives. The units-of-consumption method is used to amortize landfill cell construction and development costs and asset retirement costs. Under the units-of-consumption method, we include costs incurred to date as well as future estimated construction costs in the amortization base of the landfill assets. Additionally, where appropriate, as discussed below, we also include probable expansion airspace that has yet to be permitted in the calculation of the total remaining useful life of the landfill asset. If we determine that expansion capacity should no longer be considered in calculating the total remaining useful life of a landfill asset, we may be required to recognize an asset impairment or incur significantly higher amortization expense over the remaining estimated useful life of the landfill asset. If at any time we make the decision to abandon the expansion effort, the capitalized costs related to the expansion effort would be expensed in the period of abandonment. Our landfill assets and liabilities fall into the following two categories, each of which require accounting judgments and estimates: · Landfill assets comprised of capitalized landfill development costs. · Disposal facility retirement obligations relating to our capping, closure and post-closure liabilities that result in corresponding retirement assets. Landfill Assets Landfill assets include the costs of landfill site acquisition, permits and cell design and construction incurred to date. Landfill cells represent individual disposal areas within the overall treatment and disposal site and may be subject to specific permit requirements in addition to the general permit requirements associated with the overall site. To develop, construct and operate a landfill cell, we must obtain permits from various regulatory agencies at the local, state and federal levels. The permitting process requires an initial site study to determine whether the location is feasible for landfill operations. The initial studies are reviewed by our environmental management group and then submitted to the regulatory agencies for approval. During the development stage we capitalize certain costs that we incur after site selection but before the receipt of all required permits if we believe that it is probable that the landfill cell will be permitted. Upon receipt of regulatory approval, technical landfill cell designs are prepared. The technical designs, which include the detailed specifications to develop and construct all components of the landfill cell including the types and quantities of materials that will be required, are reviewed by our environmental management group. The technical designs are submitted to the regulatory agencies for approval. Upon approval of the technical designs, the regulatory agencies issue permits to develop and operate the landfill cell. The types of costs that are detailed in the technical design specifications generally include excavation, natural and synthetic liners, construction of leachate collection systems, installation of groundwater monitoring wells, construction of leachate management facilities and other costs associated with the development of the site. We review the adequacy of our cost estimates at least annually. These development costs, together with any costs incurred to acquire, design and permit the landfill cell, including personnel costs of employees directly associated with the landfill cell design, are recorded to the landfill asset on the balance sheet as incurred. To match the expense related to the landfill asset with the revenue generated by the landfill operations, we amortize the landfill asset on a units-of-consumption basis over its operating life, typically on a cubic yard or cubic meter of disposal space consumed. The landfill asset is fully amortized at the end of a landfill cell’s operating life. The per-unit amortization rate is calculated by dividing the sum of the landfill asset net book value plus estimated future development costs (as described above) for the landfill cell, by the landfill cell’s estimated remaining disposal capacity. Amortization rates are influenced by the original cost basis of the landfill cell, including acquisition costs, which in turn is determined by geographic location and market values. We have secured significant landfill assets through business acquisitions and valued them at the time of acquisition based on fair value. Included in the technical designs are factors that determine the ultimate disposal capacity of the landfill cell. These factors include the area over which the landfill cell will be developed, such as the depth of excavation, the height of the landfill cell elevation and the angle of the side-slope construction. Landfill cell capacity used in the determination of amortization rates of our landfill assets includes both permitted and unpermitted disposal capacity. Unpermitted disposal capacity is included when management believes achieving final regulatory approval is probable based on our analysis of site conditions and interactions with applicable regulatory agencies. We review the estimates of future development costs and remaining disposal capacity for each landfill cell at least annually. These costs and disposal capacity estimates are developed using input from independent engineers and internal technical and accounting managers and are reviewed and approved by our environmental management group. Any changes in future estimated costs or estimated disposal capacity are reflected prospectively in the landfill cell amortization rates. We assess our long-lived landfill assets for impairment when an event occurs or circumstances change that indicate the carrying amount may not be recoverable. Examples of events or circumstances that may indicate impairment of any of our landfill assets include, but are not limited to, the following: · Changes in legislative or regulatory requirements impacting the landfill site permitting process making it more difficult and costly to obtain and/or maintain a landfill permit; · Actions by neighboring parties, private citizen groups or others to oppose our efforts to obtain, maintain or expand permits, which could result in denial, revocation or suspension of a permit and adversely impact the economic viability of the landfill. As a result of opposition to our obtaining a permit, improved technical information as a project progresses, or changes in the anticipated economics associated with a project, we may decide to reduce the scope of, or abandon, a project, which could result in an asset impairment; and · Unexpected significant increases in estimated costs, significant reductions in prices we are able to charge our customers or reductions in disposal capacity that affect the ongoing economic viability of the landfill. Disposal Facility Retirement Obligations Disposal facility retirement obligations include the cost to close, maintain and monitor landfill cells and support facilities. As individual landfill cells reach capacity, we must cap and close the cells in accordance with the landfill cell permits. These capping and closure requirements are detailed in the technical design of each landfill cell and included as part of our approved regulatory permit. After the entire landfill cell has reached capacity and is certified closed, we must continue to maintain and monitor the landfill cell for a post-closure period, which generally extends for 30 years. Costs associated with closure and post-closure requirements generally include maintenance of the landfill cell and groundwater systems, and other activities that occur after the landfill cell has ceased accepting waste. Costs associated with post-closure monitoring generally include groundwater sampling, analysis and statistical reports, transportation and disposal of landfill leachate, and erosion control costs related to the final cap. We have a legally enforceable obligation to operate our landfill cells in accordance with the specific requirements, regulations and criteria set forth in our permits. This includes executing the approved closure/post-closure plan and closing/capping the entire landfill cell in accordance with the established requirements, design and criteria contained in the permit. As a result, we record the fair value of our disposal facility retirement obligations as a liability in the period in which the regulatory obligation to retire a specific asset is triggered. For our individual landfill cells, the required closure and post-closure obligations under the terms of our permits and our intended operation of the landfill cell are triggered and recorded when the cell is placed into service and waste is initially disposed in the landfill cell. The fair value is based on the total estimated costs to close the landfill cell and perform post-closure activities once the landfill cell has reached capacity and is no longer accepting waste, discounted using a credit-adjusted risk-free rate. Retirement obligations are increased each year to reflect the passage of time by accreting the balance at the weighted average credit-adjusted risk-free rate that is used to calculate the recorded liability, with accretion charged to direct operating costs. Actual cash expenditures to perform closure and post-closure activities reduce the retirement obligation liabilities as incurred. After initial measurement, asset retirement obligations are adjusted at the end of each period to reflect changes, if any, in the estimated future cash flows underlying the obligation. Disposal facility retirement assets are capitalized as the related disposal facility retirement obligations are incurred. Disposal facility retirement assets are amortized on a units-of-consumption basis as the disposal capacity is consumed. Our disposal facility retirement obligations represent the present value of current cost estimates to close, maintain and monitor landfills and support facilities as described above. Cost estimates are developed using input from independent engineers, internal technical and accounting managers, as well as our environmental management group’s interpretation of current legal and regulatory requirements, and are intended to approximate fair value. We estimate the timing of future payments based on expected annual disposal airspace consumption and then inflate the current cost estimate by an inflation rate, estimated at December 31, 2018 to be 2.6%. Inflated current costs are then discounted using our credit-adjusted risk-free interest rate, which approximates our incremental borrowing rate in effect at the time the obligation is established or when there are upward revisions to our estimated closure and post-closure costs. Our weighted-average credit-adjusted risk-free interest rate at December 31, 2018 was approximately 6.0%. Final closure and post-closure obligations are currently estimated as being paid through the year 2105. During 2018 we updated several assumptions, including estimated costs and timing of closing our disposal cells. These updates resulted in a net decrease to our post-closure obligations of $523,000. We update our estimates of future capping, closure and post-closure costs and of future disposal capacity for each landfill cell on an annual basis. Changes in inflation rates or the estimated costs, timing or extent of the required future activities to close, maintain and monitor landfills and facilities result in both: (i) a current adjustment to the recorded liability and related asset and (ii) a change in accretion and amortization rates which are applied prospectively over the remaining life of the asset. A hypothetical 1% increase in the inflation rate would increase our closure/post-closure obligation by $15.2 million. A hypothetical 10% increase in our cost estimates would increase our closure/post-closure obligation by $7.8 million. Goodwill and Intangible Assets Goodwill As of December 31, 2018, the Company’s goodwill balance was $207.2 million. We assess goodwill for impairment during the fourth quarter as of October 1 of each year, and also if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The assessment consists of comparing the fair value of the reporting unit to the carrying value of the net assets assigned to the reporting unit, including goodwill. Some of the factors that could indicate impairment include a significant adverse change in legal factors or in the business climate, an adverse action or assessment by a regulator, or failure to generate sufficient cash flows at the reporting unit. For example, field and industrial services represents an emerging business for the Company and has been the focus of a shift in strategy since the acquisition of EQ. Failure to execute on planned growth initiatives within this business could lead to the impairment of goodwill and intangible assets in future periods. We determine our reporting units by identifying the components of each operating segment, and then aggregate components having similar economic characteristics based on quantitative and/or qualitative factors. At December 31, 2018, we had 15 reporting units, 8 of which had allocated goodwill. Fair values are generally determined by an income approach, discounting projected future cash flows based on our expectations of the current and future operating environment, using a market approach, applying a multiple of earnings based on guideline for publicly traded companies, or a combination thereof. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. The rates used to discount projected future cash flows reflect a weighted average cost of capital based on our industry, capital structure and risk premiums including those reflected in the current market capitalization. In the event the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired. If the carrying amount of a reporting unit exceeds its fair value, goodwill of the reporting unit is considered impaired, and an impairment charge would be recognized during the period in which the determination has been made for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. In connection with our annual budgeting process commencing in the third quarter of 2018 and review of the projected future cash flows of our reporting units used in our annual assessment of goodwill, it was determined that the projected future cash flows of our Mobile Recycling reporting unit (described below), which is part of our Environmental Services segment, indicated that the fair value of the reporting unit may be below its carrying amount. Accordingly, we performed an interim assessment of the reporting unit’s goodwill as of September 30, 2018. Based on the results of that assessment, goodwill was deemed impaired and we recognized an impairment charge of $1.4 million in the third quarter of 2018, representing the reporting unit’s entire goodwill balance. Our Mobile Recycling reporting unit operates a fleet of mobile solvent recycling stills that provide on-site recycling services throughout the Eastern United States. The factors contributing to the $1.4 million goodwill impairment charge recorded in 2018 principally related to declining business and cash flows, which negatively impacted the reporting unit’s prospective financial information in its discounted cash flow model and the reporting unit's estimated fair value as compared to previous estimates. The result of the annual assessment of goodwill undertaken in the fourth quarter of 2018 indicated that the fair value of each of our reporting units was in excess of its respective carrying value. The result of the annual assessment of goodwill undertaken in the fourth quarter of 2017 indicated that the fair value of each of our reporting units was in excess of its respective carrying value, with the exception of the Resource Recovery reporting unit. Our Resource Recovery reporting unit offers full-service storm water management and propylene glycol (“PG”) deicing fluid recovery at major airports. Recovered fluids are transported to our recycling facility in Romulus, Michigan where they are distilled and resold to industrial users. The Resource Recovery reporting unit also generates revenues from brokered PG sales and services revenues for PG collection at the airports we service. Weak PG commodity prices and reduced PG collection volumes at the airports we service negatively impacted the reporting unit’s prospective financial information in its discounted cash flow model and the reporting unit's estimated fair value. A longer-than-expected recovery in PG commodity pricing and PG collection volumes became evident during the fourth quarter of 2017 as management completed its 2018 budgeting cycle and updated the long-term projections for the reporting unit which, as a result, decreased the reporting unit’s anticipated future cash flows as compared to those estimated previously. The estimated fair value of the Resource Recovery reporting unit was determined under an income approach using discounted projected future cash flows and then compared to the reporting unit’s carrying amount as of October 1, 2017. Based on the results of that comparison, the carrying amount of the Resource Recovery reporting unit, including $5.5 million of goodwill, exceeded the estimated fair value of the reporting unit by more than $5.5 million and, as a result, we recognized a $5.5 million impairment charge, representing the reporting unit’s entire goodwill balance, in the fourth quarter of 2017. Non-amortizing Intangible Assets We review non-amortizing intangible assets for impairment during the fourth quarter as of October 1 of each year. Fair value is generally determined by considering an internally developed discounted projected cash flow analysis. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. If the fair value of an asset is determined to be less than the carrying amount of the intangible asset, an impairment in the amount of the difference is recorded in the period in which the annual assessment occurs. In connection with the interim goodwill impairment assessment of the Mobile Recycling reporting unit, we also assessed the reporting unit’s non-amortizing intangible permit asset for impairment as of September 30, 2018. Based on the results of that assessment, the carrying amounts of the non-amortizing intangible permit asset exceeded its estimated fair value and, as a result, we recognized a $1.8 million impairment charge in the third quarter of 2018. The factors and timing contributing to the non-amortizing intangible asset charge were the same as the factors and timing described above with regards to the Mobile Recycling reporting unit goodwill impairment charge. The results of the annual assessment of non-amortizing intangible assets undertaken in the fourth quarter of 2018 indicated no impairment charges were required. The result of the annual assessment of non-amortizing intangible assets undertaken in the fourth quarter of 2017 indicated no impairment charges were required, with the exception of the non-amortizing intangible waste collection, recycling and resale permit associated with our Resource Recovery business. In performing the annual non-amortizing intangible assets impairment test, the estimated fair value of the Resource Recovery business’ waste collection, recycling and resale permit was determined under an income approach using discounted projected future cash flows associated with the permit and then compared to the $3.7 million carrying amount of the permit as of October 1, 2017. Based on the results of that evaluation, the carrying amount of the permit exceeded the estimated fair value of the permit and, as a result, we recognized a $3.4 million impairment charge in the fourth quarter of 2017. The factors and timing contributing to the non-amortizing permit impairment charge were the same as the factors and timing described above with regards to the Resource Recovery reporting unit goodwill impairment charge. We also review amortizing tangible and intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In order to assess whether a potential impairment exists, the assets’ carrying values are compared with their undiscounted expected future cash flows. Estimating future cash flows requires significant judgment about factors such as general economic conditions and projected growth rates, and our estimates often vary from the cash flows eventually realized. Impairments are measured by comparing the fair value of the asset to its carrying value. Fair value is generally determined by considering: (i) the internally developed discounted projected cash flow analysis; (ii) a third-party valuation; and/or (iii) information available regarding the current market environment for similar assets. If the fair value of an asset is determined to be less than the carrying amount of the asset, an impairment in the amount of the difference is recorded in the period in which the events or changes in circumstances that indicated the carrying value of the asset may not be recoverable occurred. Amortizing Tangible and Intangible Assets In connection with the interim goodwill impairment assessment of the Mobile Recycling reporting unit, we also assessed the reporting unit’s amortizing tangible and intangible assets for impairment as of September 30, 2018. Based on the results of that assessment, the carrying amounts of the amortizing intangible assets exceeded their estimated fair values and, as a result, we recognized a $454,000 impairment charge in the third quarter of 2018. The factors and timing contributing to the amortizing intangible asset impairment charge were the same as the factors and timing described above with regards to the Mobile Recycling reporting unit goodwill impairment charge. Otherwise, no events or circumstances occurred during 2018 that would indicate that our amortizing tangible and intangible assets may by impaired, therefore no other impairment tests were performed during 2018. In the fourth quarter of 2017, we performed an assessment of the Resource Recovery business’ amortizing tangible and intangible assets, as events indicated their carrying values may not be recoverable. The result of the assessment indicated no impairment charges were required. Otherwise, no events or circumstances occurred during 2017 that would indicate that our amortizing tangible and intangible assets were impaired, therefore no other impairment tests were performed during 2017. Our acquired permits and licenses generally have renewal terms of approximately 5-10 years. We have a history of renewing these permits and licenses as demonstrated by the fact that each of the sites’ treatment permits and licenses have been renewed regularly since the facility began operations. We intend to continue to renew our permits and licenses as they come up for renewal for the foreseeable future. Costs incurred to renew or extend the term of our permits and licenses are recorded in Selling, general and administrative expenses in our consolidated statements of operations. Share Based Payments On May 27, 2015, our stockholders approved the Omnibus Incentive Plan (“Omnibus Plan”), which was approved by our Board of Directors on April 7, 2015. The Omnibus Plan was developed to provide additional incentives through equity ownership in US Ecology and, as a result, encourage employees and directors to contribute to our success. The Omnibus Plan provides, among other things, the ability for the Company to grant restricted stock, performance stock, options, stock appreciation rights, restricted stock units, performance stock units (“PSUs”) and other share-based awards or cash awards to officers, employees, consultants and non-employee directors. Subsequent to the approval of the Omnibus Plan in May 2015, we stopped granting equity awards under our 2008 Stock Option Incentive Plan and our 2006 Restricted Stock Plan (“Previous Plans”), and the Previous Plans will remain in effect solely for the settlement of awards granted under the Previous Plans. No shares that are reserved but unissued under the Previous Plans or that are outstanding under the Previous Plans and reacquired by the Company for any reason will be available for issuance under the Omnibus Plan. The Omnibus Plan expires on April 7, 2025 and authorizes 1,500,000 shares of common stock for grant over the life of the Omnibus Plan. As of December 31, 2018, we have PSUs outstanding under the Omnibus Plan. Each PSU represents the right to receive, on the settlement date, one share of the Company’s common stock. The total number of PSUs each participant is eligible to earn ranges from 0% to 200% of the target number of PSUs granted. The actual number of PSUs that will vest and be settled in shares is determined at the end of a three-year performance period, based on total stockholder return relative to a set of peer companies and the S&P 600. The fair value of the PSUs is determined using a Monte Carlo simulation. Refer to Note 19 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for a summary of the assumptions utilized in the Monte Carlo valuation of awards granted during 2018, 2017 and 2016. As of December 31, 2018, we have stock option awards outstanding under the 2008 Stock Option Incentive Plan (“2008 Stock Option Plan”) and the Omnibus Plan. Subsequent to the approval of the Omnibus Plan in May 2015, we stopped granting equity awards under the 2008 Stock Option Plan. The 2008 Stock Option Plan will remain in effect solely for the settlement of awards previously granted. The determination of fair value of stock option awards on the date of grant using the Black-Scholes model is affected by our stock price and subjective assumptions. These assumptions include, but are not limited to, the expected term of stock options and expected stock price volatility over the term of the awards. Refer to Note 19 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for a summary of the assumptions utilized in 2018, 2017 and 2016. Our stock options have characteristics significantly different from those of traded options, and changes in the assumptions can materially affect the fair value estimates. The Company has elected to account for forfeitures as they occur, rather than estimate expected forfeitures. Income Taxes Income taxes are accounted for using an asset and liability approach whereby we recognize deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement and tax basis of assets and liabilities at the applicable tax rates. The effect of a change in tax rates on deferred tax assets and liabilities is recognized in the period that includes the enactment date. Deferred tax assets are evaluated for the likelihood of use in future periods. A valuation allowance is recorded against deferred tax assets if, based on the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. The determination of the need for a valuation allowance, if any, requires our judgment and the use of estimates. If we determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amount, we would make an adjustment to the deferred tax asset valuation allowance, which would reduce the provision for income taxes. As of December 31, 2018, we have deferred tax assets totaling approximately $20.3 million, a valuation allowance of $4.8 million and deferred tax liabilities totaling approximately $78.8 million. The application of income tax law is inherently complex. Tax laws and regulations are voluminous and at times ambiguous and interpretations of guidance regarding such tax laws and regulations change over time. This requires us to make many subjective assumptions and judgments regarding the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. A liability for uncertain tax positions is recorded in our financial statements on the basis of a two-step process whereby (1) we determine whether it is more likely than not that the tax position taken will be sustained based on the technical merits of the position and (2) for those tax positions that meet the more likely than not recognition threshold, we recognize the largest amount of tax benefit that is greater than 50% likely to be realized upon ultimate settlement with the related tax authority. At December 31, 2018, our estimated gross unrecognized tax benefits were $555,000, of which $485,000, if recognized, would favorably impact our future earnings. Due to uncertainties in any tax audit outcome, our estimates of the ultimate settlement of our unrecognized tax positions may change and the actual tax benefits may differ significantly from the estimates. As facts and circumstances change, we reassess these probabilities and record any changes in the financial statements as appropriate. Changes in our assumptions and judgments can materially affect our financial position, results of operations and cash flows. We recognize interest assessed by taxing authorities or interest associated with uncertain tax positions as a component of interest expense. We recognize any penalties assessed by taxing authorities or penalties associated with uncertain tax positions as a component of selling, general and administrative expenses. On December 22, 2017, the Tax Act was signed into law making significant changes to the Internal Revenue Code. Changes include, but are not limited to, a corporate tax rate decrease from 35% to 21% effective for tax years beginning after December 31, 2017, the transition of U.S. international taxation from a worldwide tax system to a territorial system, and a one-time transition tax on the mandatory deemed repatriation of cumulative foreign earnings as of December 31, 2017. In accordance with the Tax Act, we recorded $23.8 million as additional income tax benefit in the fourth quarter of 2017, the period in which the legislation was enacted. The total benefit included $25.2 million related to the re-measurement of certain deferred tax assets and liabilities partially, offset by $1.4 million of provisional expense related to one-time transition tax on the mandatory deemed repatriation of foreign earnings. Additionally, Staff Accounting Bulletin No. 118 (“SAB 118”) was issued to address the application of U.S. GAAP in situations when a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Act. December 22, 2018 marked the end of the measurement period for purposes of SAB 118. As such, we have completed our analysis based on legislative updates relating to the Tax Act currently available, which resulted in a net benefit for measurement period adjustments of $193,000 for the year ended December 31, 2018. The total tax provision benefit included a $2.2 million benefit related to the re-measurement of certain deferred tax assets and liabilities offset by $2.0 million of expense related to adjustments to the transition tax. See Note 17 to the Consolidated Financial Statements in “Part II, Item 8. Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for additional information regarding income taxes. Litigation We have, in the past, been involved in litigation requiring estimates of timing and loss potential whose timing and ultimate disposition is controlled by the judicial process. In the ordinary course of business, we are involved in judicial and administrative proceedings involving federal, state, provincial or local governmental authorities, including regulatory agencies that oversee and enforce compliance with permits. Fines or penalties may be assessed by our regulators for non-compliance. Actions may also be brought by individuals or groups in connection with permitting of planned facilities, modification or alleged violations of existing permits, or alleged damages suffered from exposure to hazardous substances purportedly released from our operated sites, as well as other litigation. We maintain insurance intended to cover property and damage claims asserted as a result of our operations. Periodically, management reviews and may establish reserves for legal and administrative matters, or other fees expected to be incurred in relation to these matters. On November 17, 2018, an explosion occurred at our Grand View, Idaho facility, resulting in one employee fatality and injuries to other employees. The incident severely damaged the facility’s primary waste-treatment building as well as surrounding waste handling, waste storage, maintenance and administrative support structures, resulting in the closure of the entire facility that remained in effect through January 2019. We resumed limited operations at our Grand View, Idaho facility in February 2019. In addition to initiating and conducting our own investigation into the incident, we are fully cooperating with IDEQ, the USEPA and OSHA to support their comprehensive and independent investigations of the incident. As we continue to investigate the cause of the incident, we are evaluating its impact, but, at this time, we are unable to predict the timing and outcome of the investigation. As such, we cannot presently estimate the potential liability, if any, related to the incident therefore no amounts related to such claims have been recorded in our financial statements as of December 31, 2018. We have not been named as a defendant in any action relating to the incident. We maintain workers’ compensation insurance, business interruption insurance and liability insurance for personal injury, property and casualty damage. We believe that any potential third-party claims associated with the explosion, in excess of our deductibles, are expected to be resolved primarily through our insurance policies. Although we carry business interruption insurance, a disruption of our business caused by a casualty event, including the full and partial closure of our Grand View, Idaho facility, may result in the loss of business, profits or customers during the time of such closure. Accordingly, our insurance policies may not fully compensate us for these losses. Other than as described above, we are not currently a party to any material pending legal proceedings and are not aware of any other claims that could, individually or in the aggregate, have a materially adverse effect on our financial position, results of operations or cash flows. The decision to accrue costs or write-off assets is based on the pertinent facts and our evaluation of present circumstances. Off Balance Sheet Arrangements We do not have any off balance sheet arrangements or interests in variable interest entities that would require consolidation. US Ecology operates through wholly-owned subsidiaries.

<s>[INST] US Ecology, Inc. is a leading North American provider of environmental services to commercial and government entities. The Company addresses the complex waste management needs of its customers, offering treatment, disposal and recycling of hazardous, nonhazardous and radioactive waste, as well as a wide range of complementary field and industrial services. US Ecology’s comprehensive knowledge of the waste business, its collection of waste management facilities and focus on safety, environmental compliance, and customer service enables us to effectively meet the needs of our customers and to build longlasting relationships. We have fixed facilities and service centers operating in the United States, Canada and Mexico. Our fixed facilities include five RCRA subtitle C hazardous waste landfills and one LLRW landfill located near Beatty, Nevada; Richland, Washington; Robstown, Texas; Grand View, Idaho; Detroit, Michigan and Blainville, Québec, Canada. These facilities generate revenue from fees charged to transport, recycle, treat and dispose of waste and to perform various field and industrial services for our customers. Our operations are managed in two reportable segments reflecting our internal management reporting structure and nature of services offered as follows: Environmental ServicesThis segment provides a broad range of hazardous material management services including transportation, recycling, treatment and disposal of hazardous, nonhazardous and radioactive waste at Companyowned landfill, wastewater, deepwell injection and other treatment facilities. Field & Industrial ServicesThis segment provides packaging and collection of hazardous waste and total waste management solutions at customer sites and through our 10day transfer facilities. Services include onsite management, waste characterization, transportation and disposal of nonhazardous and hazardous waste. This segment also provides specialty field services such as industrial cleaning and maintenance, remediation, lab packs, retail services, transportation, emergency response and other services to commercial and industrial facilities and to government entities. In order to provide insight into the underlying drivers of our waste volumes and related treatment and disposal (“T&D”) revenues, we evaluate periodtoperiod changes in our T&D revenue for our Environmental Services segment based on the industry of the waste generator, based on North American Industry Classification System (“NAICS”) codes. The composition of the Environmental Services segment T&D revenues by waste generator industry for the years ended December 31, 2018 and 2017 were as follows: (1) Excludes all transportation service revenue (2) Includes retail and wholesale trade, rate regulated, construction and other industries We also categorize our Environmental Services T&D revenue as either “Base Business” or “Event Business” based on the underlying nature of the revenue source. Base Business consists of waste streams from ongoing industrial activities and tends to be reoccurring in nature. We define Event Business as nonrecurring projects that are expected to equal or exceed 1,000 tons, with Base Business defined as all other business not meeting the definition of Event Business. The duration of Event Business projects can last from a severalweek cleanup of a contaminated site to a multiple year cleanup project. During 2018, Base Business revenue growth was up 7% compared to 2017. Base Business revenue was approximately 80% of total 2018 T&D revenue, up from 78% in 2017. Our business is highly competitive and no assurance can be given that we will maintain these revenue levels or increase our market share. A significant portion of our disposal revenue is attributable to discrete Event Business projects which vary widely in size, duration and unit pricing. For the year ended December 31, 2018, approximately 20% of our T&D revenue was derived from Event Business projects. The onetime nature of Event Business, diverse spectrum of waste types received and widely varying unit pricing necessarily creates variability in revenue and earnings. This variability may be influenced by general and industryspecific economic conditions, funding availability, changes in laws and regulations, government enforcement actions or court orders, public controversy, litigation, weather, commercial real estate, closed military bases and other project timing, government appropriation and funding cycles and other factors. The types and amounts of waste received from Base Business also vary from quarter to quarter. This variability can also cause significant quartertoquarter and yeartoyear differences in re [/INST] Positive. </s>

INTEGRYS ENERGY GROUP, INC.

2015-03-02

2014-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION We are an energy holding company with natural gas and electric utility operations (serving customers in Illinois, Michigan, Minnesota, and Wisconsin), an approximate 34% equity ownership interest in ATC (a federally regulated electric transmission company), and nonregulated energy operations. Strategic Overview Our goal is to create long-term value for shareholders and customers through growth in our core regulated businesses. The essential components of our business strategy are: Maintaining and Growing a Strong Utility Base - A strong utility base is essential to maintaining a strong balance sheet, predictable cash flows, the desired risk profile, attractive dividends, and quality credit ratings. We believe the following projects have helped, or will help, maintain and grow our utility base and meet our customers' needs: • An accelerated annual investment in natural gas distribution facilities (primarily replacement of cast iron mains) at PGL, • WPS's proposed new natural gas-fueled electric generating unit to be built at the site of the Fox Energy Center in Wisconsin, • WPS's continued investment in environmental projects to improve air quality and meet or exceed the requirements set by environmental regulators, • WPS's System Modernization and Reliability Project to underground and upgrade certain electric distribution facilities in northern Wisconsin, and • Our approximate 34% ownership interest in ATC, a transmission company that had over $3.7 billion of transmission assets at December 31, 2014. ATC plans to invest approximately $3.3 billion to $3.9 billion in transmission system improvements during the next ten years. Although ATC's equity requirements to fund its capital investments will primarily be met by earnings reinvestment, we plan to continue to fund our share of the equity portion of future ATC growth as necessary. For more detailed information on our capital expenditure program, see Liquidity and Capital Resources - Capital Requirements. Providing Safe, Reliable, Competitively Priced, and Environmentally Sound Energy and Related Services - Our mission is to provide customers with the best value in energy and related services. We strive to effectively operate a mixed portfolio of generation assets and prudently invest in new generation and distribution assets, while maintaining or exceeding environmental standards. This allows us to provide a safe, reliable, value-priced service for our customers. Our presence in the compressed natural gas fueling marketplace, while not currently significant, is complementary to our existing businesses and is consistent with our mission. Integrating Resources to Provide Operational Excellence - We are committed to integrating resources of all our businesses and finding the best and most efficient processes while meeting all applicable legal and regulatory requirements. We strive to provide the best value to our customers and shareholders by embracing constructive change, leveraging capabilities and expertise, and using creative solutions to meet or exceed our customers' expectations. "Operational Excellence" initiatives have been implemented to reduce costs and encourage top performance in the areas of project management, process improvement, contract administration, and compliance. Placing Strong Emphasis on Asset and Risk Management - Our asset management strategy calls for the continuous assessment of existing assets, the acquisition of assets, and contractual commitments to obtain resources that complement our existing business and strategy. The goal is to provide the most efficient use of resources while maximizing return and maintaining an acceptable risk profile. This strategy focuses on acquiring assets consistent with strategic plans and disposing of assets, including property, plant, and equipment and entire business units, that are no longer strategic to ongoing operations, are not performing as intended, or have an unacceptable risk profile. We maintain a portfolio approach to risk and earnings. Our risk management strategy includes the management of market, credit, liquidity, and operational risks through the normal course of business. Forward purchases of electric capacity, energy, natural gas, and other commodities, and the use of derivative financial instruments, including commodity swaps and options, provide tools to reduce the risk associated with price movement in a volatile energy market. Each business unit manages the risk profile related to these instruments consistent with our risk management policies, which are approved by the Board of Directors. The Corporate Risk Management Group, which reports through the Chief Financial Officer, provides corporate oversight. RESULTS OF OPERATIONS Earnings Summary 2014 Compared with 2013 The $74.9 million decrease in our earnings was driven by: • An $82.1 million after-tax decrease in income from discontinued operations at IES. See Note 4, Dispositions, for more information. • A $59.4 million after-tax increase in operating expenses at the utilities, excluding items directly offset in margins, driven by increases in natural gas distribution costs, depreciation and amortization expense, and electric utility maintenance. • A $17.4 million after-tax increase in interest expense on long-term debt, driven by higher average outstanding long-term debt during 2014. • A $13.0 million increase in income tax expense due to a remeasurement of deferred income taxes in 2014 related to the sale of IES's retail energy business. • A $9.9 million after-tax negative year-over-year impact of the 2013 reversal of reserves recorded in 2012 against decoupling accruals at PGL and NSG. See Note 25, Regulatory Environment, for more information. • An $8.1 million after-tax increase in operating expenses at the holding company due to transaction costs incurred in 2014 related to the proposed merger with Wisconsin Energy Corporation. These decreases in earnings were partially offset by: • A $51.2 million after-tax gain on the sale of UPPCO, net of transaction costs. See Note 4, Dispositions, for more information. • The approximate $45 million after-tax positive impact of rate orders at the utilities. • An approximate $6 million after-tax increase in electric utility wholesale margins driven by higher prices. • An approximate $5 million after-tax net increase in utility margins due to variances related to sales volumes, net of decoupling. A positive impact from higher sales volumes at the natural gas utilities was partially offset by a decrease in electric utility margins, driven by the sale of UPPCO at the end of August 2014. 2013 Compared with 2012 The $70.4 million increase in our earnings was driven by: • A $41.9 million after-tax increase in income from discontinued operations. See Note 4, Dispositions, for more information. • The approximate $30 million after-tax positive impact of rate orders at the utilities. • An approximate $30 million after-tax increase due to an increase in sales volumes at the natural gas utilities, net of decoupling. Weather was colder than normal in 2013 and warmer than normal in 2012. In addition, certain of our natural gas utilities did not have decoupling impacts in 2012 to offset the impact of weather. • The $9.9 million after-tax positive impact of the first quarter 2013 reversal of reserves recorded in 2012 against decoupling accruals at PGL and NSG. See Note 25, Regulatory Environment, for more information. These increases were partially offset by: • A $27.4 million after-tax increase in operating expenses at the natural gas utilities, excluding items directly offset in margins, driven by an increase in natural gas distribution costs. • A $10.9 million after-tax increase in electric transmission expense and maintenance expense, excluding the newly acquired Fox Energy Center, at the electric utilities. The increase in maintenance expense was driven primarily by a plant outage at Weston 3. Natural Gas Utility Segment Operations Natural gas utility margins are defined as natural gas utility operating revenues less purchased natural gas costs. Management believes that natural gas utility margins provide a more meaningful basis for evaluating natural gas utility operations than natural gas utility revenues, since prudently incurred natural gas commodity costs are passed through to our customers in current rates. There were approximate 43% and 7% increases in the average per-unit cost of natural gas sold during 2014 and 2013, respectively, which had no impact on margins. 2014 Compared with 2013 Margins Natural gas utility segment margins increased $97.2 million, driven by: • An approximate $38 million increase in margins related to certain riders at NSG and PGL and certain energy efficiency programs at four of our natural gas utilities. This increase was offset by an equal increase in operating expenses, resulting in no impact on earnings. ◦ NSG and PGL recovered from their customers approximately $19 million more for environmental cleanup costs at their former manufactured gas plant sites due to higher recovery rates driven by an increase in remediation costs, net of insurance settlements received, and the impact of higher sales volumes. See Note 17, Commitments and Contingencies, for more information about the manufactured gas plant sites. ◦ NSG and PGL recovered approximately $13 million more from their customers through their bad debt rider mechanisms, driven by higher natural gas costs in 2014, an increase in sales volumes, and rate increases. ◦ Our natural gas utilities recovered approximately $6 million more from customers for energy efficiency programs at MERC, MGU, NSG, and PGL in 2014. • An approximate $35 million net increase in margins due to rate orders. See Note 25, Regulatory Environment, for more information. ◦ The rate increases at NSG and PGL, effective June 27, 2013, and updated effective January 1, 2014, the impact of the Qualifying Infrastructure Plant rider at PGL, and other impacts of rate design, had an approximate $32 million positive impact on margins. ◦ The rate increase at MGU, effective January 1, 2014, resulted in an approximate $4 million positive impact on margins. ◦ The interim rate increase at MERC, effective January 1, 2014, had an approximate $4 million positive impact on margins. ◦ These increases were partially offset by the approximate $5 million negative impact of WPS's rate order, effective January 1, 2014. Although the PSCW approved a net rate increase, it was driven by the recovery of the 2012 decoupling under-collections to be recovered from customers in 2014, which has no impact on margins. See Note 25, Regulatory Environment, for more information. • An approximate $23 million net increase in margins due to sales volume variances and our decoupling mechanisms. ◦ The combined effect of the change in weather year over year and the impact of higher weather-normalized volumes, partially offset by the impact of our decoupling mechanisms, increased margins approximately $40 million. In 2014, margins at the natural gas utilities were positively impacted by colder than normal weather, net of decoupling impacts at MERC, NSG, and PGL. Effective January 1, 2014, MGU and WPS no longer have decoupling mechanisms in place. During 2014, MERC reached its maximum accrued refund to customers under the annual 10% cap provision of its decoupling mechanism. In 2013, decoupling mechanisms were in place for all the natural gas utilities. Margins for certain customer classes in both years were sensitive to volume variances as they were not covered by the decoupling mechanisms. See Note 25, Regulatory Environment, for more information on our decoupling mechanisms. ◦ Margins were negatively impacted year-over-year by approximately $17 million due to a reversal in 2013 of reserves established in 2012 against PGL and NSG regulatory assets related to decoupling. The reversal was recorded after the Illinois Appellate Court issued an opinion in March 2013 that affirmed the ICC's order approving the decoupling mechanisms. See Note 25, Regulatory Environment, for more information. Operating Income Operating income at the natural gas utility segment decreased $33.1 million. This decrease was driven by a $130.3 million increase in operating expenses, partially offset by the $97.2 million increase in margins discussed above. The increase in operating expenses was primarily due to: • A $45.9 million increase in natural gas distribution costs, primarily at PGL. The increase in costs at PGL was driven by higher repairs and maintenance expense primarily due to higher costs to meet new compliance requirements. • A $19.8 million increase driven by higher amortization of regulatory assets at certain of our natural gas utilities related to environmental cleanup costs for manufactured gas plant sites. For the majority of the increase in expenses, margins increased by an equal amount, resulting in no impact on earnings. • A $15.5 million increase in bad debt expense, driven by higher natural gas costs in 2014, an increase in sales volumes, and rate increases. The majority of the increase in bad debt expense related to PGL and NSG and had no impact on earnings since it was offset by higher rates through a rider mechanism, resulting in higher margins. • A $13.0 million increase in depreciation and amortization expense. This increase was driven by continued investment in property and equipment, primarily the AMRP at PGL. The increase was also driven by a $3.4 million reduction in expense in 2013 at MERC related to a new depreciation study approved by the MPUC on July 29, 2013, retroactive to January 1, 2012. In addition, MGU recorded a $2.5 million reduction in expense in 2013. In January 2013, the Michigan Court of Appeals issued an order reversing the MPSC's previously ordered disallowance associated with the early retirement of certain MGU assets in 2010. See Note 25, Regulatory Environment, for more information. • An $8.7 million increase driven by higher information technology costs. New servers and software for natural gas management and work asset management systems were placed in service during the third quarter of 2013, resulting in higher asset usage charges from IBS. Also, in 2014, several information technology projects and upgrades were performed, and additional information technology services were provided by IBS. • A $5.0 million increase in workers compensation and injuries and damages expense. This increase was driven by both more severe injuries and increased incidents in 2014, primarily at PGL. • A $4.6 million net increase in energy efficiency program expenses at our natural gas utilities. This net increase in expenses was more than offset by an approximate $6 million related increase in margins. • A $4.0 million increase in the cost of outside services employed, primarily driven by higher consulting and contract labor costs as a result of the AMRP at PGL. • A $3.7 million increase in unrecoverable energy efficiency program expense at MERC. In the second quarter of 2014, MERC wrote off a regulatory asset recorded for conservation improvement program costs. • A $3.0 million increase in customer accounts expense, driven in part by higher outsourced call center costs at PGL. The increase in call center costs was primarily due to additional services provided as a result of a project to standardize the customer billing system. • A $2.7 million increase in taxes other than income taxes, driven in part by the Illinois invested capital tax. This tax is based on an entity's equity and long-term debt balances, which have increased for PGL. Higher property taxes also contributed to the increase in expense. • A $0.1 million net increase in employee benefit costs, driven by: ◦ An $8.5 million increase in stock-based compensation expense, primarily due to the year-over-year increase in the fair value of awards accounted for as liabilities. The increase in fair value resulted from an increase in our stock price. ◦ A $4.3 million increase related to the negative year-over-year impact of the deferral of employee benefit costs in 2013 and the related amortization in 2014. In 2013, WPS deferred certain increases in pension and other employee benefit costs as a result of its 2013 rate order with the PSCW. WPS began amortizing this regulatory asset in 2014. ◦ These increases were partially offset by a $12.7 million decrease in other employee benefit costs, primarily driven by higher discount rates assumed in 2014. The remeasurement of certain postretirement benefit plans in the first quarter of 2014 also contributed to the decrease. See Note 18, Employee Benefit Plans, for more information on this remeasurement. Other Expense Other expense at the natural gas utilities increased $3.5 million. Interest expense on long-term debt increased, driven by higher average long-term debt outstanding in 2014. 2013 Compared with 2012 Margins Natural gas utility segment margins increased $161.8 million, driven by: • An approximate $67 million net increase in margins due to sales volume variances and our decoupling mechanisms. ◦ The combined effect of the change in weather year over year and the impact of our decoupling mechanisms increased margins approximately $50 million. In 2012, margins at the natural gas utilities were negatively impacted by unusually warm weather, and the majority of our natural gas utilities either did not have decoupling mechanisms in place or the mechanism did not cover weather-related volume variances. In 2013, decoupling mechanisms were in place for all the natural gas utilities, but colder than normal weather did have a positive impact on MGU's margins as its decoupling mechanism does not cover weather-related volume variances. Margins for certain customer classes in both years were sensitive to volume variances as they were not covered by the decoupling mechanisms. See Note 25, Regulatory Environment, for more information on our decoupling mechanisms. ◦ In 2013, PGL and NSG recorded an increase in revenues of approximately $17 million when reserves established in 2012 against regulatory assets related to decoupling from a prior period were reversed. The reversal was recorded after the Illinois Appellate Court issued an opinion in March 2013 that affirmed the ICC's order approving the decoupling mechanisms. See Note 25, Regulatory Environment, for more information. • An approximate $53 million increase in margins related to certain riders at PGL and NSG and certain energy efficiency programs at four of our natural gas utilities. This increase was offset by an equal increase in operating expenses, resulting in no impact on earnings. ◦ Our natural gas utilities recovered approximately $27 million more from customers for energy efficiency programs at MGU, NSG, PGL, and WPS in 2013. ◦ PGL and NSG recovered approximately $26 million more for environmental cleanup costs at their former manufactured gas plant sites related to an increase in remediation activity during 2013. See Note 17, Commitments and Contingencies, for more information about the manufactured gas plant sites. • An approximate $31 million net increase in margins due to rate orders. See Note 25, Regulatory Environment, for more information. ◦ The rate increases at PGL and NSG, effective June 27, 2013, and January 21, 2012, and other impacts of rate design, had an approximate $32 million positive impact on margins. ◦ MERC recognized an approximate $2 million increase in margins primarily driven by the impact of a July 2012 rate order from the MPUC. Customer refunds were accrued in 2012 as a result of 2011 interim rates that had been in effect. ◦ A reduction in rates at WPS, effective January 1, 2013, resulted in an approximate $3 million negative impact on margins. • An approximate $8 million increase in margins due to the MPUC's approval of MERC's energy conservation incentives in December 2013. These financial incentives were earned by MERC for achieving certain conservation improvement program goals. Operating Income Operating income at the natural gas utility segment increased $49.8 million. This increase was driven by the $161.8 million increase in margins discussed above, partially offset by a $112.0 million increase in operating expenses. The increase in operating expenses was primarily due to: • A $31.7 million increase in energy efficiency program expenses at our natural gas utilities. Margins increased by an equal amount, resulting in no impact on earnings. • A $28.6 million increase driven by higher amortization of regulatory assets at certain of our natural gas utilities related to environmental cleanup costs for manufactured gas plant sites. For approximately $26 million of the increase in expenses, margins increased by an equal amount, resulting in no impact on earnings. • A $22.1 million increase in natural gas distribution costs, primarily at PGL. The increase was partially due to increased labor and contractor costs driven by additional compliance work. A portion of the compliance work was driven by new local regulations related to natural gas distribution main openings and repairs in the public way. Natural gas distribution costs also increased due to a plastic pipe fittings replacement project. • An $8.3 million net increase in employee benefit costs. The total employee benefit costs increase of $10.4 million was primarily due to higher pension expense, largely at PGL, driven by a lower discount rate in 2013. The lower discount rate did not significantly impact the other natural gas utilities due to an increase in contributions to those plans in prior years, which increased plan assets. WPS deferred $2.1 million of certain increases in pension and other employee benefit costs that will be recovered in a future rate proceeding as a result of its 2013 rate order. See Note 25, Regulatory Environment, for more information. • A $7.2 million increase in bad debt expense, driven by a cost of natural gas component included as part of PGL's and NSG's bad debt expense tracking mechanisms. This natural gas component is charged to customers based on actual volumes and natural gas prices. As a result of this component, bad debt expense was primarily impacted by both higher natural gas costs in 2013 and an increase in sales volumes. However, the increase in bad debt expense does not impact earnings as it is offset by higher rates through a rider mechanism, resulting in higher margins. • A $5.2 million increase in legal and outside services expense. • A $4.2 million net increase in depreciation and amortization expense. Continued investment in property and equipment, primarily the AMRP at PGL, drove the increase in expense. Partially offsetting the increase was a $3.4 million reduction in expense at MERC related to a new depreciation study approved by the MPUC on July 29, 2013, retroactive to January 2012. The study included changes to salvage values and costs of removal, as well as extensions to the service lives of certain assets. In addition, there was a $2.5 million reduction in expense at MGU. In January 2013, the Michigan Court of Appeals issued an order reversing the MPSC's previously ordered disallowance associated with the early retirement of certain MGU assets in 2010. See Note 25, Regulatory Environment, for more information. • A $2.7 million increase in asset usage charges from IBS, driven by new software for both natural gas management and work asset management that was placed in service during the third quarter of 2013. • A $2.6 million increase in taxes other than income taxes, driven by the Illinois invested capital tax. This tax assessment is based on an entity's equity and long-term debt balances, which have increased for PGL in 2013. Other Expense Other expense at the natural gas utilities increased $2.3 million in 2013. Interest expense on long-term debt increased, driven by higher average long-term debt outstanding in 2013. Electric Utility Segment Operations Electric utility margins are defined as electric utility operating revenues less fuel and purchased power costs. Management believes that electric utility margins provide a more meaningful basis for evaluating electric utility operations than electric utility operating revenues. To the extent changes in fuel and purchased power costs are passed through to customers, the changes are offset by comparable changes in operating revenues. 2014 Compared with 2013 Margins Electric utility segment margins increased $19.6 million, driven by: • An approximate $41 million increase in margins related to WPS and UPPCO rate orders, effective January 1, 2014. Although the PSCW approved an electric rate decrease for WPS, the rate decrease was driven by 2013 fuel cost over-collections and 2012 decoupling over-collections that were being refunded to customers in 2014 and had no impact on margins. See Note 25, Regulatory Environment, for more information. ◦ Margins at WPS increased approximately $41 million as a result of the PSCW rate order, primarily driven by an increase in electric rate base from owning and operating the Fox Energy Center, which was included in rates beginning in 2014. In 2013, customer rates only included recovery of estimated purchased power costs from the Fox Energy Center. ◦ UPPCO's retail electric rate increase resulted in an approximate $6 million increase in margins. ◦ Margins at WPS were positively impacted by approximately $5 million mainly due to lower fly ash disposal costs in 2014. These costs are not included in the fuel rule recovery mechanism. ◦ Margins decreased approximately $11 million related to fuel and purchased power cost under-collections at WPS in 2014, compared with over-collections in 2013. Under the fuel rule, WPS can only defer under or over-collections of certain fuel and purchased power costs that exceed a 2% price variance from the costs included in rates. • An approximate $11 million increase in wholesale margins driven by higher prices. Wholesale prices increased due to higher generation costs as well as an increase in electric rate base, resulting from the purchase of the Fox Energy Center in 2013 and the installation of environmental projects at the Columbia plant in 2014. Wholesale customers proportionally shared in these price increases through formula rates. • A partially offsetting decrease in margins of approximately $31 million related to sales volume variances. The decrease was primarily driven by the sale of UPPCO at the end of August 2014, which lowered margins related to sales volume variances by approximately $27 million. See Note 4, Dispositions, for more information. Margins from WPS's large commercial and industrial customers as well as residential customers also decreased, driven by lower use per customer in 2014. These decreases were partially offset by the impact of the termination of our decoupling mechanisms, effective January 1, 2014. See Note 25, Regulatory Environment, for more information. Our decoupling mechanisms did not cover large commercial and industrial customers. Operating Income Operating income at the electric utility segment increased $98.6 million. The increase was primarily driven by an $85.4 million net gain on the sale of UPPCO. See Note 4, Dispositions, for more information. The remaining increase in operating income was due to the $19.6 million increase in margins discussed above, partially offset by a $6.4 million increase in operating expenses. The increase in operating expenses was driven by: • A $13.6 million increase in maintenance expense, primarily due to planned major outages in 2014 at the Pulliam plant, Fox Energy Center, and Weston 4, as well as maintenance at certain other WPS generation plants. These increases were partially offset by the year-over-year impact of maintenance expenses associated with the Weston 3 planned major outage in 2013. • A $6.0 million increase in costs at WPS associated with the acquisition and operation of the Fox Energy Center. The majority of this increase relates to the amortization of a regulatory asset related to the fee paid for the early termination of the Fox Energy Center power purchase agreement. Recovery of the amortization was included in the new rates. • A $4.4 million increase in depreciation and amortization expense, mainly due to the acquisition of the Fox Energy Center at the end of the first quarter of 2013. In addition, we completed the installation of scrubbers at the Columbia plant in April 2014. This increase is partially offset by lower depreciation driven by the sale of UPPCO in August 2014. See Note 4, Dispositions, for more information. • A $3.8 million increase in electric transmission expense, which is net of lower transmission costs driven by the sale of UPPCO in August 2014. See Note 4, Dispositions, for more information. • A $2.8 million increase in amortization of previously deferred production tax credits related to the WPS Crane Creek wind project. These increases were partially offset by: • An $8.8 million net decrease in employee benefit costs, including the impact of the prior year deferral of some of these costs. Employee benefit costs other than stock-based compensation (discussed below) decreased $27.5 million in 2014. This decrease was partially driven by the continued funding of our pension plan and higher discount rates assumed in 2014 for both our pension and postretirement plans. The remeasurement of certain other postretirement benefit plans also contributed to the overall decrease in employee benefit costs. See Note 18, Employee Benefit Plans, for more information. This decrease was partially offset by: ◦ Higher stock-based compensation expense of $4.2 million, which was primarily driven by an increase in the fair value of awards accounted for as liabilities. The increase in fair value resulted from an increase in our stock price. ◦ The year-over-year impact of a deferral of certain increases in WPS employee benefit costs in 2013, recorded in accordance with its PSCW rate order, and the related amortization in 2014. Together, these changes increased employee benefit costs by $14.5 million at WPS. • A $6.6 million decrease due to the year-over-year impact of WPS's 2013 deferral of the net difference between actual and rate case-approved costs resulting from the purchase of the Fox Energy Center. The WPS 2013 PSCW rate order did not reflect this purchase or the related termination of a power purchase agreement. However, WPS did receive PSCW approval to defer ownership costs above or below its power purchase agreement expenses in 2013. • A $3.3 million decrease in taxes other than income taxes, partially driven by the sale of UPPCO in August 2014. See Note 4, Dispositions, for more information. • A $2.9 million decrease in customer-related expenses. This was driven by the year-over-year change in the amortization of amounts recoverable from or refundable to customers related to energy efficiency, as well as the sale of UPPCO in August 2014. See Note 4, Dispositions, for more information. • A $1.3 million deferral of coal shipping costs related to minimum requirements under WPS's contracts for rail obligations. WPS received approval from the PSCW in the 2014 rate order to defer these costs. This deferral was offset by a decrease in margins. Other Expense Other expense increased $9.7 million. The primary driver was a $13.0 million increase in interest expense on long-term debt, driven by higher average outstanding long-term debt at WPS in 2014. An increase in AFUDC of $1.8 million at WPS partially offset this increase. AFUDC was higher largely due to the construction of the ReACTTM emission control technology at the Weston 3 plant and the System Modernization and Reliability Project, partially offset by environmental compliance projects at the Columbia plant completed earlier in 2014. 2013 Compared with 2012 Margins Electric utility segment margins increased $59.9 million, driven by: • An approximate $32 million increase in margins related to lower fuel and purchased power costs. The decline in purchased power costs was driven by the termination of a power purchase agreement in connection with the acquisition of Fox Energy Company LLC. WPS's retail margins were positively impacted by the reduction in the capacity charges under the agreement, which are not included in its fuel and purchased power cost recovery mechanism. This had no impact on net income as the net difference between the lower purchased power costs and the costs of owning the plant are deferred for recovery or refund in a future PSCW retail rate case (the net difference is reflected in operating expenses below). Wholesale margins also increased as a result of the acquisition. Although purchased power costs decreased, wholesale revenues subsequent to the purchase of Fox Energy Company LLC include higher operating costs resulting from the ownership of the plant (see below). • An approximate $19 million increase in margins due to a retail electric rate increase at WPS, effective January 1, 2013. See Note 25, Regulatory Environment, for more information on the 2013 PSCW rate order. • An approximate $10 million net increase in margins from residential and commercial and industrial customers due to variances related to sales volumes, including the impact of decoupling. The year-over-year impact of decoupling does not directly correlate with the year-over-year impact of the change in sales volumes, as WPS's decoupling mechanism was changed in 2013, and UPPCO did not have decoupling in 2012. See Note 25, Regulatory Environment, for more information. Partially offsetting these increases was an approximate $5 million decrease in wholesale margins driven by a decrease in sales volumes. The decrease was primarily due to a reduction in sales to one large customer. Operating Income Operating income at the electric utility segment increased $14.2 million. The increase was driven by the $59.9 million increase in margins discussed above, partially offset by a $45.7 million increase in operating expenses. The increase in operating expenses was driven by: • A $14.7 million increase in maintenance expense due to a greater number of planned outages for certain WPS generation plants in 2013, driven primarily by an outage at Weston 3. Also included in this amount is maintenance expense associated with the recently acquired Fox Energy Center. • A $9.6 million increase in depreciation and amortization expense mainly due to the acquisition of the Fox Energy Center, partially offset by a reduction in the depreciable basis of WPS's Crane Creek wind project. The reduction was the result of WPS's election to claim a Section 1603 Grant for the project in lieu of production tax credits. • A $9.5 million increase in electric transmission expense. • A $5.6 million increase due to WPS's deferral of the net difference between actual and rate case-approved costs resulting from the purchase of Fox Energy Company LLC. The WPS 2013 PSCW rate order did not reflect this purchase or the related termination of the power purchase agreement. However, WPS did receive approval from the PSCW to defer ownership costs above or below its power purchase agreement expenses for recovery or refund in a future rate case. • A $5.1 million increase in various costs associated with the acquisition and operation of the Fox Energy Center. • A $3.3 million increase in WPS's customer assistance expense, driven by the year-over-year change in the amortization of amounts recoverable from or refundable to customers related to energy efficiency. In addition, a $4.7 million increase in employee benefit expenses was more than offset by the $7.3 million positive impact of the deferral of certain components of pension and other employee benefit costs that will be recovered in a future rate proceeding as a result of the WPS 2013 PSCW rate order. The increase in employee benefit expenses was driven by a lower discount rate in 2013, which increased both the pension and other postretirement benefit expenses. Other Expense Other expense decreased $6.7 million, primarily driven by an increase in AFUDC due to environmental compliance projects at the Columbia plant. The increase in AFUDC was partially offset by an increase in interest expense driven by the financing of the purchase of Fox Energy Company LLC. Electric Transmission Investment Segment Operations 2014 Compared with 2013 Earnings from Equity Method Investments Earnings from equity method investments at the electric transmission investment segment decreased $3.4 million. The decrease resulted from lower earnings related to our approximate 34% ownership interest in ATC. In 2014, ATC recorded a reserve for an anticipated refund to customers related to a complaint filed with FERC requesting a lower return on equity for certain transmission owners. The reserve reduced our earnings from ATC by $6.6 million. 2013 Compared with 2012 Earnings from Equity Method Investments Earnings from equity method investments at the electric transmission investment segment increased $3.8 million. The increase resulted from higher earnings related to our approximate 34% ownership interest in ATC. Our income increases as ATC continues to increase its rate base by investing in transmission equipment and facilities for improved reliability and economic benefits for customers. Holding Company and Other Segment Operations 2014 Compared with 2013 Operating Loss Operating loss at the holding company and other segment decreased $2.0 million. The improvement was driven by a $5.0 million gain on the abandonment of PDI's Winnebago Energy Center, as well as a $4.6 million decrease in operating losses at ITF. Also contributing to the decrease was a $2.7 million increase in operating income at IBS driven by an increase in its return on capital charged to the utilities. Partially offsetting these decreases were $10.4 million of transaction costs recorded in 2014 related to the proposed merger with Wisconsin Energy Corporation. Other Expense Other expense at the holding company and other segment increased $4.9 million. The increase was primarily due to an $11.0 million increase in interest expense on long-term debt, driven by the issuance of $400.0 million of Junior Subordinated Notes in August 2013. This increase was partially offset by a $3.5 million gain on the sale of land at the holding company, as well as a $2.0 million unrealized gain recorded on exchange-traded funds in 2014. In July 2014, exchange-traded funds previously held by IBS were transferred to the rabbi trust at the holding company. See Note 18, Employee Benefit Plans, for more information. Prior to July 2014, the unrealized gains (losses) on these investments were allocated to the other operating segments. 2013 Compared with 2012 Operating Loss Operating loss at the holding company and other segment increased $4.0 million. Included in this amount is a $2.0 million increase in operating losses at ITF, as well as miscellaneous items at the holding company. Other Expense Other expense at the holding company and other segment decreased $0.5 million. The decrease was driven by $4.0 million of excise tax credits recorded at ITF in 2013 as a result of the American Taxpayer Relief Act of 2012, partially offset by a $2.1 million increase in interest expense, driven by the issuance of $400.0 million of Junior Subordinated Notes during August 2013. Provision for Income Taxes 2014 Compared with 2013 Our effective tax rate increased in 2014. This increase was primarily due to a $13.0 million expense caused by the remeasurement of deferred taxes related to the sale of IES's retail energy business. 2013 Compared with 2012 Our effective tax rate increased in 2013. In the fourth quarter of 2012, we elected to claim and subsequently received a Section 1603 Grant for WPS's Crane Creek wind project in lieu of production tax credits (PTCs). As a result, we no longer claim wind PTCs on any of our qualifying facilities. In 2012, our effective tax rate was also lowered by the effective settlement of certain state income tax examinations and remeasurements of uncertain tax positions included in our liability for unrecognized tax benefits. We decreased our provision for income taxes by $8.1 million in 2012, primarily related to these items. We also decreased our provision for income taxes by $5.9 million in 2012 as a result of WPS's 2013 rate case settlement agreement. WPS recorded a regulatory asset after the settlement agreement authorized recovery of deferred income taxes expensed in previous years in connection with the 2010 federal health care reform. See Note 25, Regulatory Environment, for more information. The increase in the effective tax rate was partially offset by a $3.7 million reduction in the provision for income taxes in 2013 due to the reversal of a regulatory liability. Deferred income taxes that had been recorded in prior years were reversed as a result of the treatment of scheduled income tax rate changes in Illinois in our final 2013 rate order. For information on changes in the deferred income tax balances, see Note 16, Income Taxes. Discontinued Operations 2014 Compared with 2013 Earnings from discontinued operations, net of tax, decreased $85.5 million in 2014. These lower earnings were primarily driven by a decrease of $82.1 million related to the operations of IES's retail energy business, which was sold in November 2014. Included in this amount was a $46.6 million after-tax decrease in net unrealized gains on derivative contracts. In addition, we realized a $17.3 million after-tax loss on the sale in November 2014. See Note 4, Dispositions, for more information. 2013 Compared with 2012 Earnings from discontinued operations, net of tax, increased $41.9 million in 2013. These higher earnings were primarily driven by an increase of $27.4 million related to the operations of IES's retail energy business, which was sold in November 2014. See Note 4, Dispositions, for more information. In 2013 and 2012, we also remeasured uncertain tax positions included in our liability for unrecognized tax benefits after effectively settling certain state income tax examinations. Discontinued operations increased $4.1 million as a result of these remeasurements. Finally, in 2012, we recognized after-tax losses from discontinued operations of $6.9 million related to WPS Westwood Generation, LLC (Westwood) and $4.0 million related to WPS Beaver Falls Generation, LLC (Beaver Falls) and WPS Syracuse Generation, LLC (Syracuse). We sold Westwood in November 2012 and Beaver Falls and Syracuse in March 2013. These losses were partially driven by the $5.7 million of after-tax impairment losses related to Westwood, Beaver Falls, and Syracuse recognized in 2012 when the generation facilities met the criteria for discontinued operations. See Note 4, Dispositions, for more information. LIQUIDITY AND CAPITAL RESOURCES We believe we have adequate resources to fund ongoing operations and future capital expenditures. These resources include cash balances, liquid assets, operating cash flows, access to equity and debt capital markets, and available borrowing capacity under existing credit facilities. Our borrowing costs can be impacted by short-term and long-term debt ratings assigned by independent credit rating agencies, as well as the market rates for interest. Our operating cash flows and access to capital markets can be impacted by macroeconomic factors outside of our control. Operating Cash Flows 2014 Compared with 2013 During 2014, net cash provided by operating activities was $601.4 million, compared with $554.9 million during 2013. The $46.5 million increase in net cash provided by operating activities was driven by: • A $1,538.6 million increase in cash collections from customers, mainly due to rate increases at the utilities, higher commodity prices, an increase in electric wholesale revenues, and colder weather in 2014. Included in the electric utility rate increase was the impact of the increase in rate base related to owning and operating the Fox Energy Center. • The positive year-over-year impact of a $50.0 million payment in 2013 for WPS's early termination of a tolling agreement in connection with the purchase of Fox Energy Company LLC. • A $27.0 million increase in cash from customer prepayments and credit balances. In 2013, cash received in relation to amounts billed was lower because customer prepayments had grown during an unusually warm 2012. These increases in cash were partially offset by: • A $1,274.2 million decrease in cash due to higher costs of natural gas, fuel, and purchased power in 2014. Additional cash was used in 2014 due to higher energy prices and the colder weather. • A $159.7 million decrease in cash due to increased operating and maintenance costs in 2014. The increase in operating and maintenance costs was driven by higher natural gas distribution costs at PGL related to compliance activities, higher electric utility maintenance from planned major outages at WPS, and other higher WPS costs associated with owning and operating the Fox Energy Center beginning in March 2013. • A $48.8 million decrease in cash driven by lower collateral requirements at IES in 2014. We sold IES's retail energy business in November 2014. • A $31.8 million increase in contributions to pension and other postretirement benefit plans. • A $30.7 million increase in cash paid for interest, primarily driven by higher average outstanding long-term debt in 2014. • An $11.1 million decrease in cash received for income taxes, partially driven by cash paid for income taxes related to the gain on the sale of UPPCO in August 2014. This decrease in cash was partially offset by a federal income tax refund received in the first quarter of 2014 for an amended return. • A $9.0 million decrease in cash from various deferrals at WPS, primarily for system support resource costs, precertification costs for a potential new natural gas combined cycle generating unit, and the net difference between actual and rate case-approved costs resulting from the purchase of the Fox Energy Center. • A $5.4 million increase in cash used for environmental remediation activities. 2013 Compared with 2012 During 2013, net cash provided by operating activities was $554.9 million, compared with $573.8 million million during 2012. The $18.9 million decrease in net cash provided by operating activities was largely driven by: • A $74.9 million increase in cash used to purchase natural gas that was injected into storage. The increase was driven by higher natural gas prices in 2013. • A $50.0 million payment in 2013 for WPS's early termination of a tolling agreement in connection with the purchase of Fox Energy Company LLC. • A $42.8 million decrease in cash received from income taxes, primarily driven by a federal income tax refund received in 2012 for a net operating loss incurred in 2010 that was carried back to a prior year. The 2010 net operating loss was driven by bonus tax depreciation. • A $34.3 million decrease in cash related to customer prepayments and credit balances due to higher natural gas prices and higher sales volumes in 2013. • A $24.2 million decrease in cash at PGL and NSG due to natural gas cost under-collection activity with customers in 2013 versus natural gas cost over-collection activity with customers in 2012. The year-over-year change was driven by higher natural gas prices and higher sales volumes in 2013. • A $7.3 million decrease in cash year-over-year driven by lower collateral requirements in 2012 at IES. Collateral requirements are based on forward positions with counterparties. These decreases in cash were partially offset by: • A $210.9 million decrease in contributions to pension and other postretirement benefit plans. • A $9.5 million increase in cash from a settlement received by IES related to certain Seams Elimination Charge Adjustment payments made in prior years to a transmission provider. Investing Cash Flows 2014 Compared with 2013 During 2014, net cash used for investing activities was $336.5 million, compared with $1,022.7 million during 2013. The $686.2 million decrease in net cash used for investing activities was primarily due to: • The positive year-over-year impact of cash used to purchase two businesses in 2013. WPS purchased Fox Energy Company LLC for $391.6 million, and IES purchased Compass Energy Services for $15.7 million in 2013. See Note 3, Acquisitions, for more information on the Fox Energy Company LLC acquisition. • The receipt of proceeds of $336.5 million in 2014 related to the sale of UPPCO. See Note 4, Dispositions, for more information. • The receipt of proceeds of $311.6 million in 2014 related to the sale of IES. See Note 4, Dispositions, for more information. These decreases in cash used were partially offset by: • A $195.8 million increase in cash used for capital expenditures other than the Fox Energy Center acquisition discussed above. • A $115.5 million increase in cash used due to the required funding of the rabbi trust for deferred compensation and certain nonqualified pension plans. The proposed merger with Wisconsin Energy Corporation qualified as a potential change in control event under the rabbi trust agreement, which required the funding of the rabbi trust. See Note 2, Proposed Merger with Wisconsin Energy Corporation, for more information about the merger. • The year-over-year negative impact of the receipt of a $69.0 million Section 1603 Grant for the Crane Creek wind project in 2013. 2013 Compared with 2012 During 2013, net cash used for investing activities was $1,022.7 million, compared with $602.6 million during 2012. The $420.1 million increase in net cash used for investing activities was primarily due to $391.6 million of cash used in 2013 for WPS's purchase of Fox Energy Company LLC. IES also purchased Compass Energy Services, which increased net cash used for investing activities by $15.7 million. See Note 3, Acquisitions, for more information regarding these purchases. Also contributing to the increase was a $74.8 million increase in cash used to fund other capital expenditures (discussed below). These increases in net cash used were partially offset by the receipt of a $69.0 million Section 1603 Grant for WPS's Crane Creek wind project in 2013. Capital Expenditures Capital expenditures by business segment for the year ended December 31 were as follows: 2014 Compared with 2013 The increase in capital expenditures at the natural gas utility segment was primarily due to work on the AMRP at PGL. Capital expenditures related to distribution, transmission, and natural gas storage also contributed to the increase. The decrease in capital expenditures at the electric utility segment was primarily due to WPS's purchase of Fox Energy Company LLC in 2013. Capital expenditures related to environmental compliance projects at the Columbia plant also decreased in 2014. Increased expenditures in 2014 related to the ReACTTM project at Weston 3 and the System Modernization and Reliability Project partially offset the decrease. The increase in capital expenditures at the holding company was due to increased expenditures for software projects and office leasehold improvements. 2013 Compared with 2012 The increase in capital expenditures at the electric utility segment was primarily due to WPS's purchase of Fox Energy Company LLC in 2013. Capital expenditures at the electric utility segment also increased related to WPS's ReACT™ project at Weston 3. The increase in capital expenditures at the holding company and other segment was primarily due to increased software project expenditures, partially offset by a decrease in solar investments. Financing Cash Flows 2014 Compared with 2013 During 2014, net cash used for financing activities was $269.2 million, compared with net cash provided by financing activities of $462.7 million during 2013. The $731.9 million year-over-year negative impact from financing activities was driven by: • A $785.5 million net decrease in cash due to a $974.0 million decrease in the issuance of long-term debt, which was partially offset by a $188.5 million decrease in the repayment of long-term debt. The issuance of long-term debt in 2013 was partially used to finance the acquisition of Fox Energy Company LLC. • A $140.9 million increase in cash used to purchase shares of our common stock on the open market to satisfy requirements of our Stock Investment Plan and certain stock-based employee benefit and compensation plans. We began purchasing shares of our common stock on the open market starting in February 2014 as well as for a short period during the first quarter of 2013. These decreases in cash were partially offset by: • A $148.0 million increase in cash due to lower net repayments of commercial paper in 2014. • A $47.1 million increase in cash due to higher stock option exercises in 2014. 2013 Compared with 2012 During 2013, net cash provided by financing activities was $462.7 million, compared with $28.1 million during 2012. The $434.6 million increase in cash provided by financing activities was driven by: • A $687.7 million net increase in cash due to a $746.0 million increase in the issuance of long-term debt, which was partially offset by an $58.3 million increase in the repayment of long-term debt. The issuance of long-term debt in 2013 included replacing WPS's borrowing of $200.0 million under its term credit facility in 2013, among other things. The cash proceeds from the term credit facility were used to partially finance the acquisition of Fox Energy Company LLC. • An $87.9 million decrease in cash used to purchase shares of our common stock on the open market to satisfy requirements of our Stock Investment Plan and certain stock-based employee benefit and compensation plans. We began issuing new shares to meet these obligations in February 2013. These increases were partially offset by a $335.5 million decrease in cash from $156.4 million of net repayments of commercial paper in 2013, compared with $179.1 million of net borrowings in 2012. Significant Financing Activities The following table provides a summary of common stock activity to meet the requirements of our Stock Investment Plan and certain stock-based employee benefit and compensation plans. Under the merger agreement with Wisconsin Energy Corporation, we cannot issue shares of our common stock. For information on short-term debt, see Note 13, Short-Term Debt and Lines of Credit. For information on long-term debt, see Note 14, Long-Term Debt. Credit Ratings Our current credit ratings and the credit ratings for WPS, PGL, and NSG are listed in the table below: Credit ratings are not recommendations to buy or sell securities. They are subject to change, and each rating should be evaluated independently of any other rating. On September 18, 2014, Moody's raised the senior unsecured debt rating to "A3" from "Baa1" and the junior subordinated notes rating to "Baa1" from "Baa2" for Integrys Energy Group. The upgrade in ratings reflected Moody's view that the sale of the IES retail energy business will markedly improve our business risk profile and result in more reliable and stable operating cash flows going forward from our utility operations. On January 31, 2014, Moody's confirmed the credit ratings for Integrys Energy Group and raised the credit ratings for WPS, PGL, and NSG. The issuer rating was raised to "A1" from "A2" for WPS and to "A2" from "A3" for both PGL and NSG. WPS's first mortgage bonds rating was raised to "Aa2" from "Aa3." The senior secured debt rating was raised to "Aa2" from "Aa3" for WPS and to "Aa3" from "A1" for PGL. The preferred stock rating for WPS was raised to "A3" from "Baa1." Finally, PGL's commercial paper rating was raised to "P-1" from "P-2." The upgrade in ratings of the utilities reflects Moody's views of the regulatory provisions in Wisconsin and Illinois that are consistent with a generally improving regulatory environment for electric and natural gas utilities in the United States. Future Capital Requirements and Resources Contractual Obligations The following table shows our contractual obligations as of December 31, 2014, including those of our subsidiaries: (1) Represents bonds and notes issued, as well as loans made to us and our subsidiaries. We record all principal obligations on the balance sheet. For purposes of this table, it is assumed that the current interest rates on variable rate debt will remain in effect until the debt matures. (2) The costs of energy and transportation purchase obligations are expected to be recovered in future customer rates. (3) Includes obligations related to normal business operations and large construction obligations. (4) Obligations for pension and other postretirement benefit plans, other than the Integrys Energy Group Retirement Plan, cannot reasonably be estimated beyond 2016. The proposed merger with Wisconsin Energy Corporation qualified as a potential change in control event under the rabbi trust agreement and triggered the full funding of our deferred compensation obligation and our obligation for certain nonqualified pension plans. As a result, obligations of $7.0 million will be funded through a transfer of assets from the rabbi trust for certain nonqualified pension plans in 2015. The table above does not reflect estimated future payments related to the manufactured gas plant remediation liability of $579.7 million at December 31, 2014, as the amount and timing of payments are uncertain. We expect to incur costs annually to remediate these sites. See Note 17, Commitments and Contingencies, for more information about environmental liabilities. The table also does not reflect estimated future payments for the December 31, 2014 liability of $2.7 million related to unrecognized tax benefits, as the amount and timing of payments are uncertain. See Note 16, Income Taxes, for more information about unrecognized tax benefits. Capital Requirements As of December 31, 2014, our projected capital expenditures by segment for 2015 through 2017 were as follows: * This primarily relates to the installation of ReACTTM emission control technology at Weston 3. We expect to provide capital contributions to ATC (not included in the above table) of approximately $53 million from 2015 through 2017. All projected capital and investment expenditures are subject to periodic review and may vary significantly from the estimates, depending on a number of factors. These factors include, but are not limited to, environmental requirements, regulatory constraints and requirements, changes in tax laws and regulations, acquisition and development opportunities, market volatility, and economic trends. Capital Resources Management prioritizes the use of capital and debt capacity, determines cash management policies, uses risk management strategies to hedge the impact of volatile commodity prices, and makes decisions regarding capital requirements in order to manage our liquidity and capital resource needs. We plan to meet our capital requirements for the period 2015 through 2017 primarily through internally generated funds (net of forecasted dividend payments), dividends from our subsidiaries, and debt and equity financings. We plan to keep debt to equity ratios at levels that can support current credit ratings and corporate growth. Under an existing shelf registration statement, we may issue debt, equity, certain types of hybrid securities, and other financial instruments with amounts, prices, and terms to be determined at the time of future offerings. However, under the merger agreement with Wisconsin Energy Corporation (Wisconsin Energy), we cannot issue shares of our common stock. WPS currently has a shelf registration statement under which it may issue up to $500.0 million of additional senior debt securities and/or first mortgage bonds. Amounts, prices, and terms will be determined at the time of future offerings. Under the merger agreement with Wisconsin Energy, WPS and PGL cannot issue long-term debt in excess of $300 million and $250 million, respectively, in 2015 without Wisconsin Energy's approval. We reduced the size of our credit facilities by $350 million during the fourth quarter of 2014 due to the sale of IES. We expect to reduce the credit facilities further in 2015 as the remaining credit support at IES is fully transferred to Exelon Generation Company, LLC. At December 31, 2014, we and each of our subsidiaries were in compliance with all covenants related to outstanding short-term and long-term debt. We expect to be in compliance with all such debt covenants for the foreseeable future. See Note 13, Short-Term Debt and Lines of Credit, for more information on credit facilities and other short-term credit agreements. See Note 14, Long-Term Debt, for more information on long-term debt. Various laws, regulations, and financial covenants impose restrictions on the ability of certain of our utility subsidiaries to transfer funds to us in the form of dividends. Our utility subsidiaries, with the exception of MGU, are prohibited from loaning funds to us, either directly or indirectly. Although these restrictions limit the amount of funding the various operating subsidiaries can provide to us, management does not believe these restrictions will have a significant impact on our ability to access cash for payment of dividends on common stock or other future funding obligations. See Note 20, Common Equity, for more information on dividend restrictions. Other Future Considerations Potential Addition of an Electric Generator at the Fox Energy Center Site In 2013, WPS announced a need for an additional 400 to 500 megawatts (MW) of electric generating capacity by 2019 to meet the energy needs of its customers. After evaluating various options, WPS proposed building a new 400-MW natural gas-fired, combined-cycle generating unit for approximately $517 million to be located at its Fox Energy Center site. In January 2015, WPS filed an application with the PSCW for a Certificate of Public Convenience and Necessity. The approval process involves months of PSCW study and review, as well as technical and public hearings with a decision expected by the end of 2015. If approved in that time frame, construction will begin in 2016 with plans for the new unit to be operational in 2019. Presque Isle System Support Resource (SSR) Costs In August 2013, Wisconsin Electric Power Company (Wisconsin Electric Power) notified MISO of its intention to suspend the operation of Units 5 through 9 of its Presque Isle generating facility for 16 months, starting February 1, 2014. MISO notified Wisconsin Electric Power in October 2013 that the Presque Isle facilities are required for reliability and would be SSR-designated. Under the terms of the SSR Tariff, in exchange for keeping the units in service, MISO compensates Wisconsin Electric Power by allocating the SSR costs associated with the operation of the Presque Isle units to regulated and nonregulated load-serving entities, including WPS, based on load ratio share within the ATC footprint. On February 17, 2015, Wisconsin Electric Power notified MISO of its intent to rescind its decision to retire the Presque Isle Facility and requested termination of the SSR agreement, effective February 1, 2015. This intent to rescind was driven by a settlement agreement related to the proposed merger between Wisconsin Energy Corporation and us (described below under the heading “Proposed Sale of WPS Michigan Electric Assets”). On February 18, 2015, MISO filed to terminate the SSR agreement effective February 1, 2015. The FERC has not yet addressed these requests. SSR costs for WPS retail customers will be deferred until December 31, 2015, based on an April 2013 order from the PSCW. At that time, the PSCW will determine the appropriate ratemaking treatment. As of December 31, 2014, there were no material SSR costs for WPS retail customers deferred for future recovery under the currently approved allocation method. SSR costs for Michigan customers are being recovered through the Power Supply Cost Recovery mechanism. SSR costs for WPS's wholesale customers are being recovered through formula rates. Proposed Sale of WPS Michigan Electric Assets In January 2015, Wisconsin Energy Corporation (Wisconsin Energy) entered into an agreement with the Governor of Michigan, the Attorney General of Michigan, the MPSC staff, and Cliffs Natural Resources, Inc. to resolve these parties' objections to the proposed merger between Wisconsin Energy and us. The agreement is contingent upon the settlement of a series of additional agreements. One of the agreements includes the sale of the Presque Isle facility currently owned by Wisconsin Energy, as well as the Michigan electric distribution assets of Wisconsin Energy and WPS, to UPPCO. The sale of these assets is subject to approval from the MPSC, PSCW, FERC, Federal Communications Commission, and Committee on Foreign Investment in the United States, as well as the requirements of the Hart-Scott-Rodino Act. The sale of the WPS electric distribution assets is contingent upon the close of the merger between Wisconsin Energy and us. See Note 2, Proposed Merger with Wisconsin Energy Corporation, for more information. MISO Transmission Owner Return on Equity Complaint In November 2013, a group of MISO industrial customer organizations filed a complaint with the FERC requesting, among other things, to reduce the base return on equity (ROE) used by MISO transmission owners, including ATC, to 9.15%. ATC's current authorized ROE is 12.2%. In October 2014, the FERC issued an order to hear the complaint on ROE and set a refund effective date retroactive to November 12, 2013. However, the FERC denied all other aspects of the complaint, including that the use of capital structures that include more than 50% common equity is unjust and unreasonable. The FERC ordered preliminary hearings to begin and expects to issue an initial decision by November 30, 2015. In October 2014, the FERC also issued an order, in regard to a similar complaint, to reduce the base ROE for New England transmission owners from their existing rate of 11.14% to 10.57%. The FERC used a revised method for determining the appropriate ROE for FERC-jurisdictional electric utilities, which incorporates both short-term and long-term measures of growth in dividends. The FERC has stated that it expects future decisions on pending complaints related to similar ROE issues will be guided by the New England transmission decision. Any change to ATC's ROE could result in lower equity earnings and dividends from ATC in the future. Although we are currently unable to determine how the FERC may rule in this complaint, we believe it is probable that a refund will be required upon resolution of this issue. As a result, our equity earnings and corresponding equity method investment in ATC reflected an estimated $6.6 million pretax reduction for 2014. Wisconsin Fuel Rule Under-collection "Cap" WPS uses a "fuel window" mechanism to recover fuel and purchased power costs for its Wisconsin retail electric operations. Under the fuel window rule, actual fuel and purchased power costs that exceed a 2% variance from costs included in the rates charged to customers are deferred for recovery or refund. However, if the deferral of costs in a given year would cause WPS to earn a greater return on common equity than authorized by the PSCW, the recovery of under-collected fuel and purchased power costs would be reduced by the amount the return exceeds the authorized amount by the PSCW. This is a possibility in any given year; however, this provision of the fuel rule did not have an impact on WPS in 2014. Decoupling In 2012, the Illinois Attorney General and Citizens Utility Board appealed the ICC's authority to approve PGL's and NSG's permanent decoupling mechanism. As a result, revenues collected under this mechanism were potentially subject to refund. In 2012, PGL and NSG established offsetting reserves equal to decoupling amounts accrued. In March 2013, the Illinois Appellate Court affirmed the ICC's authority to approve the permanent decoupling mechanism. Therefore, the reserves recorded in 2012 were reversed in the first quarter of 2013. In June 2013, the Illinois Attorney General and Citizens Utility Board petitioned the Illinois Supreme Court to review the Court's decision. In January 2015, the Illinois Supreme Court affirmed the ICC's authority to approve the permanent decoupling mechanism. As a result, decoupling amounts recorded in 2014 will be refunded to customers in 2015 as planned, and decoupling amounts in the future will continue to be accrued. See Note 25, Regulatory Environment, for more information on all of our subsidiaries' decoupling mechanisms. Climate Change The EPA began regulating greenhouse gas emissions under the Clean Air Act in January 2011 by applying the Best Available Control Technology (BACT) requirements (associated with the New Source Review program) to new and modified larger greenhouse gas emitters. Technology to remove and sequester greenhouse gas emissions is not commercially available at scale. Therefore, the EPA issued guidance that defines BACT in terms of improvements in energy efficiency as opposed to relying on pollution control equipment. In March 2012, the EPA issued a proposed rule that would impose a carbon dioxide emission rate limit on new electric generating units. In September 2013, the EPA re-proposed rules related to emission limits on new electric generating units, and the EPA is expected to finalize them in the middle of 2015. The proposed emission rate limits may not be achievable for coal-fired plants until applicable technology becomes commercially available. In June 2014, the EPA issued a proposed rule establishing greenhouse gas performance standards for modified and reconstructed power plants. Comments on this proposal were due in October 2014, and are currently being reviewed. Also, in June 2014, the EPA released a proposed rule establishing greenhouse gas performance standards for existing power plants. The proposal applies to “affected electric generating units,” which includes our WPS coal-fired units at Weston and Pulliam plus the natural gas-fired Fox Energy Center. The EPA is proposing state-specific emission reduction goals. States would be required to meet an “interim goal” on average over the ten-year period from 2020 through 2029 and a “final goal” in 2030, which will achieve a nationwide emission reduction of about 30% from 2005 levels. In the proposed rule, the state of Wisconsin is assigned a relatively aggressive reduction goal, which, if adopted as final, could significantly increase costs for our customers. Consequently, we are working with the other state utilities, the WDNR, the PSCW, and other stakeholders to evaluate the potential impacts and develop comments and suggested revisions for the EPA's consideration. The EPA intends to issue final rules in the summer of 2015. State implementation plans are due by June 30, 2016, with the possibility of extensions to 2017 for a state-specific plan and to 2018 if they are using a multistate approach. Facility compliance deadlines will be included in the final state plans. A risk exists that any greenhouse gas legislation or regulation will increase the cost of producing energy using fossil fuels. However, we believe that capital expenditures being made at our plants are appropriate under any reasonable mandatory greenhouse gas program. We also believe that our future expenditures that may be required to control greenhouse gas emissions or meet renewable portfolio standards will be recoverable in rates. We will continue to monitor and manage potential risks and opportunities associated with future greenhouse gas legislative or regulatory actions. The majority of our generation and distribution facilities are located in the upper Midwest region of the United States. The same is true for most of our customers' facilities. The physical risks, if any, posed by climate change for this area are not expected to be significant at this time. Ongoing evaluations will be conducted as more information on the extent of such physical changes becomes available. Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) The Dodd-Frank Act was signed into law in July 2010. Some, but not all of the Commodity Futures Trading Commission (CFTC) rulemakings to implement the new law, which are essential to the Dodd-Frank Act's new framework for swaps regulation, have become effective or are becoming effective for certain companies and certain transactions. However, some of the key rules have not been finalized yet or are subject to ongoing interpretations, clarifications, no-action letters, and other guidance being issued by the CFTC and its staff. As a result, it is difficult to evaluate in a comprehensive way how the CFTC's final Dodd-Frank Act rules will ultimately affect us. Certain provisions of the Dodd-Frank Act relating to derivatives and the CFTC's proposed rules could significantly increase our regulatory costs and/or collateral requirements or limit our ability to enter into or maintain certain derivative positions, which we use to hedge commercial risks. We continue to monitor developments related to the Dodd-Frank Act rulemakings and their potential impact on our future financial results. We have implemented or modified compliance policies and procedures to address the requirements of the Dodd-Frank Act rules that have taken effect to date. OFF BALANCE SHEET ARRANGEMENTS See Note 22, Guarantees, for information regarding guarantees. CRITICAL ACCOUNTING POLICIES AND ESTIMATES We have determined that the following accounting policies and estimates are critical to the understanding of our financial statements because their application requires significant judgment and reliance on estimations of matters that are inherently uncertain. Our management has discussed these critical accounting policies and estimates with the Audit Committee of the Board of Directors. Goodwill Impairment We completed our annual goodwill impairment tests for all of our reporting units that carried a goodwill balance as of April 1, 2014. No impairments were recorded as a result of these tests. For all of our reporting units, the fair value calculated in step one of the test was greater than the carrying value. The fair value was calculated using an equal weighting of the income approach and the market approach. For the income approach, we used internal forecasts to project cash flows. Any forecast contains a degree of uncertainty, and changes in these cash flows could significantly increase or decrease the fair value of a reporting unit. For the regulated reporting units, a fair recovery of and return on costs prudently incurred to serve customers is assumed. An unfavorable outcome in a rate case could cause the fair value of these reporting units to decrease. Key assumptions used in the income approach included return on equity (ROE) for the regulated reporting units, long-term growth rates used to determine terminal values at the end of the discrete forecast period, and discount rates. The discount rate is applied to estimated future cash flows and is one of the most significant assumptions used to determine fair value under the income approach. As interest rates rise, the calculated fair values will decrease. The discount rate is determined based on the weighted-average cost of capital for each reporting unit, taking into account both the after-tax cost of debt and cost of equity. The terminal year ROE for each utility is based on its current allowed ROE adjusted for forecasted disallowed costs and expectations regarding the direction and magnitude of movements in interest rates. The terminal growth rate is based on a combination of historical and forecasted statistics for real gross domestic product and personal income for each utility service area. We used the guideline company method for the market approach. This method uses metrics from similar publicly traded companies in the same industry to determine how much a knowledgeable investor in the marketplace would be willing to pay for an investment in a similar company. We applied multiples derived from these guideline companies to the appropriate operating metric for the utility reporting units to determine indications of fair value. The underlying assumptions and estimates used in the impairment test are made as of a point in time. Subsequent changes in these assumptions and estimates could change the results of the test. The fair values of the WPS natural gas utility and ITF reporting units exceeded the carrying values by a substantial amount. Based on these results, these reporting units are not at risk of failing step one of the goodwill impairment test. The fair values calculated in the first step of the test for MERC, MGU, NSG, and PGL exceeded the carrying values by approximately 4% to 18%. Due to the subjectivity of the assumptions and estimates underlying the impairment analyses, we cannot provide assurance that future analyses will not result in impairments. As a result, we performed a sensitivity analysis on key assumptions for these reporting units. The following table shows the change in each assumption, holding all other inputs constant, which would result in a fair value at or below carrying value, causing the applicable reporting unit to fail step one of the test. Failing step one would result in a goodwill impairment that could be material, as the carrying value of the identifiable assets and liabilities is considered fair value for regulated companies. This is because a regulator would typically not allow the assets and liabilities of a regulated company to be increased or decreased, allowing for a change in recovery from ratepayers, as a result of an acquisition or other change in ownership. If the carrying value exceeds the calculated fair value of the reporting unit, the excess would be recorded as a goodwill impairment. * Even with a terminal year growth rate of 0%, assuming all other inputs remained constant, PGL would still have passed the first step of the goodwill impairment test. In June 2014, IES performed an interim goodwill impairment analysis. This interim analysis was triggered by the announcement of the plan to sell IES's retail energy business. Based on the results of the interim goodwill impairment analysis, IES recorded a non-cash goodwill impairment loss of $6.7 million in the second quarter of 2014. In November 2014, IES's retail energy business was sold to Exelon Generation Company, LLC. See Note 4, Dispositions, for more information. Our goodwill balances by reporting unit were as follows at December 31, 2014: Accrued Unbilled Revenues We accrue estimated amounts of revenues for services provided or energy delivered but not yet billed to customers. Estimated unbilled revenues are calculated using a variety of judgments and assumptions related to customer class, contracted rates, weather, and customer use. Significant changes in these judgments and assumptions could have a material impact on our results of operations. At December 31, 2014, and 2013, our unbilled revenues were $269.4 million and $286.4 million, respectively. The amount of unbilled revenues can vary significantly from period to period as a result of numerous factors, including seasonality, weather, customer use patterns, commodity prices, and customer mix. Pension and Other Postretirement Benefits The costs of providing noncontributory defined benefit pension benefits and other postretirement benefits, described in Note 18, Employee Benefit Plans, are dependent on numerous factors resulting from actual plan experience and assumptions regarding future experience. Pension and other postretirement benefit costs are impacted by actual employee demographics (including age, compensation levels, and employment periods), the level of contributions made to the plans, and earnings on plan assets. Pension and other postretirement benefit costs may be significantly affected by changes in key actuarial assumptions, including anticipated rates of return on plan assets, discount rates, mortality rates, and expected health care cost trends. Changes made to the plan provisions may also impact current and future pension and other postretirement benefit costs. Pension and other postretirement benefit plan assets are primarily made up of equity and fixed income investments. Fluctuations in actual equity and fixed income market returns, as well as changes in general interest rates, may result in increased or decreased benefit costs in future periods. We believe that such changes in costs would be recovered or refunded at the utility segments through the ratemaking process. The following table shows how a given change in certain actuarial assumptions would impact the projected benefit obligation and the reported net periodic pension cost. Each factor below reflects an evaluation of the change based on a change in that assumption only. The following table shows how a given change in certain actuarial assumptions would impact the accumulated other postretirement benefit obligation and the reported net periodic other postretirement benefit cost. Each factor below reflects an evaluation of the change based on a change in that assumption only. In the fourth quarter of 2014, the Society of Actuaries published a new set of mortality tables, which updated life expectancy assumptions. We have adjusted the tables to better reflect our plan-specific mortality experience and other general assumptions. We have incorporated the revised mortality tables into the projected pension and other postretirement benefit obligation at December 31, 2014. The revised mortality assumptions will not have a material impact on our projected pension and other postretirement benefit obligations or costs. The discount rates are selected based on hypothetical bond portfolios consisting of noncallable (or callable with make-whole provisions), noncollateralized, high-quality corporate bonds with maturities between 0 and 30 years. The bonds are generally rated "Aa" with a minimum amount outstanding of $50.0 million. From the hypothetical bond portfolios, a single rate is determined that equates the market value of the bonds purchased to the discounted value of the plans' expected future benefit payments. We establish our expected return on asset assumption based on consideration of historical and projected asset class returns, as well as the target allocations of the benefit trust portfolios. The assumed long-term rate of return was 8.00% in both 2014 and 2013 and 8.25% in 2012. The actual rate of return on pension plan assets, net of fees, was 6.3%, 15.1%, and 14.3%, in 2014, 2013, and 2012, respectively. The determination of expected return on qualified plan assets is based on a market-related valuation of assets, which reduces year-to-year volatility, and is estimated using the following approaches by plan. For plans sponsored by IBS and WPS, we use the calculated value approach. For plans sponsored by PELLC, we use the fair market value approach. Cumulative gains and losses in excess of 10% of the greater of the pension or other postretirement benefit obligation or market-related value are amortized over the average remaining future service to expected retirement ages. Changes in realized and unrealized investment gains and losses are recognized over the subsequent five years for plans sponsored by WPS. However, for plans sponsored by IBS and PELLC, only differences between actual investment returns and the expected returns on plan assets are recognized over a five-year period. Under this method, the future value of assets is impacted as previously deferred gains or losses are included in market-related value. In selecting assumed health care cost trend rates, past performance and forecasts of health care costs are considered. For more information on health care cost trend rates and a table showing future payments that we expect to make for our pension and other postretirement benefits, see Note 18, Employee Benefit Plans. Regulatory Accounting Our natural gas and electric utility segments follow the guidance under the Regulated Operations Topic of the FASB ASC. Our financial statements reflect the effects of the ratemaking principles followed by the various jurisdictions regulating these utilities. Certain items that would otherwise be immediately recognized as revenues and expenses are deferred as regulatory assets and regulatory liabilities for future recovery or refund to customers, as authorized by our regulators. Future recovery of regulatory assets is not assured and is generally subject to review by regulators in rate proceedings for matters such as prudence and reasonableness. Once approved, the regulatory assets and liabilities are amortized into earnings over the rate recovery period. If recovery or refund of costs is not approved or is no longer considered probable, these regulatory assets or liabilities are recognized in current period earnings. Management regularly assesses whether these regulatory assets and liabilities are probable of future recovery or refund by considering factors such as changes in the regulatory environment, earnings at the natural gas and electric utility segments, and the status of any pending or potential deregulation legislation. The application of the Regulated Operations Topic of the FASB ASC would be discontinued if all or a separable portion of our natural gas and electric utility segments' operations no longer meet the criteria for application. Assets and liabilities recognized as a result of rate regulation would be written off as extraordinary items in income for the period in which the discontinuation occurred. A write-off of all our regulatory assets and regulatory liabilities at December 31, 2014, would result in a 14.5% decrease in total assets and a 7.0% decrease in total liabilities. The two largest regulatory assets at December 31, 2014, are related to environmental remediation costs and unrecognized pension and other postretirement benefit costs. A write-off of the regulatory asset related to environmental remediation costs at December 31, 2014, would result in a 5.6% decrease in total assets. A write-off of the unrecognized pension and other postretirement benefit related regulatory asset at December 31, 2014, would result in a 4.5% decrease in total assets. See Note 9, Regulatory Assets and Liabilities, for more information. Income Tax Provision We are required to estimate income taxes for each of the jurisdictions in which we operate as part of the process of preparing consolidated financial statements. This process involves estimating current income tax liabilities together with assessing temporary differences resulting from differing treatment of items, such as depreciation, for income tax and accounting purposes. These differences result in deferred income tax assets and liabilities, which are included within our balance sheets. We also assess the likelihood that our deferred income tax assets will be recovered through future taxable income. To the extent we believe that realization is not likely, we establish a valuation allowance, which is offset by an adjustment to the provision for income taxes in the income statements. Uncertainty associated with the application of tax statutes and regulations and the outcomes of tax audits and appeals requires that judgments and estimates be made in the accrual process and in the calculation of effective tax rates. Only income tax benefits that meet the "more likely than not" recognition threshold may be recognized or continue to be recognized. Unrecognized tax benefits are re-evaluated quarterly and changes are recorded based on new information, including the issuance of relevant guidance by the courts or tax authorities and developments occurring in the examinations of our tax returns. Significant management judgment is required in determining our provision for income taxes, deferred income tax assets and liabilities, the liability for unrecognized tax benefits, and any valuation allowance recorded against deferred income tax assets. The assumptions involved are supported by historical data, reasonable projections, and interpretations of applicable tax laws and regulations across multiple taxing jurisdictions. Significant changes in these assumptions could have a material impact on our financial condition and results of operations. See Note 1(r), Income Taxes, and Note 16, Income Taxes, for a discussion of accounting for income taxes. IMPACT OF INFLATION Our financial statements are prepared in accordance with GAAP. The statements provide a reasonable, objective, and quantifiable picture of financial results, but generally do not evaluate the impact of inflation. To the extent our regulated operations are not recovering the effects of inflation, they will file rate cases as necessary in the various jurisdictions in which they operate. Our nonregulated businesses include inflation in forecasted costs, which impacts product pricing.

<s>[INST] We are an energy holding company with natural gas and electric utility operations (serving customers in Illinois, Michigan, Minnesota, and Wisconsin), an approximate 34% equity ownership interest in ATC (a federally regulated electric transmission company), and nonregulated energy operations. Strategic Overview Our goal is to create longterm value for shareholders and customers through growth in our core regulated businesses. The essential components of our business strategy are: Maintaining and Growing a Strong Utility Base A strong utility base is essential to maintaining a strong balance sheet, predictable cash flows, the desired risk profile, attractive dividends, and quality credit ratings. We believe the following projects have helped, or will help, maintain and grow our utility base and meet our customers' needs: An accelerated annual investment in natural gas distribution facilities (primarily replacement of cast iron mains) at PGL, WPS's proposed new natural gasfueled electric generating unit to be built at the site of the Fox Energy Center in Wisconsin, WPS's continued investment in environmental projects to improve air quality and meet or exceed the requirements set by environmental regulators, WPS's System Modernization and Reliability Project to underground and upgrade certain electric distribution facilities in northern Wisconsin, and Our approximate 34% ownership interest in ATC, a transmission company that had over $3.7 billion of transmission assets at December 31, 2014. ATC plans to invest approximately $3.3 billion to $3.9 billion in transmission system improvements during the next ten years. Although ATC's equity requirements to fund its capital investments will primarily be met by earnings reinvestment, we plan to continue to fund our share of the equity portion of future ATC growth as necessary. For more detailed information on our capital expenditure program, see Liquidity and Capital Resources Capital Requirements. Providing Safe, Reliable, Competitively Priced, and Environmentally Sound Energy and Related Services Our mission is to provide customers with the best value in energy and related services. We strive to effectively operate a mixed portfolio of generation assets and prudently invest in new generation and distribution assets, while maintaining or exceeding environmental standards. This allows us to provide a safe, reliable, valuepriced service for our customers. Our presence in the compressed natural gas fueling marketplace, while not currently significant, is complementary to our existing businesses and is consistent with our mission. Integrating Resources to Provide Operational Excellence We are committed to integrating resources of all our businesses and finding the best and most efficient processes while meeting all applicable legal and regulatory requirements. We strive to provide the best value to our customers and shareholders by embracing constructive change, leveraging capabilities and expertise, and using creative solutions to meet or exceed our customers' expectations. "Operational Excellence" initiatives have been implemented to reduce costs and encourage top performance in the areas of project management, process improvement, contract administration, and compliance. Placing Strong Emphasis on Asset and Risk Management Our asset management strategy calls for the continuous assessment of existing assets, the acquisition of assets, and contractual commitments to obtain resources that complement our existing business and strategy. The goal is to provide the most efficient use of resources while maximizing return and maintaining an acceptable risk profile. This strategy focuses on acquiring assets consistent with strategic plans and disposing of assets, including property, plant, and equipment and entire business units, that are no longer strategic to ongoing operations, are not performing as intended, or have an unacceptable risk profile. We maintain a portfolio approach to risk and earnings. Our risk management strategy includes the management of market, credit, liquidity, and operational risks through the normal course of business. Forward purchases of electric capacity, energy, natural gas, and other commodities, and the use of derivative financial instruments, including commodity swaps and options, provide tools to reduce the risk associated with price movement in a volatile energy market. Each business unit manages the risk profile related to these instruments consistent with our risk management policies, which are approved by the Board of Directors. The Corporate Risk Management Group, which reports through the Chief Financial Officer, provides corporate oversight. RESULTS OF OPERATIONS Earnings Summary 2014 Compared with 2013 The $74.9 million decrease in our earnings was driven by: An $82.1 [/INST] Negative. </s>

EQT Corp

2015-02-12

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Consolidated Results of Continuing Operations 2014 EQT Overview: •Annual production sales volumes of 476.3 Bcfe, 26% higher than 2013 •Marcellus sales volumes of 378.2 Bcfe, 38% higher than 2013 •Gathered volumes of 590.5 TBtu, 27% higher than 2013 •Increased proved reserves by 29% to 10.7 Tcfe •The Partnership completed an underwritten public offering of common units representing limited partner interests •The Partnership issued 4.00% Senior Notes of $500.0 million due August 1, 2024 • Recognized impairment of proved and unproved oil and gas properties of $267.3 million (pre-tax) in the Ohio Utica and Permian Basin Income from continuing operations attributable to EQT Corporation for 2014 was $385.6 million, $2.53 per diluted share, compared with $298.7 million, $1.97 per diluted share, in 2013. The $86.9 million increase in income from continuing operations attributable to EQT Corporation was primarily attributable to a 26% increase in production sales volumes, favorable gains on derivatives not designated as hedges, increases in contracted transmission capacity and throughput and gathered volumes, favorable changes in hedging ineffectiveness, and lower interest expense. These factors were partially offset by impairments of long-lived assets, higher net income attributable to noncontrolling interests of the Partnership, higher transportation and processing expenses, higher income tax expense, higher selling, general and administrative (SG&A) expense and higher depreciation, depletion and amortization (DD&A) expense. Operating income was $853.4 million in 2014 compared to $654.6 million in 2013, an increase of $198.8 million. EQT Production sales volumes increased 26% primarily as a result of increased production from the 2014 and 2013 drilling programs in the Marcellus acreage partially offset by the normal production decline in the Company’s producing wells. The average realized price to EQT Production for sales volumes was $3.23 per Mcfe in 2014 compared to $3.15 per Mcfe in 2013. EQT Production total net operating revenues for the year ended December 31, 2014 included $83.8 million of derivative gains for derivative instruments not designated as hedging instruments compared to $0.3 million of derivative losses for the year ended December 31, 2013. The $83.8 million of derivative gains for derivative instruments not designated as hedging instruments for the year ended December 31, 2014 included $36.5 million of cash settlements received, which is included in the average realized price to EQT Production of $3.23 per Mcfe in 2014. The year ended December 31, 2014 also included a $24.8 million gain for hedging ineffectiveness of financial hedges compared to a $21.3 million loss for ineffectiveness of financial hedges for the year ended December 31, 2013. Transmission net operating revenues increased as a result of higher firm transmission contracted capacity and throughput for third parties and EQT Production, as well as higher interruptible transmission service. The increase in transmission net operating revenues is the result of increased production development in the Marcellus play. Gathering net operating revenues increased due to a 27% increase in gathered volumes, partially offset by an 11% decrease in the average gathering fee. The gathered volume increase was driven by higher volumes gathered for EQT Production in the Marcellus play. The decrease in the average gathering fee resulted from increased gathered volumes in the Marcellus play, as the Marcellus gathering rate is lower than the rate in other areas. Operating expenses for 2014 were $1,650.5 million compared to $1,227.0 million in 2013, an increase of $423.5 million. Excluding the $267.3 million impairment charge (described in more detail in Business Segment Results of Operations - EQT Production) and $26.2 million increase in depreciation and depletion, operating expenses increased $130.0 million. This increase was primarily attributable to higher transportation and processing expenses and higher SG&A costs consistent with the growth in the production and midstream businesses. On May 7, 2014, a wholly owned subsidiary of the Company, EQT Gathering contributed a high-pressure gathering system to EQM Gathering, a wholly owned subsidiary of the Partnership, in exchange for $1.18 billion (the Jupiter Transaction). EQM Gathering is consolidated by the Company as it is still controlled by the Company. On May 7, 2014, the Partnership completed an underwritten public offering of 12,362,500 common units, which included the full exercise of the underwriters’ overallotment option, representing Partnership limited partner interests. The Partnership received net proceeds of approximately $902.5 million from the offering, after deducting the underwriters’ discount and offering expenses of approximately $34.0 million. As of December 31, 2014, the Company held a 2% general partner interest, all incentive distribution rights and a 34.4% limited partner interest in the Partnership. The Company’s limited partner interest in the Partnership consists of 3,959,952 common units and 17,339,718 subordinated units. In June 2014, the Company exchanged certain assets with Range. The Company received approximately 73,000 net acres and approximately 900 producing wells, most of which are vertical wells, in the Permian Basin of Texas. In exchange, Range received approximately 138,000 net acres in the Company’s Nora field of Virginia, the Company’s working interest in approximately 2,000 producing vertical wells in the Nora field, the Company’s remaining 50% ownership interest in Nora LLC, which owns the supporting gathering system in the Nora field, and $167.3 million in cash. In August 2014, the Partnership issued 4.00% Senior Notes (4.00% Senior Notes) due August 1, 2024 in the aggregate principal amount of $500.0 million. Net proceeds of the offering of $492.3 million were used to repay the outstanding borrowings under the Partnership’s credit facility and for general partnership purposes. Income from continuing operations attributable to EQT Corporation for 2013 was $298.7 million, $1.97 per diluted share, compared with $135.9 million, $0.90 per diluted share, in 2012. The $162.8 million increase in income from continuing operations attributable to EQT Corporation between periods was primarily attributable to a 43% increase in natural gas volumes sold, increases in contracted transmission capacity and throughput and gathered volumes, the gain on sale of certain energy marketing contracts by EQT Energy in December 2013 and lower interest expense. These factors were partially offset by higher DD&A expense, higher income tax expense, higher SG&A expense and higher net income attributable to noncontrolling interests of the Partnership. Operating income was $654.6 million in 2013 compared to $389.6 million in 2012, an increase of $265.0 million. The increase in operating income was attributable to a 43% increase in natural gas volumes sold, increased transmission pipeline revenues and gathered volumes and a $19.6 million pre-tax gain from the disposal of customer contracts by EQT Energy, partially offset by higher DD&A expense and higher SG&A expense. Production sales volumes increased in 2013 compared to 2012 primarily as a result of increased production from the 2013 and 2012 drilling programs in the Marcellus acreage. This increase was partially offset by the normal production decline in the Company’s producing wells. The average realized price to EQT Production for sales volumes was $3.15 per Mcfe in 2013 compared to $3.00 per Mcfe in 2012. Gathering net operating revenues increased due to a 39% increase in gathered volumes, partially offset by a 17% decrease in the average gathering fee. The gathered volume increase was driven by higher volumes gathered for EQT Production in the Marcellus play. The decrease in the average gathering fee resulted from increased gathered volumes in the Marcellus play, as the Marcellus gathering rate is lower than the rate in other areas. Operating expenses for 2013 were $1,227.0 million compared to $987.6 million in 2012, an increase of $239.4 million. This increase was primarily attributable to higher DD&A charges attributable to higher production volumes at a production depletion rate of $1.50 per Mcfe in 2013 compared to $1.52 per Mcfe in 2012 and higher production-related and SG&A costs consistent with the growth in the production and midstream businesses. On July 22, 2013, Sunrise Pipeline, LLC (Sunrise), a subsidiary of the Company, merged with and into Equitrans, a subsidiary of the Partnership, with Equitrans continuing as the surviving company (the Sunrise Merger). Equitrans continues to be consolidated by the Company as it is still under common control. On July 22, 2013, the Partnership completed an underwritten public offering of 12,650,000 common units representing Partnership limited partner interests. Following the offering and the closing of the Sunrise Merger, the Company retained a 44.6% equity interest in the Partnership, which includes 3,443,902 common units, 17,339,718 subordinated units and a 2% general partner interest. The Partnership received net proceeds of $529.4 million from the offering, after deducting the underwriters’ discount and offering expenses of $20.9 million. On December 17, 2013, the Company and its wholly owned subsidiary, Distribution Holdco, LLC, completed the disposition of their ownership interests in Equitable Gas and Homeworks to PNG Companies LLC (the Equitable Gas Transaction). As consideration for the transaction, the Company received total cash proceeds of $748.0 million, select midstream assets, including the AVC facilities, with a fair value of $140.9 million and other contractual assets with a fair value of $32.5 million. On July 2, 2012, the Partnership completed its IPO of 14,375,000 common units representing limited partner interests in the Partnership, which represented 40.6% of the Partnership’s outstanding equity. The Company retained a 59.4% equity interest in the Partnership, including 2,964,718 common units, 17,339,718 subordinated units and a 2% general partner interest. See “Other Income Statement Items” for a discussion of other income, interest expense, income taxes, income from discontinued operations and net income attributable to noncontrolling interests, and “Investing Activities” in “Capital Resources and Liquidity” for a discussion of capital expenditures. Consolidated Operational Data Revenues earned by the Company at the wellhead from the sale of natural gas, NGLs and oil are split between EQT Production and EQT Midstream. The split is reflected in the calculation of EQT Production’s average sales price. The following operational information presents detailed gross liquid and natural gas operational information as well as midstream deductions to assist in the understanding of the Company’s consolidated operations. Non-GAAP Financial Measures The operational information in the table below presents an average realized price ($/Mcfe) to EQT Production and EQT Corporation, which is based on EQT Production adjusted net operating revenues, a non-GAAP supplemental financial measure. EQT Production adjusted net operating revenues are presented because it is an important measure used by the Company’s management to evaluate period-to-period comparisons of earnings. EQT Production adjusted net operating revenues should not be considered as an alternative to EQT Corporation operating revenues as reported in the Statements of Consolidated Income, the most directly comparable GAAP financial measure. See “Reconciliation of Non-GAAP Measures” for a reconciliation of EQT Production adjusted net operating revenues to EQT Corporation operating revenues, as derived from the Statements of Consolidated Income. EQT Corporation Price Reconciliation (a) NGLs and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (b) The Company’s volume weighted NYMEX natural gas price (actual average NYMEX natural gas price ($/MMBtu) was $4.41, $3.65 and $2.79 for the years ended December 31, 2014, 2013 and 2012, respectively). (c) Recoveries represent differences in natural gas prices between the Appalachian Basin and the sales points of other markets reached by utilizing transportation capacity, differences in natural gas prices between Appalachian Basin and fixed price sales contracts, term sales with fixed differentials to NYMEX and other marketing activity, including capacity releases. Recoveries includes approximately $0.19, $0.23 and $0.41 per Mcf for the years ended December 31, 2014, 2013 and 2012, respectively, for the sale of unused capacity. Reconciliation of Non-GAAP Measures The tables below reconcile EQT Production adjusted net operating revenues, a non-GAAP supplemental financial measure, to EQT Corporation operating revenues as reported in the Statements of Consolidated Income, its most directly comparable financial measure calculated in accordance with GAAP. The Company reports gain (loss) for hedging ineffectiveness and gain (loss) on derivatives not designated as hedges within operating revenues in the Statements of Consolidated Income. The Company’s management reviews and reports the EQT Production segment results with third-party transportation and processing costs reflected as a deduction from operating revenues. Third-party costs incurred to gather, process and transport gas produced by EQT Production to market sales points are recorded as a portion of transportation and processing costs in the Statements of Consolidated Income. Some transportation costs incurred by the Company are marketed for resale and are not incurred to transport gas produced by EQT Production. These transportation costs are reflected as a deduction from operating revenues in the Statements of Consolidated Income. Business Segment Results of Operations Business segment operating results from continuing operations are presented in the segment discussions and financial tables on the following pages. Operating segments are evaluated on their contribution to the Company’s consolidated results based on operating income. Other income, interest and income taxes are managed on a consolidated basis. Headquarters’ costs are billed to the operating segments based upon a fixed allocation of the headquarters’ annual operating budget. Differences between budget and actual headquarters expenses totaling $36.9 million, $45.4 million and $35.6 million were not allocated to the operating segments for the years ended December 31, 2014, 2013 and 2012, respectively. Unallocated expenses consist primarily of incentive compensation, administrative costs and for 2013 and 2012, corporate overhead charges previously allocated to the Company’s Distribution segment that were reclassified to headquarters as part of the recast of those periods to reflect the discontinued operations presentation. The Company has reported the components of each segment’s operating income from continuing operations and various operational measures in the sections below, and where appropriate, has provided information describing how a measure was derived. EQT’s management believes that presentation of this information provides useful information to management and investors regarding the financial condition, operations and trends of each of EQT’s business segments without being obscured by the financial condition, operations and trends for the other segments or by the effects of corporate allocations of interest, income taxes and other income. In addition, management uses these measures for budget planning purposes. The Company’s management reviews and reports the EQT Production segment results with third-party transportation and processing costs reflected as a deduction from operating revenues as management believes this presentation provides a more useful view of average net sales price and is consistent with industry practices. Third-party costs incurred to gather, process and transport gas produced by EQT Production to market sales points are recorded as a portion of transportation and processing costs in the Statements of Consolidated Income. Purchased gas costs at EQT Midstream include natural gas purchases, including natural gas purchases from affiliates, purchased gas costs adjustments and other gas supply expenses. These purchased gas costs are primarily with affiliates and are eliminated in consolidation. Consistent with the consolidated results, energy trading contracts recorded within storage, marketing and other are reported net within operating revenues, regardless of whether the contracts are physically or financially settled. The Company has reconciled each segment’s operating income to the Company’s consolidated operating income and net income in Note 4 to the Consolidated Financial Statements. EQT Production Results of Operations (a) Includes Upper Devonian wells. (b) NGLs and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (c) Includes $167.3 million of cash capital expenditures and $349.2 million of non-cash capital expenditures for the exchange of assets with Range during the year ended December 31, 2014; $114.2 million of cash capital expenditures for the purchase of acreage and Marcellus wells from Chesapeake Energy Corporation and its partners (Chesapeake) during the year ended December 31, 2013; and certain labor overhead costs including a portion of non-cash stock-based compensation expense and non-cash capital expense accruals that were not paid at the applicable year-end. Year Ended December 31, 2014 vs. December 31, 2013 EQT Production’s operating income totaled $506.0 million for 2014 compared to $371.2 million for 2013. The $134.8 million increase in operating income was primarily due to increased sales of produced natural gas and NGLs and a higher average realized price partially offset by an increase in operating expenses, which includes $267.3 million of noncash impairment charges. Impairment charges consist of $105.2 million associated with proved properties in the Permian Basin of Texas related to the 2014 decline in commodity prices. Impairment charges also include $86.6 million associated with undeveloped properties and $75.5 million associated with proved properties in the Utica Shale of Ohio as a result of insufficient recovery of hydrocarbons to support continued development along with the decline in commodity prices. Total net operating revenues were $1,612.7 million for 2014 compared to $1,168.7 million for 2013. The $444.0 million increase in total net operating revenues was primarily due to a 26% increase in production sales volumes, a favorable gain on derivatives not designated as hedges, a favorable change in hedging ineffectiveness and a 3% increase in the average realized price to EQT Production. The increase in production sales volumes was the result of increased production from the 2014 and 2013 drilling programs, primarily in the Marcellus play. This increase was partially offset by the normal production decline in the Company’s producing wells. Total net operating revenues for the year ended December 31, 2014 included a $24.8 million gain for hedging ineffectiveness of financial hedges compared to a $21.3 million loss for ineffectiveness of financial hedges for the year ended December 31, 2013. The year ended December 31, 2014 also included $83.8 million of derivative gains for derivative instruments not designated as hedging instruments compared to $0.3 million of derivative losses for the year ended December 31, 2013. The gains for the year ended December 31, 2014 relate to favorable changes in the fair market value of basis swaps and NYMEX collars that were not designated as hedging instruments, due to decreased NYMEX and basis prices as of December 31, 2014. The $83.8 million of derivative gains for derivative instruments not designated as hedging instruments for the year ended December 31, 2014 included $36.5 million of cash settlements received, which is included in the average price discussion above. The $0.08 per Mcfe increase in the average realized price to EQT Production was the net result of an increase in the average NYMEX natural gas price net of cash settled derivatives combined with a per unit decrease in midstream revenue deductions, partly offset by a lower average natural gas differential of $0.40 per Mcf. The average differential includes lower Appalachian Basin basis of $0.91 per Mcf, favorable recoveries of $0.45 per Mcf and favorable settlements of basis swaps of $0.06 per Mcf. Recoveries represent differences in natural gas prices between the Appalachian Basin and the sales points of other markets reached by utilizing transportation capacity, differences in natural gas prices between Appalachian Basin and fixed price sales contracts, term sales with fixed differentials to NYMEX and other marketing activity, including capacity releases. For the year ended December 31, 2014, EQT Production recognized higher recoveries compared to 2013 primarily by using its contracted transportation capacity to sell gas in higher priced markets, particularly during the winter months when market prices in the United States Northeast region were significantly higher than the Appalachian Basin prices. Much of these higher revenues resulted from sales off of the Company’s Texas Eastern Transmission (TETCO) and Tennessee Gas Pipeline capacity, including additional TETCO capacity that came online in 2014. Effective February 2014, the Company acquired new TETCO capacity of 245,000 MMBtu per day that enables the Company to reach markets in eastern Pennsylvania. Effective November 2014, additional TETCO capacity of 300,000 MMBtu per day came online that enables the Company to reach markets in New Jersey as well as markets along the Gulf coast. Additionally, the Company executed natural gas sales with fixed differentials to NYMEX for the 2014 summer term during the fourth quarter of 2013 and first quarter of 2014 when market prices were favorable compared to actual Appalachian Basin basis during the summer of 2014. Operating expenses totaled $1,134.2 million for 2014 compared to $797.4 million for 2013. The increase in operating expenses was the result of impairments of long-lived assets of $267.3 million, as previously mentioned, and increases in SG&A, production taxes, DD&A, LOE and exploration expenses. SG&A expense increased in 2014 primarily as a result of higher personnel costs of $12.4 million, including incentive compensation expenses, higher litigation and environmental reserves of $6.2 million, and an increase in professional services of $4.9 million. Production taxes increased due to an $11.6 million increase in severance taxes and property taxes as a result of higher market sales prices and higher production sales volumes in certain jurisdictions subject to these taxes. Production taxes also increased due to a $5.1 million increase in the Pennsylvania impact fee, primarily as a result of an increase in the number of wells drilled in Pennsylvania. Depletion expense increased as a result of higher production sales volumes in 2014 partially offset by a lower overall depletion rate. The increase in LOE was mainly a result of increased Marcellus activity in 2014, including a $2.8 million increase in salt water disposal expenses and a $2.7 million increase in labor expenses, along with expenses related to the exchange of properties with Range. Exploration expense increased in 2014 primarily as a result of increased geophysical activity compared to the prior year. In connection with an asset exchange with Range during the second quarter of 2014, the Company received acreage and producing wells in the Permian Basin of Texas in exchange for acreage, producing wells, the Company’s 50% ownership interest in a supporting gathering system in the Nora fields of Virginia and cash of $167.3 million. In conjunction with the transaction, EQT Production recognized a pre-tax gain of $27.4 million in 2014, which is included in gain on sale / exchange of assets in the Statements of Consolidated Income. The $27.4 million pre-tax gain included a $28.0 million pre-tax gain related to the de-designation of certain derivative instruments that were previously designated as cash flow hedges because it was probable that the forecasted transactions would not occur. Any subsequent changes in fair value of these derivative instruments will be recognized within the results of operations for EQT Production. Year Ended December 31, 2013 vs. December 31, 2012 EQT Production’s operating income totaled $371.2 million for 2013 compared to $187.9 million for 2012. The $183.3 million increase in operating income was primarily due to increased sales of produced natural gas and NGLs and a higher average realized price partially offset by an increase in operating expenses. Total net operating revenues were $1,168.7 million for 2013 compared to $793.8 million for 2012. The $374.9 million increase in total net operating revenues was primarily due to a 43% increase in production sales volumes and a 5% increase in the average realized price to EQT Production. The increase in production sales volumes was the result of increased production from the 2012 and 2011 drilling programs, primarily in the Marcellus play. This increase was partially offset by the normal production decline in the Company’s producing wells. The $0.15 per Mcfe increase in the average realized price to EQT Production was the net result of a per unit decrease in midstream revenue deductions and an increase in the average NYMEX natural gas price net of cash settled derivatives, partly offset by a lower average natural gas differential of $0.28 per Mcf and lower NGL prices. The average differential includes lower Appalachian Basin basis of $0.13 per Mcf and lower recoveries of $0.15 per Mcf. The lower recoveries primarily related to decreases in the sales of unused capacity. Total net operating revenues for the year ended December 31, 2013 included a $21.3 million loss for hedging ineffectiveness of financial hedges compared to a $0.1 million loss for ineffectiveness of financial hedges in the year ended December 31, 2012. Operating expenses totaled $797.4 million for 2013 compared to $605.9 million for 2012. The increase in operating expenses was the result of increases in DD&A, LOE, exploration expenses, SG&A and production taxes. Depletion expense increased as a result of higher production sales volumes in 2013 partially offset by a slightly lower overall depletion rate. The increase in LOE was mainly a result of increased Marcellus activity in 2013, including a $6.5 million increase in salt water disposal expenses and a $3.1 million increase in labor expenses in that region. The increase in exploration expense was due to increased impairments of unproved lease acreage of $8.7 million resulting from lease expirations during 2013, slightly offset by a reduction in geophysical activity compared to the prior year. SG&A expense increased in 2013 primarily as a result of higher personnel costs of $4.6 million, including incentive compensation expenses, and higher environmental reserves of $1.9 million partially offset by a decrease in franchise taxes of $2.2 million. Production taxes increased primarily due to an increase in severance and property taxes related to higher market sales prices and higher production sales volumes. Severance and property taxes were offset by a $3.1 million decrease in the Pennsylvania impact fee. During 2013, the Pennsylvania impact fee was $12.2 million compared to $15.3 million in 2012, of which $6.7 million represented a retroactive fee for pre-2012 Marcellus wells. EQT Midstream Results of Operations (a) Includes certain labor overhead costs including a portion of non-cash stock-based compensation expense and capital accruals not paid as of the respective year end. (b) As discussed in Note 7 to the Company’s Consolidated Financial Statements, in connection with an asset exchange with Range during the second quarter of 2014, the Company received acreage and producing wells in the Permian Basin of Texas in exchange for acreage, producing wells, the Company’s 50% ownership interest in a supporting gathering system in the Nora field of Virginia and cash of $167.3 million. In conjunction with this transaction, EQT Midstream recognized a pre-tax gain of $6.8 million, which is included in gain on sale / exchange of assets in the Statement of Consolidated Income for the year ended December 31, 2014. Year Ended December 31, 2014 vs. December 31, 2013 EQT Midstream’s operating income totaled $384.3 million, an increase of $55.5 million in 2014 compared to 2013. The increase was the result of increased transmission and gathering net operating revenues partly offset by increased operating expenses, lower gains on asset sales and a decrease in storage, marketing and other net operating revenues. Transmission net operating revenues increased by $65.9 million as a result of higher firm transmission contracted capacity and throughput of $61.9 million for third parties and EQT Production, including $14.7 million related to the AVC facilities, and higher interruptible transmission service. The increase in transmission net operating revenues is the result of increased development activity in the Marcellus Shale. Gathering net operating revenues increased due to a 27% increase in gathered volumes partly offset by an 11% decrease in the average gathering fee. The gathered volume increase was primarily driven by higher affiliate volumes, which accounted for 84% of the increase, as a result of increased activity in the Marcellus play. The average gathering fee decreased due to a higher mix of gathered volumes in the Marcellus play as these volumes have a lower average fee compared to Huron and other volumes. These increases in net operating revenues were partly offset by a decrease in storage, marketing and other net operating revenues as a result of $9.3 million of reduced marketing revenues primarily as a result of the sale of certain energy marketing contracts on December 31, 2013 and $9.0 million of lower revenues on NGLs marketed for non-affiliated producers as a result of lower prices and volumes, partly offset by increased storage revenues on the AVC facilities. Total operating revenues increased $85.0 million primarily as a result of increased transmission and gathering revenue, partly offset by reduced gas marketing activity. Total purchased gas costs decreased $24.5 million primarily as a result of reduced gas marketing activity. Operating expenses totaled $277.5 million, an increase of $41.1 million in 2014 compared to 2013. O&M expense increased as a result of $8.6 million in higher compression and pipeline operating expenses related to an increase in Marcellus activity and operating the AVC facilities as well as higher labor costs. The increase in SG&A was primarily the result of increased personnel costs including incentive compensation of $9.8 million, increased overhead allocated from affiliates of $4.2 million and increased professional services of $2.3 million. DD&A increased as a result of additional assets placed in-service, including the AVC facilities. In 2013, the Company sold certain energy marketing contracts to a third party for $20.0 million. In conjunction with this transaction, the Company recognized a pre-tax gain of $19.6 million in 2013. In connection with an asset exchange with Range during 2014, the Company received acreage and producing wells in the Permian Basin of Texas in exchange for acreage, producing wells, the Company’s 50% ownership interest in a supporting gathering system in the Nora field of Virginia and cash of $167.3 million. In conjunction with this transaction, EQT Midstream recognized a pre-tax gain of $6.8 million. The difference in the gains on these two transactions resulted in the decrease in gain on sale / exchange of assets in 2014 compared to 2013. Year Ended December 31, 2013 vs. December 31, 2012 EQT Midstream’s operating income totaled $328.8 million for 2013 compared to $237.3 million for 2012. The increase in operating income was primarily the result of increased transmission and gathering net operating revenues and gains on asset sales, partly offset by increased operating expenses and a decrease in storage, marketing and other net operating revenues. The $96.1 million increase in total net operating revenues was due to a $56.1 million increase in transmission net operating revenues and $49.2 million increase in gathering net operating revenues, partially offset by a decrease in storage, marketing and other net operating revenues. Transmission net operating revenues increased from the prior year primarily as a result of $44.0 million of additional firm capacity reservation revenues and usage charges, $10.1 million of fees associated with transported volumes in excess of firm capacity and increased pipeline safety revenues. Gathering net operating revenues increased due to a 39% increase in gathered volumes, partly offset by a 17% decrease in the average gathering fee. The gathered volume increase was driven by higher volumes gathered for EQT Production in the Marcellus play. The average gathering fee decreased due to the mix of gathered volumes as Marcellus volumes increased while Huron and other volumes, which have a higher gathering fee, decreased. Storage, marketing and other net operating revenues decreased from the prior year primarily as a result of lower realized margins and reduced activity due to lower price spreads. In addition, revenues on NGLs marketed for non-affiliated producers decreased by $2.8 million primarily as a result of lower liquids pricing partially offset by slightly higher liquids volumes. On December 31, 2013, the Company sold certain energy marketing contracts to a third party for $20.0 million. These contracts were natural gas sales agreements with approximately 1,000 end use customers with total volumes of approximately 12 Bcf in 2013. In conjunction with this transaction, the Company recognized a pre-tax gain of $19.6 million in 2013, which is included in gain on sale / exchange of assets in the Statements of Consolidated Income. Total operating revenues increased $108.5 million primarily as a result of the increase in gathered volumes and increased transmission revenue, partly offset by the lower gathering rate. Total purchased gas costs increased $12.4 million primarily as a result of an increase in commodity prices. Operating expenses totaled $236.4 million for 2013 compared to $212.1 million for 2012. The increase in SG&A was primarily the result of increased personnel costs of $5.9 million including incentive compensation expenses, $2.2 million of increased overhead allocated from affiliates, a $2.1 million unfavorable change in bad debt expense primarily as a result of lower recoveries from the Lehman Brothers settlement in 2013 and $2.0 million of lower reserve reductions in 2013, primarily related to the expected recovery of a long-term, volume-based regulatory asset. DD&A increased as a result of additional assets placed in-service. O&M expenses were flat to the prior year as increases in personnel and other gathering and transmission business expenses in 2013 were offset by reduced compressor operating expenses. Other Income Statement Items Other Income Other income includes equity in earnings of nonconsolidated investments, primarily the Company’s prior investment in Nora LLC, of $3.4 million, $7.6 million and $6.1 million for the years ended December 31, 2014, 2013 and 2012, respectively. In connection with the asset exchange with Range in 2014, the Company transferred its 50% ownership interest in Nora LLC to Range. Other income for the year ended December 31, 2014 also included $3.2 million of AFUDC compared to $1.2 million of AFUDC in 2013, a $2.0 million increase primarily as a result of construction activity on the late 2013 acquisition of the AVC and the Jefferson Expansion project. Other income for the year ended December 31, 2013 also included $1.2 million of AFUDC compared to $6.8 million of AFUDC in 2012, a $5.6 million decrease as a result of the Sunrise Pipeline being placed into service during the third quarter of 2012. The Company also recognized a gain on the sale of leases of $0.4 million in 2013 compared to a gain on the sale of leases of $2.0 million in 2012. Interest Expense Interest expense decreased $6.2 million in 2014 compared to 2013 due to higher capitalized interest of $35.0 million on increased Marcellus well development in 2014 compared to $22.9 million in 2013, partially offset by an increase in interest expense of $8.3 million related to the Partnership’s issuance of 4.00% Senior Notes due 2024 in the aggregate principal amount of $500.0 million during the third quarter of 2014. Interest expense decreased $42.1 million in 2013 compared to 2012 primarily as a result of a $23.3 million payment to settle a forward-starting interest rate swap recorded as expense in 2012 and the Company’s repayment of $200.0 million of 5.15% senior notes that matured in the fourth quarter of 2012. This decrease was also attributable to higher capitalized interest of $22.9 million on increased Marcellus well development in 2013 compared to $15.6 million in 2012. During the third quarter of 2011, the Company entered into an interest rate hedge in anticipation of refinancing $200.0 million of long-term debt scheduled to mature in November 2012. The Company retired the debt using cash on hand and recognized a $23.3 million expense in the year ended December 31, 2012 to close the interest rate hedge. The weighted average annual interest rates on the Company’s long-term debt, excluding the Partnership’s long-term debt, was 6.4% for 2014, 2013 and 2012. The weighted average annual interest rate on the Partnership’s long-term debt was 4.0% for 2014. The Partnership had no long-term debt outstanding in 2013 and 2012. The Company did not have any short-term loans outstanding at any time during the years ended December 31, 2014 and 2012. The maximum amount of outstanding short-term loans at any time under the Company’s credit facility during the year ended December 31, 2013 was $178.5 million. The average daily balance of short-term loans outstanding for the Company during the year ended December 31, 2013 was approximately $12.1 million at a weighted average annual interest rate of 1.7%. The maximum amount of outstanding short-term loans at any time under the Partnership’s credit facility during the year ended December 31, 2014 was $450 million, and the average daily balance of short-term loans outstanding was approximately $119 million at a weighted average annual interest rate of 1.7%. The Partnership had no short-term loans outstanding at any time during the years ended December 31, 2013 and 2012. Income Taxes Income tax expense increased $38.9 million in 2014 compared to 2013 as a result of higher pre-tax income partly offset by a decrease in the Company’s effective income tax rate from 33.6% to 29.6%. The decrease in the rate in 2014 compared to 2013 was primarily related to an internal reorganization of subsidiaries resulting in a reduction of state taxes as well as an increase in noncontrolling interests related to the Partnership’s ownership structure. For both periods, the overall rate was lower than the federal statutory rate as the Company consolidates 100% of the pre-tax income related to the noncontrolling public limited partners’ share of partnership earnings, but is not required to record an income tax provision with respect to the portion of the Partnership’s earnings allocated to the noncontrolling public limited partners. The Partnership’s earnings increased primarily due to the Sunrise Merger in 2013 and the Jupiter Transaction in 2014, each of which also resulted in increases in the noncontrolling limited public partners’ share of partnership earnings (as described in Note 3 to the Consolidated Financial Statements). Income tax expense increased $103.7 million in 2013 compared to 2012 as a result of higher pre-tax income and an increase in the Company’s effective income tax rate from 32.4% to 33.6%. The increase in the rate from 2012 to 2013 was primarily due to an increase in pre-tax book income on state tax paying entities as well as a shift in the Company’s business to states with higher income tax rates. This was partially offset by state tax benefits of $9.8 million realized in 2013 primarily related to the Sunrise Merger and the Equitable Gas Transaction which allowed the Company to utilize NOLs that had previously been fully reserved. As described in the preceding paragraph, the overall rate was reduced in both periods because the Company is not required to record an income tax provision with respect to the portion of the Partnership’s earnings allocated to its noncontrolling public limited partners. The Company was in an overall federal taxable income position for 2014 and 2013 primarily as a result of the Jupiter Transaction in 2014 and taxable gains generated from the Sunrise Merger and the Equitable Gas Transaction in 2013. The Company was in an overall federal tax net operating loss (NOL) position for 2012. Starting in 2013, the Company began to utilize the NOLs it generated in previous years. For federal income tax purposes, the Company deducts a portion of drilling costs as intangible drilling costs (IDCs) in the year incurred. IDCs, however, are sometimes limited for purposes of the alternative minimum tax (AMT) and can result in the Company paying AMT even when utilizing a regular tax NOL. See Note 9 to the Consolidated Financial Statements for further discussion of the Company’s income taxes. Income from Discontinued Operations, Net of Tax Income from discontinued operations, net of tax, was $1.4 million for the year ended December 31, 2014 compared to $91.8 million for the year ended December 31, 2013. On December 17, 2013, the Company and Distribution Holdco, LLC completed the disposition of their ownership interests in Equitable Gas and Homeworks to PNG Companies LLC. Income from discontinued operations in 2014 resulted from working capital adjustments to the sales price completed in 2014. Income from discontinued operations, net of tax, was $91.8 million for the year ended December 31, 2013 compared to $47.5 million for the year ended December 31, 2012. The $44.3 million increase in 2013 compared to 2012 was primarily the result of a $43.8 million gain recognized on the Equitable Gas Transaction during 2013. Excluding the gain recognized on the Equitable Gas Transaction, results for discontinued operations were relatively unchanged in 2013 compared to 2012 as favorable adjustments for the completion of a regulatory gas cost audit and colder weather in 2013 were offset by reduced revenues as a result of competitive contract renewals and an increase in bad debt expense. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests of the Partnership was $124.0 million for the year ended December 31, 2014 compared to $47.2 million for the year ended December 31, 2013. The increase resulted from higher capacity reservation revenues and higher gathering revenues in the Partnership, as well as increased noncontrolling interests in 2014. Noncontrolling interests in the Partnership increased from 55.4% to 63.6% during the year ended December 31, 2014 as a result of the underwritten public offering of additional common units representing limited partner interests in the Partnership in May 2014 in connection with the Jupiter Transaction. Net income attributable to noncontrolling interests of the Partnership was $47.2 million for the year ended December 31, 2013 compared to $13.0 million for the year ended December 31, 2012. The increase resulted from higher capacity reservation revenues in the Partnership, which completed its IPO in the third quarter of 2012, as well as increased noncontrolling interests in 2013. Noncontrolling interests in the Partnership increased from 40.6% to 55.4% during the year ended December 31, 2013 as a result of the underwritten public offering of additional common units representing limited partner interests in the Partnership in July 2013 in connection with the Sunrise Merger. Outlook The Company is committed to profitably developing its natural gas, NGL and oil reserves through environmentally responsible, cost-effective and technologically advanced horizontal drilling. The market price for commodities can be volatile and these fluctuations can impact, among other things, the Company’s revenues, earnings, liquidity, reserves, DD&A rates and development plans. Average daily prices for NYMEX West Texas Intermediate crude oil ranged from a high of $107.26 per barrel to a low of $44.45 per barrel from January 1, 2014 through February 9, 2015. Average daily prices for NYMEX Henry Hub natural gas ranged from a high of $6.15 per MMBtu to a low of $2.58 per MMBtu from January 1, 2014 through February 9, 2015. In addition, the market price for natural gas in the Appalachian Basin continues to be lower relative to Henry Hub as a result of the increased supply of natural gas in the Northeast region. In January 2015, in response to decreases in commodity prices in late 2014, the Company reduced its 2015 capital expenditure spending plan, excluding acquisitions, by approximately $450 million. The Company is unable to predict future potential movements in the market price for natural gas, including Appalachian basis, oil and NGLs and thus, cannot predict the ultimate impact of prices on its operations. If commodity prices continue to trend lower as they did in the latter part of 2014, reduced operating cash flows could signal a need to further reduce capital spending. The Company believes the outlook for its businesses is favorable despite the continued uncertainty of natural gas, NGL and oil prices. The Company’s resource base, financial strength, risk management, including commodity hedging strategy and disciplined investment of capital provide it with an opportunity to exploit and develop its positions and maximize efficiency through economies of scale in its key operating areas. Total capital investment, excluding acquisitions, is expected to be approximately $2.55 billion in 2015, revised from the Company’s previous estimate of approximately $3.0 billion, to reflect the current decrease in commodity prices. Capital spending for well development (primarily drilling) in 2015 is expected to be approximately $1.85 billion, to support the drilling of approximately 191 gross wells, including 122 Marcellus wells, 59 Upper Devonian wells and 10 other wells. Estimated sales volumes are expected to be 575 - 600 Bcfe for an anticipated production sales volume growth of approximately 23% in 2015, while NGL volumes are expected to be 9,000 - 10,000 Mbbls. To support continued growth in production, the Company plans to invest approximately $0.7 billion on midstream infrastructure in 2015. The 2015 capital spending plan is expected to be funded by cash on hand, cash flow generated from operations, proceeds from midstream asset sales (dropdowns) to the Partnership and Partnership capital raises. In July 2014, the Partnership announced that it will construct and own the Ohio Valley Connector (OVC) pipeline. The OVC includes a 36-mile pipeline that will extend the Partnership’s transmission and storage system from northern West Virginia to Clarington, Ohio, at which point it will interconnect with the Rockies Express Pipeline and the Texas Eastern Pipeline. In December 2014, the Partnership submitted the OVC certificate application to the FERC and anticipates receiving the certificate in the second half of 2015. Subject to FERC approval, construction is scheduled to begin in the third quarter of 2015 and the pipeline is expected to be in-service by mid-year 2016. The OVC will provide approximately 850 BBtu per day of transmission capacity and the 36-mile pipeline portion is estimated to cost approximately $300 million, of which $120 million to $130 million is expected to be spent in 2015. The Partnership has entered into a 20-year precedent agreement with the Company for a total of 650 BBtu per day of firm transmission capacity on the OVC. In September 2014, the Company and an affiliate of NextEra Energy, Inc. announced the formation of the MVP LLC joint venture that will construct and own the MVP. The Company expects to transfer its interest in MVP LLC to the Partnership. The approximately 300-mile pipeline will extend from the Partnership’s existing transmission and storage system in Wetzel County, West Virginia to Pittsylvania County, Virginia. The Company expects that the Partnership will own the largest interest in the joint venture and will operate the MVP, which is estimated to cost a total of approximately $2.5 billion to $3.5 billion, excluding AFUDC, with the Partnership funding its proportionate share through capital contributions made to the joint venture. In 2015, the Partnership’s capital contributions are expected to be approximately $75 million to $85 million and will be primarily in support of environmental and land assessments, design work and materials. This investment is included in the midstream totals above. Expenditures are expected to increase substantially as construction commences, with the bulk of the expenditures expected to be made in 2017 and 2018. The joint venture has secured a total of 2.0 Bcf per day of firm capacity commitments at 20-year terms and is currently in negotiation with additional shippers who have expressed interest in the MVP project. As a result, the final project scope, including pipe diameter and total capacity, has not yet been determined; however the voluntary pre-filing process with the FERC began in October 2014. The pipeline, which is subject to FERC approval, is expected to be in-service during the fourth quarter of 2018. In December 2014, the Company announced that it intends to file a registration statement with the SEC for an IPO of common units of a master limited partnership (HoldCo) that will own the general partner and the incentive distribution rights of the Partnership, as well as the Company’s 21.3 million limited partner units. EQT will file a registration statement for the IPO with the SEC during the first quarter of 2015. Under the proposed structure, EQT expects to sell a small percentage of HoldCo to the public in the IPO, subject to market conditions. At the close of the IPO, EQT would own the general partner of HoldCo, and more than 80% percent of HoldCo’s common units. EQT intends to use the net proceeds from the IPO for the development of its existing assets, future capital expenditures, and general corporate purposes. The Company continues to focus on creating and maximizing shareholder value through the implementation of a strategy that economically accelerates the monetization of its asset base and prudently pursues investment opportunities, all while maintaining a strong balance sheet with solid cash flow. While the tactics continue to evolve based on market conditions, the Company is considering arrangements, including asset sales and joint ventures, to monetize the value of certain mature assets for re-deployment into its highest value development opportunities. Capital Resources and Liquidity The Company’s primary sources of cash for the year ended December 31, 2014 were cash flows from operating activities, proceeds from the underwritten public offering of the Partnership’s common units and proceeds from the Partnership’s issuance of long-term debt. The Company’s primary use of cash in 2014 was for capital expenditures. Operating Activities The Company’s net cash provided by operating activities increased $251.8 million from $1,162.9 million in 2013 to $1,414.7 million in 2014. The increase in operating activities was primarily the result of a 26% increase in natural gas and NGL volumes sold, increases in contracted transmission capacity and gathered volumes and a $14.6 million decrease in interest payments, partially offset by a $41.1 million increase in income tax payments primarily due to taxes paid on transactions. The Company’s net cash provided by operating activities increased $366.1 million from $796.8 million in 2012 to $1,162.9 million in 2013. The increase was primarily attributable to a 43% increase in natural gas and NGL volumes sold, increases in transmission pipeline throughput and gathered volumes and a $44.7 million decrease in interest payments, partially offset by a $136.1 million increase in income tax payments primarily due to taxes paid on the Sunrise Merger and Equitable Gas Transaction. While the Company is unable to predict future movements in the market price for commodities, current prices are lower than average 2014 levels. If current low price trends continue, this trend would negatively impact the Company’s cash flows from operating activities during the year ended December 31, 2015. Investing Activities Cash flows used in investing activities totaled $2,444.2 million for 2014 as compared to $999.8 million for 2013. The $1,444.4 million increase was primarily attributable to higher capital expenditures in 2014 including the $167.3 million payment in 2014 in connection with the Range asset exchange, compared to proceeds received from the Equitable Gas Transaction of $740.6 million in 2013. As further described below, the Company increased cash capital expenditures from continuing operations by $724.9 million from 2013 to 2014. Cash flows used in investing activities totaled $999.8 million for 2013 as compared to $1,370.5 million for 2012. The $370.7 million decrease was attributable to the proceeds received from the Equitable Gas Transaction of $740.6 million and from the sale of certain energy marketing contracts of $23.0 million, partially offset by higher capital expenditures in 2013. As further described below, the Company increased cash capital expenditures from continuing operations by $380.1 million from 2012 to 2013. Capital Expenditures for Continuing Operations ($ in millions) * The Company capitalizes certain labor overhead costs including a portion of non-cash stock-based compensation expense and capital accruals that have not yet been paid. These accrued capital expenditures in the table above were $99 million, $70 million and $24 million for the years ended December 31, 2014, 2013 and 2012, respectively. The year ended December 31, 2014 also included $349 million of non-cash capital expenditures for the exchange of assets with Range. The Company is estimating a 2015 capital expenditure spending plan of approximately $2.55 billion, including $1.85 billion for well development (primarily drilling) and $0.7 billion for midstream infrastructure. The Company does not forecast property acquisitions within its capital spending plan. Capital expenditures for drilling and development totaled $1,717 million and $1,237 million during 2014 and 2013, respectively. The Company spud 345 gross wells (342 net wells) in 2014, including 196 horizontal Marcellus wells with approximately 1.1 million feet of pay, 41 horizontal Upper Devonian wells with approximately 260,000 feet of pay, 103 horizontal Huron wells with approximately 605,000 feet of pay and 5 other wells. The Company spud 225 gross wells (224 net wells) in 2013, including 146 horizontal Marcellus wells with approximately 720,000 feet of pay, 22 horizontal Upper Devonian wells with approximately 110,000 feet of pay, 50 horizontal Huron wells with approximately 300,000 feet of pay and 7 other wells. The $480 million increase in capital expenditures for well development was driven by an increase in completed frac stages, an increase in wells spud and higher spending in the Huron play. Capital expenditures for 2014 also included $724 million for property acquisitions, including $349 million of non-cash capital expenditures for the exchange of assets with Range. Capital expenditures for the midstream operations totaled $455 million for 2014. During 2014, EQT Midstream turned in-line approximately 60 miles of pipeline and 80,000 horsepower of compression primarily in the Marcellus play. EQT Midstream also added approximately 475 MMcf per day of incremental gathering capacity and 750 MMcf per day of incremental transmission capacity in 2014. During 2013, midstream capital expenditures were $369 million. EQT Midstream turned in-line approximately 49 miles of pipeline and 2,100 horsepower of compression primarily within the Marcellus play. EQT Midstream also added 385 MMcf per day of incremental gathering capacity and 450 MMcf per day of incremental transmission capacity in 2013. Capital expenditures for drilling and development totaled $1,237 million and $857 million during 2013 and 2012, respectively. The Company spud 225 gross wells (224 net wells) in 2013, including 146 horizontal Marcellus wells with approximately 720,000 feet of pay, 22 horizontal Upper Devonian wells with approximately 110,000 feet of pay, 50 horizontal Huron wells with approximately 300,000 feet of pay and 7 other wells, compared to 135 gross wells (129 net wells) in 2012, including 127 horizontal Marcellus wells with approximately 700,000 feet of pay, 7 horizontal Huron wells with approximately 37,000 feet of pay and one other well. The $380 million increase in capital expenditures for well development was driven by an increase in completed feet of pay, an increase in completed frac stages and an increase in wells spud offset slightly by lower cost per foot primarily in the Marcellus play. Capital expenditures for 2013 also included $129 million for undeveloped property acquisitions, including $13 million within the Utica play and $116 million within the Marcellus play, and $57 million for the purchase of Marcellus wells acquired in the Chesapeake acquisition. During 2012, midstream capital expenditures were $376 million. EQT Midstream turned in-line approximately 89 miles of pipeline and 36,000 horsepower of compression primarily within the Marcellus play. EQT Midstream also added 455 MMcf per day of incremental gathering capacity and 700 MMcf per day of incremental transmission capacity in 2012. Financing Activities Cash flows provided by financing activities totaled $1,261.3 million for 2014 as compared to cash flows provided by financing activities of $500.5 million for 2013. The Company received net proceeds of $902.5 million from the Partnership’s May 2014 underwritten public offering of common units and the Partnership received net proceeds of $492.3 million from its August 2014 4.00% Senior Notes issuance. The Partnership paid distributions to noncontrolling interests of $67.8 million in 2014. The Company received proceeds from employee compensation plan exercises of $52.4 million. The Company used $32.4 million to repurchase and retire shares of the Company’s common stock during 2014. In 2013, the Company received net proceeds of $529.4 million from the Partnership’s July 2013 underwritten public offering of common units, received proceeds from employee compensation plan exercises of $45.1 million, paid distributions to noncontrolling interests of $32.8 million and repaid maturing long-term debt of $23.2 million. On January 22, 2015, the Board of Directors of the Partnership’s general partner declared a cash distribution to the Partnership’s unitholders for the fourth quarter of 2014 of $0.58 per common and subordinated unit, $0.8 million to the general partner related to its 2% general partner interest and $5.2 million to the general partner related to its incentive distribution rights. The cash distribution will be paid on February 13, 2015 to unitholders of record at the close of business on February 3, 2015. As a result of this cash distribution, the subordination period with respect to the Partnership’s 17,339,718 subordinated units will expire on February 17, 2015 and all outstanding Partnership subordinated units will convert into Partnership common units on a one-for-one basis on that day. On January 21, 2015, the Board of Directors of the Company declared a regular quarterly cash dividend of three cents per share, payable March 1, 2015, to the Company’s shareholders of record at the close of business on February 13, 2015. On April 30, 2014, the Company’s Board of Directors approved a share repurchase authorization of up to 1,000,000 shares of the Company’s outstanding common stock. The Company may repurchase shares from time to time in open market or in privately negotiated transactions. The share repurchase authorization does not obligate the Company to acquire any specific number of shares, has no pre-established end date and may be discontinued by the Company at any time. During the year ended December 31, 2014, the Company repurchased and retired 300,000 shares of common stock for $32.4 million under the authorization. Cash flows provided by financing activities totaled $500.5 million for 2013 as compared to cash flows used in financing activities of $75.5 million in 2012. In 2013, the Company received net proceeds of $529.4 million from the Partnership’s July 2013 underwritten public offering of common units, paid distributions to noncontrolling interests of $32.8 million, repaid maturing long-term debt of $23.2 million and received proceeds from employee compensation plan exercises of $45.1 million. In 2012, the Company received $276.8 million from the Partnership’s IPO, repaid maturing long-term debt of $219.3 million, paid distributions to noncontrolling interests of $5.0 million and received proceeds from employee compensation plan exercises of $7.9 million. In December 2012, in connection with its announcement of a definitive agreement to transfer Equitable Gas and Homeworks to PNG Companies LLC, the Company reduced its annual dividend rate, effective January 2013, to $0.12 per share, which the Company believed better reflected the blend of the Company’s core businesses remaining after the closing of the Equitable Gas Transaction - a dividend supporting midstream business and a capital-intensive, rapidly growing production business. The $113.7 million favorable impact on cash provided by financing activities resulting from the decline in the dividend rate was partially offset by the $27.8 million increase in distributions to noncontrolling interests of the Partnership. Short-term Borrowings EQT primarily utilizes short-term borrowings to fund capital expenditures in excess of cash flow from operating activities until the expenditures can be permanently financed and to fund required margin deposits on derivative commodity instruments. Margin deposit requirements vary based on natural gas commodity prices, our credit ratings and the amount and type of derivative commodity instruments. The Company has a $1.5 billion revolving credit facility, which was amended in February 2014, that expires in February 2019. The Company may request two one-year extensions of the expiration date, the approval of which is subject to satisfaction of certain conditions. The revolving credit facility may be used for working capital, capital expenditures, share repurchases and any other lawful corporate purposes. The credit facility is underwritten by a syndicate of 18 financial institutions, each of which is obligated to fund its pro-rata portion of any borrowings by the Company. Under the terms of the revolving credit facility, the Company may obtain base rate loans or fixed period Eurodollar rate loans. Base rate loans are denominated in dollars and bear interest at a base rate plus a margin based on the Company’s then current credit ratings. Fixed period Eurodollar rate loans bear interest at a Eurodollar rate plus a margin based on the Company’s then current credit ratings. The Company had no loans or letters of credit outstanding under its revolving credit facility as of December 31, 2014 and 2013. For the years ended December 31, 2014 and 2013, the Company incurred commitment fees averaging approximately 23 basis points and 24 basis points, respectively, to maintain credit availability under its revolving credit facility. The Company did not have any short-term loans outstanding at any time during the year ended December 31, 2014. The maximum amount of outstanding short-term loans at any time under the Company’s credit facility during the year ended December 31, 2013 was $178.5 million. The average daily balance of short-term loans outstanding for the Company during the year ended December 31, 2013 was approximately $12.1 million at a weighted average annual interest rate of 1.7%. The Company’s short-term borrowings generally have original maturities of three months or less. In February 2014, the Partnership amended and restated its credit facility to increase the borrowing capacity to $750 million. The amended credit facility will expire in February 2019. The credit facility is available to fund working capital requirements and capital expenditures, to purchase assets, to pay distributions and repurchase units and for general partnership purposes. The credit facility is underwritten by a syndicate of 18 financial institutions, each of which is obligated to fund its pro-rata portion of any borrowings by the Partnership. The Company is not a guarantor of the Partnership’s obligations under the credit facility. The Partnership’s obligations under the credit facility were unconditionally guaranteed by each of the Partnership’s subsidiaries. In January 2015, the Partnership amended its credit facility to, among other things, release its subsidiaries from their guarantee of obligations under the credit facility. The Partnership’s obligations under the revolving portion of the credit facility are unsecured. Under the terms of its revolving credit facility, the Partnership may obtain base rate loans or fixed period Eurodollar rate loans. Base rate loans are denominated in dollars and bear interest at a base rate plus a margin based on the Partnership’s then current credit rating. Fixed period Eurodollar rate loans bear interest at a Eurodollar rate plus a margin based on the Partnership’s then current credit rating. The Partnership had no loans or letters of credit outstanding under its revolving credit facility as of December 31, 2014 and 2013. For the years ended December 31, 2014 and 2013, the Partnership incurred commitment fees averaging approximately 24 basis points and 25 basis points, respectively, to maintain credit availability under the revolving credit facility. The maximum amount of outstanding short-term loans at any time under the Partnership’s credit facility during the year ended December 31, 2014 was $450 million, and the average daily balance of short-term loans outstanding was approximately $119 million at a weighted average annual interest rate of 1.7%. The Partnership had no short-term loans outstanding at any time during the year ended December 31, 2013. Security Ratings and Financing Triggers The table below reflects the credit ratings for debt instruments of the Company at December 31, 2014. Changes in credit ratings may affect the Company’s cost of short-term and long-term debt (including interest rates and fees under its lines of credit), collateral requirements under derivative instruments and access to the credit markets. The table below reflects the credit ratings for debt instruments of the Partnership at December 31, 2014. Changes in credit ratings may affect the Company’s cost of short-term and long-term debt (including interest rates and fees under its lines of credit) and access to the credit markets. The Company’s and the Partnership’s credit ratings are subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating. The Company and the Partnership cannot ensure that a rating will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a credit rating agency if, in its judgment, circumstances so warrant. If the credit rating agencies downgrade the ratings, particularly below investment grade, the access to the capital markets may be limited, borrowing costs and margin deposits on the Company’s derivative contracts would increase, counterparties may request additional assurances and the potential pool of investors and funding sources may decrease. The required margin on the Company’s derivative instruments is also subject to significant change as a result of factors other than credit rating, such as gas prices and credit thresholds set forth in agreements between the hedging counterparties and the Company. The Company’s debt agreements and other financial obligations contain various provisions that, if not complied with, could result in termination of the agreements, require early payment of amounts outstanding or similar actions. The most significant covenants and events of default under the debt agreements relate to maintenance of a debt-to-total capitalization ratio, limitations on transactions with affiliates, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of other financial obligations and change of control provisions. The Company’s credit facility contains financial covenants that require a total debt-to-total capitalization ratio of no greater than 65%. The calculation of this ratio excludes the effects of accumulated other comprehensive income (OCI). As of December 31, 2014, the Company was in compliance with all debt provisions and covenants. The Partnership’s credit facility contains various provisions that, if not complied with, could result in termination of the credit facility, require early payment of amounts outstanding or similar actions. The covenants and events of default under the credit facility relate to maintenance of permitted leverage ratio, limitations on transactions with affiliates, limitations on restricted payments, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of and certain other defaults under other financial obligations and change of control provisions. Under the credit facility, the Partnership is required to maintain a consolidated leverage ratio of not more than 5.00 to 1.00 (or, not more than 5.50 to 1.00 for certain measurement periods following the consummation of certain acquisitions). As of December 31, 2014, the Partnership was in compliance with all credit facility provisions and covenants. Commodity Risk Management The substantial majority of the Company’s commodity risk management program is related to hedging sales of the Company’s produced natural gas. The Company’s overall objective in this hedging program is to protect cash flow from undue exposure to the risk of changing commodity prices. The derivative commodity instruments currently utilized by the Company are primarily NYMEX swaps and collars. The Company may also use other contractual agreements in implementing its commodity hedging strategy. The Company also enters into fixed price natural gas sales agreements that are satisfied by physical delivery. The Company’s fixed price natural gas sales agreements include contracts that fix only the NYMEX portion of the price and contracts that fix NYMEX and basis. The Company does not currently hedge its oil or NGL exposure. As of February 4, 2015, the approximate volumes and prices of the Company’s hedge position for 2015 through December 2017 production were: (a) The average price is based on a conversion rate of 1.05 MMBtu/Mcf. (b) For 2016 and 2017, the Company also has a natural gas sales agreement for approximately 35 Bcf that includes a NYMEX ceiling price of $4.88 per Mcf. The Company also sold calendar year 2016 and 2017 calls/swaptions for approximately 25 Bcf at a strike price of $4.38 per Mcf and approximately 6 Bcf at a strike price of $3.93 per Mcf, respectively. The Company sold the calendar 2016 and 2017 calls in the first quarter of 2015. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” and Note 5 to the Consolidated Financial Statements for further discussion of the Company’s hedging program. Other Items Off-Balance Sheet Arrangements In connection with the sale of its NORESCO domestic operations in December 2005, the Company agreed to maintain in place guarantees of certain warranty obligations of NORESCO. The savings guarantees provided that once the energy-efficiency construction was completed by NORESCO, the customer would experience a certain dollar amount of energy savings over a period of years. The undiscounted maximum aggregate payments that may be due related to these guarantees were approximately $153 million as of December 31, 2014, extending at a decreasing amount for approximately 13 years. In December 2014, the Company issued a $130 million performance guarantee (the Original MVP Guarantee) in connection with its subsidiary’s obligations to fund the Company’s proportionate share of the construction budget for the MVP. Upon the FERC’s initial release to begin construction of the MVP, the Original MVP Guarantee will terminate, and the Company will be obligated to issue a new guarantee in an amount equal to 33% of the subsidiary’s remaining obligations to make capital contributions to MVP LLC in connection with the then remaining construction budget. Upon the transfer of the Company’s interest in the joint venture to the Partnership, the Partnership will assume these obligations to provide performance assurances for the MVP. See Note 18 to the Consolidated Financial Statements for additional discussion regarding the MVP joint venture. The NORESCO and the MVP guarantees are exempt from ASC Topic 460, Guarantees. The Company has determined that the likelihood it will be required to perform on these arrangements is remote and any potential payments are expected to be immaterial to the Company’s financial position, results of operations and liquidity. As such, the Company has not recorded any liabilities in its Consolidated Balance Sheets related to these guarantees. Rate Regulation As described under “Regulation” in Item 1, “Business,” the Company’s transmission and storage operations and a portion of its gathering operations are subject to various forms of rate regulation. As described in Note 1 to the Consolidated Financial Statements, regulatory accounting allows the Company to defer expenses and income as regulatory assets and liabilities which reflect future collections or payments through the regulatory process. The Company believes that it will continue to be subject to rate regulation that will provide for the recovery of the deferred costs. Schedule of Contractual Obligations The table below presents the Company’s long-term contractual obligations as of December 31, 2014 in total and by periods in accordance with SEC rules, which excludes the Company’s contractual obligations relating to its natural gas transportation agreements with the Partnership and MVP LLC. For a description of the transportation agreements, see “Commitments and Contingencies” below and Note 18 to the Consolidated Financial Statements. Purchase obligations are primarily commitments for demand charges under existing long-term contracts and binding precedent agreements with various third-party pipelines, some of which extend up to approximately 20 years. The Company has entered into agreements to release some of its capacity to various third parties. Operating leases are primarily entered into for various office locations and warehouse buildings, as well as dedicated drilling rigs in support of the Company’s drilling program. The obligations for the Company’s various office locations and warehouse buildings totaled approximately $93.6 million as of December 31, 2014. The Company has agreements with Orion Drilling Company, Savanna Drilling, LLC and several other drillers to provide drilling equipment and services to the Company over the next four years. These obligations totaled approximately $132.0 million as of December 31, 2014. The other liabilities line represents commitments for total estimated payouts for the 2014 Value Driver Award Program. See “Critical Accounting Policies Involving Significant Estimates” below and Note 16 to the Consolidated Financial Statements for further discussion regarding factors that affect the ultimate amount of the payout of these obligations. As discussed in Note 9 to the Consolidated Financial Statements, the Company had a total reserve for unrecognized tax benefits at December 31, 2014 of $57.0 million, of which $10.1 million is offset against deferred tax assets since it would primarily reduce the related NOL carryover and research and experimentation tax credit carryforwards. The Company is currently unable to make reasonably reliable estimates of the period of cash settlement of these potential liabilities with taxing authorities; therefore, this amount has been excluded from the schedule of contractual obligations. Commitments and Contingencies In the ordinary course of business, various legal and regulatory claims and proceedings are pending or threatened against the Company. While the amounts claimed may be substantial, the Company is unable to predict with certainty the ultimate outcome of such claims and proceedings. The Company accrues legal and other direct costs related to loss contingencies when actually incurred. The Company has established reserves it believes to be appropriate for pending matters and, after consultation with counsel and giving appropriate consideration to available insurance, the Company believes that the ultimate outcome of any matter currently pending against the Company will not materially affect the Company’s financial position, results of operations or liquidity. EQT Energy has capacity commitments relating to natural gas transportation agreements with the Partnership and Mountain Valley Pipeline, LLC. As of December 31, 2014, future payments related to these agreements totaled $10.3 billion. These capacity commitments have terms extending up to 20 years. See Note 18 to the Consolidated Financial Statements for further discussion of the Company’s commitments and contingencies. Recently Issued Accounting Standards In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers. The standard requires an entity to recognize revenue in a manner that depicts the transfer of goods or services to customers at an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU No. 2014-09 will replace most of the existing revenue recognition requirements in United States GAAP when it becomes effective. The guidance in ASU No. 2014-09 is effective for public entities for annual reporting periods beginning after December 15, 2016, including interim periods therein. Early adoption is not permitted. The Company is currently evaluating the method of adoption and impact this standard will have on its financial statements and related disclosures. Critical Accounting Policies Involving Significant Estimates The Company’s significant accounting policies are described in Note 1 to the Consolidated Financial Statements. The discussion and analysis of the Consolidated Financial Statements and results of operations are based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of the Consolidated Financial Statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. The following critical accounting policies, which were reviewed by the Company’s Audit Committee, relate to the Company’s more significant judgments and estimates used in the preparation of its Consolidated Financial Statements. Actual results could differ from those estimates. Accounting for Oil and Gas Producing Activities: The Company uses the successful efforts method of accounting for its oil and gas production activities. The carrying values of the Company’s proved oil and gas properties are reviewed for indications of impairment when events or circumstances indicate that the remaining carrying value may not be recoverable. The estimated future cash flows used to test those properties for recoverability are based on risk-adjusted proved and, in some cases, probable reserves, utilizing assumptions about the use of the asset, market prices for oil and gas and future operating costs. Proved oil and gas properties that have carrying amounts in excess of estimated future cash flows would be written down to fair value, which would be estimated by discounting the estimated future cash flows using discount rate assumptions that marketplace participants would use in their estimates of fair value. Capitalized costs of unproved properties are evaluated at least annually for recoverability on a prospective basis. Indicators of potential impairment include changes brought about by economic factors, potential shifts in business strategy employed by management and historical experience. If it is determined that the properties will not yield proved reserves, the related costs are expensed in the period in which that determination is made. The Company believes that the accounting estimate related to the accounting for oil and gas producing activities is a “critical accounting estimate” as the evaluations of impairment of proved properties involves significant judgment about future events such as future sales prices of natural gas and NGLs, future production costs, estimates of the amount of natural gas and NGLs recorded and the timing of those recoveries. See Note 1 to the Consolidated Financial Statements for additional information regarding the Company’s impairments of proved and unproved oil and gas properties. Oil and Gas Reserves: Proved oil and gas reserves, as defined by SEC Regulation S-X Rule 4-10, are those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible from a given date forward, from known reservoirs and under existing economic conditions, operating methods and government regulations prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. The Company’s estimates of proved reserves are made and reassessed annually using geological and reservoir data as well as production performance data. Reserve estimates are prepared and updated by the Company’s engineers and audited by the Company’s independent engineers. Revisions may result from changes in, among other things, reservoir performance, development plans, prices, economic conditions and governmental restrictions. Decreases in prices, for example, may cause a reduction in some proved reserves due to reaching economic limits sooner. A material change in the estimated volumes of reserves could have an impact on the depletion rate calculation and the financial statements, including cash flow to the Company and strength of the balance sheet. The Company estimates future net cash flows from natural gas and oil reserves based on selling prices and costs using a 12-month average price, calculated as the unweighted arithmetic average of the first-day-of-the-month price for each month within the 12-month period, which is subject to change in subsequent periods. Operating costs, production and ad valorem taxes and future development costs are based on current costs with no escalation. Income tax expense is computed using expected future tax rates and giving effect to tax deductions and credits available under current laws and which relate to oil and gas producing activities. The Company believes that the accounting estimate related to oil and gas reserves is a “critical accounting estimate” because the Company must periodically reevaluate proved reserves along with estimates of future production and the estimated timing of development expenditures. Future results of operations, cash flow to the Company and strength of the balance sheet for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Income Taxes: The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the Company’s Consolidated Financial Statements or tax returns. The Company has recorded deferred tax assets principally resulting from federal and state NOL carryforwards, an alternative minimum tax credit carryforward, incentive compensation and investment in the Partnership. The Company has established a valuation allowance against a portion of the deferred tax assets related to the state NOL carryforwards, as it is believed that it is more likely than not that these deferred tax assets will not all be realized. No other significant valuation allowances have been established, as it is believed that future sources of taxable income, reversing temporary differences and other tax planning strategies will be sufficient to realize these deferred tax assets. Any determination to change the valuation allowance would impact the Company’s income tax expense and net income in the period in which such a determination is made. The Company also estimates the amount of financial statement benefit to record for uncertain tax positions as described in Note 9 to the Company’s Consolidated Financial Statements. The Company believes that accounting estimates related to income taxes are “critical accounting estimates” because the Company must assess the likelihood that deferred tax assets will be recovered from future taxable income and exercise judgment regarding the amount of financial statement benefit to record for uncertain tax positions. When evaluating whether or not a valuation allowance must be established on deferred tax assets, the Company exercises judgment in determining whether it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax assets will not be realized. The Company considers all available evidence, both positive and negative, to determine whether, based on the weight of the evidence, a valuation allowance is needed, including carrybacks, tax planning strategies, reversal of deferred tax assets and liabilities and forecasted future taxable income. In making the determination related to uncertain tax positions, the Company considers the amounts and probabilities of the outcomes that could be realized upon ultimate settlement of an uncertain tax position using the facts, circumstances and information available at the reporting date to establish the appropriate amount of financial statement benefit. To the extent that an uncertain tax position or valuation allowance is established or increased or decreased during a period, the Company must include an expense or benefit within tax expense in the income statement. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Derivative Instruments: The Company enters into derivative commodity instrument contracts primarily to mitigate exposure to commodity price risk associated with future sales of natural gas production. The Company also enters into derivative instruments to hedge other forecasted natural gas purchases and sales, to hedge basis and to hedge exposure to fluctuations in interest rates. The Company estimates the fair value of all derivative instruments using quoted market prices, where available. If quoted market prices are not available, fair value is based upon models that use as inputs market-based parameters, including but not limited to forward curves, discount rates, broker quotes, volatilities and nonperformance risk. Nonperformance risk considers the effect of the Company’s credit standing on the fair value of liabilities and the effect of the counterparty’s credit standing on the fair value of assets. The Company estimates nonperformance risk by analyzing publicly available market information, including a comparison of the yield on debt instruments with credit ratings similar to the Company’s or counterparty’s credit rating, the yield of a risk-free instrument and credit default swap rates where available. The values reported in the financial statements change as these estimates are revised to reflect actual results, or market conditions or other factors change, many of which are beyond the Company’s control. In addition, the derivative commodity instruments used to mitigate exposure to commodity price risk associated with future sales of natural gas production may limit the benefit the Company would receive from increases in the prices of natural gas and may expose the Company to margin requirements. Given the Company’s price risk management position and price volatility, the Company may be required from time to time to deposit cash with or provide letters of credit to its counterparties in order to satisfy these margin requirements. The Company believes that the accounting estimates related to derivative instruments are “critical accounting estimates” because the Company’s financial condition, results of operations and liquidity can be significantly impacted by changes in the market value of the Company’s derivative instruments due to the volatility of natural gas prices, both NYMEX and basis, and by changes in margin requirements. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Contingencies and Asset Retirement Obligations: The Company is involved in various regulatory and legal proceedings that arise in the ordinary course of business. The Company records a liability for contingencies based upon its assessment that a loss is probable and the amount of the loss can be reasonably estimated. The Company considers many factors in making these assessments, including history and specifics of each matter. Estimates are developed in consultation with legal counsel and are based upon an analysis of potential results. The Company also accrues a liability for legal asset retirement obligations based on an estimate of the timing and amount of their settlement. For oil and gas wells, the fair value of the Company’s plugging and abandonment obligations is required to be recorded at the time the obligations are incurred, which is typically at the time the wells are spud. The Company is required to operate and maintain its natural gas pipeline and storage systems, and intends to do so as long as supply and demand for natural gas exists, which the Company expects for the foreseeable future. Therefore, the Company believes that the substantial majority of its natural gas pipeline and storage system assets have indeterminate lives. The Company believes that the accounting estimates related to contingencies and asset retirement obligations are “critical accounting estimates” because the Company must assess the probability of loss related to contingencies and the expected amount and timing of asset retirement obligations. In addition, the Company must determine the estimated present value of future liabilities. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Share-Based Compensation: The Company awards share-based compensation in connection with specific programs established under the 1999, 2009 and 2014 Long-Term Incentive Plans. Awards to employees are typically made in the form of performance-based awards, time-based restricted stock and stock options. Awards to directors are typically made in the form of phantom units. Performance-based awards expected to be satisfied in cash are treated as liability awards. Awards under the 2014 EQT Value Driver Award program are treated as liability awards. Phantom units (which vest upon grant) expected to be satisfied in cash are also treated as liability awards. For liability awards, the Company is required to estimate, on grant date and on each reporting date thereafter until vesting and payment, the fair value of the ultimate payout based upon the expected performance through, and value of the Company’s common stock on, the vesting date. The Company then recognizes a proportionate amount of the expense for each period in the Company’s financial statements over the vesting period of the award, in the case of a performance-based award, and until payment, in the case of phantom units. The Company reviews its assumptions regarding performance and common stock value on a quarterly basis and adjusts its accrual when changes in these assumptions result in a material change in the fair value of the ultimate payouts. Performance-based awards expected to be satisfied in Company common stock or Partnership common units are treated as equity awards. Awards under the 2012 Executive Performance Incentive Program, the 2013 Executive Performance Incentive Program, the 2013 Value Driver Award Program, the 2014 Executive Performance Incentive Program, the 2014 EQM Value Driver Award Program and the EQM Total Return Program, which remained outstanding at December 31, 2014, are treated as equity awards. For equity awards, the Company is required to determine the grant date fair value of the awards, which is then recognized as expense in the Company’s financial statements over the vesting period of the award. Determination of the grant date fair value of the awards requires judgments and estimates regarding, among other things, the appropriate methodologies to follow in valuing the awards and the related inputs required by those valuation methodologies. Most often, the Company is required to obtain a valuation based upon assumptions regarding risk-free rates of return, dividend or distribution yields, expected volatilities and the expected term of the award. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend or distribution yield is based on the historical dividend or distribution yield of the Company’s common stock or the Partnership’s common units, as applicable, and any changes expected thereto, and, where applicable, of the common stock of the peer group members at the time of grant. Expected volatilities are based on historical volatility of the Company’s common stock or the Partnership’s common units and, where applicable, the common stock of the peer group members at the time of grant. The expected term represents the period of time elapsing during the applicable performance period. For time-based restricted stock awards, the grant date fair value of the awards is recognized as expense in the Company’s financial statements over the vesting period, historically three years. For phantom units (which vest on date of grant) expected to be satisfied in equity, the grant date fair value of the awards is recognized as an expense in the Company’s financial statements in the year of grant. The grant date fair value, in both cases, is determined based upon the closing price of the Company’s common stock on the date of the grant. For non-qualified stock options, the grant date fair value is recognized as expense in the Company’s financial statements over the vesting period, typically two or three years. The Company utilizes the Black-Scholes option pricing model to measure the fair value of stock options, which includes assumptions for a risk-free interest rate, dividend yield, volatility factor and expected term. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the dividend yield of the Company’s common stock at the time of grant. The expected volatility is based on historical volatility of the Company’s common stock at the time of grant. The expected term represents the period of time that options granted are expected to be outstanding based on historical option exercise experience at the time of grant. The Company believes that the accounting estimates related to share-based compensation are “critical accounting estimates” because they may change from period to period based on changes in assumptions about factors affecting the ultimate payout of awards, including the number of awards to ultimately vest and the market price and volatility of the Company’s common stock. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. See Note 16 to the Consolidated Financial Statements for additional information regarding the Company’s share-based compensation.

<s>[INST] 2014 EQT Overview: Annual production sales volumes of 476.3 Bcfe, 26% higher than 2013 Marcellus sales volumes of 378.2 Bcfe, 38% higher than 2013 Gathered volumes of 590.5 TBtu, 27% higher than 2013 Increased proved reserves by 29% to 10.7 Tcfe The Partnership completed an underwritten public offering of common units representing limited partner interests The Partnership issued 4.00% Senior Notes of $500.0 million due August 1, 2024 Recognized impairment of proved and unproved oil and gas properties of $267.3 million (pretax) in the Ohio Utica and Permian Basin Income from continuing operations attributable to EQT Corporation for 2014 was $385.6 million, $2.53 per diluted share, compared with $298.7 million, $1.97 per diluted share, in 2013. The $86.9 million increase in income from continuing operations attributable to EQT Corporation was primarily attributable to a 26% increase in production sales volumes, favorable gains on derivatives not designated as hedges, increases in contracted transmission capacity and throughput and gathered volumes, favorable changes in hedging ineffectiveness, and lower interest expense. These factors were partially offset by impairments of longlived assets, higher net income attributable to noncontrolling interests of the Partnership, higher transportation and processing expenses, higher income tax expense, higher selling, general and administrative (SG&A) expense and higher depreciation, depletion and amortization (DD&A) expense. Operating income was $853.4 million in 2014 compared to $654.6 million in 2013, an increase of $198.8 million. EQT Production sales volumes increased 26% primarily as a result of increased production from the 2014 and 2013 drilling programs in the Marcellus acreage partially offset by the normal production decline in the Company’s producing wells. The average realized price to EQT Production for sales volumes was $3.23 per Mcfe in 2014 compared to $3.15 per Mcfe in 2013. EQT Production total net operating revenues for the year ended December 31, 2014 included $83.8 million of derivative gains for derivative instruments not designated as hedging instruments compared to $0.3 million of derivative losses for the year ended December 31, 2013. The $83.8 million of derivative gains for derivative instruments not designated as hedging instruments for the year ended December 31, 2014 included $36.5 million of cash settlements received, which is included in the average realized price to EQT Production of $3.23 per Mcfe in 2014. The year ended December 31, 2014 also included a $24.8 million gain for hedging ineffectiveness of financial hedges compared to a $21.3 million loss for ineffectiveness of financial hedges for the year ended December 31, 2013. Transmission net operating revenues increased as a result of higher firm transmission contracted capacity and throughput for third parties and EQT Production, as well as higher interruptible transmission service. The increase in transmission net operating revenues is the result of increased production development in the Marcellus play. Gathering net operating revenues increased due to a 27% increase in gathered volumes, partially offset by an 11% decrease in the average gathering fee. The gathered volume increase was driven by higher volumes gathered for EQT Production in the Marcellus play. The decrease in the average gathering fee resulted from increased gathered volumes in the Marcellus play, as the Marcellus gathering rate is lower than the rate in other areas. Operating expenses for 2014 were $1,650.5 million compared to $1,227.0 million in 2013, an increase of $423.5 million. Excluding the $2 [/INST] Negative. </s>

EQT Corp

2016-02-11

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Consolidated Results of Continuing Operations 2015 EQT Overview: •Annual production sales volumes of 603.1 Bcfe, 27% higher than 2014 •Marcellus sales volumes of 505.1 Bcfe, 34% higher than 2014 •Gathered volumes of 754.3 TBtu, 28% higher than 2014 •The Company completed EQGP's IPO •EQM completed two underwritten public offerings of common units representing limited partner interests Income from continuing operations attributable to EQT Corporation for 2015 was $85.2 million, $0.56 per diluted share, compared with $385.6 million, $2.53 per diluted share, in 2014. The $300.4 million decrease in income from continuing operations attributable to EQT Corporation was primarily attributable to a 36% decrease in the average realized price to EQT Corporation for production sales volumes, higher operating expenses and higher net income attributable to noncontrolling interests of EQM and EQGP, partially offset by a 27% increase in production sales volumes, increased gains on derivatives not designated as hedges, increased gathering and transmission revenues and lower income tax expense. Operating expenses for 2015 and 2014 include $122.5 million and $267.3 million, respectively, of pre-tax, non-cash impairment charges related to the Company's oil and gas properties, which are included in the impairment of long-lived assets in the Statements of Consolidated Income. The average realized price to EQT Corporation for production sales volumes was $2.67 per Mcfe for 2015 compared to $4.16 per Mcfe for 2014. The decrease in the average realized price was driven by lower NYMEX natural gas prices net of cash settled derivatives, lower NGL prices and a lower average differential, which includes Appalachian Basin basis, recoveries and cash settled basis swaps. Recoveries represent differences in natural gas prices between the Appalachian Basin and other markets reached by utilizing transportation capacity, differences in natural gas prices between Appalachian Basin and fixed price sales contracts, term sales with fixed differentials to NYMEX and other marketing activity, including capacity releases. The Company's volume weighted average NYMEX natural gas index price was $2.66 per MMBtu for 2015, 39% lower than the average index price of $4.38 per MMBtu in 2014. In addition, the average differential decreased by $0.15 per Mcf, primarily due to lower Appalachian Basin basis. The Company's average NGL price was $18.84 per barrel for 2015, compared to $41.94 per barrel for 2014. Operating income was $563.1 million in 2015 compared to $853.4 million in 2014, a decrease of $290.3 million. EQT Midstream's operating income increased by $89.1 million in 2015, primarily due to increases in gathering and transmission revenues as a result of production development in the Marcellus Shale, which was more than offset by a $401.1 million decrease in EQT Production's operating income in 2015. The average realized price to EQT Production decreased to $1.74 per Mcfe in 2015 compared to $3.23 per Mcfe in 2014. The decrease in the average realized price to EQT Production was offset by an increase in sales volumes of 27% primarily as a result of increased production from the 2014 and 2013 drilling programs in the Marcellus acreage, partially offset by the normal production decline in the Company’s producing wells. EQT Production total operating revenues for the year ended December 31, 2015 also included $385.1 million of derivative gains for derivative instruments not designated as hedging instruments compared to $83.8 million of derivative gains not designated as hedges and $24.8 million of gains for ineffectiveness of financial hedges for the year ended December 31, 2014. The increased derivative gains for the year ended December 31, 2015 primarily related to favorable changes in the fair market value of EQT Production's NYMEX swaps due to decreased forward NYMEX prices during the year ended December 31, 2015. EQT Production received $170.3 million and $36.5 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2015 and 2014, respectively. These net cash settlements are included in the average realized price discussion. Operating expenses for 2015 were $1,776.6 million compared to $1,650.5 million in 2014, an increase of $126.1 million. This increase was primarily attributable to higher depreciation, depletion, and amortization (DD&A) expense, higher transportation and processing expenses and higher exploration costs, partially offset by a favorable depletion rate and a decrease in the impairment of long-lived assets. Income from continuing operations attributable to EQT Corporation for 2014 was $385.6 million, $2.53 per diluted share, compared with $298.7 million, $1.97 per diluted share, in 2013. The $86.9 million increase in income from continuing operations attributable to EQT Corporation was primarily attributable to a 26% increase in production sales volumes, favorable gains on derivatives not designated as hedges, increases in contracted transmission capacity and throughput and gathered volumes, favorable changes in hedging ineffectiveness, and lower interest expense. These factors were partially offset by impairments of long-lived assets, higher net income attributable to noncontrolling interests of EQM, higher transportation and processing expenses, higher income tax expense, higher selling, general and administrative (SG&A) expense and higher DD&A expense. Operating income was $853.4 million in 2014 compared to $654.6 million in 2013, an increase of $198.8 million. EQT Production sales volumes increased 26% primarily as a result of increased production from the 2014 and 2013 drilling programs in the Marcellus acreage partially offset by the normal production decline in the Company’s producing wells. The average realized price to EQT Production for sales volumes was $3.23 per Mcfe in 2014 compared to $3.15 per Mcfe in 2013. EQT Production total operating revenues for the year ended December 31, 2014 included $83.8 million of derivative gains for derivative instruments not designated as hedging instruments compared to $0.3 million of derivative losses for the year ended December 31, 2013. For the year ended December 31, 2014, EQT Production received $36.5 million of net cash settlements for derivatives not designated as hedges which is included in the average realized price to EQT Production of $3.23 per Mcfe in 2014. The year ended December 31, 2014 also included a $24.8 million gain for hedging ineffectiveness of financial hedges compared to a $21.3 million loss for ineffectiveness of financial hedges for the year ended December 31, 2013. Transmission operating revenues increased in 2014 compared to 2013, reflecting continued production development in the Marcellus Shale by affiliate and third-party producers. The increase primarily resulted from higher firm transmission contracted capacity and throughput for third parties and EQT Production and higher interruptible transmission service. Gathering revenues increased primarily as a result of higher affiliate volumes gathered in 2014 compared to 2013, driven by production development in the Marcellus Shale. EQT Midstream significantly increased firm reservation fee revenues in 2014 compared to 2013 as a result of increased capacity under firm contracts with affiliates. The decrease in usage fees under interruptible contracts was primarily due to affiliates contracting for additional firm capacity. Operating expenses for 2014 were $1,650.5 million compared to $1,227.0 million in 2013, an increase of $423.5 million. Excluding a $267.3 million impairment charge and $26.2 million increase in depreciation and depletion, operating expenses increased $130.0 million. This increase was primarily attributable to higher transportation and processing expenses and higher SG&A costs, consistent with the growth in the production and midstream businesses. See “Other Income Statement Items” for a discussion of other income, interest expense, income taxes, income from discontinued operations and net income attributable to noncontrolling interests, and “Investing Activities” under the caption “Capital Resources and Liquidity” for a discussion of capital expenditures. Consolidated Operational Data Revenues earned by the Company from the sale of natural gas, NGLs and oil are split between EQT Production and EQT Midstream. The split is reflected in the calculation of EQT Production’s average realized price. The following operational information presents detailed gross liquid and natural gas operational information as well as midstream deductions to assist in the understanding of the Company’s consolidated operations. The operational information in the table below presents an average realized price ($/Mcfe) to EQT Production and EQT Corporation, which is based on EQT Production adjusted net operating revenues, a non-GAAP supplemental financial measure. EQT Production adjusted net operating revenues is presented because it is an important measure used by the Company’s management to evaluate period-to-period comparisons of earnings trends. EQT Production adjusted net operating revenues should not be considered as an alternative to EQT Corporation total operating revenues as reported in the Statements of Consolidated Income, the most directly comparable GAAP financial measure. See “Reconciliation of Non-GAAP Measures” following that table for a reconciliation of EQT Production adjusted net operating revenues to EQT Corporation total operating revenues. EQT Corporation Price Reconciliation (a) NGLs and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (b) The Company’s volume weighted NYMEX natural gas price (actual average NYMEX natural gas price ($/MMBtu) was $2.66, $4.41 and $3.65 for the years ended December 31, 2015, 2014 and 2013, respectively). (c) Recoveries represent differences in natural gas prices between the Appalachian Basin and other markets reached by utilizing transportation capacity, differences in natural gas prices between Appalachian Basin and fixed price sales contracts, term sales with fixed differentials to NYMEX and other marketing activity, including the sale of unused pipeline capacity. Recoveries include approximately $0.21, $0.19 and $0.23 per Mcf for the years ended December 31, 2015, 2014 and 2013, respectively, for the sale of unused pipeline capacity. Reconciliation of Non-GAAP Measures The table below reconciles EQT Production adjusted net operating revenues, a non-GAAP supplemental financial measure, to EQT Corporation total operating revenues as reported in the Statements of Consolidated Income, its most directly comparable financial measure calculated in accordance with GAAP. The Company reports gain (loss) for hedging ineffectiveness and gain (loss) on derivatives not designated as hedges within total operating revenues in the Statements of Consolidated Income. EQT Production adjusted net operating revenues is presented because it is an important measure used by the Company’s management to evaluate period-over-period comparisons of earnings trends. EQT Production adjusted net operating revenues as presented excludes the revenue impact of changes in the fair value of derivative instruments prior to settlement and is net of transportation and processing costs. Management utilizes EQT Production adjusted net operating revenues to evaluate earnings trends because the measure reflects only the impact of settled derivative contracts and thus does not burden the revenue from natural gas sales with the often volatile fluctuations in the fair value of derivatives prior to settlement. EQT Production adjusted net operating revenues also reflects transportation and processing costs as deductions from operating revenues because management considers the net price realized for sales of products, after the costs of processing and transporting the product to sales points, to be an indicator of the quality of earnings period-over-period. Management also considers this to be an indicator of how well the Company is utilizing its transportation and processing contracts. The sale price for natural gas is significantly impacted by the market in which the gas is sold and the expense incurred to transport and process the gas is important in evaluating the quality of earnings period-over-period because the cost of reaching a higher priced market may exceed the incremental price benefit of that market as compared to the market where the gas is produced. This is particularly important to natural gas producers in the Appalachian Basin given pipeline constraints and the impact on pricing in the area. Management further believes that EQT Production adjusted net operating revenues as presented provides useful information for investors for evaluating period-over-period earnings and is consistent with industry practices. Business Segment Results of Operations Business segment operating results from continuing operations are presented in the segment discussions and financial tables on the following pages. Operating segments are evaluated on their contribution to the Company’s consolidated results based on operating income. Other income, interest and income taxes are managed on a consolidated basis. Headquarters’ costs are billed to the operating segments based upon a fixed allocation of the headquarters’ annual operating budget. Unallocated expenses consist primarily of incentive compensation, administrative costs and for 2013, corporate overhead charges previously allocated to the Company’s Distribution segment that were reclassified to headquarters as part of the recast of those periods to reflect the discontinued operations presentation. The Company has reported the components of each segment’s operating income from continuing operations and various operational measures in the sections below, and where appropriate, has provided information describing how a measure was derived. EQT’s management believes that presentation of this information provides useful information to management and investors regarding the financial condition, operations and trends of each of EQT’s business segments without being obscured by the financial condition, operations and trends for the other segment or by the effects of corporate allocations of interest, income taxes and other income. In addition, management uses these measures for budget planning purposes. Purchased gas costs at EQT Midstream include natural gas purchases, including natural gas purchases from affiliates, purchased gas costs adjustments and other gas supply expenses. These purchased gas costs are primarily attributable to transactions with affiliates and are eliminated in consolidation. Consistent with the consolidated results, energy trading contracts recorded within storage, marketing and other revenues are reported net within operating revenues, regardless of whether the contracts are physically or financially settled. The Company has reconciled each segment’s operating income to the Company’s consolidated operating income and net income in Note 5 to the Consolidated Financial Statements. EQT Production Results of Operations (a) Includes Upper Devonian wells. (b) Includes 4,173 MMcfe of deep Utica sales volume for the year ended December 31, 2015. (c) NGLs and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (d) Includes $167.3 million of cash capital expenditures and $349.2 million of non-cash capital expenditures for the exchange of assets with Range Resources Corporation (Range) during the year ended December 31, 2014 and $114.2 million of cash capital expenditures for the purchase of acreage and Marcellus wells from Chesapeake Energy Corporation and its partners (Chesapeake) during the year ended December 31, 2013. Year Ended December 31, 2015 vs. December 31, 2014 EQT Production’s operating income totaled $104.9 million for 2015 compared to $506.0 million for 2014. The $401.1 million decrease in operating income was primarily due to a lower average realized price to EQT Production and increased operating expenses partially offset by increased sales of produced natural gas and increased gains on derivatives not designated as hedges. Operating expenses included non-cash impairment charges of $118.3 million in 2015 and $267.3 million in 2014. The 2015 impairment charge consisted of impairments of proved properties in the Permian Basin of Texas of $94.3 million and impairments of proved properties in the Utica Shale of Ohio of $4.3 million, as well as $19.7 million for unproved property impairments of non-core Marcellus acreage related to lease expirations. The 2014 impairment charge consisted of impairments of proved properties in the Permian Basin of Texas of $105.2 million and impairments of proved properties in the Utica Shale of Ohio of $75.5 million, as well as impairments of $86.6 million associated with undeveloped properties. The proved properties impairments in 2015 and 2014 were a result of continued declines in commodity prices and insufficient recovery of hydrocarbons to support continued development. The 2015 and 2014 impairments related to the unproved properties were due to operational decisions to focus near-term development activities in the Company's core Marcellus and deep Utica acreage. Total operating revenues were $1,540.9 million for 2015 compared to $1,813.3 million for 2014. The $272.4 million decrease in total operating revenues was primarily due to a 46% decrease in the average realized price to EQT Production and a prior year gain on hedge ineffectiveness, partly offset by a 27% increase in production sales volumes and increased gains on derivatives not designated as hedges in 2015. The $1.49 per Mcfe decrease in the average realized price to EQT Production for the year ended December 31, 2015 was primarily due to the decrease in the average NYMEX natural gas price net of cash settled derivatives of $1.06 per Mcf, lower NGL prices and a decrease in the average natural gas differential of $0.15 per Mcf. The average differential for 2015 includes lower Appalachian Basin basis of $0.11 per Mcf. Recoveries per Mcf (also included in the average differential) for the year ended December 31, 2015 were consistent with the year ended December 31, 2014. Recoveries represent differences in natural gas prices between the Appalachian Basin and other markets reached by utilizing transportation capacity, differences in natural gas prices between Appalachian Basin and fixed price sales contracts, term sales with fixed differentials to NYMEX and other marketing activity, including capacity releases. Favorable recoveries in 2015 from fixed price sales contracts were offset by reduced differentials between the Appalachian Basin and ultimate sales prices. The increase in production sales volumes was primarily the result of increased production from the 2013 and 2014 drilling programs in the Marcellus play. This increase was partially offset by the normal production decline in the Company’s producing wells. EQT Production total operating revenues for the year ended December 31, 2015 included a $385.1 million gain on derivatives not designated as hedges compared to an $83.8 million gain on derivatives not designated as hedges for the year ended December 31, 2014. The increased gains for the year ended December 31, 2015 primarily related to favorable changes in the fair market value of EQT Production’s NYMEX swaps due to a decrease in forward NYMEX prices during the year ended December 31, 2015. EQT Production received $170.3 million and $36.5 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2015 and 2014, respectively. These net cash settlements are included in the average realized price discussion. For the year ended December 31, 2014, EQT Production total operating revenues also included a $24.8 million gain for hedging ineffectiveness. Operating expenses totaled $1,436.0 million for 2015 compared to $1,334.7 million for 2014. The increase in operating expenses was the result of increases in DD&A, transportation and processing, exploration, SG&A, and LOE expenses, partly offset by decreases in non-cash impairments of long-lived assets and production taxes. The increase in DD&A expense was the result of higher produced volumes partly offset by a lower overall depletion rate in 2015. Transportation and processing expenses increased by $73.8 million due to additional contracted capacity to move EQT Production’s natural gas out of the Appalachian Basin and increased liquids processing fees. Transportation and processing expenses are included in the average realized price to EQT Production. Exploration expense increased $40.3 million due to increased lease expirations of non-core acreage totaling $22.8 million and expenses related to exploratory wells. The increase in SG&A expense was primarily due to higher personnel costs of $14.7 million, including incentive compensation expenses, and $11.2 million of drilling program reduction charges, including rig release penalties, partly offset by $4.2 million of higher litigation and environmental remediation costs in the prior year, a $2.6 million decrease in professional services costs and a $2.4 million reduction to the reserve for uncollectible accounts. The increase in LOE was primarily due to increased Marcellus activity, including a $1.4 million increase in salt water disposal costs, and increased Permian maintenance costs. Production taxes decreased primarily due to a $16.7 million decrease in severance taxes due to lower market sales prices, partly offset by higher production sales volumes in certain jurisdictions subject to these taxes and a $3.6 million increase in property taxes. Production taxes also decreased due to a $1.4 million decrease in the Pennsylvania impact fee, primarily as a result of a decrease in the number of wells drilled in Pennsylvania in 2015. Year Ended December 31, 2014 vs. December 31, 2013 EQT Production’s operating income totaled $506.0 million for 2014 compared to $371.2 million for 2013. The $134.8 million increase in operating income was primarily due to increased sales of produced natural gas and NGLs and a higher average realized price partially offset by an increase in operating expenses, which included $267.3 million of noncash impairment charges. Impairment charges consisted of $105.2 million associated with proved properties in the Permian Basin of Texas related to the 2014 decline in commodity prices. Impairment charges also included $86.6 million associated with undeveloped properties and $75.5 million associated with proved properties in the Utica Shale of Ohio as a result of insufficient recovery of hydrocarbons to support continued development along with the decline in commodity prices. Total operating revenues were $1,813.3 million for 2014 compared to $1,310.9 million for 2013. The $502.4 million increase in total operating revenues was primarily due to a 26% increase in production sales volumes, a favorable gain on derivatives not designated as hedges, a favorable change in hedging ineffectiveness and a 3% increase in the average realized price to EQT Production. The increase in production sales volumes was the result of increased production from the 2014 and 2013 drilling programs, primarily in the Marcellus play. This increase was partially offset by the normal production decline in the Company’s producing wells. Total operating revenues for the year ended December 31, 2014 included a $24.8 million gain for hedging ineffectiveness of financial hedges compared to a $21.3 million loss for ineffectiveness of financial hedges for the year ended December 31, 2013. The year ended December 31, 2014 also included $83.8 million of derivative gains for derivative instruments not designated as hedging instruments compared to $0.3 million of derivative losses for the year ended December 31, 2013. The gains for the year ended December 31, 2014 related to favorable changes in the fair market value of basis swaps and NYMEX collars that were not designated as hedging instruments, due to decreased forward NYMEX and basis prices as of December 31, 2014. EQT Production received $36.5 million of net cash settlements for derivatives not designated as hedges for the year ended December 31, 2014. These net cash settlements are included in the average realized price. The $0.08 per Mcfe increase in the average realized price to EQT Production was the net result of an increase in the average NYMEX natural gas price net of cash settled derivatives combined with a per unit decrease in midstream revenue deductions, partly offset by a lower average natural gas differential of $0.40 per Mcf. The average differential included lower Appalachian Basin basis of $0.91 per Mcf, favorable recoveries of $0.45 per Mcf and favorable settlements of basis swaps of $0.06 per Mcf. For the year ended December 31, 2014, EQT Production recognized higher recoveries compared to 2013 primarily by using its contracted transportation capacity to sell gas in higher priced markets, particularly during the winter months when market prices in the United States Northeast region were significantly higher than the Appalachian Basin prices. Much of these higher revenues resulted from sales of the Company’s Texas Eastern Transmission (TETCO) and Tennessee Gas Pipeline capacity, including additional TETCO capacity that came online in 2014. Effective February 2014, the Company acquired new TETCO capacity of 245,000 MMBtu per day that enabled the Company to reach markets in eastern Pennsylvania. Effective November 2014, additional TETCO capacity of 300,000 MMBtu per day came online that enabled the Company to reach markets in New Jersey as well as markets along the Gulf coast. Additionally, the Company executed natural gas sales with fixed differentials to NYMEX for the 2014 summer term during the fourth quarter of 2013 and first quarter of 2014 when market prices were favorable compared to actual Appalachian Basin basis during the summer of 2014. Operating expenses totaled $1,334.7 million for 2014 compared to $939.7 million for 2013. The increase in operating expenses was the result of impairments of long-lived assets of $267.3 million, as previously mentioned, and increases in SG&A, production taxes, DD&A, LOE and exploration expenses. SG&A expense increased in 2014 primarily as a result of higher personnel costs of $12.4 million, including incentive compensation expenses, higher litigation and environmental reserves of $6.2 million, and an increase in professional services of $4.9 million. Production taxes increased due to an $11.6 million increase in severance taxes and property taxes as a result of higher market sales prices and higher production sales volumes in certain jurisdictions subject to these taxes. Production taxes also increased due to a $5.1 million increase in the Pennsylvania impact fee, primarily as a result of an increase in the number of wells drilled in Pennsylvania in 2014. Depletion expense increased as a result of higher production sales volumes in 2014, partially offset by a lower overall depletion rate. The increase in LOE was mainly a result of increased Marcellus activity in 2014, including a $2.8 million increase in salt water disposal expenses and a $2.7 million increase in labor expenses, along with expenses related to the exchange of properties with Range. Exploration expense increased in 2014 primarily as a result of increased geophysical activity compared to 2013. In connection with an asset exchange with Range in 2014, the Company received acreage and producing wells in the Permian Basin of Texas in exchange for acreage, producing wells, the Company’s 50% ownership interest in a supporting gathering system in the Nora fields of Virginia and cash of $167.3 million. In conjunction with the transaction, EQT Production recognized a pre-tax gain of $27.4 million in 2014, which is included in gain on sale / exchange of assets in the Statements of Consolidated Income. The $27.4 million pre-tax gain included a $28.0 million pre-tax gain related to the de-designation of certain derivative instruments that were previously designated as cash flow hedges because it was probable that the forecasted transactions would not occur. EQT Midstream Results of Operations (a) Includes commodity charges and fees on volumes gathered or transported in excess of firm contracted capacity. (b) Includes volumes gathered or transported under interruptible contracts and volumes in excess of firm contracted capacity. Year Ended December 31, 2015 vs. December 31, 2014 EQT Midstream’s operating income totaled $473.4 million for the year ended December 31, 2015, an increase of $89.1 million in 2015 compared to 2014. The increase in operating income was primarily the result of increased gathering and transmission operating revenues from affiliates, partly offset by increased operating expenses, a decrease in storage, marketing and other net operating revenues and a gain on the sale/exchange of assets in 2014. Gathering revenues increased by $106.7 million primarily as a result of higher affiliate volumes gathered in 2015 compared to 2014, driven by production development in the Marcellus Shale. EQT Midstream significantly increased firm reservation fee revenues in 2015 compared to 2014 as a result of increased capacity under firm contracts with affiliates. The decrease in usage fees was primarily due to affiliates contracting for additional firm capacity. Transmission revenues increased by $41.2 million in 2015 compared to 2014, reflecting continued production development in the Marcellus Shale by affiliate and third-party producers. The increase primarily resulted from higher firm reservation fees of $44.3 million, partly offset by lower usage fees under interruptible contracts. The decrease in usage fees was primarily due to customers contracting for additional firm capacity. Storage, marketing and other net operating revenues decreased from the prior year primarily as a result of lower revenues on NGLs marketed for non-affiliate producers as a result of lower liquids pricing in the current year and reduced marketing activity. Total operating revenues increased by $108.8 million primarily as a result of increased gathering and transmission revenue offset by reduced gas marketing activity. Purchased gas costs decreased $34.3 million primarily as a result of reduced natural gas purchases from affiliates for gas marketing activities. Total operating expenses increased $47.3 million in 2015 compared to 2014. O&M expense increased $15.7 million as a result of higher compressor and pipeline expenses of $5.0 million related to an increase in Marcellus activity, higher property taxes of $4.4 million, higher personnel costs of $2.4 million, increased allocated expenses from affiliates of $2.0 million and increased contract labor of $1.2 million. SG&A expense increased $19.2 million primarily as a result of increased allocated expenses from affiliates of $5.8 million, higher personnel costs of $5.5 million, higher professional services costs of $3.2 million and charges to write off expired right of ways options of $1.9 million. DD&A increased $8.2 million as a result of additional assets placed in-service. The $4.2 million impairment of long-lived assets in 2015 reflects the Company's decision to sell certain field level NGL processing equipment that is not being used. Year Ended December 31, 2014 vs. December 31, 2013 EQT Midstream’s operating income totaled $384.3 million, an increase of $55.5 million in 2014 compared to 2013. The increase was the result of increased transmission and gathering net operating revenues partly offset by increased operating expenses, lower gains on asset sales and a decrease in storage, marketing and other net operating revenues. Gathering revenues increased by $46.5 million primarily as a result of higher affiliate volumes gathered in 2014 compared to 2013, driven by production development in the Marcellus Shale. EQT Midstream significantly increased firm reservation fee revenues and related usage charges in 2014 compared to 2013 as a result of increased capacity and volumes gathered under firm contracts with affiliates. The decrease in usage fees under interruptible contracts was primarily due to affiliates contracting for additional firm capacity. Transmission revenues increased by $65.9 million in 2014 compared to 2013, reflecting continued production development in the Marcellus Shale by third-party and affiliate producers. The increase primarily resulted from higher firm reservation fee revenues of $60.6 million for third parties and EQT Production, including $14.7 million related to the AVC facilities, and higher usage fees under interruptible contracts. Storage, marketing and other net operating revenues decreased from 2013 to 2014 primarily as a result of $9.3 million of reduced marketing revenues primarily as a result of the sale of certain energy marketing contracts on December 31, 2013 and $9.0 million of lower revenues on NGLs marketed for non-affiliated producers as a result of lower prices and volumes, partly offset by increased storage revenues on the AVC facilities. Total operating revenues increased $85.0 million primarily as a result of increased transmission and gathering revenue, partly offset by reduced gas marketing activity. Total purchased gas costs decreased $24.5 million primarily as a result of reduced gas marketing activity. Operating expenses totaled $277.6 million, an increase of $41.1 million in 2014 compared to 2013. O&M expense increased as a result of $8.6 million in higher compression and pipeline operating expenses related to an increase in Marcellus activity and operating the AVC facilities as well as higher labor costs. The increase in SG&A was primarily the result of increased personnel costs of $9.8 million, increased overhead allocated from affiliates of $4.2 million and increased professional services of $2.3 million. DD&A increased as a result of additional assets placed in-service, including the AVC facilities. In 2013, the Company sold certain energy marketing contracts to a third party for $20.0 million. In conjunction with this transaction, the Company recognized a pre-tax gain of $19.6 million in 2013. In connection with an asset exchange with Range during 2014, EQT Midstream recognized a pre-tax gain of $6.8 million. The difference in the gains on these two transactions resulted in the decrease in gain on sale / exchange of assets in 2014 compared to 2013. Other Income Statement Items Other Income Other income includes equity in earnings of nonconsolidated investments. For the years ended December 31, 2015, 2014 and 2013, the Company recorded equity in earnings of nonconsolidated investments of $2.6 million related to EQM’s investment in the MVP Joint Venture, $3.4 million related to the Company’s prior investment in Nora Gathering, LLC (Nora LLC) and $7.6 million related to the Company’s prior investment in Nora LLC, respectively. In connection with the asset exchange with Range in 2014, the Company transferred its 50% ownership interest in Nora LLC to Range. See Note 8 to the Consolidated Financial Statements. Other income also includes AFUDC. For the years ended December 31, 2015, 2014 and 2013, the Company recorded AFUDC of $6.3 million, $3.2 million and $1.2 million, respectively. The increases in AFUDC primarily related to increased spending by EQM related to the OVC project. Interest Expense Interest expense increased $10.0 million in 2015 compared to 2014, primarily as a result of additional interest expense of approximately $11.7 million related to EQM's 4.00% senior notes due 2024 in the aggregate principal amount of $500.0 million issued during the third quarter of 2014, partially offset by lower interest expense resulting from the Company's repayment of $150.0 million of 5.00% senior notes and $10.0 million of 7.55% Series B notes, both of which matured in the fourth quarter of 2015. Interest expense decreased $6.2 million in 2014 compared to 2013 due to higher capitalized interest of $35.0 million on increased Marcellus well development in 2014 compared to $22.9 million in 2013, partially offset by an increase in interest expense of $8.3 million related to EQM’s issuance of 4.00% senior notes due 2024. The weighted average annual interest rates on the Company’s long-term debt, excluding EQM’s long-term debt, was 6.5%, 6.4%, and 6.4% for 2015, 2014 and 2013, respectively. The weighted average annual interest rate on EQM’s long-term debt was 4.0% for both 2015 and 2014. EQM had no long-term debt outstanding in 2013. The Company did not have any borrowings outstanding at any time under its revolving credit facility during the years ended December 31, 2015 and 2014. The maximum amount of outstanding borrowings at any time under the Company’s credit facility during the year ended December 31, 2013 was $178.5 million. The average daily balance of such borrowings outstanding for the Company during the year ended December 31, 2013 was approximately $12.1 million at a weighted average annual interest rate of 1.7%. The maximum amount of outstanding borrowings under EQM’s revolving credit facility at any time during the years ended December 31, 2015 and 2014 was $404 million and $450 million, respectively. The average daily balance of borrowings outstanding under EQM's credit facility was approximately $261 million and $119 million during the years ended December 31, 2015 and 2014, respectively. Interest was incurred on such borrowings at a weighted average annual interest rate of approximately 1.7% for the years ended December 31, 2015 and 2014, respectively. EQM had no borrowings outstanding under its credit facility at any time during the year ended December 31, 2013. Income Taxes Income tax expense decreased $109.4 million in 2015 compared to 2014 primarily as a result of lower pre-tax income and a realized $35.4 million tax benefit in connection with recent Internal Revenue Service (IRS) guidance received by the Company in connection with the Company’s sale of Equitable Gas in 2013 (discussed below). These benefits were partially offset by an increase in expense of $79.5 million primarily related to valuation allowances recorded on Pennsylvania state net operating loss (NOL) carryforwards during the period. The Company’s effective income tax rate decreased to 24.5% in 2015 from 29.6% in 2014. The decrease in the effective income tax rate from 2014 is primarily attributable to an increase in earnings allocated to noncontrolling limited partners of EQGP and EQM, the effects of the IRS guidance, a decrease in EQT Production’s operating income, increased tax credits in 2015 and a decrease in state taxes in 2015 as a result of lower pre-tax income on state income tax paying entities. These items were significantly offset by the valuation allowance recorded primarily on Pennsylvania state NOLs. The overall rate was lower for both periods as the Company consolidates 100% of the pre-tax income related to the noncontrolling public limited partners’ share of EQGP earnings, but is not required to record an income tax provision with respect to the portion of the earnings allocated to EQM and EQGP noncontrolling public limited partners. Earnings allocated to the EQM and EQGP noncontrolling public limited partners increased in 2015 compared to 2014 primarily as a result of higher net income at EQM and increased noncontrolling interests as a result of EQM’s March and November 2015 public offerings of common units, issuances of EQM common units under the $750 million ATM Program and EQGP’s IPO. During 2015, the Company realized a $35.4 million tax benefit in connection with recent IRS guidance received by the Company regarding the Company’s sale of Equitable Gas, a regulated entity, in 2013. The transaction included a partial like-kind exchange of assets that resulted in tax deferral for the Company. However, in order to be in compliance with the normalization rules of the Internal Revenue Code, the IRS guidance held that the deferred tax liability associated with the exchanged regulatory assets should not be considered for ratemaking purposes. As a result, during the second quarter of 2015, the Company recorded a regulatory asset equal to the taxes deferred from the exchange and an associated income tax benefit. The regulatory asset and deferred taxes will be reversed when the assets are disposed of in a taxable transaction such as a sale of assets or amortized over the 32-year remaining life of the assets received in the exchange, in either event increasing tax expense at that time. Income tax expense increased $38.9 million in 2014 compared to 2013 as a result of higher pre-tax income partly offset by a decrease in the Company’s effective income tax rate from 33.6% to 29.6%. The decrease in the rate in 2014 compared to 2013 was primarily related to an internal reorganization of subsidiaries resulting in a reduction of state taxes as well as an increase in noncontrolling interests related to EQM’s ownership structure. For both periods, the overall rate was lower than the federal statutory rate as the Company consolidates 100% of the pre-tax income related to the noncontrolling public limited partners’ share of partnership earnings, but is not required to record an income tax provision with respect to the portion of EQM’s earnings allocated to the noncontrolling public limited partners. EQM’s earnings increased primarily due to the Sunrise Merger in 2013 and the Jupiter Transaction in 2014, each of which also resulted in increases in the noncontrolling limited public partners’ share of partnership earnings (as described in Note 4 to the Consolidated Financial Statements). The Company has been in an overall federal taxable income position for the past three years primarily as a result of tax gains generated from the net proceeds received from the EQGP IPO and the NWV Gathering Transaction in 2015, the Jupiter Transaction in 2014 and the Sunrise Merger and the Equitable Gas Transaction in 2013. During these periods, the Company utilized the NOLs generated from previous years and no longer had federal NOLs available as of December 31, 2015. For federal income tax purposes, the Company deducts a portion of drilling costs as intangible drilling costs (IDCs) in the year incurred. IDCs, however, are sometimes limited for purposes of the alternative minimum tax (AMT) and can result in the Company paying AMT even when generating large tax deductions or utilizing a regular tax NOL. See Note 10 to the Consolidated Financial Statements for further discussion of the Company’s income taxes. Income from Discontinued Operations, Net of Tax Income from discontinued operations, net of tax, was $1.4 million for the year ended December 31, 2014 compared to $91.8 million for the year ended December 31, 2013. On December 17, 2013, the Company and Distribution Holdco, LLC completed the disposition of their ownership interests in Equitable Gas and Homeworks to PNG Companies LLC. See Note 2 to the Consolidated Financial Statements for further discussion of the Company’s discontinued operations. Net Income Attributable to Noncontrolling Interests Net income attributable to noncontrolling interests of EQGP and EQM was $236.7 million for 2015 compared to net income attributable to noncontrolling interests of EQM of $124.0 million for 2014. The $112.7 million increase was primarily the result of increased net income at EQM, increased ownership of EQM common units by third parties as a result of EQM's March and November 2015 public offerings of common units and issuances under the $750 million ATM Program, and third-party ownership of EQGP common units as a result of EQGP's IPO. Net income attributable to noncontrolling interests of EQM was $124.0 million for the year ended December 31, 2014 compared to $47.2 million for the year ended December 31, 2013. The increase resulted from higher capacity reservation revenues and higher gathering revenues in EQM, as well as increased noncontrolling interests in 2014. Noncontrolling interests in EQM increased from 55.4% to 63.6% during the year ended December 31, 2014 as a result of the underwritten public offering of additional common units representing limited partner interests in EQM in May 2014 in connection with the Jupiter Transaction. Outlook The Company is committed to profitably developing its natural gas, NGL and oil reserves through environmentally responsible, cost-effective and technologically advanced horizontal drilling. The Company’s revenues, earnings, liquidity and ability to grow are substantially dependent on the prices it receives for, and the Company’s ability to develop its reserves of natural gas, NGLs and oil. Despite the continued depressed price environment for natural gas, NGLs and oil, the Company believes the long-term outlook for its business is favorable due to the Company's resource base, low cost structure, financial strength, risk management, including commodity hedging strategy, and disciplined investment of capital. The Company believes the combination of these factors provide it with an opportunity to exploit and develop its positions and maximize efficiency through economies of scale in its strategic operating area. The market prices for natural gas, NGLs and oil were depressed throughout 2015 and the early part of 2016 and continue to be volatile. The average daily prices for NYMEX Henry Hub natural gas ranged from a high of $3.23 per MMBtu to a low of $1.76 per MMBtu from January 1, 2015 through February 10, 2016, and the average daily prices for NYMEX West Texas Intermediate crude oil ranged from a high of $61.43 per barrel to a low of $26.55 per barrel during the same period. In addition, the market price for natural gas in the Appalachian Basin continues to be lower relative to NYMEX Henry Hub as a result of the significant increases in the supply of natural gas in the Northeast region in recent years. Due to the volatility of commodity prices, the Company is unable to predict future potential movements in the market prices for natural gas, including Appalachian basis, NGLs and oil and thus cannot predict the ultimate impact of prices on its operations. However, the Company does expect natural gas and NGL prices, particularly in the Appalachian Basin, to remain depressed during 2016. As a result of the continued low price environment, the Company suspended drilling on its Permian Basin, Upper Devonian and Central Pennsylvania Marcellus acreage during 2015 and focused its development plans on its core Marcellus acreage in southwestern Pennsylvania and northern West Virginia and its deep Utica acreage. The Company's 2016 capital expenditure forecast for well development is $820 million, which is 51% lower than its 2015 capital expenditures for well development. Prolonged low, and/or significant or extended declines in, natural gas, NGL and oil prices could adversely affect, among other things, the Company's development plans, which would decrease the pace of the development and the level of the Company's reserves, as well as the Company's revenues, earnings or liquidity. Low prices may signal a need to further reduce capital spending or record additional non-cash impairments in the book value of the Company’s oil and gas properties or additional downward adjustments to the Company’s estimated proved reserves. Any such additional impairment and/or downward adjustment to the Company’s estimated reserves could potentially be material to the Company. See “Impairment of Oil and Gas Properties” below. In July 2015, the Company turned in-line its first dry gas focused deep Utica well, which experienced prolific initial results. The Company turned in-line its second deep Utica well in Greene County, Pennsylvania in late December 2015. Given the success of the two initial Utica wells in Greene County, Pennsylvania, the Company has decided to begin development of its deep Utica acreage. Total capital investment by EQT in 2016, excluding acquisitions, is expected to be approximately $1.8 billion (including EQM). Capital spending for well development (primarily drilling and completion) of approximately $0.8 billion in 2016 is expected to support the drilling of approximately 77 gross wells, including 72 Marcellus wells and 5 deep Utica wells. Depending upon the results of the 5 initial deep Utica wells, the Company may drill an additional 5 deep Utica wells during 2016. Estimated sales volumes are expected to be 700 - 720 Bcfe for an anticipated production sales volume growth of approximately 18% in 2016, while NGL volumes are expected to be 10,000 - 10,500 Mbbls. To support continued growth in production, the Company plans to invest approximately $0.8 billion on midstream infrastructure in 2016, primarily through EQM. The 2016 capital investment plan is expected to be funded by cash on hand, cash flow generated from operations, proceeds from midstream asset sales (dropdowns) to EQM and EQM capital raises. The Company continues to focus on creating and maximizing shareholder value through the implementation of a strategy that economically accelerates the monetization of its asset base and prudently pursues investment opportunities, all while maintaining a strong balance sheet with solid cash flow. The Company monitors current and expected market conditions, including the commodity price environment, and its liquidity needs and may adjust its capital investment plan accordingly. While the tactics continue to evolve based on market conditions, the Company periodically considers arrangements to monetize the value of certain mature assets for re-deployment into its highest value development opportunities. Impairment of Oil and Gas Properties See “Critical Accounting Policies and Estimates” below and Note 1 to the Consolidated Financial Statements for a discussion of the Company’s accounting policies and significant assumptions related to impairment of the Company’s oil and gas properties. Due to declines in the five-year NYMEX forward strip prices during 2015, an indication of impairment of the Company’s proved oil and gas properties existed as of December 31, 2015. In accordance with its normal procedures, the Company estimated the future undiscounted cash flows from its oil and gas properties and compared these estimates to the carrying value of the properties. As a result of these evaluations, the Company performed discounted cash flow analyses and recorded non-cash, pre-tax impairment charges to its proved oil and gas properties in 2015 including $94.3 million in the non-core Permian basin. After this charge to the Permian assets, the carrying value of Permian properties as of December 31, 2015 was approximately $345 million, including approximately $300 million of undeveloped properties. Because the estimated future undiscounted cash flows from the Company’s proved oil and gas properties in the Marcellus play and the non-core Huron and Coalbed Methane plays exceeded the carrying values of the respective properties, the Company did not recognize an impairment charge in 2015 related to these oil and gas properties. However, all other things being equal, a further decline in the average five-year NYMEX forward strip prices in a future period may cause the Company to recognize a significant impairment on the assets in the Huron play, which had a carrying value of approximately $3 billion at December 31, 2015. As described under “Critical Accounting Policies and Estimates” below, the Company makes a number of assumptions related to its accounting for oil and gas properties, many of which require the Company’s management to make significant judgments. These assumptions, which are generally consistent with the assumptions utilized by the Company’s management for internal planning and budgeting purposes, include, among other things, anticipated production from reserves; future market prices for natural gas, NGLs and oil adjusted accordingly for basis differentials; future operating and capital costs; and inflation, some of which are interdependent. Future market prices for natural gas, NGLs and oil are often volatile, and assumptions regarding basis differentials, future production and future operating costs are highly judgmental and in some cases difficult to predict. Due to the uncertainty inherent in, and the interdependence of these factors, the Company cannot predict if future impairment charges, including impairment charges related to its Huron oil and gas properties, will be recognized and, if so, an estimate of the impairment charges that would be recorded in any future period. See “Recent natural gas, NGL and oil price declines have resulted in impairment of certain of our non-core oil and gas properties. Future declines in commodity prices, increases in operating costs or adverse changes in well performance may result in additional write-downs of the carrying amounts of our assets, which could materially and adversely affect our results of operations in future periods.” under Item 1A, “Risk Factors.” Capital Resources and Liquidity The Company’s primary sources of cash for the year ended December 31, 2015 were cash flows from operating activities, cash on hand, proceeds from the IPO of EQGP's common units, proceeds from the public offerings of EQM’s common units and an increase in EQM’s debt. The Company’s primary use of cash in 2015 was for capital expenditures. Operating Activities The Company’s net cash provided by operating activities decreased $197.8 million from $1,414.7 million in 2014 to $1,216.9 million in 2015. The decrease in cash provided by operating activities was primarily the result of a 36% lower average realized price to EQT Corporation on natural gas, NGL, and oil sales, partially offset by a 27% increase in production sales volume and a decrease in income tax payments. The Company’s net cash provided by operating activities increased $251.8 million from $1,162.9 million in 2013 to $1,414.7 million in 2014. The increase in cash provided by operating activities was primarily the result of a 26% increase in natural gas and NGL volumes sold, increases in contracted transmission capacity and gathered volumes and a $14.6 million decrease in interest payments, partially offset by a $41.1 million increase in income tax payments primarily due to taxes paid on transactions. While the Company is unable to predict future movements in the market price for commodities, current prices are lower than average 2015 levels. If current low price trends continue, this trend would negatively impact the Company’s cash flows from operating activities during the year ending December 31, 2016. Investing Activities Cash flows used in investing activities totaled $2,525.6 million for 2015 as compared to $2,444.2 million for 2014. The $81.4 million increase was primarily attributable to a $156.7 million increase in capital expenditures for continuing operations and $74.5 million of capital contributions made to the MVP Joint Venture through EQM during 2015, partially offset by $174.2 million of capital expenditures in 2014 in connection with the 2014 exchange of assets with Range. Cash flows used in investing activities totaled $2,444.2 million for 2014 as compared to $999.8 million for 2013. The $1,444.4 million increase was primarily attributable to higher capital expenditures in 2014 including the $167.3 million payment in 2014 in connection with the Range asset exchange, compared to proceeds received from the Equitable Gas Transaction of $740.6 million in 2013. As further described below, the Company increased cash capital expenditures from continuing operations by $725 million from 2013 to 2014. Capital Expenditures for Continuing Operations ($ in millions) * Capital expenditures for continuing operations included a portion of non-cash stock-based compensation expense and the impact of capital accruals. The capital accrual impact included reversal of the prior year accrual as well as the current year estimate, both of which are non-cash items. The impact of these non-cash items in the table above were $(90) million, $99 million and $70 million for the years ended December 31, 2015, 2014 and 2013, respectively. The year ended December 31, 2014 also included $349 million of non-cash capital expenditures for the exchange of assets with Range. The Company is estimating a 2016 capital expenditure spending plan of approximately $1.8 billion, which includes $0.8 billion for well development (primarily drilling and completion) and $0.8 billion for total midstream infrastructure. The midstream infrastructure capital expenditures will be made primarily through EQM, for which the Company is estimating a 2016 capital expenditure spending plan of approximately $0.7 billion. The Company does not forecast property acquisitions within its capital spending plan. Capital expenditures for drilling and development totaled $1,670 million and $1,717 million during 2015 and 2014, respectively. The Company spud 161 gross wells in 2015, including 133 horizontal Marcellus wells with approximately 722,000 feet of pay, 24 horizontal Upper Devonian wells with approximately 146,000 feet of pay and 4 other wells, including 2 deep Utica wells. The Company spud 345 gross wells (342 net wells) in 2014, including 196 horizontal Marcellus wells with approximately 1.1 million feet of pay, 41 horizontal Upper Devonian wells with approximately 260,000 feet of pay, 103 horizontal Huron wells with approximately 605,000 feet of pay and 5 other wells. The $47 million decrease in capital expenditures for well development in 2015 was driven primarily by a decrease in wells spud partly offset by increased costs of deep Utica drilling. Capital expenditures for 2015 also included $189 million for property acquisitions, compared to $724 million of capital expenditures in 2014 for property acquisitions. Capital expenditures for the midstream operations totaled $487 million for 2015. During 2015, EQT Midstream turned in-line approximately 50 miles of pipeline and 34,000 horsepower of compression primarily in the Marcellus play. During 2014, midstream capital expenditures were $455 million. EQT Midstream turned in-line approximately 60 miles of pipeline and 80,000 horsepower of compression primarily within the Marcellus play. EQT Midstream also added 475 MMcf per day of incremental gathering capacity and 750 MMcf per day of incremental transmission capacity in 2014. Capital expenditures for drilling and development totaled $1,717 million and $1,237 million during 2014 and 2013, respectively. The Company spud 345 gross wells (342 net wells) in 2014, including 196 horizontal Marcellus wells with approximately 1.1 million feet of pay, 41 horizontal Upper Devonian wells with approximately 260,000 feet of pay, 103 horizontal Huron wells with approximately 605,000 feet of pay and 5 other wells. The Company spud 225 gross wells (224 net wells) in 2013, including 146 horizontal Marcellus wells with approximately 720,000 feet of pay, 22 horizontal Upper Devonian wells with approximately 110,000 feet of pay, 50 horizontal Huron wells with approximately 300,000 feet of pay and 7 other wells. The $480 million increase in capital expenditures for well development in 2014 was driven by an increase in completed frac stages, an increase in wells spud and higher spending in the Huron play. Capital expenditures for 2014 also included $724 million for property acquisitions, including $349 million of non-cash capital expenditures for the exchange of assets with Range. Capital expenditures for the midstream operations totaled $455 million for 2014. During 2014, EQT Midstream turned in-line approximately 60 miles of pipeline and 80,000 horsepower of compression primarily in the Marcellus play. EQT Midstream also added approximately 475 MMcf per day of incremental gathering capacity and 750 MMcf per day of incremental transmission capacity in 2014. During 2013, midstream capital expenditures were $369 million. EQT Midstream turned in-line approximately 49 miles of pipeline and 2,100 horsepower of compression primarily within the Marcellus play. EQT Midstream also added 385 MMcf per day of incremental gathering capacity and 450 MMcf per day of incremental transmission capacity in 2013. Financing Activities Cash flows provided by financing activities totaled $1,832.5 million for 2015 as compared to cash flows provided by financing activities of $1,261.3 million for 2014. In 2015, the Company received net proceeds of $1,182.0 million from EQM’s public offerings of common units, including sales under the $750 million ATM Program, net proceeds of $674.0 million from EQGP's IPO and net proceeds of $299.0 million from increased borrowings on EQM's revolving credit facility. The Company repaid maturing long-term debt of approximately $169.0 million, paid distributions to noncontrolling interests of $121.8 million and paid $47.0 million for income tax withholdings related to the vesting or exercise of equity awards during the year ended December 31, 2015. Under the Company's share-based incentive awards, in connection with the settlement of equity awards, the Company may withhold shares or accept surrendered shares from Company employees holding the awards in exchange for satisfying the cash income tax withholding obligations with respect to the settlement of the awards. The Company received proceeds from option exercises and excess tax benefits resulting from option exercises and vesting of awards under employee compensation programs of $37.0 million during the year ended December 31, 2015. On January 20, 2016, the Board of Directors of the Company declared a regular quarterly cash dividend of three cents per share, payable March 1, 2016, to the Company’s shareholders of record at the close of business on February 17, 2016. On January 21, 2016, the Board of Directors of EQGP's general partner declared a cash distribution to EQGP's unitholders for the fourth quarter of 2015 of $0.122 per common unit, or approximately $32.5 million. The cash distribution will be paid on February 22, 2016 to unitholders of record, including the Company, at the close of business on February 1, 2016. On January 21, 2016, the Board of Directors of EQM’s general partner declared a cash distribution to EQM’s unitholders for the fourth quarter of 2015 of $0.71 per common unit. The cash distribution will be paid on February 12, 2016 to unitholders of record, including EQGP, at the close of business on February 1, 2016. EQGP will receive approximately $33.0 million consisting of $15.5 million in respective to its limited partner interest, $1.3 million in respect of its general partner interest and $16.2 million in respect of its IDRs in EQM. Cash flows provided by financing activities totaled $1,261.3 million for 2014 as compared to cash flows provided by financing activities of $500.5 million for 2013. The Company received net proceeds of $902.5 million from EQM’s May 2014 public offering of common units and EQM received net proceeds of $492.3 million from its August 2014 4.00% Senior Notes issuance. EQM paid distributions to noncontrolling interests of $67.8 million in 2014. The Company received proceeds from option exercises and excess tax benefits from exercises and vesting of awards under employee compensation plans of $52.4 million in 2014. The Company used $32.4 million to repurchase and retire shares of the Company’s common stock during 2014. In 2013, the Company received net proceeds of $529.4 million from EQM’s July 2013 public offering of common units, received proceeds from option exercises and excess tax benefits from exercises and vesting of awards under employee compensation plans of $45.1 million, paid distributions to noncontrolling interests of $32.8 million and repaid maturing long-term debt of $23.2 million. On April 30, 2014, the Company’s Board of Directors approved a share repurchase authorization of up to 1,000,000 shares of the Company’s outstanding common stock. The Company may repurchase shares from time to time in open market or in privately negotiated transactions. The share repurchase authorization does not obligate the Company to acquire any specific number of shares, has no pre-established end date and may be discontinued by the Company at any time. During the year ended December 31, 2014, the Company repurchased and retired 300,000 shares of common stock for $32.4 million under the authorization. The Company made no repurchases under the authorization during 2015. The Company may from time to time seek to repurchase its outstanding debt securities. Such repurchases, if any, will depend on prevailing market conditions, our liquidity requirements, contractual and legal restrictions and other factors. Revolving Credit Facilities EQT primarily utilizes borrowings to fund capital expenditures in excess of cash flow from operating activities until the expenditures can be permanently financed and to fund required margin deposits on derivative commodity instruments. Margin deposit requirements vary based on natural gas commodity prices, the Company's credit ratings and the amount and type of derivative commodity instruments. The Company has a $1.5 billion unsecured revolving credit facility that expires in February 2019. The Company may request two one-year extensions of the expiration date, the approval of which is subject to satisfaction of certain conditions. The revolving credit facility may be used for working capital, capital expenditures, share repurchases and any other lawful corporate purposes. The credit facility is underwritten by a syndicate of 18 financial institutions, each of which is obligated to fund its pro-rata portion of any borrowings by the Company. Under the terms of the revolving credit facility, the Company may obtain base rate loans or fixed period Eurodollar rate loans. Base rate loans are denominated in dollars and bear interest at a base rate plus a margin based on the Company’s then current credit ratings. Fixed period Eurodollar rate loans bear interest at a Eurodollar rate plus a margin based on the Company’s then current credit ratings. The Company had no borrowings or letters of credit outstanding under its revolving credit facility as of December 31, 2015 and 2014 or at any time during the years ended December 31, 2015 and 2014. For the years ended December 31, 2015 and 2014, the Company incurred commitment fees averaging approximately 23 basis points to maintain credit availability under its revolving credit facility. The Company’s short-term borrowings generally have original maturities of three months or less. EQM has a $750 million credit facility that expires in February 2019. The credit facility is available to fund working capital requirements and capital expenditures, to purchase assets, to pay distributions and repurchase units and for general partnership purposes. The credit facility is underwritten by a syndicate of 18 financial institutions, each of which is obligated to fund its pro-rata portion of any borrowings by EQM. The Company is not a guarantor of EQM’s obligations under the credit facility. Under the terms of its revolving credit facility, EQM may obtain base rate loans or fixed period Eurodollar rate loans. Base rate loans are denominated in dollars and bear interest at a base rate plus a margin based on EQM’s then current credit rating. Fixed period Eurodollar rate loans bear interest at a Eurodollar rate plus a margin based on EQM’s then current credit ratings. EQM had $299 million of borrowings and no letters of credit outstanding under its revolving credit facility as of December 31, 2015. EQM had no borrowings or letters of credit outstanding under its revolving credit facility as of December 31, 2014. For the years ended December 31, 2015 and 2014, EQM incurred commitment fees averaging approximately 23 basis points and 24 basis points, respectively, to maintain credit availability under the revolving credit facility. The maximum amount of outstanding borrowings at any time under EQM’s credit facility during the year ended December 31, 2015 was $404 million, and the average daily balance of borrowings outstanding was approximately $261 million at a weighted average annual interest rate of 1.7%. The maximum amount of outstanding borrowings at any time under EQM’s credit facility during the year ended December 31, 2014 was $450 million, and the average daily balance of borrowings outstanding was approximately $119 million at a weighted average annual interest rate of 1.7%. Security Ratings and Financing Triggers The table below reflects the credit ratings for debt instruments of the Company at February 10, 2016. Changes in credit ratings may affect the Company’s cost of short-term and long-term debt (including interest rates and fees under its lines of credit), collateral requirements under derivative instruments, pipeline capacity contracts, joint venture arrangements, subsidiary construction contracts and access to the credit markets. The table below reflects the credit ratings for debt instruments of EQM at December 31, 2015. Changes in credit ratings may affect EQM’s cost of short-term and long-term debt (including interest rates and fees under its lines of credit), collateral requirements under joint venture arrangements and construction contracts and access to the credit markets. The Company’s and EQM’s credit ratings are subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating. The Company and EQM cannot ensure that a rating will remain in effect for any given period of time or that a rating will not be lowered or withdrawn entirely by a credit rating agency if, in its judgment, circumstances so warrant. On December 16, 2015, Moody's announced that it had placed 29 U.S. exploration and production companies, including the Company, under review for a downgrade due to the low commodity price environment. On January 25, 2016, Moody’s also announced that it had placed three midstream partnerships, including EQM, under review for a downgrade primarily due to their affiliations with sponsoring exploration and production companies. If Moody's or another credit rating agency downgrades the ratings, particularly below investment grade, the Company's or EQM's access to the capital markets may be limited, borrowing costs and margin deposits on the Company’s derivative contracts would increase, the Company may be required to provide additional credit assurances in support of commercial agreements, such as pipeline capacity contracts, joint venture arrangements and subsidiary construction contracts, the amount of which may be substantial, and the potential pool of investors and funding sources may decrease. The required margin on the Company’s derivative instruments is also subject to significant change as a result of factors other than credit rating, such as gas prices and credit thresholds set forth in agreements between the hedging counterparties and the Company. Investment grade refers to the quality of a company's credit as assessed by one or more credit ratings agencies. In order to be considered investment grade, a company must be rated BBB- or higher by S&P, Baa3 or higher by Moody’s and BBB- or higher by Fitch. Anything below these ratings is considered non-investment grade. The Company’s debt agreements and other financial obligations contain various provisions that, if not complied with, could result in termination of the agreements, require early payment of amounts outstanding or similar actions. The most significant covenants and events of default under the debt agreements relate to maintenance of a debt-to-total capitalization ratio, limitations on transactions with affiliates, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of other financial obligations and change of control provisions. The Company’s credit facility contains financial covenants that require a total debt-to-total capitalization ratio of no greater than 65%. The calculation of this ratio excludes the effects of accumulated other comprehensive income (OCI). As of December 31, 2015, the Company was in compliance with all debt provisions and covenants. EQM’s debt agreements and other financial obligations contain various provisions that, if not complied with, could result in termination of the agreements, require early payment of amounts outstanding or similar actions. The covenants and events of default under the debt agreements relate to maintenance of permitted leverage ratio, limitations on transactions with affiliates, limitations on restricted payments, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of and certain other defaults under other financial obligations and change of control provisions. Under EQM's credit facility, EQM is required to maintain a consolidated leverage ratio of not more than 5.00 to 1.00 (or not more than 5.50 to 1.00 for certain measurement periods following the consummation of certain acquisitions). As of December 31, 2015, EQM was in compliance with all debt provisions and covenants. EQM ATM Program During 2015, EQM entered into an equity distribution agreement that established EQM's $750 million ATM Program. EQM had approximately $663 million in remaining capacity under the program as of February 10, 2016. Commodity Risk Management The substantial majority of the Company’s commodity risk management program is related to hedging sales of the Company’s produced natural gas. The Company’s overall objective in this hedging program is to protect cash flow from undue exposure to the risk of changing commodity prices. The derivative commodity instruments currently utilized by the Company are primarily NYMEX swaps and collars. The Company may also use other contractual agreements in implementing its commodity hedging strategy. The Company also enters into fixed price natural gas sales agreements that are satisfied by physical delivery. The Company does not currently hedge its oil or NGL exposure. As of February 2, 2016, the approximate volumes and prices of the Company's total hedge position for 2016 through 2018 production are: * The average price is based on a conversion rate of 1.05 MMBtu/Mcf. ** For 2016 through 2018, the Company also has a natural gas sales agreement for approximately 35 Bcf per year that includes a NYMEX ceiling price of $4.88 per Mcf. The Company also sold calendar year 2016, 2017 and 2018 calls for approximately 11 Bcf, 29 Bcf and 12 Bcf at strike prices of $3.65 per Mcf, $3.52 per Mcf and $3.45 per Mcf, respectively. *** Fixed price physical sales impact is included in recoveries on the EQT Corporation Price Reconciliation. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” and Note 6 to the Consolidated Financial Statements for further discussion of the Company’s hedging program. Other Items Off-Balance Sheet Arrangements In connection with the sale of its NORESCO domestic operations in December 2005, the Company agreed to maintain in place guarantees of certain warranty obligations of NORESCO. The savings guarantees provided that once the energy-efficiency construction was completed by NORESCO, the customer would experience a certain dollar amount of energy savings over a period of years. The undiscounted maximum aggregate payments that may be due related to these guarantees were approximately $134 million as of December 31, 2015, extending at a decreasing amount for approximately 12 years. In December 2014, the Company issued a performance guarantee (the EQT MVP Guarantee) in connection with the obligations of MVP Holdco to fund its proportionate share of the construction budget for the MVP. Upon the transfer of the Company’s interest in MVP Holdco to EQM on March 30, 2015, EQM entered into a performance guarantee (the Initial EQM Guarantee) on terms and conditions similar to the EQT MVP Guarantee, and the EQT MVP Guarantee was concurrently terminated. Upon the FERC’s initial release to begin construction of the MVP, the Initial EQM Guarantee will terminate, and EQM will be obligated to issue a new guarantee in an amount equal to 33% of MVP Holdco’s remaining obligations to make capital contributions to the MVP Joint Venture in connection with the then remaining construction budget, less any credit assurances issued by any affiliate of EQM under such affiliate's precedent agreement with the MVP Joint Venture. As of February 11, 2016, the Initial EQM Guarantee was in the amount of $91 million. The NORESCO guarantees and the Initial EQM Guarantee are exempt from ASC Topic 460, Guarantees. The Company has determined that the likelihood it will be required to perform on these arrangements is remote and any potential payments are expected to be immaterial to the Company’s financial position, results of operations and liquidity. As such, the Company has not recorded any liabilities in its Consolidated Balance Sheets related to these guarantees. Rate Regulation As described under “Regulation” in Item 1, “Business,” the Company’s transmission and storage operations and a portion of its gathering operations are subject to various forms of rate regulation. As described in Note 1 to the Consolidated Financial Statements, regulatory accounting allows the Company to defer expenses and income as regulatory assets and liabilities which reflect future collections or payments through the regulatory process. The Company believes that it will continue to be subject to rate regulation that will provide for the recovery of the deferred costs. Schedule of Contractual Obligations The table below presents the Company’s long-term contractual obligations as of December 31, 2015 in total and by periods. Purchase obligations exclude the Company’s contractual obligations relating to its binding precedent agreements and other natural gas transmission and gathering capacity agreements with EQM, for which future payments related to such agreements totaled $5.7 billion as of December 31, 2015. These capacity commitments have terms extending up to 20 years. For a description of the transportation agreements, see Note 19 to the Consolidated Financial Statements. Purchase obligations also exclude future capital contributions to the MVP Joint Venture and purchase obligations of the MVP Joint Venture. (a) Interest payments exclude interest due related to the credit facility borrowings as the interest rate on the credit facility agreement is variable. Purchase obligations are primarily commitments for demand charges under existing long-term contracts and binding precedent agreements with various unconsolidated pipelines (including MVP), some of which extend up to approximately 20 years. The Company has entered into agreements to release some of its capacity to various third parties. Purchase obligations also include commitments with third parties for processing capacity in order to extract heavier liquid hydrocarbons from the natural gas stream. Operating leases are primarily entered into for various office locations and warehouse buildings, as well as dedicated drilling rigs in support of the Company’s drilling program. The obligations for the Company’s various office locations and warehouse buildings totaled approximately $90.9 million as of December 31, 2015. The Company has agreements with Orion Drilling Company, Savanna Drilling, LLC and several other drillers to provide drilling equipment and services to the Company over the next four years. These obligations totaled approximately $63.2 million as of December 31, 2015. The other liabilities line represents commitments for total estimated payouts for the second tranche of the 2014 EQT Value Driver Award Program. See “Critical Accounting Policies and Estimates” below and Note 17 to the Consolidated Financial Statements for further discussion regarding factors that affect the ultimate amount of the payout of these obligations. As discussed in Note 10 to the Consolidated Financial Statements, the Company had a total reserve for unrecognized tax benefits at December 31, 2015 of $259.3 million, of which $102.7 million is offset against deferred tax assets since it would primarily reduce the alternative minimum tax credit carryforwards. The Company is currently unable to make reasonably reliable estimates of the period of cash settlement of these potential liabilities with taxing authorities; therefore, this amount has been excluded from the schedule of contractual obligations. Commitments and Contingencies In the ordinary course of business, various legal and regulatory claims and proceedings are pending or threatened against the Company. While the amounts claimed may be substantial, the Company is unable to predict with certainty the ultimate outcome of such claims and proceedings. The Company accrues legal and other direct costs related to loss contingencies when actually incurred. The Company has established reserves it believes to be appropriate for pending matters and, after consultation with counsel and giving appropriate consideration to available insurance, the Company believes that the ultimate outcome of any matter currently pending against the Company will not materially affect the Company’s financial position, results of operations or liquidity. See Note 19 to the Consolidated Financial Statements for further discussion of the Company’s commitments and contingencies. Recently Issued Accounting Standards The Company's recently issued accounting standards are described in Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Critical Accounting Policies and Estimates The Company’s significant accounting policies are described in Note 1 to the Consolidated Financial Statements. The discussion and analysis of the Consolidated Financial Statements and results of operations are based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with United States GAAP. The preparation of the Consolidated Financial Statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. The following critical accounting policies, which were reviewed by the Company’s Audit Committee, relate to the Company’s more significant judgments and estimates used in the preparation of its Consolidated Financial Statements. Actual results could differ from those estimates. Accounting for Oil and Gas Producing Activities: The Company uses the successful efforts method of accounting for its oil and gas producing activities. The carrying values of the Company’s proved oil and gas properties are reviewed for impairment generally on a field-by-field basis when events or circumstances indicate that the remaining carrying value may not be recoverable. The estimated future cash flows used to test those properties for recoverability are based on proved and, if determined reasonable by management, risk-adjusted probable and possible reserves, utilizing assumptions generally consistent with the assumptions utilized by the Company's management for internal planning and budgeting purposes, including, among other things, the intended use of the asset, anticipated production from reserves, future market prices for natural gas, NGLs and oil, adjusted accordingly for basis differentials, future operating costs and inflation, some of which are interdepedent. Proved oil and gas properties that have carrying amounts in excess of estimated future cash flows are written down to fair value, which is estimated by discounting the estimated future cash flows using discount rates and other assumptions that marketplace participants would use in their estimates of fair value. Capitalized costs of unproved properties are evaluated at least annually for recoverability on a prospective basis. Indicators of potential impairment include changes in development plans resulting from economic factors, potential shifts in business strategy employed by management and historical experience. If it is determined that the properties will not yield proved reserves prior to their expirations, the related costs are expensed in the period in which that determination is made. The Company believes that the accounting estimate related to the accounting for oil and gas producing activities is a “critical accounting estimate” as the evaluations of impairment of proved properties involves significant judgment about future events such as future sales prices of natural gas and NGLs, future production costs, estimates of the amount of natural gas and NGLs recorded and the timing of those recoveries. See "Impairment of Oil and Gas Properties" above and Note 1 to the Consolidated Financial Statements for additional information regarding the Company’s impairments of proved and unproved oil and gas properties. Oil and Gas Reserves: Proved oil and gas reserves, as defined by SEC Regulation S-X Rule 4-10, are those quantities of oil and gas which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible from a given date forward, from known reservoirs and under existing economic conditions, operating methods and government regulations prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. The Company’s estimates of proved reserves are made and reassessed annually using geological and reservoir data as well as production performance data. Reserve estimates are prepared and updated by the Company’s engineers and audited by the Company’s independent engineers. Revisions may result from changes in, among other things, reservoir performance, development plans, prices, operating costs, economic conditions and governmental restrictions. Decreases in prices, for example, may cause a reduction in some proved reserves due to reaching economic limits sooner. A material change in the estimated volumes of reserves could have an impact on the depletion rate calculation and the Company's financial statements, including strength of the balance sheet. The Company estimates future net cash flows from natural gas, NGL and oil reserves based on selling prices and costs using a 12-month average price, calculated as the unweighted arithmetic average of the first-day-of-the-month price for each month within the 12-month period, which is subject to change in subsequent periods. Operating costs, production and ad valorem taxes and future development costs are based on current costs with no escalation. Income tax expense is computed using statutory future tax rates and giving effect to tax deductions and credits available under current laws and which relate to oil and gas producing activities. The Company believes that the accounting estimate related to oil and gas reserves is a “critical accounting estimate” because the Company must periodically reevaluate proved reserves along with estimates of future production rates, production costs and the estimated timing of development expenditures. Future results of operations and strength of the balance sheet for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. See "Impairment of Oil and Gas Properties" above for additional information regarding the Company’s oil and gas reserves. Income Taxes: The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the Company’s Consolidated Financial Statements or tax returns. The Company has recorded deferred tax assets principally resulting from federal and state NOL carryforwards, an alternative minimum tax credit carryforward, incentive compensation and investment in EQM. The Company has established a valuation allowance against a portion of the deferred tax assets related to the state NOL carryforwards, as it is believed that it is more likely than not that these deferred tax assets will not all be realized. No other significant valuation allowances have been established, as it is believed that future sources of taxable income, reversing temporary differences and other tax planning strategies will be sufficient to realize these deferred tax assets. Any determination to change the valuation allowance would impact the Company’s income tax expense and net income in the period in which such a determination is made. The Company also estimates the amount of financial statement benefit to record for uncertain tax positions as described in Note 10 to the Company’s Consolidated Financial Statements. The Company believes that accounting estimates related to income taxes are “critical accounting estimates” because the Company must assess the likelihood that deferred tax assets will be recovered from future taxable income and exercise judgment regarding the amount of financial statement benefit to record for uncertain tax positions. When evaluating whether or not a valuation allowance must be established on deferred tax assets, the Company exercises judgment in determining whether it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax assets will not be realized. The Company considers all available evidence, both positive and negative, to determine whether, based on the weight of the evidence, a valuation allowance is needed, including carrybacks, tax planning strategies, reversal of deferred tax assets and liabilities and forecasted future taxable income. In making the determination related to uncertain tax positions, the Company considers the amounts and probabilities of the outcomes that could be realized upon ultimate settlement of an uncertain tax position using the facts, circumstances and information available at the reporting date to establish the appropriate amount of financial statement benefit. To the extent that an uncertain tax position or valuation allowance is established or increased or decreased during a period, the Company must include an expense or benefit within tax expense in the income statement. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Derivative Instruments: The Company enters into derivative commodity instrument contracts primarily to mitigate exposure to commodity price risk associated with future sales of natural gas production. The Company also enters into derivative instruments to hedge other forecasted natural gas purchases and sales, to hedge basis and to hedge exposure to fluctuations in interest rates. The Company estimates the fair value of all derivative instruments using quoted market prices, where available. If quoted market prices are not available, fair value is based upon models that use market-based parameters as inputs, including forward curves, discount rates, volatilities and nonperformance risk. Nonperformance risk considers the effect of the Company’s credit standing on the fair value of liabilities and the effect of the counterparty’s credit standing on the fair value of assets. The Company estimates nonperformance risk by analyzing publicly available market information, including a comparison of the yield on debt instruments with credit ratings similar to the Company’s or counterparty’s credit rating, the yield of a risk-free instrument and credit default swap rates where available. The values reported in the financial statements change as these estimates are revised to reflect actual results, or market conditions or other factors change, many of which are beyond the Company’s control. The Company believes that the accounting estimates related to derivative instruments are “critical accounting estimates” because the Company’s financial condition and results of operations can be significantly impacted by changes in the market value of the Company’s derivative instruments due to the volatility of natural gas prices, both NYMEX and basis. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Contingencies and Asset Retirement Obligations: The Company is involved in various regulatory and legal proceedings that arise in the ordinary course of business. The Company records a liability for contingencies based upon its assessment that a loss is probable and the amount of the loss can be reasonably estimated. The Company considers many factors in making these assessments, including history and specifics of each matter. Estimates are developed in consultation with legal counsel and are based upon an analysis of potential results. The Company also accrues a liability for asset retirement obligations based on an estimate of the timing and amount of their settlement. For oil and gas wells, the fair value of the Company’s plugging and abandonment obligations is required to be recorded at the time the obligations are incurred, which is typically at the time the wells are spud. The Company is required to operate and maintain its natural gas pipeline and storage systems, and intends to do so as long as supply and demand for natural gas exists, which the Company expects for the foreseeable future. Therefore, the Company believes that the substantial majority of its natural gas pipeline and storage system assets have indeterminate lives. The Company believes that the accounting estimates related to contingencies and asset retirement obligations are “critical accounting estimates” because the Company must assess the probability of loss related to contingencies and the expected amount and timing of asset retirement obligations. In addition, the Company must determine the estimated present value of future liabilities. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Share-Based Compensation: The Company awards share-based compensation in connection with specific programs established under the 2009 and 2014 Long-Term Incentive Plans. Awards to employees are typically made in the form of performance-based awards, time-based restricted stock, time-based restricted phantom units and stock options. Awards to directors are typically made in the form of phantom units. Performance-based awards expected to be satisfied in cash are treated as liability awards. Awards under the 2014 EQT Value Driver Award program are treated as liability awards. Phantom units expected to be satisfied in cash are also treated as liability awards. For liability awards, the Company is required to estimate, on grant date and on each reporting date thereafter until vesting and payment, the fair value of the ultimate payout based upon the expected performance through, and value of the Company’s common stock on, the vesting date. The Company then recognizes a proportionate amount of the expense for each period in the Company’s financial statements over the vesting period of the award, in the case of a performance-based award, and until payment, in the case of phantom units. The Company reviews its assumptions regarding performance and common stock value on a quarterly basis and adjusts its accrual when changes in these assumptions result in a material change in the fair value of the ultimate payouts. Performance-based awards expected to be satisfied in Company common stock or EQM common units are treated as equity awards. Awards under the 2013 Executive Performance Incentive Program, the 2014 Executive Performance Incentive Program, the 2014 EQM Value Driver Award Program, the 2015 Executive Performance Incentive Program, the 2015 EQT Value Driver Award Program and the EQM Total Return Program, each of which remained outstanding at December 31, 2015, are treated as equity awards. For equity awards, the Company is required to determine the grant date fair value of the awards, which is then recognized as expense in the Company’s financial statements over the vesting period of the award. Determination of the grant date fair value of the awards requires judgments and estimates regarding, among other things, the appropriate methodologies to follow in valuing the awards and the related inputs required by those valuation methodologies. Most often, the Company is required to obtain a valuation based upon assumptions regarding risk-free rates of return, dividend or distribution yields, expected volatilities and the expected term of the award. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend or distribution yield is based on the historical dividend or distribution yield of the Company’s common stock or EQM’s common units, as applicable, and any changes expected thereto, and, where applicable, of the common stock of the peer group members at the time of grant. Expected volatilities are based on historical volatility of the Company’s common stock or EQM’s common units and, where applicable, the common stock of the peer group members at the time of grant. The expected term represents the period of time elapsing during the applicable performance period. For time-based restricted stock awards, the grant date fair value of the awards is recognized as expense in the Company’s financial statements over the vesting period, historically three years. For director phantom units (which vest on date of grant) expected to be satisfied in equity, the grant date fair value of the awards is recognized as an expense in the Company’s financial statements in the year of grant. The grant date fair value, in both cases, is determined based upon the closing price of the Company’s common stock on the date of the grant. For non-qualified stock options, the grant date fair value is recognized as expense in the Company’s financial statements over the vesting period, typically two or three years. The Company utilizes the Black-Scholes option pricing model to measure the fair value of stock options, which includes assumptions for a risk-free interest rate, dividend yield, volatility factor and expected term. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the dividend yield of the Company’s common stock at the time of grant. The expected volatility is based on historical volatility of the Company’s common stock at the time of grant. The expected term represents the period of time that options granted are expected to be outstanding based on historical option exercise experience at the time of grant. The Company believes that the accounting estimates related to share-based compensation are “critical accounting estimates” because they may change from period to period based on changes in assumptions about factors affecting the ultimate payout of awards, including the number of awards to ultimately vest and the market price and volatility of the Company’s common stock and EQM's common units. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. See Note 17 to the Consolidated Financial Statements for additional information regarding the Company’s share-based compensation.

<s>[INST] 2015 EQT Overview: Annual production sales volumes of 603.1 Bcfe, 27% higher than 2014 Marcellus sales volumes of 505.1 Bcfe, 34% higher than 2014 Gathered volumes of 754.3 TBtu, 28% higher than 2014 The Company completed EQGP's IPO EQM completed two underwritten public offerings of common units representing limited partner interests Income from continuing operations attributable to EQT Corporation for 2015 was $85.2 million, $0.56 per diluted share, compared with $385.6 million, $2.53 per diluted share, in 2014. The $300.4 million decrease in income from continuing operations attributable to EQT Corporation was primarily attributable to a 36% decrease in the average realized price to EQT Corporation for production sales volumes, higher operating expenses and higher net income attributable to noncontrolling interests of EQM and EQGP, partially offset by a 27% increase in production sales volumes, increased gains on derivatives not designated as hedges, increased gathering and transmission revenues and lower income tax expense. Operating expenses for 2015 and 2014 include $122.5 million and $267.3 million, respectively, of pretax, noncash impairment charges related to the Company's oil and gas properties, which are included in the impairment of longlived assets in the Statements of Consolidated Income. The average realized price to EQT Corporation for production sales volumes was $2.67 per Mcfe for 2015 compared to $4.16 per Mcfe for 2014. The decrease in the average realized price was driven by lower NYMEX natural gas prices net of cash settled derivatives, lower NGL prices and a lower average differential, which includes Appalachian Basin basis, recoveries and cash settled basis swaps. Recoveries represent differences in natural gas prices between the Appalachian Basin and other markets reached by utilizing transportation capacity, differences in natural gas prices between Appalachian Basin and fixed price sales contracts, term sales with fixed differentials to NYMEX and other marketing activity, including capacity releases. The Company's volume weighted average NYMEX natural gas index price was $2.66 per MMBtu for 2015, 39% lower than the average index price of $4.38 per MMBtu in 2014. In addition, the average differential decreased by $0.15 per Mcf, primarily due to lower Appalachian Basin basis. The Company's average NGL price was $18.84 per barrel for 2015, compared to $41.94 per barrel for 2014. Operating income was $563.1 million in 2015 compared to $853.4 million in 2014, a decrease of $290.3 million. EQT Midstream's operating income increased by $89.1 million in 2015, primarily due to increases in gathering and transmission revenues as a result of production development in the Marcellus Shale, which was more than offset by a $401.1 million decrease in EQT Production's operating income in 2015. The average realized price to EQT Production decreased to $1.74 per Mcfe in 2015 compared to $3.23 per Mcfe in 2014. The decrease in the average realized price to EQT Production was offset by an increase in sales volumes of 27% primarily as a result of increased production from the 2014 and 2013 drilling programs in the Marcellus acreage, partially offset by the normal production decline in the Company’s producing wells. EQT Production total operating revenues for the year ended December 31, 2015 also included $385.1 million of derivative gains for derivative instruments not designated as hedging instruments compared to $83.8 million of derivative gains not designated as hedges and $24.8 million of gains for ineffectiveness of financial hed [/INST] Negative. </s>

EQT Corp

2017-02-09

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis of financial condition and results of operations in conjunction with the consolidated financial statements, and the notes thereto, included in Item 8 of this Annual Report on Form 10-K. Consolidated Results of Continuing Operations 2016 EQT Highlights: • Annual production sales volumes of 759.0 Bcfe, 26% higher than 2015 • Marcellus sales volumes of 660.1 Bcfe, 31% higher than 2015 • The Company completed two underwritten public offerings of common stock • The Company increased its Marcellus acreage position by acquiring approximately 145,500 net Marcellus acres located primarily in northern West Virginia and southwestern Pennsylvania, including 122,100 net Marcellus acres acquired through the Statoil Acquisition, the Republic Transaction, the Trans Energy Merger and the Pennsylvania Acquisition • EQM issued common units through its $750 million ATM program, receiving proceeds of $217.1 million • EQM issued $500.0 million of 4.125% Senior Notes due December 1, 2026 Net loss from continuing operations attributable to EQT Corporation for 2016 was $453.0 million, a loss of $2.71 per diluted share, compared with income from continuing operations attributable to EQT Corporation of $85.2 million, $0.56 per diluted share, in 2015. The $538.2 million decrease in income from continuing operations attributable to EQT Corporation was primarily attributable to a loss on derivatives not designated as hedges, a 20% decrease in the average realized price, higher operating expenses and higher net income attributable to noncontrolling interests of EQM and EQGP, partially offset by a 26% increase in production sales volumes and lower income tax expense. EQT Production received $279.4 million and $172.1 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2016 and 2015, respectively, that are included in the average realized price but are not in GAAP operating revenues. During the year ended December 31, 2016, the Company recorded an impairment of long-lived assets of approximately $59.7 million related to certain gathering assets sold to EQM in October 2016. The impairment was a result of a reduction in estimated future cash flows caused by the low commodity price environment and the related reduced producer drilling activity and throughput. This impairment is reflected in unallocated expenses and not recorded on any operating segment. Income from continuing operations attributable to EQT Corporation for 2015 was $85.2 million, $0.56 per diluted share, compared with $385.6 million, $2.53 per diluted share, in 2014. The $300.4 million decrease in income from continuing operations attributable to EQT Corporation was primarily attributable to a 31% decrease in the average realized price, higher operating expenses, higher net income attributable to noncontrolling interests of EQM and EQGP and a gain on sale / exchange of assets in 2014, partially offset by a 27% increase in production sales volumes, increased gains on derivatives not designated as hedges and lower income tax expense. EQT Production received $172.1 million and $34.2 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2015 and 2014, respectively. These net cash settlements are included in the average realized price but are not in GAAP operating revenues. See “Business Segment Results of Operations” for a discussion of items impacting operating income and “Other Income Statement Items” for a discussion of other income, interest expense, income taxes, income from discontinued operations and net income attributable to noncontrolling interests, and “Investing Activities” under the caption “Capital Resources and Liquidity” for a discussion of capital expenditures. Consolidated Operational Data The following table presents detailed natural gas and liquids operational information to assist in the understanding of the Company’s consolidated operations, including the calculation of the Company's average realized price ($/Mcfe), which is based on EQT Production adjusted operating revenues, a non-GAAP supplemental financial measure. EQT Production adjusted operating revenues is presented because it is an important measure used by the Company’s management to evaluate period-to-period comparisons of earnings trends. EQT Production adjusted operating revenues should not be considered as an alternative to EQT Corporation total operating revenues as reported in the Statements of Consolidated Operations, the most directly comparable GAAP financial measure. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of EQT Production adjusted operating revenues to EQT Corporation total operating revenues. (a) The Company’s volume weighted NYMEX natural gas price (actual average NYMEX natural gas price ($/MMBtu) was $2.46, $2.66 and $4.41 for the years ended December 31, 2016, 2015 and 2014, respectively). (b) Basis represents the difference between the ultimate sales price for natural gas and the NYMEX natural gas price. (c) NGLs, ethane and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (d) Also referred to in this report as EQT Production adjusted operating revenues, a non-GAAP supplemental financial measure. Reconciliation of Non-GAAP Measures The table below reconciles EQT Production adjusted operating revenues, a non-GAAP supplemental financial measure, to EQT Corporation total operating revenues as reported in the Statements of Consolidated Operations, its most directly comparable financial measure calculated in accordance with GAAP. EQT Production adjusted operating revenues (also referred to as total natural gas & liquids sales, including cash settled derivatives) is presented because it is an important measure used by the Company’s management to evaluate period-over-period comparisons of earnings trends. EQT Production adjusted operating revenues as presented excludes the revenue impact of changes in the fair value of derivative instruments prior to settlement and the revenue impact of certain pipeline and net marketing services. Management utilizes EQT Production adjusted operating revenues to evaluate earnings trends because the measure reflects only the impact of settled derivative contracts and thus does not impact the revenue from natural gas sales with the often volatile fluctuations in the fair value of derivatives prior to settlement. EQT Production adjusted operating revenues also excludes "Pipeline and net marketing services" because management considers these revenues to be unrelated to the revenues for its natural gas and liquids production. "Pipeline and net marketing services" primarily includes revenues for gathering services provided to third-parties as well as both the cost of and recoveries on third-party pipeline capacity not used for EQT Production sales volumes. Management further believes that EQT Production adjusted operating revenues as presented provides useful information to investors for evaluating period-over-period earnings trends. Business Segment Results of Operations Business segment operating results from continuing operations are presented in the segment discussions and financial tables on the following pages. Operating segments are evaluated on their contribution to the Company’s consolidated results based on operating income. Other income, interest and income taxes are managed on a consolidated basis. Headquarters’ costs are billed to the operating segments based upon a fixed allocation of the headquarters’ annual operating budget. Unallocated expenses consist primarily of incentive compensation and administrative costs. In 2016, unallocated expenses also included impairment of long-lived assets of approximately $59.7 million related to certain gathering assets sold to EQM in October 2016. This impairment was recorded by EQT Midstream prior to the sale and change in segments discussed below and does not relate to any of the recast segments. The Company has reported the components of each segment’s operating income from continuing operations and various operational measures in the sections below, and where appropriate, has provided information describing how a measure was derived. EQT’s management believes that presentation of this information provides useful information to management and investors regarding the financial condition, operations and trends of each of EQT’s business segments without being obscured by the financial condition, operations and trends for the other segments or by the effects of corporate allocations of interest, income taxes and other income. In addition, management uses these measures for budget planning purposes. The Company has reconciled each segment’s operating income to the Company’s consolidated operating income and net income in Note 5 to the Consolidated Financial Statements. Prior to the October 2016 Sale, the Company reported its results of operations through two business segments: EQT Production and EQT Midstream. EQT Midstream included the Company’s gathering, transmission and storage businesses as well as the Company's marketing operations that were conducted for the benefit of third-parties. Marketing operations for the benefit of EQT Production were reported in the EQT Production segment. These reporting segments reflected the Company's lines of business and were reported in the same manner in which the Company evaluated its operating performance through September 30, 2016. Following the October 2016 Sale, the Company adjusted its internal reporting structure to align with EQM's operations. These adjustments included transferring to EQT Production (i) the operation of all midstream assets not owned by EQM and (ii) marketing operations conducted for the benefit of third-parties and resulted in changes to the Company's reporting segments effective for this Annual Report on Form 10-K. Under the new reporting structure, the EQT Production segment now includes the Company’s production activities, all of the Company's marketing operations and certain non-core midstream operations primarily supporting the Company's production activities. The EQT Gathering segment contains the Company's gathering assets that are included in EQM. The EQT Transmission segment includes the Company's FERC-regulated interstate pipeline and storage operations. The EQT Gathering and EQT Transmission segments are composed entirely of EQM’s operations and no EQM activities are included within the EQT Production segment. Therefore, the financial and operational disclosures related to EQT Gathering and EQT Transmission in this Annual Report on Form 10-K are the same as EQM’s disclosures in its Annual Report on Form 10-K for the year ended December 31, 2016. The segment disclosures and discussions contained within this Report have been recast to reflect the current reporting structure for all periods presented. EQT Production Results of Operations (a) Includes Upper Devonian wells. (b) Includes 14,612 MMcfe and 4,173 MMcfe of Utica sales volume for the years ended December 31, 2016 and 2015, respectively. (c) NGLs, ethane and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (d) Includes cash capital expenditures of $1,051.2 million and non-cash capital expenditures of $87.6 million related to the Statoil Acquisition, Republic Transaction, Trans Energy Merger and the Pennsylvania Acquisition during the year ended December 31, 2016. Includes $167.3 million of cash capital expenditures and $349.2 million of non-cash capital expenditures for the exchange of assets with Range Resources Corporation (Range Resources) during the year ended December 31, 2014. See Notes 8 and 9 to the Consolidated Financial Statements for additional information related to these transactions. Year Ended December 31, 2016 vs. December 31, 2015 EQT Production’s operating loss totaled $719.7 million for 2016 compared to operating income of $132.0 million for 2015. The $851.7 million decrease in operating income was primarily due to a loss on derivatives not designated as hedges in 2016 compared to gains on derivatives not designated as hedges in 2015, a lower average realized price, increased operating expenses and decreased pipeline and net marketing services partly offset by increased sales volumes of produced natural gas and NGLs. Total operating revenues were $1,387.1 million for 2016 compared to $2,131.7 million for 2015. Sales of natural gas, oil and NGLs decreased as a result of a lower average realized price, partly offset by a 26% increase in production sales volumes in 2016. EQT Production received $279.4 million and $172.1 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2016 and 2015, respectively, that are included in the average realized price but are not in GAAP operating revenues. Changes in fair market value of derivative instruments prior to settlement are recognized in gain (loss) on derivatives not designated as hedges. The increase in production sales volumes was primarily the result of increased production from the 2014 and 2015 drilling programs, primarily in the Marcellus play, partially offset by the normal production decline in the Company’s producing wells. The $0.62 per Mcfe decrease in the average realized price for the year ended December 31, 2016 was primarily due to the decrease in the average NYMEX natural gas price net of cash settled derivatives of $0.53 per Mcf and a decrease in the average natural gas differential of $0.12 per Mcf. The decrease in the average differential primarily related to lower basis partly offset by favorable cash settled basis swaps. While Appalachian Basin basis improved slightly for the year ended December 31, 2016 compared to the year ended December 31, 2015, basis in the United States Northeast was significantly lower, particularly in the first quarter of 2016 compared to the first quarter of 2015, due to reduced demand attributable to warmer than normal weather conditions. Additionally, the impact of changes in natural gas prices on physical basis sales contracts and fixed price sales contracts reduced basis year over year. The Company started flowing EQT Production’s produced volumes to its Rockies Express pipeline capacity and Texas Eastern Transmission Gulf Markets pipeline capacity in the fourth quarter of 2016, which resulted in a favorable impact to basis in 2016. Pipeline and net marketing services primarily includes gathering revenues for gathering services provided to third-parties and both the cost of and recoveries on third-party pipeline capacity not used to transport the Company’s produced volumes. The $14.5 million decrease in these revenues primarily related to reduced spreads on the Company’s Tennessee Gas Pipeline capacity. EQT Production total operating revenues for the year ended December 31, 2016 included a $249.0 million loss on derivatives not designated as hedges compared to a $385.8 million gain on derivatives not designated as hedges for the year ended December 31, 2015. The losses for the year ended December 31, 2016 primarily related to unfavorable changes in the fair market value of EQT Production’s NYMEX swaps, partly offset by favorable changes in the fair market value of its basis swaps. During the year ended December 31, 2016, forward NYMEX prices increased while basis prices decreased. Operating expenses totaled $2,114.8 million for 2016 compared to $1,999.7 million for 2015. The increase in operating expenses primarily resulted from increases in DD&A, gathering, transmission and processing, partly offset by reductions in non-cash impairments of long-lived assets and exploration expense. Gathering expense increased by $56.1 million due to increased affiliate firm capacity and volumetric charges and by $27.1 million due to increased third-party volumetric charges. Transmission expense increased by $39.9 million related to increased third-party costs incurred to move EQT Production’s natural gas out of the Appalachian Basin and by $33.3 million primarily due to increased affiliate firm capacity charges. Processing expenses increased $24.5 million due to increased production volumes. The decrease in LOE was primarily due to a $3.4 million decrease in salt water disposal costs as a result of increased recycling in the Marcellus Shale and certain operational cost savings in the Huron operations, partly offset by $1.8 million of costs related to the consolidation of the Company’s Huron operations. Production taxes were essentially flat as a higher Pennsylvania impact fee and severance tax settlement were offset by lower unhedged sales prices, a favorable property tax settlement and the expiration of the West Virginia volume based tax in 2016. The state of West Virginia previously imposed a $0.047 per Mcf additional volume based severance tax that was terminated on July 1, 2016. Exploration expense decreased primarily due to a $28.6 million decrease in lease expirations related to acreage that the Company does not intend to drill prior to expiration and expenses related to exploratory wells in 2015. SG&A expense increased $7.7 million due to an increase in litigation costs of $10.4 million, a $9.4 million charge related to the termination of the EQT Corporation Retirement Plan for Employees incurred in 2016, a $5.7 million increase to the reserve for uncollectible accounts, $2.6 million of non-recurring costs related to the consolidation of the Company’s Huron operations and acquisition related expenses in 2016. These increases were partly offset by $11.2 million for drilling program reduction charges in the Permian and Huron Basins in 2015, $4.5 million of decreased personnel costs, $3.2 million of decreased professional service costs and $1.9 million of charges to write off expired right of ways options in 2015. The increase in depletion expense within DD&A expense was the result of higher produced volumes partly offset by a lower overall depletion rate in 2016. Depreciation expense within DD&A increased as a result of additional assets in service. Impairment of long-lived assets decreased $115.5 million for the year ended December 31, 2016 compared to the year ended December 31, 2015. The 2016 impairment charge of $6.9 million primarily consisted of lease impairments on acreage that the Company did not intend to drill prior to expiration. The 2015 impairment charge consisted of impairments of proved properties in the Permian Basin of Texas of $94.3 million and impairments of proved properties in the Utica Shale of Ohio of $4.3 million, as well as unproved property impairments of $19.7 million and a $4.2 million impairment of field level NGLs processing equipment that was not being used. The proved properties impairments in 2015 were a result of continued declines in commodity prices and insufficient recovery of hydrocarbons to support continued development. The 2016 and 2015 impairments related to the unproved properties resulted from operational decisions to focus near-term development activities in the Company's Marcellus, Upper Devonian and Utica acreage. During the fourth quarter of 2016, EQT Production sold a gathering system that primarily gathered gas for third-parties for $75.0 million. In conjunction with this transaction, the Company realized a pre-tax gain of $8.0 million, which is included in gain on sale / exchange of assets in the Statements of Consolidated Operations. Year Ended December 31, 2015 vs. December 31, 2014 EQT Production’s operating income totaled $132.0 million for 2015 compared to $556.9 million for 2014. The $424.9 million decrease in operating income was primarily due to a lower average realized price and increased operating expenses partly offset by increased sales volumes of produced natural gas and NGLs and increased gains on derivatives not designated as hedges. Total operating revenues were $2,131.7 million for 2015 compared to $2,285.1 million for 2014. Sales of natural gas, oil and NGLs decreased as a result of a lower average realized price, partly offset by a 27% increase in production sales volumes in 2015. EQT Production received $172.1 million and $34.2 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2015 and 2014, respectively that are included in the average realized price but are not in GAAP operating revenues. Changes in fair market value of derivative instruments prior to settlement are recognized in gain (loss) on derivatives not designated as hedges. The increase in production sales volumes was primarily the result of increased production from the 2013 and 2014 drilling programs, primarily in the Marcellus play. This increase was partially offset by the normal production decline in the Company’s producing wells. The $1.41 per Mcfe decrease in the average realized price for the year ended December 31, 2015 was primarily due to the decrease in the average NYMEX natural gas price net of cash settled derivatives of $1.07 per Mcf, lower NGLs prices and a decrease in the average natural gas differential of $0.08 per Mcf. The decrease in the average differential primarily related to decreased basis in the Appalachian Basin and the United States northeast that was partly offset by the impact of changes in natural gas prices on fixed price sales contracts. The $16.2 million decrease in pipeline and net marketing services primarily related to costs, net of recoveries, of $15.3 million for the Company’s Rockies Express Pipeline capacity contract that started in the third quarter of 2015 and other decreased net marketing activity, including lower revenues on NGLs marketed for non-affiliate producers. EQT Production total operating revenues for the year ended December 31, 2015 included a $385.8 million gain on derivatives not designated as hedges compared to an $80.9 million gain on derivatives not designated as hedges for the year ended December 31, 2014. The increased gains for the year ended December 31, 2015 primarily related to favorable changes in the fair market value of EQT Production’s NYMEX swaps due to a decrease in forward NYMEX prices during the year ended December 31, 2015. For the year ended December 31, 2014, EQT Production total operating revenues also included a $24.8 million gain for hedging ineffectiveness. The Company discontinued hedge accounting in 2015. Operating expenses totaled $1,999.7 million for 2015 compared to $1,762.4 million for 2014. The increase in operating expenses was the result of increases in DD&A, gathering, transmission, exploration, processing and SG&A expenses, partly offset by decreases in non-cash impairments of long-lived assets and production taxes. Gathering expense increased by $96.0 million due to increased affiliate firm capacity and volumetric charges and by $2.3 million due to increased third-party volumetric charges. Transmission expense increased by $35.5 million due to increased third-party costs incurred to move EQT Production’s natural gas out of the Appalachian Basin and by $22.9 million due to increased affiliate firm capacity charges. Processing expense increased by $36.0 million due to increased production volumes. Production taxes decreased primarily due to a $16.7 million decrease in severance taxes due to lower market sales prices, partly offset by higher production sales volumes in certain jurisdictions subject to these taxes and a $4.8 million increase in property taxes. Production taxes also decreased due to a $1.4 million decrease in the Pennsylvania impact fee, primarily as a result of a decrease in the number of wells drilled in Pennsylvania in 2015. Exploration expense increased $40.3 million due to increased lease expirations of acreage that the Company did not intend to drill prior to expiration totaling $22.8 million and expenses related to exploratory wells. The increase in SG&A expense was primarily due to higher personnel costs of $17.6 million, $11.2 million of drilling program reduction charges, including rig release penalties and $1.9 million of charges to write off expired right of ways options, partly offset by $3.8 million of higher litigation and environmental remediation costs in 2014 and a $1.9 million reduction to the reserve for uncollectible accounts. The increase in depletion expense within DD&A was the result of higher produced volumes partly offset by a lower overall depletion rate in 2015. Depreciation expense within DD&A increased as a result of additional assets in service. Operating expenses included non-cash impairment charges of $122.5 million in 2015 and $267.3 million in 2014. The 2015 impairment charge consisted of (i) impairments of proved properties in the Permian Basin of Texas of $94.3 million and in the Utica Shale of Ohio of $4.3 million, (ii) unproved property impairments of $19.7 million and (iii) a $4.2 million impairment of field level NGLs processing equipment that was not being used in operations. The 2014 impairment charge consisted of impairments of proved properties in the Permian Basin of Texas of $105.2 million and in the Utica Shale of Ohio of $75.5 million, as well as impairments of $86.6 million associated with undeveloped properties. The proved properties impairments in 2015 and 2014 were a result of declines in commodity prices and insufficient recovery of hydrocarbons to support continued development. The 2015 and 2014 impairments related to the unproved properties resulted from operational decisions to focus near-term development activities in the Company's Marcellus and Utica acreage. EQT Gathering Results of Operations (a) Includes fees on volumes gathered in excess of firm contracted capacity. (b) Includes volumes gathered under interruptible contracts and volumes gathered in excess of firm contracted capacity. Year Ended December 31, 2016 vs. December 31, 2015 Gathering revenues increased by $62.4 million primarily as a result of higher affiliate and third party volumes gathered in 2016 compared to 2015, driven by production development in the Marcellus Shale. EQT Gathering increased firm reservation fee revenues in 2016 compared to 2015 as a result of affiliates and third parties contracting for additional capacity under firm contracts, which resulted in increased firm gathering capacity of approximately 300 MMcf per day following the completion of the NWV and Jupiter expansion projects in the fourth quarter of 2015. The decrease in usage fees under interruptible contracts was primarily due to these additional contracts for firm capacity. Operating expenses increased by $16.6 million for the year ended December 31, 2016 compared to the year ended December 31, 2015. Selling, general and administrative expenses increased as a result of higher allocations and personnel costs from EQT. The increase in depreciation and amortization expense resulted from additional assets placed in-service including those associated with the NWV Gathering and Jupiter expansion projects (defined in Note 4 to the Consolidated Financial Statements). Year Ended December 31, 2015 vs. December 31, 2014 Gathering revenues increased by $101.2 million primarily as a result of higher affiliate volumes gathered driven by production development in the Marcellus Shale. EQT Gathering significantly increased firm reservation fee revenues in 2015 compared to 2014 as a result of increased capacity under firm contracts with affiliates. The decrease in usage fees was primarily due to affiliates contracting for additional firm capacity. Operating expenses increased by $5.3 million for the year ended December 31, 2015 compared to the year ended December 31, 2014. Operating and maintenance expense increased as a result of higher allocations, including personnel costs, from EQT of $2.7 million and higher repairs and maintenance expenses associated with increased throughput. EQT Transmission Results of Operations (a) Includes commodity charges and fees on volumes transported in excess of firm contracted capacity. (b) Includes volumes transported under interruptible contracts and volumes transported in excess of firm contracted capacity. Year Ended December 31, 2016 vs. December 31, 2015 Transmission and storage revenues increased by $40.3 million. Firm reservation revenues increased due to affiliates contracting for additional capacity under firm contracts, primarily on the OVC, as well as higher contractual rates on existing contracts in the current year. Higher usage fees under firm contracts were driven by an increase in affiliate volumes in excess of firm capacity associated with increased production development in the Marcellus Shale, partly offset by lower usage fees from third party producers which is reflected in reduced firm capacity reservation throughput for the year ended December 31, 2016 compared to the year ended December 31, 2015. These volumes also decreased as a result of warmer weather in the first quarter of 2016. This decrease in transported volumes did not have a significant impact on firm reservation fee revenues. Usage fees under interruptible contracts for the year ended December 31, 2016 increased as a result of higher third party volumes transported or stored on an interruptible basis. Operating expenses increased by $10.1 million for the year ended December 31, 2016 compared to the year ended December 31, 2015. The increase in operating and maintenance expense resulted primarily from higher repairs and maintenance expenses associated with increased throughput. Selling, general and administrative expenses increased primarily as a result of higher allocations and personnel costs from EQT. The increase in depreciation and amortization expense was primarily a result of higher depreciation on the increased investment in transmission infrastructure, including those associated with the OVC and the AVC facilities. Year Ended December 31, 2015 vs. December 31, 2014 Transmission and storage revenues increased by $42.6 million reflecting production development in the Marcellus Shale by affiliate and third party producers. The increase primarily resulted from higher firm reservation fees of $45.1 million partly offset by lower usage fees under interruptible contracts. The decrease in usage fees was primarily due to customers contracting for additional firm capacity. Operating expenses increased $19.9 million for the year ended December 31, 2015 compared to the year ended December 31, 2014. The increase in operating and maintenance expense resulted from higher repairs and maintenance expenses of $4.3 million associated with increased throughput, higher property taxes of $2.3 million and higher allocations, including personnel costs, from EQT. Selling, general and administrative expense increased primarily as a result of higher allocations and personnel costs from EQT. Other Income Statement Items Other Income For the years ended December 31, 2016 and 2015, the Company recorded equity in earnings of nonconsolidated investments of $9.9 million and $2.6 million, respectively, related to EQM's portion of the MVP Joint Venture's AFUDC on the MVP project. For the year ended December 31, 2014, the Company recorded equity in earnings of nonconsolidated investments of $3.4 million related to the Company’s prior investment in Nora Gathering, LLC (Nora LLC). In connection with the asset exchange with Range Resources in 2014, the Company transferred its 50% ownership interest in Nora LLC to Range Resources. See Note 8 to the Consolidated Financial Statements. For the years ended December 31, 2016, 2015 and 2014, the Company recorded AFUDC of $19.4 million, $6.3 million and $3.2 million, respectively. The increases in AFUDC were mainly attributable to increased spending on the OVC project. Interest Expense Interest expense increased $1.4 million in 2016 compared to 2015. Decreased capitalized interest of $13.3 million and additional interest expense of approximately $3.3 million related to EQM's $500 million 4.125% senior notes issued during the fourth quarter of 2016 were mostly offset by higher interest income earned on short-term investments of $6.7 million, lower interest expense resulting from the Company's repayment of $160.0 million of debt that matured in the fourth quarter of 2015, and lower EQM revolver fees. Interest expense increased $10.0 million in 2015 compared to 2014, primarily as a result of additional interest expense of approximately $11.7 million related to EQM's 4.00% senior notes due 2024 in the aggregate principal amount of $500.0 million issued during the third quarter of 2014, partially offset by lower interest expense resulting from the Company's repayment of $150.0 million of 5.00% senior notes and $10.0 million of 7.55% Series B notes, both of which matured in the fourth quarter of 2015. The weighted average annual interest rates on the Company’s long-term debt, excluding EQM’s long-term debt, was 6.5%, 6.5%, and 6.4% for 2016, 2015 and 2014, respectively. The weighted average annual interest rate on EQM’s long-term debt was 4.0% for each of 2016, 2015 and 2014. The Company did not have any borrowings outstanding at any time under its revolving credit facility during the years ended December 31, 2016, 2015 and 2014. The maximum amount of outstanding borrowings under EQM’s $750 million credit facility at any time during the years ended December 31, 2016, 2015 and 2014 was $401 million, $404 million and $450 million, respectively. The average daily balance of borrowings outstanding under EQM's $750 million credit facility was approximately $77 million, $261 million and $119 million during the years ended December 31, 2016, 2015 and 2014, respectively. Interest was incurred on such borrowings at weighted average annual interest rates of approximately 2.0%, 1.7% and 1.7% for the years ended December 31, 2016, 2015 and 2014, respectively. Income Taxes All of EQGP's income is included in the Company's pre-tax income (loss). However, the Company is not required to record income tax expense with respect to the portions of EQGP's income allocated to the noncontrolling public limited partners of EQGP and EQM, which reduces the Company's effective tax rate in periods when the Company has consolidated pre-tax income and increases the Company's effective tax rate in periods when the Company has consolidated pre-tax loss. For federal income tax purposes, the Company may deduct a portion of its drilling costs as intangible drilling costs (IDCs) in the year incurred. IDCs, however, are sometimes limited for purposes of the alternative minimum tax (AMT) and can result in the Company paying AMT even when generating large tax deductions or utilizing a net operating loss (NOL) carryforward. For 2016, the Company is in a breakeven federal taxable income position and is paying a small amount of tax. For 2015 and 2014, the Company paid a larger amount of tax as a result of the large tax gains generated from EQGP’s IPO in 2015, the NWV Gathering Transaction in 2015 and the Jupiter Transaction in 2014 (defined in Note 4 to the Consolidated Financial Statements). See Note 10 to the Consolidated Financial Statements for further discussion of the Company’s income tax (benefit) expense. Net Income Attributable to Noncontrolling Interests The increase in net income attributable to noncontrolling interests for all periods was primarily the result of increased net income at EQM, increased ownership of EQM common units by third-parties and EQGP's IPO in 2015. Outlook The Company is committed to profitably developing its natural gas and NGLs reserves through environmentally responsible, cost-effective and technologically advanced horizontal drilling. The Company’s revenues, earnings, liquidity and ability to grow are substantially dependent on the prices it receives for, and the Company’s ability to develop its reserves of natural gas and NGLs. Despite the continued low price environment for natural gas and NGLs, the Company believes the long-term outlook for its business is favorable due to the Company's resource base, low cost structure, financial strength, risk management, including commodity hedging strategy, and disciplined investment of capital. The Company believes the combination of these factors provide it with an opportunity to exploit and develop its positions and maximize efficiency through economies of scale in its strategic operating area. The daily spot prices for NYMEX Henry Hub natural gas ranged from a high of $3.76 per MMBtu to a low of $1.49 per MMBtu from January 1, 2015 through December 31, 2016. In addition, the market price for natural gas in the Appalachian Basin was lower relative to NYMEX Henry Hub as a result of the significant increases in the supply of natural gas in the Northeast region in recent years. Due to the volatility of commodity prices, we are unable to predict future potential movements in the market prices for natural gas, including Appalachian basis, and NGLs and thus cannot predict the ultimate impact of prices on our operations. The Company's 2017 capital expenditure forecast for well development is $1.3 billion, which is 66% higher than its 2016 capital expenditures for well development. Changes in natural gas, NGLs and oil prices could affect, among other things, the Company's development plans, which would increase or decrease the pace of the development and the level of the Company's reserves, as well as the Company's revenues, earnings or liquidity. Significant changes in prices may result in an increase or decrease in capital spending. Lower prices could result in additional non-cash impairments in the book value of the Company’s oil and gas properties or additional downward adjustments to the Company’s estimated proved reserves. Any such additional impairment and/or downward adjustment to the Company’s estimated reserves could potentially be material to the Company. See “Impairment of Oil and Gas Properties” below. In July 2015, the Company turned in-line its first dry gas focused Utica well, which experienced prolific initial results. The Company has subsequently turned in-line 4 additional Utica wells located in Greene County, Pennsylvania and Wetzel County, West Virginia, with 2 additional wells spud but not yet complete as of December 31, 2016. Given the results of its initial Utica wells, the Company will continue development of its Utica acreage in 2017. Total capital investment by EQT in 2017, excluding acquisitions, is expected to be approximately $2.0 billion (including EQM). Capital spending for well development (primarily drilling and completion) of approximately $1.3 billion in 2017 is expected to support the drilling of approximately 207 gross wells, including 119 Marcellus wells, 81 Upper Devonian wells and 7 Utica wells. Estimated sales volumes are expected to be 810 - 830 Bcfe, which includes volume growth of approximately 60 Bcfe, the majority of which stems from the previous year's drilling program. The majority of the volume expected from the 2017 drilling program will be realized in 2018, at which time EQT forecasts production volume growth of 15 - 20% per year for several years. The anticipated production sales volume growth is approximately 8% in 2017, while total NGLs volumes are expected to be 13,200 - 13,800 Mbbls. To support continued growth in production, the Company plans to invest approximately $0.5 billion on midstream infrastructure through EQM. The 2017 capital investment plan for EQT Production is expected to be funded by cash generated from operations, cash on hand and sales of trading securities. EQM's available sources of liquidity include cash generated from operations, borrowings under its credit facilities, cash on hand, debt offerings and issuances of additional EQM partnership interests. The Company continues to focus on creating and maximizing shareholder value through the implementation of a strategy that economically accelerates the monetization of its asset base and prudently pursues investment opportunities, all while maintaining a strong balance sheet with solid cash flow. The Company monitors current and expected market conditions, including the commodity price environment, and its liquidity needs and may adjust its capital investment plan accordingly. While the tactics continue to evolve based on market conditions, the Company periodically considers arrangements to monetize the value of certain mature assets for re-deployment into its highest value development opportunities. The Company continues to pursue transactions that would add to its Marcellus, Upper Devonian and Utica positions and would consider purchasing assets or companies of various sizes within those positions. Impairment of Oil and Gas Properties See “Critical Accounting Policies and Estimates” below and Note 1 to the Consolidated Financial Statements for a discussion of the Company’s accounting policies and significant assumptions related to impairment of the Company’s oil and gas properties. Due to declines in the five-year NYMEX forward strip prices during 2015 and into 2016, the Company determined that indicators of potential impairment existed for certain of the Company’s proved oil and gas properties as of December 31, 2016. In accordance with its normal procedures, the Company estimated the future undiscounted cash flows from these oil and gas properties and compared these estimates to the carrying value of the properties. Based on these evaluations, the Company determined that no impairment existed during 2016. Although the Company did not record an impairment on its oil and gas producing properties during 2016, all other things being equal, a further decline in the average five-year NYMEX forward strip price in a future period may cause the Company to recognize impairments on non-core assets, including the Company's assets in the Huron play, which had a carrying value of approximately $3 billion at December 31, 2016. As described under “Critical Accounting Policies and Estimates” below, the Company makes a number of assumptions related to its evaluation of its oil and gas properties for impairment, many of which require the Company’s management to make significant judgments. These assumptions, which are generally consistent with the assumptions utilized by the Company’s management for internal planning and budgeting purposes, include, among other things, anticipated production from reserves; future market prices for natural gas, NGLs and oil adjusted accordingly for basis differentials; future operating and capital costs; and inflation. Future market prices for natural gas, NGLs and oil are often volatile, and assumptions regarding basis differentials, future production and future operating costs are highly judgmental and in some cases difficult to predict. Due to the uncertainty inherent in, and the interdependence of these factors, the Company cannot predict if future impairment charges, including impairment charges related to its Huron oil and gas properties, will be recognized and, if so, an estimate of the impairment charges that would be recorded in any future period. See “Recent natural gas, NGLs and oil price declines have resulted in impairment of certain of our non-core assets. Future declines in commodity prices, increases in operating costs or adverse changes in well performance may result in additional write-downs of the carrying amounts of our assets, which could materially and adversely affect our results of operations in future periods.” under Item 1A, “Risk Factors.” Capital Resources and Liquidity The Company’s primary sources of cash for the year ended December 31, 2016 were proceeds from the public offerings of EQT common stock and cash flows from operating activities, while the primary use of cash was for capital expenditures. Operating Activities The Company’s net cash provided by operating activities decreased $152.6 million from full year 2015 to full year 2016 and by $197.8 million from full year 2014 to full year 2015. Decreases in cash flows provided by operating activities in both periods were primarily the result of a lower commodity price and higher operating expenses, partly offset by higher production sales volumes, cash settlements on derivatives not designated as hedges, decreases in cash paid for income taxes and the timing of payments between periods. The Company's cash flows from operating activities will be impacted by future movements in the market price for commodities. The Company is unable to predict these future price movements. See "Natural gas, NGLs and oil price volatility, or a prolonged period of low natural gas, NGLs and oil prices may have an adverse effect upon our revenue, profitability, future rate of growth, liquidity and financial position" under Item 1A, "Risk Factors" for further information. Investing Activities Cash flows used in investing activities totaled $2,961.5 million for 2016 as compared to $2,525.6 million for 2015. The $435.9 million increase was primarily due to an increase in capital expenditures for acquisitions of $1,051.2 million and investments in trading securities of $288.8 million, partly offset by a reduction in the drilling and completions capital expenditures. During 2016, the Company invested in trading securities, which consist of liquid debt securities carried at fair value, to maximize returns. The Company also placed $75.0 million of the proceeds received from the sale of a gathering system into restricted cash for a potential like-kind exchange for tax purposes. Cash flows used in investing activities totaled $2,525.6 million for 2015 as compared to $2,444.2 million for 2014. The $81.4 million increase was primarily attributable to a $156.7 million increase in capital expenditures and $74.5 million of net capital contributions made to the MVP Joint Venture through EQM during 2015, partly offset by $174.2 million of capital expenditures in 2014 in connection with the 2014 exchange of assets with Range Resources. Capital Expenditures from Continuing Operations (in millions) * Represents the net impact of non-cash capital expenditures including capitalized non-cash stock-based compensation expense and accruals. The impact of accrued capital expenditures includes the reversal of the prior period accrual as well as the current period estimate, both of which are non-cash items. The year ended December 31, 2016 included $87.6 million of non-cash capital expenditures related to acquisitions, and the year ended December 31, 2014 included $349 million of non-cash capital expenditures for the exchange of assets with Range Resources. The Company has forecast a 2017 capital expenditure spending plan of approximately $2.0 billion (excluding acquisitions), which includes $1.3 billion for well development (primarily drilling and completion), an EQM 2017 capital expenditure spending plan of approximately $0.5 billion and $0.2 billion for other items. The Company does not forecast property acquisitions within its capital spending plan. Capital expenditures for drilling and development totaled $783 million and $1,670 million during 2016 and 2015, respectively. The Company spud 135 gross wells in 2016, including 117 horizontal Marcellus wells, 13 horizontal Upper Devonian wells and 4 Utica wells. The Company spud 161 gross wells in 2015, including 133 horizontal Marcellus wells, 24 horizontal Upper Devonian wells and 4 other wells, including 2 Utica wells. The decrease in capital expenditures for well development in 2016 was driven primarily by the timing of drilling and completions activities between years, a decrease in wells spud, lower costs per well and operational efficiencies. Capital expenditures for 2016 also included $1,284 million for property acquisitions, compared to $182 million of capital expenditures in 2015 for property acquisitions. The Company executed multiple large transactions during 2016 that resulted in the Company's acquisition of approximately 122,100 net Marcellus acres located primarily in northern West Virginia and southwestern Pennsylvania discussed in Note 8 to the Consolidated Financial Statements. Capital expenditures for drilling and development totaled $1,670 million and $1,717 million during 2015 and 2014, respectively. The Company spud 345 gross wells in 2014, including 196 horizontal Marcellus wells, 41 horizontal Upper Devonian wells, 103 horizontal Huron wells and 5 other wells. The $47 million decrease in capital expenditures for well development in 2015 was driven primarily by a decrease in wells spud partly offset by increased costs of Utica drilling. Capital expenditures for 2015 also included $182 million for property acquisitions, compared to $724 million of capital expenditures in 2014 for property acquisitions. Capital expenditures for the gathering and transmission operations totaled $587 million for 2016 and $430 million for 2015, primarily related to expansion capital expenditures. Expansion capital expenditures are expenditures incurred for capital improvements that EQM expects to increase its operating income or operating capacity over the long term. This increase in expansion capital expenditures primarily related to OVC, which was placed into service in the fourth quarter of 2016. Capital expenditures for the gathering, transmission and storage operations totaled $430 million for 2015 and $391 million for 2014, primarily related to expansion capital expenditures. Financing Activities Cash flows provided by financing activities totaled $1,399.5 million for 2016 as compared to $1,832.5 million for 2015. During 2016, the Company's primary sources of financing cash flows were net proceeds from its public offerings of common stock and from EQM's public offerings of common units under the $750 million ATM Program, as well as proceeds received from the issuance of EQM debt. The primary financing uses of cash during 2016 were net credit facility repayments under the EQM credit facility, distributions to noncontrolling interests, taxes related to the vesting or exercise of equity awards and dividends. On January 18, 2017, the Board of Directors of the Company declared a regular quarterly cash dividend of three cents per share, payable March 1, 2017, to the Company’s shareholders of record at the close of business on February 17, 2017. On January 19, 2017, the Board of Directors of EQGP's general partner declared a cash distribution to EQGP's unitholders for the fourth quarter of 2016 of $0.177 per common unit, or approximately $47.1 million. The cash distribution will be paid on February 23, 2017 to unitholders of record, including the Company, at the close of business on February 3, 2017. On January 19, 2017, the Board of Directors of EQM’s general partner declared a cash distribution to EQM’s unitholders for the fourth quarter of 2016 of $0.85 per common unit. The cash distribution will be paid on February 14, 2017 to unitholders of record, including EQGP, at the close of business on February 3, 2017. Based on the 80,581,758 EQM common units outstanding on February 9, 2017, the aggregate cash distributions by EQM to EQGP will be approximately $47.9 million consisting of: $18.5 million in respective to its limited partner interest, $1.8 million in respect of its general partner interest and $27.6 million in respect of its IDRs in EQM. Cash flows provided by financing activities totaled $1,832.5 million for 2015 as compared to $1,261.3 million for 2014. During 2015, the Company's primary sources of financing cash flows were net proceeds from EQM's public offerings of common units, including sales under the $750 million ATM Program, net proceeds from EQGP's IPO and net borrowings on EQM's revolving credit facility. The primary financing uses of cash during 2015 were payments on maturing long-term debt, distributions to noncontrolling interests and taxes related to the vesting or exercise of equity awards. On April 30, 2014, the Company’s Board of Directors approved a share repurchase authorization of up to 1,000,000 shares of the Company’s outstanding common stock. The Company may repurchase shares from time to time in open market or in privately negotiated transactions. The share repurchase authorization does not obligate the Company to acquire any specific number of shares, has no pre-established end date and may be discontinued by the Company at any time. During the year ended December 31, 2014, the Company repurchased and retired 300,000 shares of common stock for $32.4 million under the authorization. The Company made no repurchases under the authorization during 2016 and 2015. The Company may from time to time seek to repurchase its outstanding debt securities. Such repurchases, if any, will depend on prevailing market conditions, the Company's liquidity requirements, contractual and legal restrictions and other factors. Revolving Credit Facilities EQT primarily utilizes borrowings under its revolving credit facilities to fund capital expenditures in excess of cash flow from operating activities until the expenditures can be permanently financed and to fund required margin deposits on derivative commodity instruments. Margin deposit requirements vary based on natural gas commodity prices, the Company's credit ratings and the amount and type of derivative commodity instruments. The Company has a $1.5 billion unsecured revolving credit facility that expires in February 2019. The Company may request two one-year extensions of the expiration date, the approval of which is subject to satisfaction of certain conditions. The revolving credit facility may be used for working capital, capital expenditures, share repurchases and any other lawful corporate purposes. The credit facility is underwritten by a syndicate of 18 financial institutions, each of which is obligated to fund its pro-rata portion of any borrowings by the Company. Under the terms of the revolving credit facility, the Company may obtain base rate loans or fixed period Eurodollar rate loans. Base rate loans are denominated in dollars and bear interest at a base rate plus a margin based on the Company’s then current credit ratings. Fixed period Eurodollar rate loans bear interest at a Eurodollar rate plus a margin based on the Company’s then current credit ratings. The Company had no borrowings or letters of credit outstanding under its revolving credit facility as of December 31, 2016 and 2015 or at any time during the years ended December 31, 2016 and 2015. For the years ended December 31, 2016 and 2015, the Company incurred commitment fees averaging approximately 23 basis points to maintain credit availability under its revolving credit facility. EQM has a $750 million credit facility that expires in February 2019. The credit facility is available to fund working capital requirements and capital expenditures, to purchase assets, to pay distributions and repurchase units and for general partnership purposes. The credit facility is underwritten by a syndicate of 18 financial institutions, each of which is obligated to fund its pro-rata portion of any borrowings by EQM. The Company is not a guarantor of EQM’s obligations under the credit facility. Under the terms of its revolving credit facility, EQM may obtain base rate loans or fixed period Eurodollar rate loans. Base rate loans are denominated in dollars and bear interest at a base rate plus a margin based on EQM’s then current credit rating. Fixed period Eurodollar rate loans bear interest at a Eurodollar rate plus a margin based on EQM’s then current credit ratings. EQM had no borrowings and no letters of credit outstanding under its revolving credit facility as of December 31, 2016. EQM had $299 million of borrowings and no letters of credit outstanding under its revolving credit facility as of December 31, 2015. For the years ended December 31, 2016 and 2015, EQM incurred commitment fees averaging approximately 23 basis points to maintain credit availability under the revolving credit facility. The maximum amount of outstanding borrowings at any time under EQM’s credit facility during the year ended December 31, 2016 was $401 million, and the average daily balance of borrowings outstanding was approximately $77 million at a weighted average annual interest rate of 2.0%. The maximum amount of outstanding borrowings at any time under EQM’s credit facility during the year ended December 31, 2015 was $404 million, and the average daily balance of borrowings outstanding was approximately $261 million at a weighted average annual interest rate of 1.7%. See also the discussion of the revolving loan agreement between EQT and EQM in Note 4 to the Consolidated Financial Statements. Security Ratings and Financing Triggers The table below reflects the credit ratings for debt instruments of the Company at December 31, 2016. Changes in credit ratings may affect the Company’s cost of short-term debt through interest rates and fees under its lines of credit. These ratings may also affect collateral requirements under derivative instruments, pipeline capacity contracts, joint venture arrangements and subsidiary construction contracts, rates available on new long-term debt and access to the credit markets. The table below reflects the credit ratings for debt instruments of EQM at December 31, 2016. Changes in credit ratings may affect EQM’s cost of short-term debt through interest rates and fees under its lines of credit. These ratings may also affect collateral requirements under joint venture arrangements and subsidiary construction contracts, rates available on new long-term debt and access to the credit markets. The Company’s and EQM’s credit ratings are subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating. The Company and EQM cannot ensure that a rating will remain in effect for any given period of time or that a rating will not be lowered or withdrawn by a credit rating agency if, in its judgment, circumstances so warrant. If any credit rating agency downgrades the ratings, particularly below investment grade, the Company’s or EQM’s access to the capital markets may be limited, borrowing costs and margin deposits on the Company’s derivative contracts would increase, counterparties may request additional assurances, including collateral, and the potential pool of investors and funding sources may decrease. The required margin on the Company’s derivative instruments is also subject to significant change as a result of factors other than credit rating, such as gas prices and credit thresholds set forth in agreements between the hedging counterparties and the Company. Investment grade refers to the quality of a company's credit as assessed by one or more credit rating agencies. In order to be considered investment grade, a company must be rated BBB- or higher by S&P, Baa3 or higher by Moody's, and BBB- or higher by Fitch. Anything below these ratings is considered non-investment grade. The Company’s debt agreements and other financial obligations contain various provisions that, if not complied with, could result in termination of the agreements, require early payment of amounts outstanding or similar actions. The most significant covenants and events of default under the debt agreements relate to maintenance of a debt-to-total capitalization ratio, limitations on transactions with affiliates, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of other financial obligations and change of control provisions. The Company’s credit facility contains financial covenants that require a total debt-to-total capitalization ratio no greater than 65%. The calculation of this ratio excludes the effects of accumulated other comprehensive income (OCI). As of December 31, 2016, the Company was in compliance with all debt provisions and covenants. EQM’s debt agreements and other financial obligations contain various provisions that, if not complied with, could result in termination of the agreements, require early payment of amounts outstanding or similar actions. The covenants and events of default under the debt agreements relate to maintenance of a permitted leverage ratio, limitations on transactions with affiliates, limitations on restricted payments, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of and certain other defaults under other financial obligations and change of control provisions. Under EQM's $750 million credit facility, EQM is required to maintain a consolidated leverage ratio of not more than 5.00 to 1.00 (or not more than 5.50 to 1.00 for certain measurement periods following the consummation of certain acquisitions). As of December 31, 2016, EQM was in compliance with all debt provisions and covenants. EQM ATM Program During 2015, EQM entered into an equity distribution agreement that established the $750 million ATM Program. EQM had approximately $443 million in remaining capacity under the program as of February 9, 2017. Commodity Risk Management The substantial majority of the Company’s commodity risk management program is related to hedging sales of the Company’s produced natural gas. The Company’s overall objective in this hedging program is to protect cash flow from undue exposure to the risk of changing commodity prices. The derivative commodity instruments currently utilized by the Company are primarily NYMEX swaps and collars. As of January 31, 2017, the approximate volumes and prices of the Company’s derivative commodity instruments hedging sales of produced gas for 2017 through 2019 were: (a) The Company also sold calendar year 2017 and 2018 calls for approximately 32 Bcf and 16 Bcf, respectively, at strike prices of $3.53 per Mcf and $3.48 per Mcf, respectively. (b) For 2017 and 2018, the Company also sold puts for approximately 3 Bcf each year at a strike price of $2.63 per Mcf. (c) The average price is based on a conversion rate of 1.05 MMBtu/Mcf. The Company also enters into fixed price natural gas sales agreements that are satisfied by physical delivery. The difference between these sales prices and NYMEX are included in average differential on the Company's price reconciliation under "Consolidated Operational Data". The Company has fixed price physical sales for 2017 and 2018 of 44 Bcf and 5 Bcf, respectively, at average prices of $3.16 per Mcf and $3.29 per Mcf, respectively. For 2017 and 2018, the Company has a natural gas sales agreement for approximately 35 Bcf per year that includes a NYMEX ceiling price of $4.88 per Mcf. For 2018 and 2019, the Company has a natural gas sales agreement for approximately 7 Bcf per year that includes a NYMEX floor price of $2.16 per Mcf and a ceiling price of $4.47 per Mcf. Currently, the Company has also entered into derivative instruments to hedge basis and a limited number of contracts to hedge its NGLs exposure. The Company may also use other contractual agreements in implementing its commodity hedging strategy. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” and Note 6 to the Consolidated Financial Statements for further discussion of the Company’s hedging program. Other Items Off-Balance Sheet Arrangements In connection with the sale of its NORESCO domestic operations in December 2005, the Company agreed to maintain in place guarantees of certain warranty obligations of NORESCO. The savings guarantees provided that once the energy-efficiency construction was completed by NORESCO, the customer would experience a certain dollar amount of energy savings over a period of years. The undiscounted maximum aggregate payments that may be due related to these guarantees were approximately $115 million as of December 31, 2016, extending at a decreasing amount for approximately 12 years. As of December 31, 2016, EQM had issued a $91 million performance guarantee (the Initial Guarantee) in connection with the obligations of MVP Holdco, LLC (MVP Holdco) to fund its proportionate share of the construction budget for the MVP. Upon the FERC’s initial release to begin construction of the MVP, the Initial Guarantee will terminate, and EQM will be obligated to issue a new guarantee in an amount equal to 33% of MVP Holdco’s remaining obligations to make capital contributions to the MVP Joint Venture in connection with the then remaining construction budget, less, subject to certain limits, any credit assurances issued by an affiliate of EQM under such affiliate's precedent agreement with the MVP Joint Venture. The NORESCO guarantees and the Initial Guarantee are exempt from ASC Topic 460, Guarantees. The Company has determined that the likelihood it will be required to perform on these arrangements is remote and any potential payments are expected to be immaterial to the Company’s financial position, results of operations and liquidity. As such, the Company has not recorded any liabilities in its Consolidated Balance Sheets related to these guarantees. Rate Regulation As described under “Regulation” in Item 1, “Business,” the Company’s transmission and storage operations and a portion of its gathering operations are subject to various forms of rate regulation. As described in Note 1 to the Consolidated Financial Statements, regulatory accounting allows the Company to defer expenses and income as regulatory assets and liabilities which reflect future collections or payments through the regulatory process. The Company believes that it will continue to be subject to rate regulation that will provide for the recovery of the deferred costs. Schedule of Contractual Obligations The table below presents the Company’s long-term contractual obligations as of December 31, 2016 in total and by periods. Purchase obligations exclude the Company’s contractual obligations relating to its binding precedent agreements and other natural gas transmission and gathering capacity agreements with EQM, for which future payments related to such agreements totaled $6.0 billion as of December 31, 2016. These capacity commitments have terms extending up to 20 years. For a description of the transportation agreements, see Note 20 to the Consolidated Financial Statements. Purchase obligations also exclude future capital contributions to the MVP Joint Venture and purchase obligations of the MVP Joint Venture. (a) Interest payments exclude interest due related to the credit facility borrowings as the interest rate on EQM's credit facility agreement is variable. Purchase obligations are primarily commitments for demand charges under existing long-term contracts and binding precedent agreements with various unconsolidated pipelines, including commitments from the Company to the MVP Joint Venture, some of which extend up to approximately 20 years. The Company has entered into agreements to release some of its capacity to various third parties. Purchase obligations also include commitments with third parties for processing capacity in order to extract heavier liquid hydrocarbons from the natural gas stream. Operating leases are primarily entered into for various office locations and warehouse buildings, as well as dedicated drilling rigs in support of the Company’s drilling program. The obligations for the Company’s various office locations and warehouse buildings totaled approximately $44.1 million as of December 31, 2016. The Company has agreements with several drillers to provide drilling equipment and services to the Company over the next four years. These obligations totaled approximately $60.9 million as of December 31, 2016. The other liabilities line represents commitments for total estimated payouts for the 2016 EQT Value Driver Award Program and 2016 restricted stock unit liability awards. See “Critical Accounting Policies and Estimates” below and Note 18 to the Consolidated Financial Statements for further discussion regarding factors that affect the ultimate amount of the payout of these obligations. As discussed in Note 10 to the Consolidated Financial Statements, the Company had a total reserve for unrecognized tax benefits at December 31, 2016 of $252.4 million, of which $75.4 million is offset against deferred tax assets since it would primarily reduce the alternative minimum tax credit carryforwards. The Company is currently unable to make reasonably reliable estimates of the period of cash settlement of these potential liabilities with taxing authorities; therefore, this amount has been excluded from the schedule of contractual obligations. Commitments and Contingencies In the ordinary course of business, various legal and regulatory claims and proceedings are pending or threatened against the Company. While the amounts claimed may be substantial, the Company is unable to predict with certainty the ultimate outcome of such claims and proceedings. The Company accrues legal and other direct costs related to loss contingencies when actually incurred. The Company has established reserves it believes to be appropriate for pending matters and, after consultation with counsel and giving appropriate consideration to available insurance, the Company believes that the ultimate outcome of any matter currently pending against the Company will not materially affect the Company’s financial position, results of operations or liquidity. See Note 20 to the Consolidated Financial Statements for further discussion of the Company’s commitments and contingencies. See also the discussion of the revolving loan agreement between EQT and EQM in Note 4 to the Consolidated Financial Statements. Recently Issued Accounting Standards The Company's recently issued accounting standards are described in Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Critical Accounting Policies and Estimates The Company’s significant accounting policies are described in Note 1 to the Consolidated Financial Statements. The discussion and analysis of the Consolidated Financial Statements and results of operations are based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with United States GAAP. The preparation of the Consolidated Financial Statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. The following critical accounting policies, which were reviewed by the Company’s Audit Committee, relate to the Company’s more significant judgments and estimates used in the preparation of its Consolidated Financial Statements. Actual results could differ from those estimates. Accounting for Oil and Gas Producing Activities: The Company uses the successful efforts method of accounting for its oil and gas producing activities. The carrying values of the Company’s proved oil and gas properties are reviewed for impairment generally on a field-by-field basis when events or circumstances indicate that the remaining carrying value may not be recoverable. The estimated future cash flows used to test those properties for recoverability are based on proved and, if determined reasonable by management, risk-adjusted probable reserves, utilizing assumptions generally consistent with the assumptions utilized by the Company's management for internal planning and budgeting purposes, including, among other things, the intended use of the asset, anticipated production from reserves, future market prices for natural gas, NGLs and oil, adjusted accordingly for basis differentials, future operating costs and inflation, some of which are interdependent. Proved oil and gas properties that have carrying amounts in excess of estimated future cash flows are written down to fair value, which is estimated by discounting the estimated future cash flows using discount rates and other assumptions that marketplace participants would use in their estimates of fair value. Capitalized costs of unproved properties are evaluated at least annually for recoverability on a prospective basis. Indicators of potential impairment include changes in development plans resulting from economic factors, potential shifts in business strategy employed by management and historical experience. If it is determined that the properties will not yield proved reserves prior to their expirations, the related costs are expensed in the period in which that determination is made. The Company believes that the accounting estimate related to the accounting for oil and gas producing activities is a “critical accounting estimate” as the evaluations of impairment of proved properties involve significant judgment about future events such as future sales prices of natural gas and NGLs, future production costs, estimates of the amount of natural gas and NGLs recorded and the timing of those recoveries. See "Impairment of Oil and Gas Properties" above and Note 1 to the Consolidated Financial Statements for additional information regarding the Company’s impairments of proved and unproved oil and gas properties. Oil and Gas Reserves: Proved oil and gas reserves, as defined by SEC Regulation S-X Rule 4-10, are those quantities of oil and gas which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible from a given date forward, from known reservoirs and under existing economic conditions, operating methods and government regulations prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. The Company’s estimates of proved reserves are made and reassessed annually using geological and reservoir data as well as production performance data. Reserve estimates are prepared and updated by the Company’s engineers and audited by the Company’s independent engineers. Revisions may result from changes in, among other things, reservoir performance, development plans, prices, operating costs, economic conditions and governmental restrictions. Decreases in prices, for example, may cause a reduction in some proved reserves due to reaching economic limits sooner. A material change in the estimated volumes of reserves could have an impact on the depletion rate calculation and the Company's financial statements, including strength of the balance sheet. The Company estimates future net cash flows from natural gas, NGLs and oil reserves based on selling prices and costs using a 12-month average price, calculated as the unweighted arithmetic average of the first-day-of-the-month price for each month within the 12-month period, which is subject to change in subsequent periods. Operating costs, production and ad valorem taxes and future development costs are based on current costs with no escalation. Income tax expense is computed using statutory future tax rates and giving effect to tax deductions and credits available under current laws and which relate to oil and gas producing activities. The Company believes that the accounting estimate related to oil and gas reserves is a “critical accounting estimate” because the Company must periodically reevaluate proved reserves along with estimates of future production rates, production costs and the estimated timing of development expenditures. Future results of operations and strength of the balance sheet for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. See "Impairment of Oil and Gas Properties" above for additional information regarding the Company’s oil and gas reserves. Income Taxes: The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the Company’s Consolidated Financial Statements or tax returns. The Company has recorded deferred tax assets principally resulting from federal and state NOL carryforwards, an alternative minimum tax credit carryforward, incentive compensation, unrealized hedge losses and investment in EQGP. The Company has established a valuation allowance against a portion of the deferred tax assets related to the federal and state NOL carryforwards, as it is believed that it is more likely than not that these deferred tax assets will not all be realized. No other significant valuation allowances have been established, as it is believed that future sources of taxable income, reversing temporary differences and other tax planning strategies will be sufficient to realize these deferred tax assets. Any determination to change the valuation allowance would impact the Company’s income tax expense and net income in the period in which such a determination is made. The Company also estimates the amount of financial statement benefit to record for uncertain tax positions as described in Note 10 to the Company’s Consolidated Financial Statements. The Company believes that accounting estimates related to income taxes are “critical accounting estimates” because the Company must assess the likelihood that deferred tax assets will be recovered from future taxable income and exercise judgment regarding the amount of financial statement benefit to record for uncertain tax positions. When evaluating whether or not a valuation allowance must be established on deferred tax assets, the Company exercises judgment in determining whether it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax assets will not be realized. The Company considers all available evidence, both positive and negative, to determine whether, based on the weight of the evidence, a valuation allowance is needed, including carrybacks, tax planning strategies, reversal of deferred tax assets and liabilities and forecasted future taxable income. In making the determination related to uncertain tax positions, the Company considers the amounts and probabilities of the outcomes that could be realized upon ultimate settlement of an uncertain tax position using the facts, circumstances and information available at the reporting date to establish the appropriate amount of financial statement benefit. To the extent that an uncertain tax position or valuation allowance is established or increased or decreased during a period, the Company must include an expense or benefit within tax expense in the income statement. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Derivative Instruments: The Company enters into derivative commodity instrument contracts primarily to mitigate exposure to commodity price risk associated with future sales of natural gas production. The Company also enters into derivative instruments to hedge basis and to hedge exposure to fluctuations in interest rates. The Company estimates the fair value of all derivative instruments using quoted market prices, where available. If quoted market prices are not available, fair value is based upon models that use market-based parameters as inputs, including forward curves, discount rates, volatilities and nonperformance risk. Nonperformance risk considers the effect of the Company’s credit standing on the fair value of liabilities and the effect of the counterparty’s credit standing on the fair value of assets. The Company estimates nonperformance risk by analyzing publicly available market information, including a comparison of the yield on debt instruments with credit ratings similar to the Company’s or counterparty’s credit rating and the yield of a risk-free instrument, and credit default swap rates where available. The values reported in the financial statements change as these estimates are revised to reflect actual results, or market conditions or other factors change, many of which are beyond the Company’s control. The Company believes that the accounting estimates related to derivative instruments are “critical accounting estimates” because the Company’s financial condition and results of operations can be significantly impacted by changes in the market value of the Company’s derivative instruments due to the volatility of natural gas prices, both NYMEX and basis. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Contingencies and Asset Retirement Obligations: The Company is involved in various regulatory and legal proceedings that arise in the ordinary course of business. The Company records a liability for contingencies based upon its assessment that a loss is probable and the amount of the loss can be reasonably estimated. The Company considers many factors in making these assessments, including history and specifics of each matter. Estimates are developed in consultation with legal counsel and are based upon an analysis of potential results. The Company also accrues a liability for asset retirement obligations based on an estimate of the timing and amount of their settlement. For oil and gas wells, the fair value of the Company’s plugging and abandonment obligations is required to be recorded at the time the obligations are incurred, which is typically at the time the wells are spud. The Company is required to operate and maintain its natural gas pipeline and storage systems, and intends to do so as long as supply and demand for natural gas exists, which the Company expects for the foreseeable future. Therefore, the Company believes that the substantial majority of its natural gas pipeline and storage system assets have indeterminate lives. The Company believes that the accounting estimates related to contingencies and asset retirement obligations are “critical accounting estimates” because the Company must assess the probability of loss related to contingencies and the expected amount and timing of asset retirement obligations. In addition, the Company must determine the estimated present value of future liabilities. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Share-Based Compensation: The Company awards share-based compensation in connection with specific programs established under the 2009 and 2014 Long-Term Incentive Plans. Awards to employees are typically made in the form of performance-based awards, time-based restricted stock, time-based restricted units and stock options. Awards to directors are typically made in the form of phantom units that vest upon grant. Restricted units and performance-based awards expected to be satisfied in cash are treated as liability awards. For liability awards, the Company is required to estimate, on grant date and on each reporting date thereafter until vesting and payment, the fair value of the ultimate payout based upon the expected performance through, and value of the Company’s common stock on, the vesting date. The Company then recognizes a proportionate amount of the expense for each period in the Company’s financial statements over the vesting period of the award. The Company reviews its assumptions regarding performance and common stock value on a quarterly basis and adjusts its accrual when changes in these assumptions result in a material change in the fair value of the ultimate payouts. Performance-based awards expected to be satisfied in Company common stock are treated as equity awards. For equity awards, the Company is required to determine the grant date fair value of the awards, which is then recognized as expense in the Company’s financial statements over the vesting period of the award. Determination of the grant date fair value of the awards requires judgments and estimates regarding, among other things, the appropriate methodologies to follow in valuing the awards and the related inputs required by those valuation methodologies. Most often, the Company is required to obtain a valuation based upon assumptions regarding risk-free rates of return, dividend yields, expected volatilities and the expected term of the award. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the historical dividend yield of the Company’s common stock adjusted for any expected changes and, where applicable, of the common stock of the peer group members at the time of grant. Expected volatilities are based on historical volatility of the Company’s common stock and, where applicable, the common stock of the peer group members at the time of grant. The expected term represents the period of time elapsing during the applicable performance period. For time-based restricted stock awards, the grant date fair value of the awards is recognized as expense in the Company’s financial statements over the vesting period, historically three years. For director phantom units (which vest on date of grant) expected to be satisfied in equity, the grant date fair value of the awards is recognized as an expense in the Company’s financial statements in the year of grant. The grant date fair value, in both cases, is determined based upon the closing price of the Company’s common stock on the date of the grant. For non-qualified stock options, the grant date fair value is recognized as expense in the Company’s financial statements over the vesting period, typically two or three years. The Company utilizes the Black-Scholes option pricing model to measure the fair value of stock options, which includes assumptions for a risk-free interest rate, dividend yield, volatility factor and expected term. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the dividend yield of the Company’s common stock at the time of grant. The expected volatility is based on historical volatility of the Company’s common stock at the time of grant. The expected term represents the period of time that options granted are expected to be outstanding based on historical option exercise experience at the time of grant. The Company believes that the accounting estimates related to share-based compensation are “critical accounting estimates” because they may change from period to period based on changes in assumptions about factors affecting the ultimate payout of awards, including the number of awards to ultimately vest and the market price and volatility of the Company’s common stock. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. See Note 18 to the Consolidated Financial Statements for additional information regarding the Company’s share-based compensation.

<s>[INST] Consolidated Results of Continuing Operations 2016 EQT Highlights: Annual production sales volumes of 759.0 Bcfe, 26% higher than 2015 Marcellus sales volumes of 660.1 Bcfe, 31% higher than 2015 The Company completed two underwritten public offerings of common stock The Company increased its Marcellus acreage position by acquiring approximately 145,500 net Marcellus acres located primarily in northern West Virginia and southwestern Pennsylvania, including 122,100 net Marcellus acres acquired through the Statoil Acquisition, the Republic Transaction, the Trans Energy Merger and the Pennsylvania Acquisition EQM issued common units through its $750 million ATM program, receiving proceeds of $217.1 million EQM issued $500.0 million of 4.125% Senior Notes due December 1, 2026 Net loss from continuing operations attributable to EQT Corporation for 2016 was $453.0 million, a loss of $2.71 per diluted share, compared with income from continuing operations attributable to EQT Corporation of $85.2 million, $0.56 per diluted share, in 2015. The $538.2 million decrease in income from continuing operations attributable to EQT Corporation was primarily attributable to a loss on derivatives not designated as hedges, a 20% decrease in the average realized price, higher operating expenses and higher net income attributable to noncontrolling interests of EQM and EQGP, partially offset by a 26% increase in production sales volumes and lower income tax expense. EQT Production received $279.4 million and $172.1 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2016 and 2015, respectively, that are included in the average realized price but are not in GAAP operating revenues. During the year ended December 31, 2016, the Company recorded an impairment of longlived assets of approximately $59.7 million related to certain gathering assets sold to EQM in October 2016. The impairment was a result of a reduction in estimated future cash flows caused by the low commodity price environment and the related reduced producer drilling activity and throughput. This impairment is reflected in unallocated expenses and not recorded on any operating segment. Income from continuing operations attributable to EQT Corporation for 2015 was $85.2 million, $0.56 per diluted share, compared with $385.6 million, $2.53 per diluted share, in 2014. The $300.4 million decrease in income from continuing operations attributable to EQT Corporation was primarily attributable to a 31% decrease in the average realized price, higher operating expenses, higher net income attributable to noncontrolling interests of EQM and EQGP and a gain on sale / exchange of assets in 2014, partially offset by a 27% increase in production sales volumes, increased gains on derivatives not designated as hedges and lower income tax expense. EQT Production received $172.1 million and $34.2 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2015 and 2014, respectively. These net cash settlements are included in the average realized price but are not in GAAP operating revenues. See “Business Segment Results of Operations” for a discussion of items impacting operating income and “Other Income Statement Items” for a discussion of other income, interest expense, income taxes, income from discontinued operations and net income attributable to noncontrolling interests, and “Investing Activities” under the caption “Capital Resources and Liquidity” for a discussion of capital expenditures. Consolidated Operational Data The following table presents detailed natural gas and liquids operational information to assist in the understanding of the Company’s consolidated operations, including the calculation of the Company's average realized price ($/Mcfe), which is based on E [/INST] Positive. </s>

EQT Corp

2018-02-15

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis of financial condition and results of operations in conjunction with the consolidated financial statements, and the notes thereto, included in Item 8 of this Annual Report on Form 10-K. Consolidated Results of Operations 2017 EQT Highlights: • Closed the Rice Merger on November 13, 2017 • Achieved annual production sales volumes of 887.5 Bcfe, 17% higher than 2016 • Completed the 2017 Notes Offering (defined in Note 15 to the Consolidated Financial Statements) totaling $3.0 billion • Received FERC Certificate for Mountain Valley Pipeline Net income attributable to EQT Corporation for 2017 was $1,508.5 million, $8.04 per diluted share, compared with a loss attributable to EQT Corporation of $453.0 million, a loss of $2.71 per diluted share, in 2016. The $1,961.5 million increase in net income attributable to EQT Corporation was primarily attributable to an income tax benefit recorded as a result of the lower federal corporate tax rate beginning in 2018, the result of a gain on derivatives not designated as hedges in 2017 compared to a loss in 2016, a 23% increase in the average realized price, a 17% increase in production sales volumes, and higher pipeline, water and net marketing services, partially offset by higher operating expenses, higher interest expense, higher net income attributable to noncontrolling interests and a loss on debt extinguishment in 2017. During the year ended December 31, 2017, the Company recorded acquisition expenses of approximately $237.3 million related to the Rice Merger, including $141.3 million of employee related expenses for payments to former Rice employees under the Merger Agreement. Additional expenses were for investment banking, legal and other professional fees. Acquisition costs are reflected in unallocated expenses and not recorded on any operating segment. EQT Production received $40.7 million and $279.4 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2017 and 2016, respectively, that are included in the average realized price but are not in GAAP operating revenues. Net loss attributable to EQT Corporation for 2016 was $453.0 million, a loss of $2.71 per diluted share, compared with net income attributable to EQT Corporation of $85.2 million, $0.56 per diluted share, in 2015. The $538.2 million decrease in income attributable to EQT Corporation was primarily attributable to a loss on derivatives not designated as hedges, a 20% decrease in the average realized price, higher operating expenses and higher net income attributable to noncontrolling interests, partially offset by a 26% increase in production sales volumes and lower income tax expense. EQT Production received $279.4 million and $172.1 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2016 and 2015, respectively, that are included in the average realized price but are not in GAAP operating revenues. During the year ended December 31, 2016, the Company recorded an impairment of long-lived assets of approximately $59.7 million related to certain gathering assets sold to EQM in October 2016. The impairment was a result of a reduction in estimated future cash flows caused by the low commodity price environment and the related reduced producer drilling activity and throughput. This impairment is reflected in unallocated expenses and not recorded on any operating segment. See “Business Segment Results of Operations” for a discussion of items impacting operating income, “Other Income Statement Items” for a discussion of other income, interest expense, income taxes and net income attributable to noncontrolling interests, and “Investing Activities” under the caption “Capital Resources and Liquidity” for a discussion of capital expenditures. Consolidated Operational Data The following table presents detailed natural gas and liquids operational information to assist in the understanding of the Company’s consolidated operations, including the calculation of the Company's average realized price ($/Mcfe), which is based on EQT Production adjusted operating revenues, a non-GAAP supplemental financial measure. EQT Production adjusted operating revenues is presented because it is an important measure used by the Company’s management to evaluate period-to-period comparisons of earnings trends. EQT Production adjusted operating revenues should not be considered as an alternative to EQT Production total operating revenues. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of EQT Production adjusted operating revenues to EQT Production total operating revenues and Note 6 to the Consolidated Financial Statements for a reconciliation of EQT Production total operating revenues to EQT Corporation total operating revenues. (a) The Company’s volume weighted NYMEX natural gas price (actual average NYMEX natural gas price ($/MMBtu) was $3.11, $2.46 and $2.66 for the years ended December 31, 2017, 2016 and 2015, respectively). (b) Basis represents the difference between the ultimate sales price for natural gas and the NYMEX natural gas price. (c) NGLs, ethane and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (d) Also referred to in this report as EQT Production adjusted operating revenues, a non-GAAP supplemental financial measure. (e) For the year ended December 31, 2017, EQT Production includes the results of production operations acquired in the Rice Merger for the period of November 13, 2017 through December 31, 2017. Reconciliation of Non-GAAP Financial Measures The table below reconciles EQT Production adjusted operating revenues, a non-GAAP supplemental financial measure, to EQT Production total operating revenues as reported under EQT Production Results of Operations, its most directly comparable financial measure calculated in accordance with GAAP. See Note 6 to the Consolidated Financial Statements for a reconciliation of EQT Production operating revenues to EQT Corporation total operating revenues as reported in the Statements of Consolidated Operations. EQT Production adjusted operating revenues (also referred to as total natural gas & liquids sales, including cash settled derivatives) is presented because it is an important measure used by the Company’s management to evaluate period-over-period comparisons of earnings trends. EQT Production adjusted operating revenues as presented excludes the revenue impact of changes in the fair value of derivative instruments prior to settlement and the revenue impact of certain pipeline and net marketing services. Management utilizes EQT Production adjusted operating revenues to evaluate earnings trends because the measure reflects only the impact of settled derivative contracts and thus does not impact the revenue from natural gas sales with the often volatile fluctuations in the fair value of derivatives prior to settlement. EQT Production adjusted operating revenues also excludes "Pipeline and net marketing services" because management considers these revenues to be unrelated to the revenues for its natural gas and liquids production. "Pipeline and net marketing services" primarily includes revenues for gathering services provided to third parties as well as both the cost of and recoveries on third party pipeline capacity not used for EQT Production sales volumes. Management further believes that EQT Production adjusted operating revenues as presented provides useful information to investors for evaluating period-over-period earnings trends. Business Segment Results of Operations Business segment operating results from continuing operations are presented in the segment discussions and financial tables on the following pages. Operating segments are evaluated on their contribution to the Company’s consolidated results based on operating income. Other income, interest and income taxes are managed on a consolidated basis. Headquarters’ costs are billed to the operating segments based upon a fixed allocation of the headquarters’ annual operating budget. Unallocated expenses consist primarily of incentive compensation and administrative costs. In 2017, unallocated expenses also included the Rice Merger acquisition related expenses of $237.3 million, including $141.3 million of employee related expenses for payments to former Rice employees under the Merger Agreement as well as investment banking, legal and other professional fees. In 2016, unallocated expenses also included an impairment of long-lived assets of approximately $59.7 million related to certain gathering assets sold to EQM in October 2016. The Company has reported the components of each segment’s operating income and various operational measures in the sections below, and where appropriate, has provided information describing how a measure was derived. EQT’s management believes that presentation of this information provides useful information to management and investors regarding the financial condition, operations and trends of each of EQT’s business segments without being obscured by the financial condition, operations and trends for the other segments or by the effects of corporate allocations of interest, income taxes and other income. In addition, management uses these measures for budget planning purposes. The Company has reconciled each segment’s operating income to the Company’s consolidated operating income and net income in Note 6 to the Consolidated Financial Statements. Prior to the Rice Merger, the Company reported its results of operations through three business segments: EQT Production, EQT Gathering and EQT Transmission. These reporting segments reflected the Company's lines of business and were reported in the same manner in which the Company evaluated its operating performance through September 30, 2017. Following the Rice Merger, the Company adjusted its internal reporting structure to incorporate the newly acquired assets. The Company now conducts its business through five business segments: EQT Production, EQM Gathering (formerly known as EQT Gathering), EQM Transmission (formerly known as EQT Transmission), RMP Gathering and RMP Water. The EQT Production segment includes the Company’s production activities, including those acquired in the Rice Merger, the Company's marketing operations and certain gathering operations primarily supporting the Company's production activities, including the Rice retained gathering assets. The EQM Gathering segment and the EQM Transmission segment include all of the Company's assets and operations that are owned by EQM; therefore, the financial and operational disclosures related to EQM Gathering and EQM Transmission in this Annual Report on Form 10-K are the same as EQM’s disclosures in its Annual Report on Form 10-K for the year ended December 31, 2017. The RMP Gathering segment contains the Company's gathering assets that are owned by RMP. The RMP Water segment contains the Company's water pipelines, impoundment facilities, pumping stations, take point facilities and measurement facilities owned by RMP. Following the Rice Merger, the financial and operational disclosures related to RMP Gathering and RMP Water will be the same as RMP’s successor disclosures in its Annual Report on Form 10-K for the year ended December 31, 2017. EQT Production Results of Operations (a) Includes Upper Devonian wells. (b) NGLs, ethane and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (c) Includes cash capital expenditures of $819.0 million, non-cash capital expenditures of $10.0 million and measurement period adjustments of $(14.3) million for acquisitions during the year ended December 31, 2017. Includes cash capital expenditures of $1,051.2 million and non-cash capital expenditures of $87.6 million related to acquisitions during the year ended December 31, 2016. See Note 10 to the Consolidated Financial Statements for additional information related to these transactions. (d) For the year ended December 31, 2017, the operating income for EQT Production includes the results of operations for the production operations and retained midstream operations acquired in the Rice Merger for the period of November 13, 2017 through December 31, 2017. See Note 2 for a discussion of the Rice Merger. Year Ended December 31, 2017 vs. December 31, 2016 EQT Production’s operating income totaled $589.7 million for 2017 compared to operating loss of $719.7 million for 2016. The $1,309.4 million increase was primarily due to gains on derivatives not designated as hedges for the year ended December 31, 2017 compared to losses on derivatives not designated as hedges for the year ended December 31, 2016, higher average realized price and increased sales volumes of produced natural gas and NGLs, partly offset by increased operating expenses. These variances include the impact of the operations of Rice for the period subsequent to the Rice Merger, which added approximately $165.6 million of operating income for the year ended December 31, 2017, including $114.6 million in gains on derivatives not designated as hedges. Total operating revenues were $3,106.3 million for 2017 compared to $1,387.1 million for 2016. Sales of natural gas, oil and NGLs increased as a result of a higher average realized price and a 17% increase in production sales volumes in 2017. EQT Production received $40.7 million and $279.4 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2017 and 2016, respectively, that are included in the average realized price but are not in GAAP operating revenues. Changes in fair market value of derivative instruments prior to settlement are recognized in gain (loss) on derivatives not designated as hedges. The increase in production sales volumes was primarily the result of recent acquisition activity, including the Rice Merger, as well as increased production from the 2015 and 2016 drilling programs, primarily in the Marcellus play, partially offset by the normal production decline in the Company's producing wells in 2017. The $0.57 per Mcfe increase in the average realized price for the year ended December 31, 2017 was primarily due to the increase in the average NYMEX natural gas price net of cash settled derivatives of $0.29 per Mcf, an increase in the average natural gas differential of $0.19 per Mcf and an increase in liquids prices. The improvement in the average differential primarily related to more favorable basis partly offset by unfavorable cash settled basis swaps. During 2017, basis improved in the Appalachian Basin and at sales points reached through the Company’s transportation portfolio, particularly in the United States Northeast. In addition, the Company started flowing its produced volumes to its Rockies Express pipeline capacity and Texas Eastern Transmission Gulf Markets pipeline capacity in the fourth quarter of 2016, which resulted in a favorable impact to basis for the year ended December 31, 2017 compared to the year ended December 31, 2016. Pipeline and net marketing services primarily includes gathering revenues for gathering services provided to third parties and both the cost of and recoveries on third party pipeline capacity not used to transport the Company’s produced volumes. The $24.0 million increase in these revenues primarily related to increased gathering revenues for services provided to third parties on gathering lines acquired from Rice in addition to costs, net of recoveries, for the Company’s Rockies Express Pipeline capacity in 2016. EQT Production total operating revenues for the year ended December 31, 2017 included a $390.0 million gain on derivatives not designated as hedges compared to a $249.0 million loss on derivatives not designated as hedges for the year ended December 31, 2016. The gains for the year ended December 31, 2017 primarily related to increases in the fair market value of EQT Production’s NYMEX swaps due to decreased NYMEX prices, partly offset by decreases in the fair market value of its basis swaps due to increased basis prices. Gathering expense increased due to increased affiliate and third party gathering capacity. The Rice Merger increased affiliate gathering expense as a result of volumes gathered by RMP Gathering which added approximately $21.0 million of expense for the post-Rice Merger period. In addition, EQT Production increased firm gathering capacity on the affiliate gathering systems owned by EQM Gathering in the fourth quarter of 2016 and 2017. The Company’s 2016 and 2017 acquisitions, excluding Rice, added third party gathering capacity and expense. Transmission expense increased due to increased third party capacity and increased firm contracts with affiliates incurred to move EQT Production’s natural gas out of the Appalachian Basin. During the fourth quarter of 2016, EQM's Ohio Valley Connector (OVC) was placed into service and as a result, the Company started flowing its produced volumes to its Rockies Express pipeline capacity. Additionally, the Company's firm capacity on Rockies Express pipeline increased in the first quarter of 2017. Firm capacity acquired in connection with the Rice Merger also increased transmission expenses by approximately $24.2 million. In the fourth quarter of 2016, the Company started flowing its produced volumes to its Texas Eastern Transmission Gulf Markets pipeline capacity. Processing expense increased 44% as a result of increased processing capacity acquired through recent acquisitions and higher volumes processed, which is consistent with higher ethane and NGLs sales volumes of approximately 50% during 2017. The increase in LOE was primarily due to higher salt water disposal costs. Production taxes increased as a result of higher market prices during the year ended December 31, 2017 in combination with an increase in the number of wells drilled in Pennsylvania and an increase in production volumes from recent acquisitions. Exploration expense increased primarily due to expenses related to an exploratory well in a non-core operating area classified as a dry hole in 2017. SG&A expense decreased primarily due to lower pension expense of $9.4 million related to the termination of the EQT Corporation Retirement Plan for Employees in the second quarter of 2016, lower legal reserves in 2017, a reduction to the reserve for uncollectible accounts, and the absence of costs related to the consolidation of the Company’s Huron operations in 2016. This was partly offset by higher costs associated with recent acquisitions. DD&A expense increased on higher production depletion as a result of higher produced volumes partly offset by a lower overall depletion rate in 2017. Amortization of intangible assets increased as a result of intangible assets acquired in connection with the Rice Merger in 2017. Impairment of long-lived assets decreased $6.9 million for the year ended December 31, 2017 compared to the year ended December 31, 2016. The 2016 impairment charge of $6.9 million primarily consisted of lease impairments on acreage that the Company did not intend to drill prior to expiration. The Company did not identify any such leases in 2017. During the fourth quarter of 2016, EQT Production sold a gathering system that primarily gathered gas for third parties for $75.0 million. In conjunction with this transaction, the Company realized a pre-tax gain of $8.0 million, which is included in gain on sale / exchange of assets in the Statements of Consolidated Operations. Year Ended December 31, 2016 vs. December 31, 2015 EQT Production’s operating loss totaled $719.7 million for 2016 compared to operating income of $132.0 million for 2015. The $851.7 million decrease in operating income was primarily due to a loss on derivatives not designated as hedges in 2016 compared to gains on derivatives not designated as hedges in 2015, a lower average realized price, increased operating expenses and decreased pipeline and net marketing services partly offset by increased sales volumes of produced natural gas and NGLs. Total operating revenues were $1,387.1 million for 2016 compared to $2,131.7 million for 2015. Sales of natural gas, oil and NGLs decreased as a result of a lower average realized price, partly offset by a 26% increase in production sales volumes in 2016. EQT Production received $279.4 million and $172.1 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2016 and 2015, respectively, that are included in the average realized price but are not in GAAP operating revenues. The increase in production sales volumes was primarily the result of increased production from the 2014 and 2015 drilling programs, primarily in the Marcellus play, partially offset by the normal production decline in the Company’s producing wells. The $0.62 per Mcfe decrease in the average realized price for the year ended December 31, 2016 was primarily due to the decrease in the average NYMEX natural gas price net of cash settled derivatives of $0.53 per Mcf and a decrease in the average natural gas differential of $0.12 per Mcf. The decrease in the average differential primarily related to lower basis partly offset by favorable cash settled basis swaps. While Appalachian Basin basis improved slightly for the year ended December 31, 2016 compared to the year ended December 31, 2015, basis in the United States Northeast was significantly lower, particularly in the first quarter of 2016 compared to the first quarter of 2015, due to reduced demand attributable to warmer than normal weather conditions. Additionally, the impact of changes in natural gas prices on physical basis sales contracts and fixed price sales contracts reduced basis year over year. The Company started flowing EQT Production’s produced volumes to its Rockies Express pipeline capacity and Texas Eastern Transmission Gulf Markets pipeline capacity in the fourth quarter of 2016, which resulted in a favorable impact to basis in 2016. Pipeline and net marketing services primarily includes gathering revenues for gathering services provided to third parties and both the cost of and recoveries on third party pipeline capacity not used to transport the Company’s produced volumes. The decrease in these revenues primarily related to reduced spreads on the Company’s Tennessee Gas Pipeline capacity. EQT Production total operating revenues for the year ended December 31, 2016 included a $249.0 million loss on derivatives not designated as hedges compared to an $385.8 million gain on derivatives not designated as hedges for the year ended December 31, 2015. The losses for the year ended December 31, 2016 primarily related to unfavorable changes in the fair market value of EQT Production’s NYMEX swaps, partly offset by favorable changes in the fair market value of its basis swaps. During the year ended December 31, 2016, forward NYMEX prices increased while basis prices decreased. Operating expenses totaled $2,114.8 million for 2016 compared to $1,999.7 million for 2015. The increase in operating expenses primarily resulted from increases in DD&A, gathering, transmission and processing, partly offset by reductions in non-cash impairments of long-lived assets and exploration expense. Gathering expense increased due to increased affiliate firm capacity and volumetric charges and due to increased third party volumetric charges. Transmission expense increased as a result of higher third party costs incurred to move EQT Production’s natural gas out of the Appalachian Basin and increased affiliate firm capacity charges. Processing expenses increased due to higher production volumes. The decrease in LOE was primarily due to lower salt water disposal costs as a result of increased recycling in the Marcellus Shale and certain operational cost savings in the Huron operations, partly offset by costs related to the consolidation of the Company’s Huron operations. Production taxes were essentially flat as a higher Pennsylvania impact fee and severance tax settlement were offset by lower unhedged sales prices, a favorable property tax settlement and the expiration of the West Virginia volume based tax in 2016. The state of West Virginia previously imposed a $0.047 per Mcf additional volume based severance tax that was terminated on July 1, 2016. Exploration expense was lower primarily due to a decrease in lease expirations related to acreage that the Company does not intend to drill prior to expiration and expenses related to exploratory wells in 2015. SG&A expense increased due to higher litigation costs, a $9.4 million charge related to the termination of the EQT Corporation Retirement Plan for Employees incurred in 2016, an increase to the reserve for uncollectible accounts, and non-recurring costs related to the consolidation of the Company’s Huron operations and acquisition related expenses in 2016. These increases were partly offset by drilling program reduction charges in the Permian and Huron Basins in 2015, decreased personnel costs, decreased professional service costs and charges to write off expired right of ways options in 2015. The increase in depletion expense within DD&A expense was the result of higher produced volumes partly offset by a lower overall depletion rate in 2016. Depreciation expense within DD&A increased as a result of additional assets in service. Impairment of long-lived assets decreased $115.5 million for the year ended December 31, 2016 compared to the year ended December 31, 2015. The 2016 impairment charge primarily consisted of lease impairments on acreage that the Company did not intend to drill prior to expiration. The 2015 impairment charge consisted of impairments of proved properties in the Permian Basin of Texas and impairments of proved properties in the Utica Shale of Ohio, as well as unproved property impairments and impairment of field level NGLs processing equipment that was not being used. The proved properties impairments in 2015 were a result of continued declines in commodity prices and insufficient recovery of hydrocarbons to support continued development. The 2016 and 2015 impairments related to the unproved properties resulted from operational decisions to focus near-term development activities in the Company's Marcellus, Upper Devonian and Utica acreage. During the fourth quarter of 2016, EQT Production sold a gathering system that primarily gathered gas for third parties for $75.0 million. In conjunction with this transaction, the Company realized a pre-tax gain of $8.0 million, which is included in gain on sale / exchange of assets in the Statements of Consolidated Operations. EQM Gathering Results of Operations (a) Includes fees on volumes gathered in excess of firm contracted capacity. (b) Includes volumes gathered under interruptible contracts and volumes gathered in excess of firm contracted capacity. Year Ended December 31, 2017 vs. December 31, 2016 Gathering revenues increased by $57.0 million driven by third party and affiliate production development in the Marcellus Shale. EQM Gathering increased firm reservation fee revenues in 2017 compared to 2016 as a result of third parties and affiliates contracting for additional firm gathering capacity, which increased firm gathering capacity by approximately 475 MMcf per day following the completion of the Range Resources header pipeline project and various affiliate wellhead gathering expansion projects. The decrease in usage fees under firm contracts was due to lower affiliate volumes in excess of firm contracted capacity. The decrease in usage fees under interruptible contracts was primarily due to the additional contracts for firm capacity. Operating expenses increased by $12.5 million for the year ended December 31, 2017 compared to the year ended December 31, 2016. Operating and maintenance expense increased primarily as a result of higher personnel costs and increased property taxes. Selling, general and administrative expenses decreased primarily due to lower corporate allocations from the Company as a result of the Company’s shift in focus during 2017 from midstream drop-down transactions to upstream asset and corporate acquisition projects partly offset by increased miscellaneous administrative costs. Depreciation and amortization expense increased $8.4 million due to additional assets placed in-service including those associated with the Range Resources header pipeline project and various affiliate wellhead gathering expansion projects. Year Ended December 31, 2016 vs. December 31, 2015 Gathering revenues increased by $62.4 million primarily as a result of higher affiliate and third party volumes gathered in 2016 compared to 2015, driven by production development in the Marcellus Shale. EQM Gathering increased firm reservation fee revenues in 2016 compared to 2015 as a result of affiliates and third parties contracting for additional capacity under firm contracts, which resulted in increased firm gathering capacity of approximately 300 MMcf per day following the completion of the Northern West Virginia gathering system (NWV Gathering) and Jupiter gathering system (Jupiter) expansion projects in the fourth quarter of 2015. The decrease in usage fees under interruptible contracts was primarily due to these additional contracts for firm capacity. Operating expenses increased by $16.6 million for the year ended December 31, 2016 compared to the year ended December 31, 2015. Selling, general and administrative expenses increased as a result of higher allocations and personnel costs from EQT. The increase in depreciation and amortization expense resulted from additional assets placed in-service including those associated with the NWV Gathering and Jupiter expansion projects. EQM Transmission Results of Operations (a) Includes commodity charges and fees on all volumes transported under firm contracts as well as transmission fees on volumes in excess of firm contracted capacity. (b) Includes volumes transported under interruptible contracts and volumes transported in excess of firm contracted capacity. Year Ended December 31, 2017 vs. December 31, 2016 Total operating revenues increased by $41.4 million. Firm reservation fee revenues increased due to affiliates and third parties contracting for additional firm capacity, primarily on the OVC, as well as higher contractual rates on existing contracts in the current year. The firm capacity on the OVC resulted in lower affiliate usage fees under firm contracts. The increase in usage fees under interruptible contracts includes increased storage and parking revenue, which does not have pipeline throughput associated with it, partly offset by reduced throughput on interruptible contracts. Operating expenses increased by $32.2 million for the year ended December 31, 2017 compared to the year ended December 31, 2016. Operating and maintenance expense increased primarily due to property taxes on the OVC and higher personnel costs. Selling, general and administrative expenses decreased primarily due to lower corporate allocations from the Company as a result of the Company’s shift in focus during 2017 from midstream drop-down transactions to upstream asset and corporate acquisition projects. The increase in depreciation and amortization expense was the result of the OVC project placed in-service in the fourth quarter of 2016 and a non-cash charge to depreciation and amortization expense of $10.5 million related to the revaluation of differences between the regulatory and tax bases in EQM's regulated property, plant and equipment. The related regulatory liability will be amortized over the estimated useful life of the underlying property which is 43 years. Year Ended December 31, 2016 vs. December 31, 2015 Total operating revenues increased by $40.3 million. Firm reservation revenues increased due to affiliates contracting for additional capacity under firm contracts, primarily on the OVC, as well as higher contractual rates on existing contracts in 2016. Higher usage fees under firm contracts were driven by an increase in affiliate volumes in excess of firm capacity associated with increased production development in the Marcellus Shale, partly offset by lower usage fees from third party producers which is reflected in reduced firm capacity reservation throughput for the year ended December 31, 2016 compared to the year ended December 31, 2015. These volumes also decreased as a result of warmer weather in the first quarter of 2016. This decrease in transported volumes did not have a significant impact on firm reservation fee revenues. Usage fees under interruptible contracts for the year ended December 31, 2016 increased as a result of higher third party volumes transported or stored on an interruptible basis. Operating expenses increased by $10.1 million for the year ended December 31, 2016 compared to the year ended December 31, 2015. The increase in operating and maintenance expense resulted primarily from higher repairs and maintenance expenses associated with increased throughput. Selling, general and administrative expenses increased primarily as a result of higher allocations and personnel costs from EQT. The increase in depreciation and amortization expense was primarily a result of higher depreciation on the increased investment in transmission infrastructure, including those associated with the OVC and the AVC facilities. RMP Gathering Results of Operations (a) This table sets forth selected financial and operational data for RMP Gathering for the period November 13, 2017 through December 31, 2017, as the Company acquired RMP Gathering on November 13, 2017 as part of the Rice Merger. The majority of RMP Gathering revenues are from contracts with EQT Production to gather gas in Washington and Greene Counties, Pennsylvania. RMP Gathering provides all services under long-term contracts that are supported in most cases by acreage dedications. RMP Gathering charges separate rates for gathering and compression services based on the actual volumes gathered and compressed. During the period from November 13, 2017 through December 31, 2017, operating expenses are composed of customary expenses for a gathering business. RMP Water Results of Operations (a) This table sets forth selected financial and operational data for RMP Water for the period November 13, 2017 through December 31, 2017, as the Company acquired RMP Water on November 13, 2017 as part of the Rice Merger. RMP Water provides fresh water for well completions operations in the Marcellus and Utica Shales and collects and recycles or disposes of flowback and produced water. The majority of RMP Water's services are provided to EQT Production. RMP Water offers its services on a volumetric basis, supported by an acreage dedication from EQT Production for certain drilling areas. RMP Water charges customers a fee per gallon of water; this fee is tiered and thus is lower on a per gallon basis once the customer meets certain volumetric thresholds. During the period from November 13, 2017 through December 31, 2017, operating expenses are composed of customary expenses for a water business. Other Income Statement Items Other Income For the years ended December 31, 2017, 2016 and 2015, the Company recorded equity in earnings of nonconsolidated investments of $22.2 million, $9.9 million and $2.6 million, respectively, related to EQM's portion of the MVP Joint Venture's AFUDC on the MVP project. For the years ended December 31, 2017, 2016 and 2015, the Company recorded AFUDC of $5.1 million, $19.4 million and $6.3 million, respectively. The changes in AFUDC were mainly attributable to the timing of spending on the OVC project. The Company initiated its investments in trading securities in 2016 to enhance returns on a portion of its significant cash balance at that time.Trading securities consist of liquid debt securities that are carried at fair value. For the years ended December 31, 2017 and 2016 the Company recorded realized losses of $2.6 million and unrealized gains of $1.5 million, respectively, on these debt securities. As of March 31, 2017, the Company closed its positions on all trading securities. Loss on Debt Extinguishment For the year ended December 31, 2017, the Company recorded loss on debt extinguishment of $12.6 million in connection with the early extinguishment on November 3, 2017 of the $200 million aggregate principal amount 5.15% Senior Notes due 2018 and $500 million aggregate principal amount 6.50% Senior Notes due 2018. The loss consists of $12.2 million paid in excess of par in order to extinguish the debt prior to maturity and $0.4 million in non-cash expenses related to the write-off of unamortized financing costs and discounts. Interest Expense Interest expense increased $54.9 million in 2017 compared to 2016 primarily driven by $23.6 million of interest incurred on Senior Notes issued in October 2017, $17.4 million of interest incurred on EQM's Senior Notes issued in November 2016, $8.0 million of expense related to the bridge financing commitment for the Rice Merger and $6.0 million of interest incurred on credit facility borrowings partly offset by a $7.0 million decrease due to the early extinguishment of EQT Senior Notes. Interest expense increased $1.4 million in 2016 compared to 2015. Decreased capitalized interest of $13.3 million and additional interest expense of approximately $3.3 million related to EQM's $500 million 4.125% Senior Notes issued during the fourth quarter of 2016 were mostly offset by higher interest income earned on short-term investments of $6.7 million, lower interest expense resulting from the Company's repayment of $160.0 million of debt that matured in the fourth quarter of 2015, and lower EQM revolver fees. The weighted average annual interest rates on the weighted average principal outstanding of the Company’s Senior Notes, excluding EQM’s Senior Notes, were 5.6%, 6.5%, and 6.5% for 2017, 2016 and 2015, respectively. The weighted average annual interest rates on EQM’s Senior Notes were 4.1% for 2017 and 4.0% for each of 2016 and 2015. See Note 14 to the Consolidated Financial Statements for discussion of the borrowings and weighted average interest rates for EQT's, EQM's and RMP's credit facilities. Income Taxes On December 22, 2017, the U.S. Congress enacted the law known as the Tax Cuts and Jobs Act of 2017 (the Tax Reform Legislation), which made significant changes to U.S. federal income tax law, including lowering the federal corporate tax rate to 21% from 35% beginning January 1, 2018. As a result of the change in the corporate tax rate, the Company recorded a deferred tax benefit of $1.2 billion during the year ended December 31, 2017 to revalue its existing net deferred tax liabilities to the lower rate. For federal income tax purposes, the Company may deduct a portion of its drilling costs as intangible drilling costs (IDCs) in the year incurred. IDCs, however, have historically been limited for purposes of the alternative minimum tax (AMT) and this has resulted in the Company paying AMT even when generating or utilizing a net operating loss carryforward (NOL) to offset regular taxable income. The Tax Reform Legislation also repealed the AMT for tax years beginning January 1, 2018 and provides that existing AMT credit carryforwards can be utilized to offset current federal tax liability in tax years 2018 through 2020. In addition, 50% of any unused AMT credit carryforwards can be refunded during these years with any remaining AMT credit carryforward being fully refunded in 2021. The Company had approximately $435 million of AMT credit carryforward as of December 31, 2017. In addition, the Tax Reform Legislation preserved deductibility of IDCs, and provides for 100% bonus depreciation on some tangible property expenditures through 2022. The Tax Reform Legislation contains several other provisions, such as limiting the utilization of NOLs generated after December 31, 2017 that are carried into future years to 80% of taxable income and limitations on the deductibility of interest expense, which are not expected to have a material effect on the Company's results of operations. As of December 31, 2017, the Company has not completed its accounting for the effects of the Tax Reform Legislation, but has recorded provisional amounts for the revaluing of net deferred tax liabilities as well as the state income tax effects related to the Tax Reform Legislation. The Company also considered whether existing deferred tax amounts will be recovered in future periods under this legislation. However, the Company is still analyzing certain aspects of the Tax Reform Legislation and refining calculations, which could potentially impact the measurement of these balances or potentially give rise to new deferred tax amounts. The Company will refine its estimates to incorporate new or better information as it comes available through the filing date of its 2017 U.S. income tax returns in the fourth quarter of 2018. All of EQGP's, RMP's and Strike Force Midstream's income is included in the Company's pre-tax income (loss). However, the Company is not required to record income tax expense with respect to the portions of EQGP's and RMP's income allocated to the noncontrolling public limited partners of EQGP, EQM, and RMP or to the minority owner of Strike Force Midstream, which reduces the Company's effective tax rate in periods when the Company has consolidated pre-tax income and increases the Company's effective tax rate in periods when the Company has consolidated pre-tax loss. For 2017 and 2016, the Company generated a federal taxable loss and the Company paid AMT in 2016. The federal and AMT NOLs generated by the taxable losses for 2017 and 2016 will be carried back to 2015 and 2014 to generate a tax refund from 2015 and an increase in AMT credit carryforwards for those years. The Company paid federal income tax in 2015 as a result of tax gains related to EQGP's IPO and the sale of NWV Gathering to EQM during that year. See Note 11 to the Consolidated Financial Statements for further discussion of the Company’s income tax (benefit) expense, including a reconciliation between income tax expense calculated at the current federal statutory rate and the effective tax rate reflected in the Company's financial statements for each of the years ended December 31, 2017, 2016 and 2015. Net Income Attributable to Noncontrolling Interests The increase in net income attributable to noncontrolling interests for the year ended December 31, 2017 was the result of higher net income at EQM and noncontrolling interests in RMP and Strike Force Midstream as a result of the Rice Merger. The increase in net income attributable to noncontrolling interests for the year ended December 31, 2016 was primarily the result of increased net income at EQM, increased ownership of EQM common units by third parties and EQGP's IPO in 2015. Outlook The Company’s board of directors has formed a committee to evaluate options for addressing the Company’s sum-of-the-parts discount. The board will announce a decision by the end of March, 2018, after considering the committee’s recommendation. The Company is committed to profitably and safely developing its Appalachian Basin natural gas and NGL reserves through environmentally responsible, cost-effective and technologically advanced horizontal drilling. The Company believes the long-term outlook for its business is favorable due to the Company’s substantial resource base, low cost structure, financial strength, risk management, including its commodity hedging strategy, and disciplined investment of capital. The Company believes the combination of these factors provide it with an opportunity to exploit and develop its positions and maximize efficiency through economies of scale in its strategic operating area. The Company monitors current and expected market conditions, including the commodity price environment, and its liquidity needs and may adjust its capital investment plan accordingly. While the tactics continue to evolve based on market conditions, the Company periodically considers arrangements to monetize the value of certain mature assets for re-deployment into the highest value development opportunities. Upon the closing of the Rice Merger, the Company’s consolidation goals were largely met and the Company plans to focus on integrating the Rice assets and realizing higher returns through longer laterals and achieving an even lower operating cost structure. The Company will also continue to pursue tactical acquisitions of fill-in acreage to extend laterals and has announced its intention to sell the Rice retained midstream assets to EQM through one or more drop-down transactions. EQT Production expects to spend approximately $2.2 billion for well development (primarily drilling and completion) in 2018, which is expected to support the drilling of approximately 195 gross wells, including 134 Marcellus wells, 16 Upper Devonian wells and 45 Ohio Utica wells. The Company also intends to spend approximately $0.2 billion for acreage fill-ins, bolt-on leasing and other items. Estimated sales volumes are expected to be 1,520 - 1,560 Bcfe for 2018. The 2018 drilling program is expected to support a 15% increase in production sales volume in 2019 over our 2018 expected sales volumes with total NGLs volumes expected to be 12,300 - 12,600 Mbbls. To support continued growth in production, the Company plans to invest approximately $1.5 billion on midstream infrastructure through EQM in 2018, including capital contributions to the MVP Joint Venture of $1.1 billion. RMP investments in organic projects are expected to total approximately $260 million in 2018, including $215 million for gathering and compression and $45 million for water infrastructure. The 2018 capital investment plan for EQT Production is expected to be funded by cash generated from operations and cash on hand. EQM's available sources of liquidity include cash on hand and generated from operations, borrowings under its credit facilities, debt offerings and issuances of additional EQM partnership interests. RMP's 2018 capital investment plan is expected to be funded by cash generated from operations and borrowings under its credit facility. The Company’s revenues, earnings, liquidity and ability to grow are substantially dependent on the prices it receives for, and the Company’s ability to develop its reserves of, natural gas and NGLs. Due to the volatility of commodity prices, the Company is unable to predict future potential movements in the market prices for natural gas, including Appalachian and other market point basis, and NGLs and thus cannot predict the ultimate impact of prices on its operations. The Company's 2018 capital expenditure forecast for well development is 59% higher than its 2017 well development spending. Changes in natural gas, NGLs and oil prices could affect, among other things, the Company's development plans, which would increase or decrease the pace of the development and the level of the Company's reserves, as well as the Company's revenues, earnings or liquidity. Lower prices could also result in non-cash impairments in the book value of the Company’s oil and gas properties, goodwill or other long lived intangible assets or downward adjustments to the Company’s estimated proved reserves. Any such impairment and/or downward adjustment to the Company’s estimated reserves could potentially be material to the Company. Impairment of Oil and Gas Properties and Goodwill See “Critical Accounting Policies and Estimates” and Note 1 to the Consolidated Financial Statements for a discussion of the Company’s accounting policies and significant assumptions related to impairment of the Company’s oil and gas properties. Due to declines in the five-year NYMEX forward strip prices during 2015 and into 2016, the Company determined that indicators of potential impairment existed for certain of the Company’s proved oil and gas properties in those years. No indicators of impairment were identified as of December 31, 2017. Although the Company did not have indicators of impairment or record an impairment on its oil and gas producing properties during 2017, all other things being equal, a further decline in the average five-year NYMEX forward strip price in a future period may cause the Company to recognize impairments on non-core assets, including the Company's assets in the Huron play, which had a carrying value of approximately $3 billion at December 31, 2017. See “Critical Accounting Policies and Estimates” for a discussion of the Company’s accounting policies and significant assumptions related to evaluating the Company’s goodwill for impairment. The Company evaluated goodwill for impairment at December 31, 2017 and determined there was no indicator of impairment. We use a combination of the income and market approach to estimate the fair value of a reporting unit. The fair value estimation process requires considerable judgment and determining the fair value is sensitive to changes in assumptions impacting management’s estimates of future financial results as well as other assumptions such as movement in the Company's stock price, weighted-average cost of capital, terminal growth rates and industry multiples. Although we believe the estimates and assumptions used in estimating the fair value are reasonable and appropriate, different estimates and assumptions could materially impact the calculated fair value of the reporting units. Additionally, future results could differ from our current estimates and assumptions. Any potential change in such estimates and assumptions would have an impact on the results of operations and financial position. Due to the uncertainty inherent in, and the interdependence of, the assumptions of underlying assets and goodwill impairment determinations, the Company cannot predict if future impairment charges will be recognized and, if so, an estimate of the impairment charges that would be recorded in any future period. See “Natural gas, NGLs and oil price declines have resulted in impairment of certain of our non-core assets. Future declines in commodity prices, increases in operating costs, adverse changes in well performance or impairment of goodwill and other long lived intangible assets may result in additional write-downs of the carrying amounts of our assets, which could materially and adversely affect our results of operations in future periods.” under Item 1A, “Risk Factors.” Capital Resources and Liquidity The Company’s primary sources of cash for the year ended December 31, 2017 were proceeds from the 2017 Notes Offering (defined in Note 15 to the Consolidated Financial Statements), borrowings on credit facilities and cash flows from operating activities, while the primary uses of cash were for redemptions and repayments of Rice's Senior Notes and credit facilities in connection with the closing of the Rice Merger, capital expenditures, the cash portion of the Merger Consideration for the Rice Merger, and redemptions of Company Senior Notes. Operating Activities The Company’s net cash provided by operating activities increased $573.4 million from full year 2016 to full year 2017. The increase in cash flows provided by operating activities was primarily driven by higher operating income for which contributing factors are discussed in the "Consolidated Results of Operations" and "Business Segment Results of Operations" sections herein and the timing of payments between the two periods, partly offset by lower cash settlements received on derivatives not designated as hedges. The Company’s net cash provided by operating activities decreased by $152.6 million from full year 2015 to full year 2016. The decrease in cash flows provided by operating activities was primarily the result of a lower commodity price and higher operating expenses, partly offset by higher production sales volumes, cash settlements on derivatives not designated as hedges, decreases in cash paid for income taxes and the timing of payments between periods. The Company's cash flows from operating activities will be impacted by future movements in the market price for commodities. The Company is unable to predict these future price movements outside of the current market view as reflected in forward strip pricing. Refer to "Natural gas, NGLs and oil price volatility, or a prolonged period of low natural gas, NGLs and oil prices may have an adverse effect upon our revenue, profitability, future rate of growth, liquidity and financial position." under Item 1A, "Risk Factors" for further information. Investing Activities Cash flows used in investing activities totaled $4,127.1 million for 2017 as compared to $2,961.5 million for 2016. The $1,165.6 million increase was primarily due to investment in the Rice Merger, an increase in capital expenditures for drilling and completions spending, and higher capital contributions to the MVP Joint Venture, partly offset by a decrease in capital expenditures for other property acquisitions, cash received from the sale of trading securities and lower EQM capital expenditures. On November 13, 2017, in conjunction with the Rice Merger, each share of the common stock, par value $0.01 per share, of Rice (the Rice Common Stock) issued and outstanding immediately prior to the Effective Time was converted into the right to receive 0.37 (the Exchange Ratio) of a share of the common stock, no par value, of the Company (Company Common Stock) and $5.30 in cash (collectively, the Merger Consideration). The aggregate Merger Consideration consisted of approximately 91 million shares of Company Common Stock and approximately $1.6 billion in cash (net of cash acquired and inclusive of amounts payable to employees of Rice who did not continue with the Company following the Effective Time). See Note 2 to the Consolidated Financial Statements for further discussion of the Rice Merger. Cash flows used in investing activities totaled $2,961.5 million for 2016 as compared to $2,525.6 million for 2015. The $435.9 million increase was primarily due to an increase in capital expenditures for acquisitions of $1,051.2 million and investments in trading securities of $288.8 million, partly offset by a reduction in the drilling and completions capital expenditures. During 2016, the Company invested in trading securities, which consist of liquid debt securities carried at fair value, to maximize returns. The Company also placed $75.0 million of the proceeds received from the sale of a gathering system into restricted cash for a potential like-kind exchange for tax purposes. Capital Expenditures (in millions) * Represents the net impact of non-cash capital expenditures including capitalized non-cash stock-based compensation expense and accruals. The impact of accrued capital expenditures includes the reversal of the prior period accrual as well as the current period estimate, both of which are non-cash items. The year ended December 31, 2017 included $10.0 million of non-cash capital expenditures related to 2017 acquisitions and $(14.3) million of measurement period adjustments for 2016 acquisitions. The year ended December 31, 2016 included $87.6 million of non-cash capital expenditures related to 2016 acquisitions. The Company has forecast a 2018 capital expenditure spending plan of approximately $2.4 billion for EQT Production, which includes $2.2 billion for well development (primarily drilling and completion) and $0.2 billion for acreage fill-ins, bolt-on leasing and other items. The Company has also forecast an EQM 2018 capital expenditure spending plan of approximately $1.5 billion on midstream infrastructure including capital contributions to MVP and an RMP 2018 capital expenditure spending plan of approximately $260 million for gathering infrastructure and water infrastructure. Capital expenditures for drilling and development totaled $1,385 million and $783 million during 2017 and 2016, respectively. The Company spud 201 gross wells in 2017, including 144 horizontal Marcellus wells, 49 horizontal Upper Devonian wells, seven horizontal Ohio Utica wells and one other well. The Company spud 135 gross wells in 2016, including 117 horizontal Marcellus wells, 13 horizontal Upper Devonian wells and 4 horizontal Utica wells. The increase in capital expenditures for well development in 2017 was driven primarily by the timing of drilling and completions activities between years and an increase in wells spud. Capital expenditures for 2017 also included $1,007 million for property acquisitions, compared to $1,284 million of capital expenditures in 2016 for property acquisitions. These acquisitions are discussed in Note 10 to the Consolidated Financial Statements. Capital expenditures for drilling and development totaled $783 million and $1,670 million during 2016 and 2015, respectively. The Company spud 161 gross wells in 2015, including 133 horizontal Marcellus wells, 24 horizontal Upper Devonian wells and 4 other wells, including 2 Utica wells. The decrease in capital expenditures for well development in 2016 was driven primarily by the timing of drilling and completions activities between years, a decrease in wells spud, lower costs per well and operational efficiencies. Capital expenditures for 2016 also included $1,284 million for property acquisitions, compared to $182 million of capital expenditures in 2015 for property acquisitions. The Company executed multiple large transactions during 2016 that resulted in the Company's acquisition of approximately 122,100 net Marcellus acres located primarily in northern West Virginia and southwestern Pennsylvania discussed in Note 10 to the Consolidated Financial Statements. Capital expenditures for the EQM gathering and transmission operations totaled $308 million for 2017 and $587 million for 2016, primarily related to expansion capital expenditures. Expansion capital expenditures are expenditures incurred for capital improvements that EQM expects to increase its operating income or operating capacity over the long term. This decrease in expansion capital expenditures primarily related to OVC, which was placed into service in the fourth quarter of 2016. Capital expenditures for the gathering, transmission and storage operations totaled $430 million for 2015, primarily related to expansion capital expenditures. Financing Activities Cash flows provided by financing activities totaled $1,533.1 million for 2017 as compared to $1,399.5 million for 2016. During 2017, the Company's primary sources of financing cash flows were net proceeds from the 2017 Notes Offering (defined in Note 15 to the Consolidated Financial Statements) and borrowings on credit facilities. The primary financing uses of cash during 2017 were redemptions and repayment of Rice's Senior Notes and credit facilities in connection with the closing of the Rice Merger, redemption of the Company's Senior Notes and distributions to noncontrolling interests. On January 17, 2018, the Board of Directors of the Company declared a regular quarterly cash dividend of three cents per share, payable March 1, 2018, to the Company’s shareholders of record at the close of business on February 14, 2018. On January 18, 2018, the Board of Directors of EQGP's general partner declared a cash distribution to EQGP's unitholders for the fourth quarter of 2017 of $0.244 per common unit, or approximately $64.9 million. The cash distribution will be paid on February 23, 2018 to unitholders of record, including the Company, at the close of business on February 2, 2018. On January 18, 2018, the Board of Directors of EQM’s general partner declared a cash distribution to EQM’s unitholders for the fourth quarter of 2017 of $1.025 per common unit. The cash distribution was paid on February 14, 2018 to unitholders of record, including EQGP, at the close of business on February 2, 2018. Cash distributions by EQM to EQGP were approximately $65.7 million consisting of: $22.4 million in respect of its limited partner interest, $2.2 million in respect of its general partner interest and $41.1 million in respect of its IDRs in EQM. On January 18, 2018, the Board of Directors of RMP’s general partner declared a cash distribution to RMP’s unitholders for the fourth quarter of 2017 of $0.2917 per common and subordinated unit. The cash distribution was paid on February 14, 2018 to unitholders of record, including Rice Midstream GP Holdings, LP (RMGP), which is an indirect wholly owned subsidiary of EQT, at the close of business on February 2, 2018. Cash distributions by RMP to RMGP were approximately $11.4 million, consisting of $8.4 million in respect of its limited partner interest and $3 million in respect of its IDRs in RMP. Cash flows provided by financing activities totaled $1,399.5 million for 2016 as compared to $1,832.5 million for 2015. During 2016, the Company's primary sources of financing cash flows were net proceeds from its public offerings of common stock and from EQM's public offerings of common units under EQM’s $750 million at-the-market (ATM) common unit offering program (the EQM $750 Million ATM Program), as well as proceeds received from the issuance of EQM Senior Notes. The primary financing uses of cash during 2016 were net credit facility repayments under the EQM credit facility, distributions to noncontrolling interests, taxes related to the vesting or exercise of equity awards and dividends. In 2015, the Company’s primary sources of financing cash flows were the issuance of EQM and EQGP common units and net borrowings on EQM’s credit facility while the primary uses of financing cash flows were repayments of Senior Notes and distributions to noncontrolling interests. The Company may from time to time seek to repurchase its outstanding debt securities. Such repurchases, if any, will depend on prevailing market conditions, the Company's liquidity requirements, contractual and legal restrictions and other factors. Revolving Credit Facilities EQT primarily utilizes borrowings under its revolving credit facilities to fund capital expenditures in excess of cash flow from operating activities until the expenditures can be permanently financed and to fund required margin deposits on derivative commodity instruments. Margin deposit requirements vary based on natural gas commodity prices, the Company's credit ratings and the amount and type of derivative commodity instruments. During the year ended December 31, 2017, the Company also borrowed under the Company's $2.5 billion revolving credit facility to fund a portion of the cash Merger Consideration and pay expenses related to the Rice Merger. In addition, upon the closing of the Rice Merger on November 13, 2017, certain existing letters of credit issued for the account of Rice and its subsidiaries were transferred to the Company's $2.5 billion credit facility. See Note 14 to the Consolidated Financial Statements for further discussion of EQT's, EQM's and RMP's credit facilities. See also the discussion of the revolving loan agreement between EQT and EQM in Note 4 to the Consolidated Financial Statements. Security Ratings and Financing Triggers The table below reflects the credit ratings for debt instruments of the Company at December 31, 2017. Changes in credit ratings may affect the Company’s cost of short-term debt through interest rates and fees under its lines of credit. These ratings may also affect collateral requirements under derivative instruments, pipeline capacity contracts, joint venture arrangements and subsidiary construction contracts, rates available on new long-term debt and access to the credit markets. The table below reflects the credit ratings for debt instruments of EQM at December 31, 2017. Changes in credit ratings may affect EQM’s cost of short-term debt through interest rates and fees under its lines of credit. These ratings may also affect collateral requirements under joint venture arrangements and subsidiary construction contracts, rates available on new long-term debt and access to the credit markets. RMP has no long-term debt and is not currently rated by Moody’s, S&P, or Fitch. The Company’s and EQM’s credit ratings are subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating. The Company and EQM cannot ensure that a rating will remain in effect for any given period of time or that a rating will not be lowered or withdrawn by a credit rating agency if, in its judgment, circumstances so warrant. If any credit rating agency downgrades the ratings, particularly below investment grade, the Company’s or EQM’s access to the capital markets may be limited, borrowing costs and margin deposits on the Company’s derivative contracts would increase, counterparties may request additional assurances, including collateral, and the potential pool of investors and funding sources may decrease. The required margin on the Company’s derivative instruments is also subject to significant change as a result of factors other than credit rating, such as gas prices and credit thresholds set forth in agreements between the hedging counterparties and the Company. Investment grade refers to the quality of a company's credit as assessed by one or more credit rating agencies. In order to be considered investment grade, a company must be rated BBB- or higher by S&P, Baa3 or higher by Moody's, and BBB- or higher by Fitch. Anything below these ratings is considered non-investment grade. The Company’s debt agreements and other financial obligations contain various provisions that, if not complied with, could result in termination of the agreements, require early payment of amounts outstanding or similar actions. The most significant covenants and events of default under the debt agreements relate to maintenance of a debt-to-total capitalization ratio, limitations on transactions with affiliates, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of other financial obligations and change of control provisions. The Company’s credit facility contains financial covenants that require a total debt-to-total capitalization ratio no greater than 65%. The calculation of this ratio excludes the effects of accumulated other comprehensive income (OCI). As of December 31, 2017, the Company was in compliance with all debt provisions and covenants. EQM’s debt agreements and other financial obligations contain various provisions that, if not complied with, could result in termination of the agreements, require early payment of amounts outstanding or similar actions. The most significant covenants and events of default under the debt agreements relate to maintenance of a permitted leverage ratio, limitations on transactions with affiliates, limitations on restricted payments, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of and certain other defaults under other financial obligations and change of control provisions. Under EQM's $1 billion credit facility, EQM is required to maintain a consolidated leverage ratio of not more than 5.00 to 1.00 (or not more than 5.50 to 1.00 for certain measurement periods following the consummation of certain acquisitions). As of December 31, 2017, EQM was in compliance with all debt provisions and covenants. The RMP credit facility contains various provisions that, if not complied with, could result in termination of the agreement, require early payment of amounts outstanding or similar actions. The most significant covenants and events of default under the RMP credit facility relate to maintenance of certain financial ratios, as described below, limitations on certain investments and acquisitions, limitations on transactions with affiliates, limitations on restricted payments, limitations on the incurrence of additional indebtedness, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of and certain other defaults under other financial obligations and change of control provisions. The RMP credit facility requires RMP to maintain the following financial ratios: •an interest coverage ratio of at least 2.50 to 1.0; •a consolidated total leverage ratio of not more than 4.75 to 1.0, and after electing to issue senior unsecured notes, a consolidated total leverage ratio of not more than 5.25 to 1.0 (with certain increases for measurement periods following the completion of certain acquisitions); and •if RMP elects to issue senior unsecured notes, a consolidated senior secured leverage ratio of not more than 3.50 to 1.0. As of December 31, 2017, RMP and RMP OpCo were in compliance with all credit facility provisions and covenants. EQM ATM Program During 2015, EQM entered into an equity distribution agreement that established the EQM $750 million ATM Program. EQM had approximately $443 million in remaining capacity under the program as of February 15, 2018. RMP ATM Program During 2016, RMP entered into an equity distribution agreement that established the RMP $100 million ATM equity distribution program. RMP had approximately $83.7 million in remaining capacity under the program as of February 15, 2018. Commodity Risk Management The substantial majority of the Company’s commodity risk management program is related to hedging sales of the Company’s produced natural gas. The Company’s overall objective in this hedging program is to protect cash flow from undue exposure to the risk of changing commodity prices. The derivative commodity instruments currently utilized by the Company are primarily NYMEX swaps, collars and options. As of January 31, 2018, the approximate volumes and prices of the Company’s derivative commodity instruments hedging sales of produced gas for 2018 through 2020 were: (a) Full year 2018 (b) The Company also sold calendar year 2018 and 2019 calls for approximately 64 Bcf and 45 Bcf, respectively, at strike prices of $3.49 per Mcf and $3.69 per Mcf, respectively. (c) For 2018, the Company also sold puts for approximately 3 Bcf at a strike price of $2.63 per Mcf. (d) The average price is based on a conversion rate of 1.05 MMBtu/Mcf. The Company also enters into fixed price natural gas sales agreements that are satisfied by physical delivery. The difference between these sales prices and NYMEX are included in average differential on the Company's price reconciliation under "Consolidated Operational Data". The Company has fixed price physical sales for 2018 and 2019 of 121 Bcf and 37 Bcf, respectively, at average NYMEX prices of $2.93 per Mcf and $3.04 per Mcf, respectively. For 2018, the Company has a natural gas sales agreement for approximately 35 Bcf per year that includes a NYMEX ceiling price of $4.88 per Mcf. For 2018, 2019 and 2020, the Company has a natural gas sales agreement for approximately 49 Bcf per year that includes a NYMEX ceiling price of $3.36 per Mcf. For 2018, 2019 and 2020, the Company also has a natural gas sales agreement for approximately 7 Bcf per year that includes a NYMEX floor price of $2.16 per Mcf and a NYMEX ceiling price of $4.47 per Mcf. Currently, the Company has also entered into derivative instruments to hedge basis and a limited number of contracts to hedge its NGLs exposure. The Company may also use other contractual agreements in implementing its commodity hedging strategy. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” and Note 7 to the Consolidated Financial Statements for further discussion of the Company’s hedging program. Other Items Off-Balance Sheet Arrangements In connection with the sale of its NORESCO domestic operations in December 2005, the Company agreed to maintain in place guarantees of certain warranty obligations of NORESCO. The savings guarantees provided that once the energy-efficiency construction was completed by NORESCO, the customer would experience a certain dollar amount of energy savings over a period of years. The undiscounted maximum aggregate payments that may be due related to these guarantees were approximately $95 million as of December 31, 2017, extending at a decreasing amount for approximately 11 years. As of December 31, 2017, EQM had issued a $91 million performance guarantee in favor of the MVP Joint Venture to provide performance assurances for MVP Holdco's obligations to fund its proportionate share of the construction budget for the MVP. The NORESCO guarantees and the MVP Guarantee are exempt from ASC Topic 460, Guarantees. The Company has determined that the likelihood it will be required to perform on these arrangements is remote and any potential payments are expected to be immaterial to the Company’s financial position, results of operations and liquidity. As such, the Company has not recorded any liabilities in its Consolidated Balance Sheets related to these guarantees. Rate Regulation As described under “Regulation” in Item 1, “Business,” the Company’s transmission and storage operations and a portion of its gathering operations are subject to various forms of rate regulation. As described in Note 1 to the Consolidated Financial Statements, regulatory accounting allows the Company to defer expenses and income as regulatory assets and liabilities which reflect future collections or payments through the regulatory process. The Company believes that it will continue to be subject to rate regulation that will provide for the recovery of the deferred costs. See “Our need to comply with comprehensive, complex and sometimes unpredictable government regulations may increase our costs and limit our revenue growth, which may result in reduced earnings.” in Item 1A, “Risk Factors” for potential risks related to the regulation of rates by the FERC. Schedule of Contractual Obligations The table below presents the Company’s long-term contractual obligations as of December 31, 2017 in total and by periods. Purchase obligations exclude the Company’s contractual obligations relating to its binding precedent agreements and other natural gas transmission and gathering capacity agreements with EQM, for which future payments related to such agreements totaled $5.6 billion as of December 31, 2017. These capacity commitments have terms extending up to 20 years. Purchase obligations also exclude future capital contributions to the MVP Joint Venture and purchase obligations of the MVP Joint Venture. (a) Purchase obligations are primarily commitments for demand charges under existing long-term contracts and binding precedent agreements with various unconsolidated pipelines, including commitments from the Company to the MVP Joint Venture, some of which extend up to 20 years or longer. The Company has entered into agreements to release some of its capacity to various third parties. Purchase obligations also include commitments with third parties for processing capacity in order to extract heavier liquid hydrocarbons from the natural gas stream. (b) Interest payments exclude interest related to the credit facility borrowings and the Floating Rate Notes (defined in Note 15 to the Consolidated Financial Statements) as the interest rates on the Company's, EQM's and RMP's credit facilities and the Floating Rate Notes are variable. (c) Credit facility borrowings were classified based on the termination dates of the Company's, EQM's and RMP's credit facilities. (d) Operating leases are primarily entered into for various office locations and warehouse buildings, as well as dedicated drilling rigs in support of the Company’s drilling program. The obligations for the Company’s various office locations and warehouse buildings totaled approximately $139.2 million as of December 31, 2017. The Company has agreements with several drillers to provide drilling equipment and services to the Company over the next four years. These obligations totaled approximately $92.3 million as of December 31, 2017. As of December 31, 2017, the Company had eight horizontal drilling rigs under contract, and an additional horizontal rig will become active on April 1, 2018. All of these will expire in 2019 with dates in this order: June 30, July 31, August 31 (2), September 30, October 31, November 30 and December 31 (2). The Company also had seven tophole drilling rigs under contract, six of which expire in 2018 and one that expires in 2019. Of the six tophole rigs that expire in 2018, the dates are in this order: January 3, February 3, February 25, June 2, August 27 and December 22. The expiration date for the tophole rig in 2019 is March 29. These drilling obligations have been included in the table above. The values in the table represent the gross amounts that the Company is committed to pay as operator. However, the Company will record in the Consolidated Financial Statements the Company's proportionate share of the amounts shown based on its working interest. (e) See Note 20 for additional information. (f) The other liabilities line represents commitments for total estimated payouts for the 2017 EQT Value Driver Award Program, 2017 Incentive PSU Program, 2017 restricted stock unit liability awards, 2016 EQT Value Driver Award Program and 2016 restricted stock unit liability awards. See “Critical Accounting Policies and Estimates” below and Note 18 to the Consolidated Financial Statements for further discussion regarding factors that affect the ultimate amount of the payout of these obligations. As discussed in Note 11 to the Consolidated Financial Statements, the Company had a total reserve for unrecognized tax benefits at December 31, 2017 of $301.6 million, of which $84.1 million is offset against deferred tax assets since it would primarily reduce the alternative minimum tax credit carryforwards. The Company is currently unable to make reasonably reliable estimates of the period of cash settlement of these potential liabilities with taxing authorities; therefore, this amount has been excluded from the schedule of contractual obligations. Commitments and Contingencies In the ordinary course of business, various legal and regulatory claims and proceedings are pending or threatened against the Company. While the amounts claimed may be substantial, the Company is unable to predict with certainty the ultimate outcome of such claims and proceedings. The Company accrues legal and other direct costs related to loss contingencies when actually incurred. The Company has established reserves it believes to be appropriate for pending matters and, after consultation with counsel and giving appropriate consideration to available insurance, the Company believes that the ultimate outcome of any matter currently pending against the Company will not materially affect the Company’s financial position, results of operations or liquidity. See Note 20 to the Consolidated Financial Statements for further discussion of the Company’s commitments and contingencies. See also the discussion of the revolving loan agreement between EQT and EQM in Note 4 to the Consolidated Financial Statements. Recently Issued Accounting Standards The Company's recently issued accounting standards are described in Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Critical Accounting Policies and Estimates The Company’s significant accounting policies are described in Note 1 to the Consolidated Financial Statements. The discussion and analysis of the Consolidated Financial Statements and results of operations are based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with United States GAAP. The preparation of the Consolidated Financial Statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. The following critical accounting policies, which were reviewed by the Company’s Audit Committee, relate to the Company’s more significant judgments and estimates used in the preparation of its Consolidated Financial Statements. Actual results could differ from those estimates. Accounting for Oil and Gas Producing Activities: The Company uses the successful efforts method of accounting for its oil and gas producing activities. The carrying values of the Company’s proved oil and gas properties are reviewed for impairment generally on a field-by-field basis when events or circumstances indicate that the remaining carrying value may not be recoverable. The estimated future cash flows used to test those properties for recoverability are based on proved and, if determined reasonable by management, risk-adjusted probable reserves, utilizing assumptions generally consistent with the assumptions utilized by the Company's management for internal planning and budgeting purposes, including, among other things, the intended use of the asset, anticipated production from reserves, future market prices for natural gas, NGLs and oil, adjusted accordingly for basis differentials, future operating costs and inflation, some of which are interdependent. Proved oil and gas properties that have carrying amounts in excess of estimated future cash flows are written down to fair value, which is estimated by discounting the estimated future cash flows using discount rates and other assumptions that marketplace participants would use in their estimates of fair value. Capitalized costs of unproved properties are evaluated at least annually for recoverability on a prospective basis. Indicators of potential impairment include changes in development plans resulting from economic factors, potential shifts in business strategy employed by management and historical experience. If it is determined that the properties will not yield proved reserves prior to their expirations, the related costs are expensed in the period in which that determination is made. The Company believes that the accounting estimate related to the accounting for oil and gas producing activities is a “critical accounting estimate” as the evaluations of impairment of proved properties involve significant judgment about future events such as future sales prices of natural gas and NGLs, future production costs, estimates of the amount of natural gas and NGLs recorded and the timing of those recoveries. See "Impairment of Oil and Gas Properties and Goodwill" above and Note 1 to the Consolidated Financial Statements for additional information regarding the Company’s impairments of proved and unproved oil and gas properties. Oil and Gas Reserves: Proved oil and gas reserves, as defined by SEC Regulation S-X Rule 4-10, are those quantities of oil and gas which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible from a given date forward, from known reservoirs and under existing economic conditions, operating methods and government regulations prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. The Company’s estimates of proved reserves are made and reassessed annually using geological and reservoir data as well as production performance data. Reserve estimates are prepared and updated by the Company’s engineers and audited by the Company’s independent engineers. Revisions may result from changes in, among other things, reservoir performance, development plans, prices, operating costs, economic conditions and governmental restrictions. Decreases in prices, for example, may cause a reduction in some proved reserves due to reaching economic limits sooner. A material change in the estimated volumes of reserves could have an impact on the depletion rate calculation and the Company's financial statements. The Company estimates future net cash flows from natural gas, NGLs and oil reserves based on selling prices and costs using a 12-month average price, calculated as the unweighted arithmetic average of the first-day-of-the-month price for each month within the 12-month period, which is subject to change in subsequent periods. Operating costs, production and ad valorem taxes and future development costs are based on current costs with no escalation. Income tax expense is computed using future statutory tax rates and giving effect to tax deductions and credits available under current laws and which relate to oil and gas producing activities. The Company believes that the accounting estimate related to oil and gas reserves is a “critical accounting estimate” because the Company must periodically reevaluate proved reserves along with estimates of future production rates, production costs and the estimated timing of development expenditures. Future results of operations and strength of the balance sheet for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. See "Impairment of Oil and Gas Properties and Goodwill" above for additional information regarding the Company’s oil and gas reserves. Income Taxes: The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the Company’s Consolidated Financial Statements or tax returns. The Company has recorded deferred tax assets principally resulting from federal and state NOL carryforwards, an alternative minimum tax credit carryforward, other federal tax credit carryforwards, incentive compensation and investment in partnerships. The Company has established a valuation allowance against a portion of the deferred tax assets related to the federal and state NOL carryforwards and alternative minimum tax credit carryforward, as it is believed that it is more likely than not that certain deferred tax assets will not all be realized. No other significant valuation allowances have been established, as it is believed that future sources of taxable income, reversing temporary differences and other tax planning strategies will be sufficient to realize these deferred tax assets. Any determination to change the valuation allowance would impact the Company’s income tax expense and net income in the period in which such a determination is made. The Company also estimates the amount of financial statement benefit to record for uncertain tax positions as described in Note 11 to the Company’s Consolidated Financial Statements. The Company believes that accounting estimates related to income taxes are “critical accounting estimates” because the Company must assess the likelihood that deferred tax assets will be recovered from future taxable income and exercise judgment regarding the amount of financial statement benefit to record for uncertain tax positions. When evaluating whether or not a valuation allowance must be established on deferred tax assets, the Company exercises judgment in determining whether it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax assets will not be realized. The Company considers all available evidence, both positive and negative, to determine whether, based on the weight of the evidence, a valuation allowance is needed, including carrybacks, tax planning strategies, reversal of deferred tax assets and liabilities and forecasted future taxable income. In making the determination related to uncertain tax positions, the Company considers the amounts and probabilities of the outcomes that could be realized upon ultimate settlement of an uncertain tax position using the facts, circumstances and information available at the reporting date to establish the appropriate amount of financial statement benefit. To the extent that an uncertain tax position or valuation allowance is established or increased or decreased during a period, the Company must include an expense or benefit within tax expense in the income statement. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Derivative Instruments: The Company enters into derivative commodity instrument contracts primarily to mitigate exposure to commodity price risk associated with future sales of natural gas production. The Company also enters into derivative instruments to hedge basis and to hedge exposure to fluctuations in interest rates. The Company estimates the fair value of all derivative instruments using quoted market prices, where available. If quoted market prices are not available, fair value is based upon models that use market-based parameters as inputs, including forward curves, discount rates, volatilities and nonperformance risk. Nonperformance risk considers the effect of the Company’s credit standing on the fair value of liabilities and the effect of the counterparty’s credit standing on the fair value of assets. The Company estimates nonperformance risk by analyzing publicly available market information, including a comparison of the yield on debt instruments with credit ratings similar to the Company’s or counterparty’s credit rating and the yield of a risk-free instrument, and credit default swap rates where available. The values reported in the financial statements change as these estimates are revised to reflect actual results, or market conditions or other factors change, many of which are beyond the Company’s control. The Company believes that the accounting estimates related to derivative instruments are “critical accounting estimates” because the Company’s financial condition and results of operations can be significantly impacted by changes in the market value of the Company’s derivative instruments due to the volatility of natural gas prices, both NYMEX and basis. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Contingencies and Asset Retirement Obligations: The Company is involved in various regulatory and legal proceedings that arise in the ordinary course of business. The Company records a liability for contingencies based upon its assessment that a loss is probable and the amount of the loss can be reasonably estimated. The Company considers many factors in making these assessments, including history and specifics of each matter. Estimates are developed in consultation with legal counsel and are based upon an analysis of potential results. The Company also accrues a liability for asset retirement obligations based on an estimate of the timing and amount of their settlement. For oil and gas wells, the fair value of the Company’s plugging and abandonment obligations is required to be recorded at the time the obligations are incurred, which is typically at the time the wells are spud. The Company operates and maintains its gathering systems and transmission and storage system and it intends to do so as long as supply and demand for natural gas exists, which the Company expects for the foreseeable future. The Company is under no legal or contractual obligation to restore or dismantle its gathering systems and transmission and storage system upon abandonment. Therefore, the Company does not have any asset retirement obligations related to its gathering systems and transmission and storage system as of December 31, 2017 and 2016. The Company believes that the accounting estimates related to contingencies and asset retirement obligations are “critical accounting estimates” because the Company must assess the probability of loss related to contingencies and the expected amount and timing of asset retirement obligations. In addition, the Company must determine the estimated present value of future liabilities. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Share-Based Compensation: The Company awards share-based compensation in connection with specific programs established under the 2009 and 2014 Long-Term Incentive Plans. Awards to employees are typically made in the form of performance-based awards, time-based restricted stock, time-based restricted units and stock options. Awards to directors are typically made in the form of phantom units that vest upon grant. Restricted units and performance-based awards expected to be satisfied in cash are treated as liability awards. For liability awards, the Company is required to estimate, on the grant date and on each reporting date thereafter until vesting and payment, the fair value of the ultimate payout based upon the expected performance through, and value of the Company’s common stock on, the vesting date. The Company then recognizes a proportionate amount of the expense for each period in the Company’s financial statements over the vesting period of the award. The Company reviews its assumptions regarding performance and common stock value on a quarterly basis and adjusts its accrual when changes in these assumptions result in a material change in the fair value of the ultimate payouts. Performance-based awards expected to be satisfied in Company common stock are treated as equity awards. For equity awards, the Company is required to determine the grant date fair value of the awards, which is then recognized as expense in the Company’s financial statements over the vesting period of the award. Determination of the grant date fair value of the awards requires judgments and estimates regarding, among other things, the appropriate methodologies to follow in valuing the awards and the related inputs required by those valuation methodologies. Most often, the Company is required to obtain a valuation based upon assumptions regarding risk-free rates of return, dividend yields, expected volatilities and the expected term of the award. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the historical dividend yield of the Company’s common stock adjusted for any expected changes and, where applicable, of the common stock of the peer group members at the time of grant. Expected volatilities are based on historical volatility of the Company’s common stock and, where applicable, the common stock of the peer group members at the time of grant. The expected term represents the period of time elapsing during the applicable performance period. For time-based restricted stock awards, the grant date fair value of the awards is recognized as expense in the Company’s financial statements over the vesting period, historically three years. For director phantom units (which vest on the date of grant) expected to be satisfied in equity, the grant date fair value of the awards is recognized as an expense in the Company’s financial statements in the year of grant. The grant date fair value, in both cases, is determined based upon the closing price of the Company’s common stock on the date of the grant. For non-qualified stock options, the grant date fair value is recognized as expense in the Company’s financial statements over the vesting period, typically three years. The Company utilizes the Black-Scholes option pricing model to measure the fair value of stock options, which includes assumptions for a risk-free interest rate, dividend yield, volatility factor and expected term. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the dividend yield of the Company’s common stock at the time of grant. The expected volatility is based on historical volatility of the Company’s common stock at the time of grant. The expected term represents the period of time that options granted are expected to be outstanding based on historical option exercise experience at the time of grant. The Company believes that the accounting estimates related to share-based compensation are “critical accounting estimates” because they may change from period to period based on changes in assumptions about factors affecting the ultimate payout of awards, including the number of awards to ultimately vest and the market price and volatility of the Company’s common stock. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. See Note 18 to the Consolidated Financial Statements for additional information regarding the Company’s share-based compensation. Business Combinations: Accounting for the acquisition of a business requires the identifiable assets and liabilities acquired to be recorded at fair value. The most significant assumptions in a business combination include those used to estimate the fair value of the oil and gas properties acquired. The fair value of proved natural gas properties is determined using a risk-adjusted after-tax discounted cash flow analysis based upon significant assumptions including commodity prices; projections of estimated quantities of reserves; projections of future rates of production; timing and amount of future development and operating costs; projected reserve recovery factors; and a weighted average cost of capital. The Company utilizes the guideline transaction method to estimate the fair value of unproved properties acquired in a business combination which requires the Company to use judgment in considering the value per undeveloped acre in recent comparable transactions to estimate the value of unproved properties. The estimated fair value of midstream facilities and equipment, generally consisting of pipeline systems and compression stations, is estimated using the cost approach, which incorporates assumptions about the replacement costs for similar assets, the relative age of assets and any potential economic or functional obsolescence. The fair values of the intangible assets are estimated using the multi-period excess earnings model which estimates revenues and cash flows derived from the intangible asset and then deducts portions of the cash flow that can be attributed to supporting assets otherwise recognized. The Company’s intangible assets are comprised of customer relationships and non-compete agreements. The Rice Merger resulted in share-based compensation modification accounting which is treated as an exchange of the original award for a new award with total compensation cost equal to the grant-date fair value of the original award plus the incremental value of the modification to the award. The calculation of the incremental value is based on the excess of the fair value of the new (modified) award based on current circumstances over the fair value of the original option measured immediately before its terms are modified based on current circumstances. The Company believes that the accounting estimates related to business combinations are “critical accounting estimates” because the Company must, in determining the fair value of assets acquired, make assumptions about future commodity prices; projections of estimated quantities of reserves; projections of future rates of production; projections regarding the timing and amount of future development and operating costs; and projections of reserve recovery factors, per acre values of undeveloped property, replacement cost of and future cash flows from midstream assets, cash flow from customer relationships and non-compete agreements and the pre and post modification value of stock based awards. Different assumptions may result in materially different values for these assets which would impact the Company’s financial position and future results of operations. Goodwill: Goodwill is the cost of an acquisition less the fair value of the identifiable net assets of the acquired business. Goodwill is evaluated for impairment at least annually, or whenever events or changes in circumstances indicate it is more likely than not that the fair value of a reporting unit is less than its carrying amount. The Company may first consider qualitative factors to assess whether there are indicators that it is more likely than not that the fair value of a reporting unit may not exceed its carrying amount. To the extent that such indicators exist, a two-step goodwill impairment test is completed. The first step compares the fair value of a reporting unit to its carrying value. If the carrying amount of a reporting unit exceeds its fair value, the second step is required which compares the implied fair value of the goodwill of a reporting unit to its carrying value. If the carrying value of the goodwill of a reporting unit exceeds its implied fair value, the difference is recognized as an impairment charge. The Company uses a combination of an income and market approach to estimate the fair value of a reporting unit. The Company believes that the accounting estimates related to goodwill are “critical accounting estimates” because the fair value estimation process requires considerable judgment and determining the fair value is sensitive to changes in assumptions impacting management’s estimates of future financial results. The fair value estimation process requires considerable judgment and determining the fair value is sensitive to changes in assumptions impacting management’s estimates of future financial results as well as other assumptions such as movement in the Company's stock price, weighted-average cost of capital, terminal growth rates and industry multiples. The Company believes the estimates and assumptions used in estimating the fair value are reasonable and appropriate; however, different assumptions and estimates could materially impact the calculated fair value and the resulting determinations about goodwill impairment which could materially impact the Company’s results of operations and financial position. Additionally, future estimates may differ materially from current estimates and assumptions.

<s>[INST] Consolidated Results of Operations 2017 EQT Highlights: Closed the Rice Merger on November 13, 2017 Achieved annual production sales volumes of 887.5 Bcfe, 17% higher than 2016 Completed the 2017 Notes Offering (defined in Note 15 to the Consolidated Financial Statements) totaling $3.0 billion Received FERC Certificate for Mountain Valley Pipeline Net income attributable to EQT Corporation for 2017 was $1,508.5 million, $8.04 per diluted share, compared with a loss attributable to EQT Corporation of $453.0 million, a loss of $2.71 per diluted share, in 2016. The $1,961.5 million increase in net income attributable to EQT Corporation was primarily attributable to an income tax benefit recorded as a result of the lower federal corporate tax rate beginning in 2018, the result of a gain on derivatives not designated as hedges in 2017 compared to a loss in 2016, a 23% increase in the average realized price, a 17% increase in production sales volumes, and higher pipeline, water and net marketing services, partially offset by higher operating expenses, higher interest expense, higher net income attributable to noncontrolling interests and a loss on debt extinguishment in 2017. During the year ended December 31, 2017, the Company recorded acquisition expenses of approximately $237.3 million related to the Rice Merger, including $141.3 million of employee related expenses for payments to former Rice employees under the Merger Agreement. Additional expenses were for investment banking, legal and other professional fees. Acquisition costs are reflected in unallocated expenses and not recorded on any operating segment. EQT Production received $40.7 million and $279.4 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2017 and 2016, respectively, that are included in the average realized price but are not in GAAP operating revenues. Net loss attributable to EQT Corporation for 2016 was $453.0 million, a loss of $2.71 per diluted share, compared with net income attributable to EQT Corporation of $85.2 million, $0.56 per diluted share, in 2015. The $538.2 million decrease in income attributable to EQT Corporation was primarily attributable to a loss on derivatives not designated as hedges, a 20% decrease in the average realized price, higher operating expenses and higher net income attributable to noncontrolling interests, partially offset by a 26% increase in production sales volumes and lower income tax expense. EQT Production received $279.4 million and $172.1 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2016 and 2015, respectively, that are included in the average realized price but are not in GAAP operating revenues. During the year ended December 31, 2016, the Company recorded an impairment of longlived assets of approximately $59.7 million related to certain gathering assets sold to EQM in October 2016. The impairment was a result of a reduction in estimated future cash flows caused by the low commodity price environment and the related reduced producer drilling activity and throughput. This impairment is reflected in unallocated expenses and not recorded on any operating segment. See “Business Segment Results of Operations” for a discussion of items impacting operating income, “Other Income Statement Items” for a discussion of other income, interest expense, income taxes and net income attributable to noncontrolling interests, and “Investing Activities” under the caption “Capital Resources and Liquidity” for a discussion of capital expenditures. Consolidated Operational Data The following table presents detailed natural gas and liquids operational information to assist in the understanding of the Company’s consolidated [/INST] Positive. </s>

EQT Corp

2019-02-14

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis of financial condition and results of operations in conjunction with the consolidated financial statements, and the notes thereto, included in Item 8 of this Annual Report on Form 10-K. The Statements of Consolidated Operations and Consolidated Balance Sheets of Equitrans Midstream are reflected as discontinued operations for all periods presented. Prior periods have been recast to reflect this presentation. This recast also includes presenting certain transportation and processing expenses in continuing operations for all periods presented which were previously eliminated in consolidation prior to the Separation and Distribution. The cash flows related to Equitrans Midstream have not been segregated and are included within the Statements of Consolidated Cash Flows for all periods presented. See Note 2 to the Consolidated Financial Statements for amounts of the discontinued operations related to Equitrans Midstream which are included in the Statements of Consolidated Cash Flows. Consolidated Results of Operations Key Events in 2018: • Completed the Separation and Distribution on November 12, 2018 • Completed the 2018 Divestitures • Achieved annual sales volumes of 1,488 Bcfe and average daily sales volumes of 4,076 MMcfe/d. Adjusted for the impact of the 2018 Divestitures, total annual sales volumes were 1,447 Bcfe or 3,964 MMcfe/d. See further discussion of the Separation, Distribution and the 2018 Divestitures as discussed in the "Key Events in 2018" section of Item 1, "Business." Loss from continuing operations for 2018 was $2.4 billion, a loss of $9.12 per diluted share, compared with income from continuing operations of $1.4 billion, $7.39 per diluted share, in 2017. The $3.8 billion decrease was primarily attributable to $3.5 billion of impairments and losses on the sale of long-lived assets including: $2.7 billion associated with the 2018 Divestitures, goodwill impairment and higher lease impairments. Excluding these items, a $1.5 billion increase in operating revenues was offset by higher operating expenses including depreciation and depletion and transportation and processing expenses and higher interest expense as well as a lower tax benefit. Income from continuing operations for 2017 was $1.4 billion, $7.39 per diluted share, compared with a loss from continuing operations of $0.5 billion, a loss of $3.18 per diluted share, in 2016. The $1.9 billion increase in income from continuing operations was primarily attributable to higher sales of natural gas, oil and NGLs, an income tax benefit recorded as a result of the lower federal corporate tax rate beginning in 2018 and a gain on derivatives not designated as hedges in 2017 compared to a loss in 2016, partly offset by higher operating expenses, higher interest expense and a loss on debt extinguishment in 2017. See “Sales Volumes and Revenues” and “Operating Expenses” for a discussion of items impacting operating income and “Other Income Statement Items” for a discussion of other income statement items. Average Realized Price Reconciliation The following table presents detailed natural gas and liquids operational information to assist in the understanding of the Company’s consolidated operations, including the calculation of the Company's average realized price ($/Mcfe), which is based on adjusted operating revenues, a non-GAAP supplemental financial measure. Adjusted operating revenues is presented because it is an important measure used by the Company’s management to evaluate period-to-period comparisons of earnings trends. Adjusted operating revenues should not be considered as an alternative to total operating revenues. See “Reconciliation of Non-GAAP Financial Measures” for a reconciliation of adjusted operating revenues to total operating revenues. (a) The Company’s volume weighted NYMEX natural gas price (actual average NYMEX natural gas price ($/MMBtu) was $3.09, $3.11 and $2.46 for the years ended December 31, 2018, 2017 and 2016, respectively). (b) Basis represents the difference between the ultimate sales price for natural gas and the NYMEX natural gas price. (c) NGLs, ethane and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (d) Also referred to in this report as adjusted operating revenues, a non-GAAP supplemental financial measure. (e) For the year ended December 31, 2018, results include operations acquired in the Rice Merger (defined in Note 3 to the Consolidated Financial Statements). For the year ended December 31, 2017, results include operations acquired in the Rice Merger for the period of November 13, 2017 through December 31, 2017. Reconciliation of Non-GAAP Financial Measures The table below reconciles adjusted operating revenues, a non-GAAP supplemental financial measure, to total operating revenues, its most directly comparable financial measure calculated in accordance with GAAP. Adjusted operating revenues (also referred to as total natural gas & liquids sales, including cash settled derivatives) is presented because it is an important measure used by the Company’s management to evaluate period-over-period comparisons of earnings trends. Adjusted operating revenues as presented excludes the revenue impact of changes in the fair value of derivative instruments prior to settlement and the revenue impact of "Net marketing services and other". Management utilizes adjusted operating revenues to evaluate earnings trends because the measure reflects only the impact of settled derivative contracts and thus does not impact the revenue from natural gas sales with the often volatile fluctuations in the fair value of derivatives prior to settlement. Adjusted operating revenues also excludes "Net marketing services and other" because management considers these revenues to be unrelated to the revenues for its natural gas and liquids production. "Net marketing services and other" primarily includes the cost of and recoveries on pipeline capacity not used for the Company's sales volumes and revenues for gathering services. Management further believes that adjusted operating revenues as presented provides useful information to investors for evaluating period-over-period earnings trends. Sales Volumes and Revenues (a) Includes Upper Devonian wells. (b) NGLs, ethane and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (c) For the year ended December 31, 2018, results include operations acquired in the Rice Merger (defined in Note 3 to the Consolidated Financial Statements). For the year ended December 31, 2017, results include operations acquired in the Rice Merger for the period of November 13, 2017 through December 31, 2017. Total operating revenues were $4,557.9 million for 2018 compared to $3,091.0 million for 2017. Sales of natural gas, oil and NGLs increased as a result of a 68% increase in sales volumes in 2018, which was primarily a result of the Rice Merger and increased production from the 2016 and 2017 drilling programs, partly offset by the 2018 Divestitures and the normal production decline in the Company’s producing wells. The average realized price decreased in 2018 compared to 2017 due to a decrease in the average NYMEX natural gas price net of cash settled derivatives and a decrease in higher priced liquids sales as a result of the 2018 Divestitures partly offset by an increase in the average natural gas differential. The Company paid $225.3 million and received $40.7 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2018 and 2017, respectively, that are included in the average realized price but are not in GAAP operating revenues. Changes in fair market value of derivative instruments prior to settlement are recognized in (loss) gain on derivatives not designated as hedges. The increase in the average differential primarily related to higher prices during the first quarter of 2018 at sales points in the United States Northeast where colder weather led to increased demand, higher Appalachian Basin basis as well as increased sales volumes at higher priced Gulf Coast and Midwest markets accessible through the Company’s increased transportation portfolio following the Rice Merger. Total operating revenues for 2018 included a $178.6 million loss on derivatives not designated as hedges compared to a $390.0 million gain on derivatives not designated as hedges in 2017. The loss in 2018 primarily related to decreases in the fair market value of the Company’s 2018 NYMEX swaps and options and basis swaps from December 31, 2017 through the date of settlement as a result of increases in the underlying prices throughout this period. These losses were partly offset by increases in the fair market value of the Company's open NYMEX positions at December 31, 2018 due to a decrease in forward NYMEX during 2018. Total operating revenues were $3,091.0 million for 2017 compared to $1,387.1 million for 2016. Sales of natural gas, oil and NGLs increased as a result of higher average realized price and a 17% increase in sales volumes in 2017. EQT received $40.7 million and $279.4 million of net cash settlements for derivatives not designated as hedges for the years ended December 31, 2017 and 2016, respectively, that are included in the average realized price but are not in GAAP operating revenues. The increase in sales volumes was primarily the result of acquisition activity, including the Rice Merger, as well as increased production from the 2015 and 2016 drilling programs, primarily in the Marcellus play, partially offset by the normal production decline in the Company's producing wells in 2017. The $0.57 per Mcfe increase in the average realized price for the year ended December 31, 2017 was primarily due to the increase in the average NYMEX natural gas price net of cash settled derivatives of $0.29 per Mcf, an increase in the average natural gas differential of $0.19 per Mcf and an increase in liquids prices. The improvement in the average differential primarily related to more favorable basis partly offset by unfavorable cash settled basis swaps. During 2017, basis improved in the Appalachian Basin and at sales points reached through the Company’s transportation portfolio, particularly in the United States Northeast. In addition, the Company started flowing its produced volumes to its Rockies Express pipeline capacity and Texas Eastern Transmission Gulf Markets pipeline capacity in the fourth quarter of 2016, which resulted in a favorable impact to basis for the year ended December 31, 2017 compared to the year ended December 31, 2016. Total operating revenues for the year ended December 31, 2017 included a $390.0 million gain on derivatives not designated as hedges compared to a $249.0 million loss on derivatives not designated as hedges for the year ended December 31, 2016. The gains for the year ended December 31, 2017 primarily related to increases in the fair market value of the Company’s NYMEX swaps due to decreased NYMEX prices, partly offset by decreases in the fair market value of its basis swaps due to increased basis prices. Operating Expenses The following presents information about certain of the Company's operating expenses for each of the last three years. Gathering. Gathering expense increased on an absolute basis in 2018 compared to 2017 due to the 68% increase in sales volumes partly offset by a lower gathering rate per unit on gathering capacity acquired in the Rice Merger, which also decreased the rate per Mcfe. Gathering expense increased in 2017 compared to 2016 on an absolute basis due to increased gathering capacity and expense from the Company’s 2016 and 2017 acquisitions. Transmission. Transmission expense increased on an absolute basis in 2018 compared to 2017 due to increased third party capacity incurred to move the Company’s natural gas out of the Appalachian Basin, primarily firm capacity acquired in connection with the Rice Merger, the Company's capacity on the Rover pipeline, which started in 2018, as well as an increase in the Company’s firm capacity on Columbia Gas Transmission pipeline which increased in the first quarter of 2018. These increases were partly offset by reduced firm capacity costs as a result of the Huron Divestiture. Transmission expense per Mcfe decreased as a result of increased sales volumes in 2018. Transmission expense increased on an absolute basis in 2017 compared to 2016 due to increased capacity incurred to move the Company’s natural gas out of the Appalachian Basin. During the fourth quarter of 2016, the Company started flowing its produced volumes to its Rockies Express and Texas Eastern Transmission Gulf Markets pipeline capacity. Additionally, the Company's firm capacity on Rockies Express pipeline increased in the first quarter of 2017. Firm capacity acquired in connection with the Rice Merger also increased transmission expenses by approximately $24.2 million. Transmission expense per Mcfe increased in 2017 compared to 2016 as the impact of the above items exceeded the 17% growth in sales volumes during the period. Processing. Processing expense decreased on an absolute basis in 2018 compared to 2017 primarily as a result of the 2018 Divestitures and decreased on a per Mcfe basis as a result of a 68% increase in sales volumes when combined with the impact of the 2018 Divestitures. Processing expense increased on an absolute basis in 2017 compared to 2016 as a result of increased processing capacity acquired through acquisitions and higher volumes processed, which is consistent with higher ethane and NGLs sales volumes of approximately 50% in 2017 compared to 2016. These factors also contributed to an increase in processing expense on a per Mcfe basis as they exceeded the offsetting impact of growth in sales volumes during the period. LOE. LOE decreased on an absolute and per Mcfe basis in 2018 compared to 2017 primarily as a result of the 2018 Divestitures and growth in sales volumes in 2018 partly offset by higher salt water disposal costs and personnel costs due to increased activity in the Company's Marcellus and Utica operations. Excluding the costs related to the 2018 Divestitures, per unit LOE was $0.05 per Mcfe in 2018 as compared to a divestiture adjusted $0.07 per Mcfe in 2017. LOE increased on an absolute basis in 2017 compared to 2016 primarily due to increased salt water disposal costs as a result of increased activity in the Company’s Marcellus operations, but decreased on a per Mcfe basis due to the growth in sales volumes during the period. Production taxes. Production taxes increased on an absolute basis in 2018 compared to 2017 primarily as a result of the significant increase in the number of wells subject to the Pennsylvania Impact Fee as well as the increased asset base and production volumes in Ohio following the Rice Merger, partly offset by the lower asset base and production volumes in Kentucky, West Virginia, Virginia and Texas following the 2018 Divestitures. Production taxes decreased on a per Mcfe basis in 2018 compared to 2017 due to an increase in sales volumes. Production taxes increased on an absolute basis in 2017 compared to 2016 as a result of higher market prices in 2017 in combination with an increase in the number of wells subject to the Pennsylvania Impact Fee as well as an increased asset base and production from acquisitions. Exploration. Exploration expense decreased in 2018 compared to 2017 and increased in 2017 compared to 2016 on an absolute and per Mcfe basis, primarily due to expenses related to an exploratory well in a non-core operating area classified as a dry hole in 2017. SG&A. SG&A expense increased on an absolute basis in 2018 compared to 2017, primarily due to increased legal reserves, increased charitable contributions to the EQT Foundation and increased personnel costs associated with workforce reductions. SG&A expense decreased on an absolute basis in 2017 compared 2016, primarily due to lower pension expense related to the termination of the EQT Corporation Retirement Plan for Employees in the second quarter of 2016, lower legal reserves in 2017, a reduction to the reserve for uncollectible accounts, and the absence of costs related to the consolidation of the Company’s Huron operations in 2016. This was partly offset by higher costs associated with acquisitions. SG&A expense per Mcfe decreased in 2018 compared to 2017 and in 2017 compared 2016 due to an increase in sales volumes for each respective period. Depreciation and depletion. Depreciation and depletion increased as a result of higher produced volumes in 2018, partly offset by lower depreciation as a result of the 2018 Divestitures. Depreciation and depletion increased as a result of higher produced volumes partly offset by a lower overall depletion rate in 2017 compared to 2016. Impairment of long-lived assets. Impairment of long-lived assets increased $2,710.0 million in 2018 compared 2017, related to the 2018 Divestitures. See Note 8 to the Consolidated Financial Statements for a discussion of the asset impairment. Impairment of goodwill. Impairment of goodwill was $530.8 million in 2018. As a result of the Company's single reporting unit's fair value falling below its carrying value, the full carrying value of goodwill was written off and recorded as impairment of goodwill. See Note 1 to the Consolidated Financial Statements for a discussion of the goodwill impairment. Lease impairments and expirations. Lease impairments and expirations increased in 2018 compared to 2017, primarily due to an increase in the amount of leases that expired during 2018 that were primarily located in non-contiguous or non-core development areas and for impairments of leases not yet expired that are not expected to be drilled or extended prior to expiration during 2019. The increase in the number of leases expiring in 2018 and 2019 is primarily due to acquisition activity completed by the Company throughout 2016 and 2017 in addition to the Rice Merger. Lease impairments and expirations decreased in 2017 compared to 2016, primarily due to a decrease in the number of leases that expired in 2017 and impairments recorded in 2016 for leases not yet expired that would not be drilled prior to expiration. Transaction costs. Transaction costs in 2018 and 2017 were primarily legal and banking fees related to the Rice Merger. Transaction costs associated with the Separation and Distribution and a proportionate share of the transaction costs associated with the Rice Merger were allocated to discontinued operations as described in Note 2 to the Company’s Consolidated Financial Statements. Amortization of intangible assets. In connection with the Rice Merger, the Company obtained intangible assets composed of non-compete agreements with former Rice executives. Amortization expense for 2018 and 2017 was $41.4 million and $5.4 million, respectively, for these non-compete agreements, which are being amortized over three years. Other Income Statement Items Other expense. Other expense increased in 2018 as compared to 2017, primarily due to changes in the fair market value of the Company's investment in Equitrans Midstream which generated an unrealized loss of $72.4 million. The Company initiated its investments in trading securities in 2016 to enhance returns on a portion of its significant cash balance at that time. For the years ended December 31, 2017 and 2016 the Company recorded realized losses of $2.6 million and unrealized gains of $1.5 million, respectively, on these debt securities. As of March 31, 2017, the Company closed its positions on all trading securities. Loss on debt extinguishment. In 2017, the Company recorded loss on debt extinguishment of $12.6 million in connection with the early extinguishment on November 3, 2017 of the $200 million aggregate principal amount 5.15% Senior Notes due 2018 and $500 million aggregate principal amount 6.50% Senior Notes due 2018. The loss consists of $12.2 million paid in excess of par in order to extinguish the debt prior to maturity and $0.4 million in non-cash expenses related to the write-off of unamortized financing costs and discounts. Interest expense. Interest expense increased $61.0 million in 2018 compared to 2017 primarily driven by an additional $74.3 million of interest incurred on Senior Notes issued in October 2017 and an additional $24.0 million of interest incurred on credit facility borrowings partly offset by a $35.9 million decrease due to the early extinguishment of certain Senior Notes and a decrease of $5.1 million related to expense incurred in 2017 on the Company's senior unsecured bridge loans. Interest expense increased $36.8 million for the year ended December 31, 2017 compared to the year ended December 31, 2016 primarily driven by $23.6 million of interest incurred on Senior Notes issued in October 2017, $5.1 million of expense related to the bridge financing commitment for the Rice Merger and $5.5 million of interest incurred on credit facility borrowings partly offset by a $7.0 million decrease due to the early extinguishment of Senior Notes. See Note 10 to the Consolidated Financial Statements for discussion of the borrowings and weighted average interest rates for the Company's credit facility. Income tax (benefit). On December 22, 2017, Congress enacted the law known as the Tax Cuts and Jobs Act of 2017 (the Tax Cuts and Jobs Act), which made significant changes to U.S. federal income tax law, including lowering the federal corporate tax rate to 21% from 35% beginning January 1, 2018. As a result of the change in the corporate tax rate, the Company recorded a deferred tax benefit of $1.2 billion during the year ended December 31, 2017 to revalue its existing net deferred tax liabilities to the lower rate. The Company applied the guidance in SAB 118 when accounting for the enactment-date effects of the Tax Cuts and Jobs Act in 2017 and throughout 2018. At December 31, 2017, the Company had not completed the accounting for all of the enactment-date income tax effects of the legislation under ASC 740, Income Taxes, for the following aspects: remeasurement of deferred tax assets and liabilities and incentive-based compensation limitations. At December 31, 2018, the Company completed the accounting for all of the enactment-date income tax effects of the Tax Cuts and Jobs Act. During 2018, the Company recognized adjustments of $5.3 million to the provisional amounts recorded at December 31, 2017 and included these adjustments as a component of income tax benefit from continuing operations. The additional expense is primarily the result of adjustments to the increased limitations on deductible executive compensation. For federal income tax purposes, the Company continues to have the ability to deduct a portion of its drilling costs as intangible drilling costs (IDCs) in the year incurred after the Tax Cuts and Jobs Act. For periods prior to January 1, 2018, IDCs were limited for purposes of the alternative minimum tax (AMT) and this has resulted in the Company paying AMT even when generating or utilizing a net operating loss carryforward (NOL) to offset regular taxable income. For periods after January 1, 2018, AMT has been repealed by the Tax Cuts and Jobs Act, and the Company has the ability to utilize any existing AMT credit carryforwards against its current federal tax liability and then receive a refund equal to 50% of the remaining balance in each tax year from 2018 through 2020 with any remaining AMT credit carryforward in 2021 being fully refunded . As a result, the Company will receive a Federal tax refund for the 2018 tax year of $128 million and has $295 million of AMT credit carryforward remaining, net of valuation allowances for sequestration of $13 million, as of December 31, 2018. As a result of an announcement by the IRS in January 2019 reversing its position that AMT refunds were subject to sequestration by the federal government at a rate equal to 6.2% of the refund, the Company will reverse the related valuation allowance in the first quarter of 2019. The Tax Cuts and Jobs Act limits the utilization of NOLs generated after December 31, 2017 that are carried into future years to 80% of taxable income and limits the deductibility of interest expense. As a result of the interest limitation, the Company recorded a valuation allowance in 2018 for a portion of the interest expense limit imposed for separate company state income tax purposes. See Note 9 to the Consolidated Financial Statements for further discussion of the Company’s income tax (benefit) expense, including a reconciliation between income tax (benefit) expense calculated at the current federal statutory rate and the effective tax rate reflected in the Company's financial statements for each of the years ended December 31, 2018, 2017 and 2016. Outlook See Item 1, “Business” for the Company's outlook. Impairment of Oil and Gas Properties and Goodwill See “Critical Accounting Policies and Estimates” and Note 1 to the Consolidated Financial Statements for a discussion of the Company’s accounting policies and significant assumptions related to impairment of the Company’s oil and gas properties and goodwill. See Item 1A, "Risk Factors - Natural gas, NGLs and oil price declines have resulted in impairment of certain of our non-core assets. Future declines in commodity prices, increases in operating costs or adverse changes in well performance may result in additional write-downs of the carrying amounts of our assets, including long lived intangible assets, which could materially and adversely affect our results of operations in future periods.” Capital Resources and Liquidity The Statement of Consolidated Cash Flows has not been restated for discontinued operations, therefore the discussion below concerning cash from operating activities, investing activities and financing activities includes the results of both continuing and discontinued operations through the completion of the Separation and Distribution on November 12, 2018. See Note 2 to the Consolidated Financial Statements for amounts attributable to discontinued operations which are included in the Statements of Consolidated Cash Flows. Although the Company cannot provide any assurance, it believes cash flows from operating activities and availability under the revolving credit facility should be sufficient to meet the Company's cash requirements inclusive of, but not limited to, normal operating needs, debt service obligations, planned capital expenditures and commitments for at least the next 12 months. Operating Activities Net cash provided by operating activities increased $1,338.6 million for 2018 as compared to 2017. The increase was primarily driven by higher operating revenues partly offset by increased cash operating expenses for which contributing factors are discussed in the "Consolidated Results of Operations" section herein, the timing of payments between the two periods and cash settlements paid on derivatives not designated as hedges. Net cash provided by operating activities increased $573.4 million for 2017 as compared to 2016. The increase in cash flows provided by operating activities was primarily driven by higher operating income for which contributing factors are discussed in the "Consolidated Results of Operations" section herein and the timing of payments between the two periods, partly offset by lower cash settlements received on derivatives not designated as hedges. The Company's cash flows from operating activities will be impacted by future movements in the market price for commodities. The Company is unable to predict these future price movements outside of the current market view as reflected in forward strip pricing. Refer to Item 1A, "Risk Factors - Natural gas, NGLs and oil price volatility, or a prolonged period of low natural gas, NGLs and oil prices, may have an adverse effect upon our revenue, profitability, future rate of growth, liquidity and financial position." for further information. Investing Activities Net cash used in investing activities decreased $223.0 million for 2018 as compared to 2017. The decrease was primarily due to investment in the Rice Merger in 2017, a decrease in capital expenditures for other property acquisitions and proceeds from the 2018 Divestitures partly offset by an increase in capital expenditures primarily for reserve development and midstream infrastructure attributable to discontinued operations, higher capital contributions to Mountain Valley Pipeline, LLC (the MVP Joint Venture) and cash received from the sale of trading securities in 2017. Net cash used in investing activities increased $1,315.6 million for 2017 as compared to 2016. The increase was primarily due to investment in the Rice Merger, an increase in capital expenditures primarily for reserve development and higher capital contributions to the MVP Joint Venture, partly offset by a decrease in capital expenditures for other property acquisitions, cash received from the sale of trading securities and lower capital expenditures on midstream infrastructure attributable to discontinued operations. See Note 3 to the Consolidated Financial Statements for further discussion of the Rice Merger. Capital Expenditures (a) Capital expenditures related to midstream infrastructure are presented as discontinued operations as described in Note 2 to the Company’s Consolidated Financial Statements. (b) Represents the net impact of non-cash capital expenditures including capitalized non-cash share-based compensation expense, accruals and receivables from working interest partners. The impact of accrued capital expenditures includes the reversal of the prior period accrual as well as the current period estimate. The year ended December 31, 2018 included $14.4 million of measurement period adjustments for 2017 acquisitions. The year ended December 31, 2017 included $10.0 million of non-cash capital expenditures related to 2017 acquisitions and $(14.3) million of measurement period adjustments for 2016 acquisitions. The year ended December 31, 2016 included $87.6 million of non-cash capital expenditures related to 2016 acquisitions. The Company spud 153 gross wells in 2018, including 117 horizontal Marcellus wells, 5 horizontal Upper Devonian wells and 31 horizontal Utica wells. The Company spud 201 gross wells in 2017, including 144 horizontal Marcellus wells, 49 horizontal Upper Devonian wells, seven horizontal Utica wells and one other well. The Company spud 135 gross wells in 2016, including 117 horizontal Marcellus wells, 13 horizontal Upper Devonian wells and four horizontal Utica wells. The increase in capital expenditures for well development in 2018 was driven primarily by the timing of drilling and completions activities between years, service cost increases and inefficiencies resulting from higher activity levels and the learning curve on ultra-long laterals, partly offset by a decrease in property acquisitions. The increase in capital expenditures for well development in 2017 was driven primarily by the timing of drilling and completions activities between years and an increase in wells spud, partly offset by a decrease in property acquisitions. These acquisitions are discussed in Note 7 to the Consolidated Financial Statements. Capital expenditures for the midstream infrastructure are primarily related to expansion capital expenditures, which are expenditures incurred for capital improvements that EQM expects to increase its operating income or operating capacity over the long term. The increase in expansion capital expenditures in 2018 as compared to 2017 primarily related to new gathering and transmission expansion projects in 2018, including the the Hammerhead project, the Equitrans, L.P. expansion project and various wellhead gathering expansion projects. The decrease in expansion capital expenditures in 2017 as compared to 2016 primarily related to the Ohio Valley Connector, which was placed into service in the fourth quarter of 2016. Financing Activities Cash flows provided by financing activities totaled $859.0 million for 2018 as compared to $1,533.1 million for 2017. During 2018, the primary source of financing cash flows was net proceeds from an EQM senior notes offering and the primary uses of financing cash flows were repurchases and retirements of common stock, distributions to noncontrolling interests, net repayments of credit facility borrowings, EQM's acquisition of a 25% ownership interest in Strike Force Midstream LLC, net cash transferred as part of the Separation and Distribution, dividends paid and cash paid for taxes on share-based incentive awards. During 2017, the primary sources of financing cash flows were net proceeds from the 2017 Notes Offering (defined in Note 10 to the Consolidated Financial Statements) and net borrowings on credit facilities. The primary uses of financing cash flows during 2017 were redemptions and repayment of Rice's debt in connection with the closing of the Rice Merger, redemption of the Company's Senior Notes and distributions to noncontrolling interests. On January 16, 2019, the Board of Directors of the Company declared a quarterly cash dividend of three cents per share, payable March 1, 2019, to the Company’s shareholders of record at the close of business on February 15, 2019. Cash flows provided by financing activities totaled $1,533.1 million for 2017 as compared to $1,399.5 million for 2016. During 2016, the primary sources of financing cash flows were net proceeds from its public offerings of common stock, EQM's public offerings of its common units and proceeds received from the issuance of EQM senior notes. The primary uses of financing cash flows during 2016 were net EQM credit facility repayments and distributions to noncontrolling interests. The Company may from time to time seek to repurchase its outstanding debt securities. Such repurchases, if any, will depend on prevailing market conditions, the Company's liquidity requirements, contractual and legal restrictions and other factors. Revolving Credit Facility The Company primarily utilizes borrowings under its revolving credit facility to fund working capital needs, timing differences between capital expenditures and other cash uses and cash flows from operating activities and required margin deposits on derivative commodity instruments. Margin deposit requirements vary based on natural gas commodity prices, the Company's credit ratings and the amount and type of derivative commodity instruments. See Note 10 to the Consolidated Financial Statements for further discussion of the Company's credit facility. Security Ratings and Financing Triggers The table below reflects the credit ratings for debt instruments of the Company at December 31, 2018. Changes in credit ratings may affect the Company’s cost of short-term debt through interest rates and fees under its lines of credit. These ratings may also affect collateral requirements under derivative instruments, pipeline capacity contracts and rates available on new long-term debt and access to the credit markets. The Company’s credit ratings are subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating. The Company cannot ensure that a rating will remain in effect for any given period of time or that a rating will not be lowered or withdrawn by a credit rating agency if, in its judgment, circumstances so warrant. If any credit rating agency downgrades the ratings, particularly below investment grade, the Company’s access to the capital markets may be limited, borrowing costs and margin deposits on the Company’s derivative contracts would increase, counterparties may request additional assurances, including collateral, and the potential pool of investors and funding sources may decrease. The required margin on the Company’s derivative instruments is also subject to significant change as a result of factors other than credit rating, such as gas prices and credit thresholds set forth in agreements between the hedging counterparties and the Company. Investment grade refers to the quality of a company's credit as assessed by one or more credit rating agencies. In order to be considered investment grade, a company must be rated BBB- or higher by S&P, Baa3 or higher by Moody's, and BBB- or higher by Fitch. Anything below these ratings is considered non-investment grade. The Company’s debt agreements and other financial obligations contain various provisions that, if not complied with, could result in termination of the agreements, require early payment of amounts outstanding or similar actions. The most significant covenants and events of default under the debt agreements relate to maintenance of a debt-to-total capitalization ratio, limitations on transactions with affiliates, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of other financial obligations and change of control provisions. The Company’s credit facility contains financial covenants that require a total debt-to-total capitalization ratio no greater than 65%. The calculation of this ratio excludes the effects of accumulated other comprehensive income (OCI). As of December 31, 2018, the Company was in compliance with all debt provisions and covenants. Commodity Risk Management The substantial majority of the Company’s commodity risk management program is related to hedging sales of the Company’s produced natural gas. The Company’s overall objective in this hedging program is to protect cash flow from undue exposure to the risk of changing commodity prices. The derivative commodity instruments currently utilized by the Company are primarily swaps, calls and puts. As of January 31, 2019, the approximate volumes and prices of the Company’s NYMEX hedge positions through 2023 are: (a) Full year 2019 (b) The difference between the fixed price and NYMEX are included in average differential on the Company’s price reconciliation under "Consolidated Results of Operations." The fixed price natural gas sales agreements can be physically or financially settled. For 2019, 2020, 2021, 2022 and 2023, the Company has natural gas sales agreements for approximately 33 MMDth, 13 MMDth, 18MMDth, 18MMDth and 18MMDth, respectively, that include average NYMEX ceiling prices of $3.37, $3.68, $3.17, $3.17 and $3.17, respectively. Currently, the Company has also entered into derivative instruments to hedge basis and a limited number of contracts to hedge its NGLs exposure. The Company may also use other contractual agreements in implementing its commodity hedging strategy. See Item 7A, “Quantitative and Qualitative Disclosures About Market Risk,” and Note 5 to the Consolidated Financial Statements for further discussion of the Company’s hedging program. Other Items Off-Balance Sheet Arrangements See Note 16 to the Consolidated Financial Statements for further discussion of the Company’s guarantees. Schedule of Contractual Obligations The table below presents the Company’s long-term contractual obligations as of December 31, 2018 in total and by periods. (a) Purchase obligations are primarily commitments for demand charges under existing long-term contracts and binding precedent agreements with various pipelines, some of which extend up to 20 years or longer. The Company has entered into agreements to release some of its capacity. Purchase obligations also include commitments for processing capacity in order to extract heavier liquid hydrocarbons from the natural gas stream. (b) Interest payments exclude interest related to the credit facility borrowings and the Floating Rate Notes (defined in Note 10 to the Consolidated Financial Statements) as the interest rates on the Company's credit facility and the Floating Rate Notes are variable. (c) Credit facility borrowings were classified based on the termination dates of the Company's credit facility. (d) Operating leases are primarily entered into for dedicated drilling rigs in support of the Company’s drilling program and various office locations and warehouse buildings. The Company has agreements with several drillers to provide drilling equipment and services to the Company over the next year. These obligations were approximately $60.0 million as of December 31, 2018. The obligations for the Company’s various office locations and warehouse buildings were approximately $49.8 million as of December 31, 2018. (e) Other liabilities primarily represents commitments for estimated payouts as of December 31, 2018 for various EQT liability stock award plans. See “Critical Accounting Policies and Estimates” below and Note 13 to the Consolidated Financial Statements for further discussion regarding factors that affect the ultimate amount of the payout of these obligations. As discussed in Note 9 to the Consolidated Financial Statements, the Company had a total reserve for unrecognized tax benefits at December 31, 2018 of $315.3 million, of which $88.2 million is offset against deferred tax assets since it would primarily reduce the general business tax credit carryforwards. The Company is currently unable to make reasonably reliable estimates of the period of cash settlement of these potential liabilities with taxing authorities; therefore, this amount has been excluded from the schedule of contractual obligations. Commitments and Contingencies In the ordinary course of business, various legal and regulatory claims and proceedings are pending or threatened against the Company. While the amounts claimed may be substantial, the Company is unable to predict with certainty the ultimate outcome of such claims and proceedings. The Company accrues legal and other direct costs related to loss contingencies when actually incurred. The Company has established reserves it believes to be appropriate for pending matters and, after consultation with counsel and giving appropriate consideration to available insurance, the Company believes that the ultimate outcome of any matter currently pending against the Company will not materially affect the Company’s financial condition, results of operations or liquidity. See Note 15 to the Consolidated Financial Statements for further discussion of the Company’s commitments and contingencies. Recently Issued Accounting Standards The Company's recently issued accounting standards are described in Note 1 to the Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Critical Accounting Policies and Estimates The Company’s significant accounting policies are described in Note 1 to the Consolidated Financial Statements. The discussion and analysis of the Consolidated Financial Statements and results of operations are based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with GAAP. The preparation of the Consolidated Financial Statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the related disclosure of contingent assets and liabilities. The following critical accounting policies, which were reviewed by the Company’s Audit Committee, relate to the Company’s more significant judgments and estimates used in the preparation of its Consolidated Financial Statements. Actual results could differ from those estimates. Accounting for Oil and Gas Producing Activities: The Company uses the successful efforts method of accounting for its oil and gas producing activities. The carrying values of the Company’s proved oil and gas properties are reviewed for impairment generally on a field-by-field basis when events or circumstances indicate that the remaining carrying value may not be recoverable. The estimated future cash flows used to test those properties for recoverability are based on proved and, if determined reasonable by management, risk-adjusted probable reserves, utilizing assumptions generally consistent with the assumptions utilized by the Company's management for internal planning and budgeting purposes, including, among other things, the intended use of the asset, anticipated production from reserves, future market prices for natural gas, NGLs and oil, adjusted accordingly for basis differentials, future operating costs and inflation, some of which are interdependent. Proved oil and gas properties that have carrying amounts in excess of estimated future cash flows are written down to fair value, which is estimated by discounting the estimated future cash flows using discount rates and other assumptions that marketplace participants would use in their estimates of fair value. Capitalized costs of unproved oil and gas properties are evaluated at least annually for recoverability on a prospective basis. Indicators of potential impairment include changes brought about by economic factors, potential shifts in business strategy employed by management and historical experience. The likelihood of an impairment of unproved oil and gas properties increases as the expiration of a lease term approaches if drilling activity has not commenced. If it is determined that the Company does not intend to drill on the property prior to expiration or does not have the intent and ability to extend, renew, trade, or sell the lease prior to expiration, an impairment expense is recorded. The Company believes that the accounting estimate related to the accounting for oil and gas producing activities is a “critical accounting estimate” as the evaluations of impairment of proved properties involve significant judgment about future events such as future sales prices of natural gas and NGLs, future production costs, estimates of the amount of natural gas and NGLs recorded and the timing of those recoveries. See "Impairment of Oil and Gas Properties and Goodwill" above and Note 1 to the Consolidated Financial Statements for additional information regarding the Company’s impairments of proved and unproved oil and gas properties. Oil and Gas Reserves: Proved oil and gas reserves, as defined by SEC Regulation S-X Rule 4-10, are those quantities of oil and gas which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible from a given date forward, from known reservoirs and under existing economic conditions, operating methods and government regulations prior to the time at which contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain, regardless of whether deterministic or probabilistic methods are used for the estimation. The Company’s estimates of proved reserves are made and reassessed annually using geological and reservoir data as well as production performance data. Reserve estimates are prepared and updated by the Company’s engineers and audited by the Company’s independent engineers. Revisions may result from changes in, among other things, reservoir performance, development plans, prices, operating costs, economic conditions and governmental restrictions. Decreases in prices, for example, may cause a reduction in some proved reserves due to reaching economic limits sooner. A material change in the estimated volumes of reserves could have an impact on the depletion rate calculation and the Company's financial statements. The Company estimates future net cash flows from natural gas, NGLs and oil reserves based on selling prices and costs using a 12-month average price, calculated as the unweighted arithmetic average of the first-day-of-the-month price for each month within the 12-month period, which is subject to change in subsequent periods. Operating costs, production and ad valorem taxes and future development costs are based on current costs with no escalation. Income tax expense is computed using future statutory tax rates and giving effect to tax deductions and credits available under current laws and which relate to oil and gas producing activities. The Company believes that the accounting estimate related to oil and gas reserves is a “critical accounting estimate” because the Company must periodically reevaluate proved reserves along with estimates of future production rates, production costs and the estimated timing of development expenditures. Future results of operations and strength of the balance sheet for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. See "Impairment of Oil and Gas Properties and Goodwill" above for additional information regarding the Company’s oil and gas reserves. Income Taxes: The Company recognizes deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the Company’s Consolidated Financial Statements or tax returns. The Company has recorded deferred tax assets principally resulting from federal and state NOL carryforwards, an AMT credit carryforward, other federal tax credit carryforwards, unrealized capacity contract loss, incentive compensation and investment in securities. The Company has established a valuation allowance against a portion of the deferred tax assets related to the federal and state NOL carryforwards and AMT credit carryforward, as it is believed that it is more likely than not that certain deferred tax assets will not all be realized. As a result of an announcement by the IRS in January 2019 reversing its prior position that AMT refunds were subject to sequestration by the Government at a rate equal to 6.2% of the refund, the Company will reverse the related valuation allowance in the first quarter of 2019. In addition, a valuation allowance was recorded for a portion of the interest limitation disallowance imposed with the Tax Cuts and Jobs Act due to separate company reporting requirements. No other significant valuation allowances have been established, as it is believed that future sources of taxable income, reversing temporary differences and other tax planning strategies will be sufficient to realize these deferred tax assets. Any determination to change the valuation allowance would impact the Company’s income tax expense and net income in the period in which such a determination is made. The Company also estimates the amount of financial statement benefit to record for uncertain tax positions as described in Note 9 to the Company’s Consolidated Financial Statements. The Company believes that accounting estimates related to income taxes are “critical accounting estimates” because the Company must assess the likelihood that deferred tax assets will be recovered from future taxable income and exercise judgment regarding the amount of financial statement benefit to record for uncertain tax positions. When evaluating whether or not a valuation allowance must be established on deferred tax assets, the Company exercises judgment in determining whether it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax assets will not be realized. The Company considers all available evidence, both positive and negative, to determine whether, based on the weight of the evidence, a valuation allowance is needed, including carrybacks, tax planning strategies, reversal of deferred tax assets and liabilities and forecasted future taxable income. In making the determination related to uncertain tax positions, the Company considers the amounts and probabilities of the outcomes that could be realized upon ultimate settlement of an uncertain tax position using the facts, circumstances and information available at the reporting date to establish the appropriate amount of financial statement benefit. To the extent that an uncertain tax position or valuation allowance is established or increased or decreased during a period, the Company must include an expense or benefit within tax expense in the income statement. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Derivative Instruments: The Company enters into derivative commodity instrument contracts primarily to mitigate exposure to commodity price risk associated with future sales of natural gas production. The Company estimates the fair value of all derivative instruments using quoted market prices, where available. If quoted market prices are not available, fair value is based upon models that use market-based parameters as inputs, including forward curves, discount rates, volatilities and nonperformance risk. Nonperformance risk considers the effect of the Company’s credit standing on the fair value of liabilities and the effect of the counterparty’s credit standing on the fair value of assets. The Company estimates nonperformance risk by analyzing publicly available market information, including a comparison of the yield on debt instruments with credit ratings similar to the Company’s or counterparty’s credit rating and the yield of a risk-free instrument, and credit default swap rates where available. The values reported in the financial statements change as these estimates are revised to reflect actual results, or market conditions or other factors change, many of which are beyond the Company’s control. The Company believes that the accounting estimates related to derivative instruments are “critical accounting estimates” because the Company’s financial condition and results of operations can be significantly impacted by changes in the market value of the Company’s derivative instruments due to the volatility of natural gas prices, both NYMEX and basis. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Contingencies and Asset Retirement Obligations: The Company is involved in various regulatory and legal proceedings that arise in the ordinary course of business. The Company records a liability for contingencies based upon its assessment that a loss is probable and the amount of the loss can be reasonably estimated. The Company considers many factors in making these assessments, including history and specifics of each matter. Estimates are developed in consultation with legal counsel and are based upon an analysis of potential results. The Company also accrues a liability for asset retirement obligations based on an estimate of the timing and amount of their settlement. For oil and gas wells, the fair value of the Company’s plugging and abandonment obligations is required to be recorded at the time the obligations are incurred, which is typically at the time the wells are spud. The Company believes that the accounting estimates related to contingencies and asset retirement obligations are “critical accounting estimates” because the Company must assess the probability of loss related to contingencies and the expected amount and timing of asset retirement obligations. In addition, the Company must determine the estimated present value of future liabilities. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. Share-Based Compensation: The Company awards share-based compensation in connection with specific programs established under the 2009 and 2014 Long-Term Incentive Plans. Awards to employees are typically made in the form of performance-based awards, time-based restricted stock, time-based restricted units and stock options. Awards to directors are typically made in the form of phantom units that vest upon grant. Restricted units and performance-based awards expected to be satisfied in cash are treated as liability awards. For liability awards, the Company is required to estimate, on the grant date and on each reporting date thereafter until vesting and payment, the fair value of the ultimate payout based upon the expected performance through, and value of the Company’s common stock on, the vesting date. The Company then recognizes a proportionate amount of the expense for each period in the Company’s financial statements over the vesting period of the award. The Company reviews its assumptions regarding performance and common stock value on a quarterly basis and adjusts its accrual when changes in these assumptions result in a material change in the fair value of the ultimate payouts. Performance-based awards expected to be satisfied in Company common stock are treated as equity awards. For equity awards, the Company is required to determine the grant date fair value of the awards, which is then recognized as expense in the Company’s financial statements over the vesting period of the award. Determination of the grant date fair value of the awards requires judgments and estimates regarding, among other things, the appropriate methodologies to follow in valuing the awards and the related inputs required by those valuation methodologies. Most often, the Company is required to obtain a valuation based upon assumptions regarding risk-free rates of return, dividend yields, expected volatilities and the expected term of the award. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the historical dividend yield of the Company’s common stock adjusted for any expected changes and, where applicable, of the common stock of the peer group members at the time of grant. Expected volatilities are based on historical volatility of the Company’s common stock and, where applicable, the common stock of the peer group members at the time of grant. The expected term represents the period of time elapsing during the applicable performance period. For time-based restricted stock awards, the grant date fair value of the awards is recognized as expense in the Company’s financial statements over the vesting period, historically three years. For director phantom units (which vest on the date of grant) expected to be satisfied in equity, the grant date fair value of the awards is recognized as an expense in the Company’s financial statements in the year of grant. The grant date fair value, in both cases, is determined based upon the closing price of the Company’s common stock on the date of the grant. For non-qualified stock options, the grant date fair value is recognized as expense in the Company’s financial statements over the vesting period, typically three years. The Company utilizes the Black-Scholes option pricing model to measure the fair value of stock options, which includes assumptions for a risk-free interest rate, dividend yield, volatility factor and expected term. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The dividend yield is based on the dividend yield of the Company’s common stock at the time of grant. The expected volatility is based on historical volatility of the Company’s common stock at the time of grant. The expected term represents the period of time that options granted are expected to be outstanding based on historical option exercise experience at the time of grant. The Company believes that the accounting estimates related to share-based compensation are “critical accounting estimates” because they may change from period to period based on changes in assumptions about factors affecting the ultimate payout of awards, including the number of awards to ultimately vest and the market price and volatility of the Company’s common stock. Future results of operations for any particular quarterly or annual period could be materially affected by changes in the Company’s assumptions. See Note 13 to the Consolidated Financial Statements for additional information regarding the Company’s share-based compensation. Business Combinations: Accounting for the acquisition of a business requires the identifiable assets and liabilities acquired to be recorded at fair value. The most significant assumptions in a business combination include those used to estimate the fair value of the oil and gas properties acquired. The fair value of proved natural gas properties is determined using a risk-adjusted after-tax discounted cash flow analysis based upon significant assumptions including commodity prices; projections of estimated quantities of reserves; projections of future rates of production; timing and amount of future development and operating costs; projected reserve recovery factors; and a weighted average cost of capital. The Company utilizes the guideline transaction method to estimate the fair value of unproved properties acquired in a business combination which requires the Company to use judgment in considering the value per undeveloped acre in recent comparable transactions to estimate the value of unproved properties. The estimated fair value of midstream facilities and equipment, generally consisting of pipeline systems and compression stations, is estimated using the cost approach, which incorporates assumptions about the replacement costs for similar assets, the relative age of assets and any potential economic or functional obsolescence. The fair values of the intangible assets are estimated using the multi-period excess earnings model which estimates revenues and cash flows derived from the intangible asset and then deducts portions of the cash flow that can be attributed to supporting assets otherwise recognized. The Company believes that the accounting estimates related to business combinations are “critical accounting estimates” because the Company must, in determining the fair value of assets acquired, make assumptions about future commodity prices; projections of estimated quantities of reserves; projections of future rates of production; projections regarding the timing and amount of future development and operating costs; and projections of reserve recovery factors, per acre values of undeveloped property, replacement cost of and future cash flows from midstream assets, cash flow from customer relationships and non-compete agreements and the pre and post modification value of stock based awards. Different assumptions may result in materially different values for these assets which would impact the Company’s financial position and future results of operations. Goodwill: The Company believes that the accounting estimates related to goodwill are “critical accounting estimates” because the fair value estimation process requires considerable judgment and determining the fair value is sensitive to changes in assumptions impacting management’s estimates of future financial results. The fair value estimation process requires considerable judgment and determining the fair value is sensitive to changes in assumptions impacting management’s estimates of future financial results as well as other assumptions. The Company believes the estimates and assumptions used in estimating the fair value are reasonable and appropriate; however, different assumptions and estimates could materially impact the calculated fair value and the resulting determinations about goodwill impairment which could materially impact the Company’s results of operations and financial position. Additionally, future estimates may differ materially from current estimates and assumptions. See Note 1 to the Consolidated Financial Statements for additional information regarding the Company’s goodwill.

<s>[INST] Consolidated Results of Operations Key Events in 2018: Completed the Separation and Distribution on November 12, 2018 Completed the 2018 Divestitures Achieved annual sales volumes of 1,488 Bcfe and average daily sales volumes of 4,076 MMcfe/d. Adjusted for the impact of the 2018 Divestitures, total annual sales volumes were 1,447 Bcfe or 3,964 MMcfe/d. See further discussion of the Separation, Distribution and the 2018 Divestitures as discussed in the "Key Events in 2018" section of Item 1, "Business." Loss from continuing operations for 2018 was $2.4 billion, a loss of $9.12 per diluted share, compared with income from continuing operations of $1.4 billion, $7.39 per diluted share, in 2017. The $3.8 billion decrease was primarily attributable to $3.5 billion of impairments and losses on the sale of longlived assets including: $2.7 billion associated with the 2018 Divestitures, goodwill impairment and higher lease impairments. Excluding these items, a $1.5 billion increase in operating revenues was offset by higher operating expenses including depreciation and depletion and transportation and processing expenses and higher interest expense as well as a lower tax benefit. Income from continuing operations for 2017 was $1.4 billion, $7.39 per diluted share, compared with a loss from continuing operations of $0.5 billion, a loss of $3.18 per diluted share, in 2016. The $1.9 billion increase in income from continuing operations was primarily attributable to higher sales of natural gas, oil and NGLs, an income tax benefit recorded as a result of the lower federal corporate tax rate beginning in 2018 and a gain on derivatives not designated as hedges in 2017 compared to a loss in 2016, partly offset by higher operating expenses, higher interest expense and a loss on debt extinguishment in 2017. See “Sales Volumes and Revenues” and “Operating Expenses” for a discussion of items impacting operating income and “Other Income Statement Items” for a discussion of other income statement items. Average Realized Price Reconciliation The following table presents detailed natural gas and liquids operational information to assist in the understanding of the Company’s consolidated operations, including the calculation of the Company's average realized price ($/Mcfe), which is based on adjusted operating revenues, a nonGAAP supplemental financial measure. Adjusted operating revenues is presented because it is an important measure used by the Company’s management to evaluate periodtoperiod comparisons of earnings trends. Adjusted operating revenues should not be considered as an alternative to total operating revenues. See “Reconciliation of NonGAAP Financial Measures” for a reconciliation of adjusted operating revenues to total operating revenues. (a) The Company’s volume weighted NYMEX natural gas price (actual average NYMEX natural gas price ($/MMBtu) was $3.09, $3.11 and $2.46 for the years ended December 31, 2018, 2017 and 2016, respectively). (b) Basis represents the difference between the ultimate sales price for natural gas and the NYMEX natural gas price. (c) NGLs, ethane and crude oil were converted to Mcfe at the rate of six Mcfe per barrel for all periods. (d) Also referred to in this report as adjusted operating revenues, a nonGAAP supplemental financial measure. (e) For the year ended December 31, 2018, results include operations acquired in the Rice Merger (defined in Note 3 to the Consolidated Financial Statements). For the year ended December 31, 2017, results include operations acquired in the Rice Merger for the period of November 13, 2017 through December 31, 2017. [/INST] Negative. </s>

EQT Corp

2020-02-27

2019-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of financial condition and results of operations should be read in conjunction with the Consolidated Financial Statements and the notes thereto included in Item 8., "Financial Statements and Supplementary Data." For all periods prior to the Separation and Distribution, the results of operations of Equitrans Midstream are reflected as discontinued operations. The Statements of Consolidated Operations for the years ended December 31, 2018 and 2017 have been recast to reflect discontinued operations and include certain transportation and processing expenses in continuing operations that had previously been eliminated in consolidation. Cash flows related to Equitrans Midstream are included in the Statements of Consolidated Cash Flows for all periods prior to the Separation and Distribution. See Note 2 to the Consolidated Financial Statements for amounts attributable to discontinued operations included in the Statements of Consolidated Cash Flows and Statements of Consolidated Operations. Consolidated Results of Operations Loss from continuing operations for 2019 was $1,222 million, $4.79 per diluted share, an improvement of $1,159 million compared to loss from continuing operations for 2018 of $2,381 million, $9.12 per diluted share. The variance was attributable primarily to lower impairments of long-lived assets and goodwill and higher dividends received on the Company's investment in Equitrans Midstream, partly offset by lower income tax benefit and higher impairment and expiration of leases, unrealized loss on the Company's investment in Equitrans Midstream and operating revenues. See Item 7., "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in the Company's Annual Report on Form 10-K for the year ended December 31, 2018, which is incorporated herein by reference, for discussion and analysis of consolidated results of operations for the year ended December 31, 2017. See "Sales Volumes and Revenues," "Production-Related Operating Expenses" and "Other Operating Expenses" for discussions of items affecting operating income and "Other Income Statement Items" for a discussion of other income statement items. See "Investing Activities" under "Capital Resources and Liquidity" for a discussion of capital expenditures. Average Realized Price Reconciliation The following table presents detailed natural gas and liquids operational information to assist in the understanding of the Company's consolidated operations, including the calculation of the Company's average realized price ($/Mcfe), which is based on adjusted operating revenues, a non-GAAP supplemental financial measure. Adjusted operating revenues is presented because it is an important measure used by the Company's management to evaluate period-to-period comparisons of earnings trends. Adjusted operating revenues should not be considered as an alternative to total operating revenues. See "Reconciliation of Non-GAAP Financial Measures" for a reconciliation of adjusted operating revenues with total operating revenues, the most directly comparable financial measure calculated in accordance with GAAP. (a) The Company's volume weighted NYMEX natural gas price (actual average NYMEX natural gas price ($/MMBtu)) was $2.63 and $3.09 for the years ended December 31, 2019 and 2018, respectively. (b) Basis represents the difference between the ultimate sales price for natural gas and the NYMEX natural gas price. (c) NGLs, ethane and oil were converted to Mcfe at a rate of six Mcfe per barrel. (d) Total natural gas and liquids sales, including cash settled derivatives, is also referred to in this report as adjusted operating revenues, a non-GAAP supplemental financial measure. Non-GAAP Financial Measures Reconciliation The table below reconciles adjusted operating revenues, a non-GAAP supplemental financial measure, with total operating revenues, its most directly comparable financial measure calculated in accordance with GAAP. Adjusted operating revenues (also referred to as total natural gas and liquids sales, including cash settled derivatives) is presented because it is an important measure used by the Company's management to evaluate period-to-period comparisons of earnings trends. Adjusted operating revenues as presented excludes the revenue impact of changes in the fair value of derivative instruments prior to settlement and the revenue impact of net marketing services and other. Management uses adjusted operating revenues to evaluate earnings trends because the measure reflects only the impact of settled derivative contracts and, thus, excludes the impact of the often-volatile fluctuations in the fair value of derivatives prior to settlement. Adjusted operating revenues also excludes net marketing services and other because management considers these revenues to be unrelated to revenues from its natural gas and liquids production. Net marketing services and other primarily includes the cost of, and recoveries on, pipeline capacity releases and revenues for gathering services. Management further believes that adjusted operating revenues as presented provides useful information to investors for evaluating period-to-period earnings trends. Sales Volumes and Revenues (a) Includes Upper Devonian wells. (b) NGLs, ethane and oil were converted to Mcfe at a rate of six Mcfe per barrel. Sales of natural gas, NGLs and oil decreased for 2019 compared to 2018 due to a lower average realized price, partly offset by a 1.4% increase in sales volumes. Excluding 2018 sales volumes related to the 2018 Divestitures (discussed in Note 7 to the Consolidated Financial Statements), sales volumes increased by 4.2% in 2019. Average realized price decreased due to lower NYMEX and liquids prices and lower Btu uplift, partly offset by higher cash settled derivatives. For 2019 and 2018, the Company received $266.3 million and paid $224.8 million, respectively, of net cash settlements, including net premiums received, on derivatives not designated as hedges, which are included in average realized price but may not be included in operating revenues. For 2019 the Company recognized a gain on derivatives not designated as hedges of $616.6 million compared to a loss of $178.6 million for 2018. The gain for 2019 was related to increases in the fair market value of the Company's NYMEX swaps and options due to decreases in NYMEX forward prices. The loss for 2018 was related primarily to settlements of NYMEX swaps and options and basis swaps, partly offset by decreases in NYMEX forward prices. Net marketing services and other decreased for 2019 compared to 2018 as a result of fewer capacity releases at lower capacity release rates on the Tennessee Gas Pipeline and lower revenues from gathering services following the 2018 Divestitures. Production-Related Operating Expenses The following table presents information on the Company's production-related operating expenses. Transportation and processing. Gathering expense increased on an absolute and per Mcfe basis for 2019 compared to 2018 due primarily to the sales volume mix between firm and volumetric gathering contracts. Transmission expense increased on an absolute and per Mcfe basis for 2019 compared to 2018 due primarily to higher costs associated with unreleased capacity on the Tennessee Gas Pipeline, increased transmission capacity and rates contracted to move the Company's natural gas out of the Appalachian Basin and higher volumetric charges, partly offset by lower firm capacity charges following the 2018 Divestitures. Processing expense decreased on an absolute and per Mcfe basis for 2019 compared to 2018 due primarily to lower liquids sales volumes, which were driven by the 2018 Divestitures, and decreased West Virginia production. Production. LOE decreased on an absolute and per Mcfe basis for 2019 compared to 2018 primarily as a result of the 2018 Divestitures, partly offset by higher salt water disposal costs. Excluding costs related to the 2018 Divestitures, LOE per Mcfe was $0.05 in 2018. Production taxes decreased on an absolute and per Mcfe basis for 2019 compared to 2018 due primarily to (i) lower Pennsylvania impact fees as a result of less wells spud and lower pricing, (ii) lower severance taxes as a result of decreased West Virginia production and lower pricing and (iii) lower property taxes as a result of the 2018 Divestitures. Selling, general and administrative. Selling, general and administrative expense decreased on an absolute and per Mcfe basis for 2019 compared to 2018 primarily as a result of lower personnel costs due to reductions in workforce, the $15 million charitable contribution made to the EQT Foundation in 2018 and decreased long-term incentive compensation due to changes in the fair value of awards, partly offset by increased litigation expenses. Long-term incentive compensation may fluctuate with changes in the Company's stock price and performance conditions. Depreciation and depletion. Production depletion decreased on an absolute and per Mcfe basis for 2019 compared to 2018 due primarily to a lower depletion rate, partly offset by higher sales volumes. Other depreciation and depletion decreased as a result of the 2018 Divestitures. Other Operating Expenses Impairment/ loss on sale/exchange of long-lived assets. During the fourth quarter of 2019 the Company recorded impairment of long-lived assets of $1,124.4 million, of which $1,035.7 million was associated with the Company's non-strategic assets located in Ohio Utica and $88.7 million was associated with the Company's Pennsylvania and West Virginia Utica assets. The impairment was due primarily to depressed natural gas prices and changes in the Company's development strategy, including the Company's contemplation of a potential asset divestiture of certain of its non-strategic exploration and production assets. During the third quarter of 2019, the Company recorded a loss on exchange of long-lived assets of $13.9 million related to the Asset Exchange Transaction (defined and discussed in Note 6 to the Consolidated Financial Statements). For 2018, the Company recorded impairment/ loss on sale of long-lived assets of $2.7 billion related to the 2018 Divestitures. See Note 1 to the Consolidated Financial Statements for a discussion of 2019 and 2018 impairment tests and Note 7 to the Consolidated Financial Statements for a discussion of the 2018 Divestitures. Amortization and impairment of intangible assets. During the third quarter of 2019, the Company recognized impairment of intangible assets associated with non-compete agreements for former Rice Energy Inc. executives who are now employees of the Company. The impairment resulted in decreased amortization in the second half of 2019. Impairment of goodwill. During the fourth quarter of 2018, the Company recognized impairment of goodwill because the Company's single reporting unit's fair value was below its carrying value. See Note 1 to the Consolidated Financial Statements for further discussion of the 2018 goodwill impairment test. Impairment and expiration of leases. Impairment and expiration of leases increased from $556.4 million for 2019 compared to $279.7 million for 2018 due primarily to impairment of leases located in non-strategic development areas that are not expected to be developed due to changes in the Company's development strategy, which includes a renewed focus on a refined core operating footprint. To a lesser extent, impairment increased due to lease expirations, a majority of which were related to leases acquired in 2017 and 2016. Proxy, transaction and reorganization. Proxy, transaction and reorganization expense increased for 2019 compared to 2018 due primarily to reductions in workforce and other strategic alignment initiatives, which resulted in severance and other termination benefits of $74.1 million and contract termination fees of $22.1 million, as well as proxy costs recognized in the first half of 2019 of $19.3 million. Prior period transaction costs were related to the Rice Merger (discussed in Note 8 to the Consolidated Financial Statements). Other Income Statement Items The Company's investment in Equitrans Midstream is recorded at fair value, which is calculated by multiplying the closing stock price of Equitrans Midstream's common stock by the number of shares of Equitrans Midstream's common stock owned by the Company. Changes in fair value are recorded in unrealized loss on investment in Equitrans Midstream Corporation in the Statements of Consolidated Operations. The Company's investment in Equitrans Midstream fluctuates with changes in Equitrans Midstream's stock price, which was $13.36 and $20.02 as of December 31, 2019 and 2018, respectively. Dividend and other income increased due to dividends received on the Company's investment in Equitrans Midstream during the year ended December 31, 2019. Interest expense decreased for 2019 compared to 2018 due to repayment of the $700 million aggregate principal amount of the Company's 8.125% senior notes that matured on June 1, 2019 and decreased borrowings under the Company's credit facility, partly offset by interest incurred on borrowings under the Term Loan Facility. See Note 9 to the Consolidated Financial Statements for a discussion of income tax benefit. Outlook See Item 1., "Business." Impairment of Oil and Gas Properties See "Critical Accounting Policies and Estimates" and Note 1 to the Consolidated Financial Statements for a discussion of the Company's accounting policies and significant assumptions related to impairment of the Company's oil and gas properties. See Item 1A., "Risk Factors - Natural gas, NGLs and oil price declines, and changes in our development strategy, have resulted in impairment of certain of our assets. Future declines in commodity prices, increases in operating costs or adverse changes in well performance or additional changes in our development strategy may result in additional write-downs of the carrying amounts of our assets, including long-lived intangible assets, which could materially and adversely affect our results of operations in future periods." Capital Resources and Liquidity The Statements of Consolidated Cash Flows for the years ended December 31, 2018 and 2017 have not been restated for discontinued operations; therefore, the following discussion of operating, investing and financing activities includes cash flows of both continuing and discontinued operations through the Separation and Distribution. See Note 2 to the Consolidated Financial Statements for amounts attributable to discontinued operations included in the Statements of Consolidated Cash Flows. Although the Company cannot provide any assurance, it believes cash flows from operating activities and availability under the revolving credit facility should be sufficient to meet the Company's cash requirements inclusive of, but not limited to, normal operating needs, debt service obligations, planned capital expenditures and commitments for at least the next twelve months. See Item 7., "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in the Company's Annual Report on Form 10-K for the year ended December 31, 2018, which is incorporated herein by reference, for discussion and analysis of operating, investing and financing activities for the year ended December 31, 2017. Operating Activities Net cash flows provided by operating activities were $1,852 million for 2019 compared to $2,976 million for 2018. The decrease was driven by cash provided by discontinued operations included in 2018 and lower cash operating revenues, partly offset by favorable timing of working capital payments and dividends received on the Company's investment in Equitrans Midstream. The Company's cash flows from operating activities will be affected by movements in the market price for commodities. The Company is unable to predict such movements outside of the current market view as reflected in forward strip pricing. Refer to Item 1A., "Risk Factors - Natural gas, NGLs and oil price volatility, or a prolonged period of low natural gas, NGLs and oil prices, may have an adverse effect upon our revenue, profitability, future rate of growth, liquidity and financial position." for further information. Investing Activities Net cash flows used in investing activities were $1,601 million for 2019 compared to $3,979 million for 2018. The decrease was due primarily to lower capital expenditures as a result of the Company's change in strategic focus from production growth to capital efficiency and cash used for capital expenditures and capital contributions by discontinued operations included in 2018, partly offset by proceeds received from asset sales in 2018. Capital Expenditures (a) Midstream infrastructure capital expenditures are presented as discontinued operations. See Note 2 to the Consolidated Financial Statements. (b) Represents the net impact of non-cash capital expenditures, including capitalized share-based compensation costs and the effect of timing of receivables from working interest partners and accrued capital expenditures. The impact of accrued capital expenditures includes the reversal of the prior period accrual as well as the current period estimate. The year ended December 31, 2018 included $14.4 million of measurement period adjustments for 2017 acquisitions. Financing Activities Net cash flows used in financing activities were $249 million for 2019 compared to net cash flows provided by financing activities of $859 million for 2018. For 2019, the primary uses of financing cash flows were net repayments of debt and credit facility borrowings, and the primary source of financing cash flows was net proceeds from borrowings on the Term Loan Facility. For 2018, the primary source of financing cash flows was net proceeds from a debt offering by EQM Midstream Partners, LP (EQM), the Company's former midstream affiliate, and the primary uses of financing cash flows were the repurchase and retirement of common stock, distributions to noncontrolling interests, net repayments of credit facility borrowings, EQM's acquisition of 25% ownership interest in Strike Force Midstream LLC, net cash transferred in connection with the Separation and Distribution, cash paid for dividends and taxes on share-based incentive awards. On February 4, 2020, the Company's Board of Directors declared a quarterly cash dividend of three cents per share, payable March 1, 2020 to the Company's shareholders of record at the close of business on February 14, 2020. On January 21, 2020, the Company issued $1.0 billion aggregate principal amount of 6.125% senior notes due February 1, 2025 and $750 million aggregate principal amount of 7.000% senior notes due February 1, 2030 (together, the Adjustable Rate Notes). The Company used the net proceeds from the Adjustable Rate Notes to repay $500 million aggregate principal amount of the Company's floating rate notes and $500 million aggregate principal amount of the Company's 2.50% senior notes and expects to use the remaining proceeds to repay or redeem other outstanding indebtedness, which may include all or a portion of the Company's outstanding 4.875% senior notes due November 15, 2021. The Adjustable Rate Notes have covenants that are consistent with the Company's existing senior unsecured notes, with an additional interest rate adjustment provision that provides for adjustments to its interest rates based on credit ratings assigned by Moody's, S&P and Fitch to the Adjustable Rate Notes. As a result of the S&P and Fitch downgrades of the Company's senior notes credit rating (discussed in section "Security Ratings and Financing Triggers"), the interest rate on the 6.125% senior notes increased to 6.875% and the interest rate on the 7.000% senior notes increased to 7.750%. On February 3, 2020, the Company's 2.50% senior notes and floating rate notes, each due October 1, 2020, were fully redeemed by the Company at a redemption price of 100.446% and 100%, respectively, plus accrued but unpaid interest of $4.2 million and $1.2 million, respectively. This resulted in the payment of make whole call premiums of $2.2 million related to the 2.50% senior notes. On February 12, 2020, the Company announced its commencement of a cash tender offer (the Tender Offer) for up to $400 million aggregate principal amount of its 4.875% senior notes due 2021 (the 4.875% Notes). Consideration paid in the Tender Offer for the 4.875% Notes that are validly tendered on or prior to March 2, 2020, and accepted for purchase by the Company, will be $1,020 per $1,000 principal amount, including an early tender premium of $30 per $1,000 principal amount. The settlement date for such notes is expected to be March 4, 2020. Consideration paid in the Tender Offer for the 4.875% Notes that are validly tendered after March 2, 2020 and on or prior to March 16, 2020, and accepted for purchase by the Company, will be $990 per $1,000 principal amount. The settlement date for such notes is expected to be March 18, 2020. Payments for the 4.875% Notes purchased will also include accrued and unpaid interest from, and including, the last interest payment date on the 4.875% Notes up to, but not including, the applicable settlement date for such 4.875% Notes accepted for purchase by the Company. The Company may from time to time seek to repurchase its outstanding debt securities. Such repurchases, if any, will depend on prevailing market conditions, the Company's liquidity requirements, contractual and legal restrictions and other factors. Additionally, the Company plans to dispose of its remaining retained shares of Equitrans Midstream's common stock and use the proceeds to reduce the Company's debt. Revolving Credit Facility The Company primarily uses borrowings under its revolving credit facility to fund working capital needs, timing differences between capital expenditures and other cash uses and cash flows from operating activities, margin deposits on derivative instruments and collateral requirements on midstream services contracts. See section "Security Ratings and Financing Triggers" for further discussion of margin deposits and collateral requirements on the Company's derivative instruments and midstream services contracts. See Note 10 to the Consolidated Financial Statements for further discussion of the Company's credit facility. Security Ratings and Financing Triggers The table below reflects the credit ratings and rating outlooks assigned to the Company's debt instruments at February 26, 2020. The Company's credit ratings and rating outlooks are subject to revision or withdrawal at any time by the assigning rating agency, and each rating should be evaluated independent from any other rating. The Company cannot ensure that a rating will remain in effect for any given period of time or that a rating will not be lowered or withdrawn by a rating agency if, in its judgment, circumstances so warrant. See Note 4 to the Consolidated Financial Statements for further discussion of what is deemed investment grade. As of December 31, 2019, the Company's senior notes were rated "Baa3" by Moody's, "BBB-" by S&P and "BBB-" by Fitch, each with a "Negative" outlook. In January 2020, Moody's downgraded the Company's senior notes credit rating to "Ba1," and, in February 2020, S&P and Fitch downgraded the Company's senior notes rating to "BB+" and "BB," respectively. The Company is not aware of any current plans of Moody's, S&P or Fitch to further downgrade its rating of the Company's senior notes. Further changes in credit ratings may affect the Company's access to the capital markets, the cost of short-term debt through interest rates and fees under the Company's lines of credit, the interest rate on the Company's Term Loan Facility and Adjustable Rate Notes, the rates available on new long-term debt, the Company's pool of investors and funding sources, the borrowing costs and margin deposit requirements on the Company's derivative instruments and credit assurance requirements, including collateral, in support of the Company's midstream service contracts, joint venture arrangements or construction contracts. Margin deposits on the Company's derivative instruments are also subject to factors other than credit rating, such as natural gas prices and credit thresholds set forth in the agreements between hedging counterparties and the Company. As of February 26, 2020, the Company had sufficient unused borrowing capacity under its credit facility, net of letters of credit, to satisfy any requests for margin deposit or other collateral that its counterparties would be permitted to request of the Company pursuant to the Company's derivative instruments and midstream services contracts in the event that Moody's and S&P downgrade the Company's credit rating two categories further. As of February 26, 2020, such margin deposit or other collateral amounts could be up to approximately $1.4 billion, inclusive of assurances posted of approximately $0.6 billion in the aggregate. See Notes 4 and 10 to the Consolidated Financial Statements for further information. The Company's debt agreements and other financial obligations contain various provisions that, if not complied with, could result in default or event of default under the Company's credit facility and Term Loan Facility, mandatory partial or full repayment of the amounts outstanding, reduced loan capacity or other similar actions. The most significant covenants and events of default under the debt agreements relate to maintenance of a debt-to-total capitalization ratio, limitations on transactions with affiliates, insolvency events, nonpayment of scheduled principal or interest payments, acceleration of other financial obligations and change of control provisions. The Company's credit facility and Term Loan Facility each contain financial covenants that require the Company to have a total debt-to-total capitalization ratio no greater than 65%. The calculation of this ratio excludes the effects of accumulated other comprehensive income. As of December 31, 2019, the Company was in compliance with all debt provisions and covenants. See Note 10 to the Consolidated Financial Statements for a discussion of the borrowings under the Company's credit facility and Term Loan Facility. Commodity Risk Management The substantial majority of the Company's commodity risk management program is related to hedging sales of the Company's produced natural gas. The Company's overall objective in its hedging program is to protect cash flows from undue exposure to the risk of changing commodity prices. The derivative commodity instruments currently used by the Company are primarily swap, collar and option agreements. During the third quarter of 2019, the Company terminated certain OTC hedge positions related to years 2021 and onward. The value associated with these terminated positions was rolled into new hedge positions with the same counterparties for 2020. No cash was exchanged related to these terminations or the associated execution of new hedge positions. The following table summarizes the approximate volumes and prices of the Company's NYMEX hedge positions through 2023 as of February 25, 2020. (a) Full year 2020. (b) The difference between the fixed price and NYMEX price is included in average differential presented in the Company's price reconciliation in the "Average Realized Price Reconciliation." The fixed price natural gas sales agreements can be physically or financially settled. For 2020, 2021, 2022, 2023 and 2024, the Company has natural gas sales agreements for approximately 13 MMDth, 18 MMDth, 18 MMDth, 79 MMDth and 11 MMDth, respectively, that include average NYMEX ceiling prices of $3.68, $3.17, $3.17, $2.84 and $3.21, respectively. The Company also has derivative instruments to hedge basis. The Company may use other contractual agreements to implement its commodity hedging strategy. See

<s>[INST] Consolidated Results of Operations Loss from continuing operations for 2019 was $1,222 million, $4.79 per diluted share, an improvement of $1,159 million compared to loss from continuing operations for 2018 of $2,381 million, $9.12 per diluted share. The variance was attributable primarily to lower impairments of longlived assets and goodwill and higher dividends received on the Company's investment in Equitrans Midstream, partly offset by lower income tax benefit and higher impairment and expiration of leases, unrealized loss on the Company's investment in Equitrans Midstream and operating revenues. See Item 7., "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in the Company's Annual Report on Form 10K for the year ended December 31, 2018, which is incorporated herein by reference, for discussion and analysis of consolidated results of operations for the year ended December 31, 2017. See "Sales Volumes and Revenues," "ProductionRelated Operating Expenses" and "Other Operating Expenses" for discussions of items affecting operating income and "Other Income Statement Items" for a discussion of other income statement items. See "Investing Activities" under "Capital Resources and Liquidity" for a discussion of capital expenditures. Average Realized Price Reconciliation The following table presents detailed natural gas and liquids operational information to assist in the understanding of the Company's consolidated operations, including the calculation of the Company's average realized price ($/Mcfe), which is based on adjusted operating revenues, a nonGAAP supplemental financial measure. Adjusted operating revenues is presented because it is an important measure used by the Company's management to evaluate periodtoperiod comparisons of earnings trends. Adjusted operating revenues should not be considered as an alternative to total operating revenues. See "Reconciliation of NonGAAP Financial Measures" for a reconciliation of adjusted operating revenues with total operating revenues, the most directly comparable financial measure calculated in accordance with GAAP. (a) The Company's volume weighted NYMEX natural gas price (actual average NYMEX natural gas price ($/MMBtu)) was $2.63 and $3.09 for the years ended December 31, 2019 and 2018, respectively. (b) Basis represents the difference between the ultimate sales price for natural gas and the NYMEX natural gas price. (c) NGLs, ethane and oil were converted to Mcfe at a rate of six Mcfe per barrel. (d) Total natural gas and liquids sales, including cash settled derivatives, is also referred to in this report as adjusted operating revenues, a nonGAAP supplemental financial measure. NonGAAP Financial Measures Reconciliation The table below reconciles adjusted operating revenues, a nonGAAP supplemental financial measure, with total operating revenues, its most directly comparable financial measure calculated in accordance with GAAP. Adjusted operating revenues (also referred to as total natural gas and liquids sales, including cash settled derivatives) is presented because it is an important measure used by the Company's management to evaluate periodtoperiod comparisons of earnings trends. Adjusted operating revenues as presented excludes the revenue impact of changes in the fair value of derivative instruments prior to settlement and the revenue impact of net marketing services and other. Management uses adjusted operating revenues to evaluate earnings trends because the measure reflects only the impact of settled derivative contracts and, thus, excludes the impact of the oftenvolatile fluctuations in the fair value of derivatives prior to settlement. Adjusted operating revenues also excludes net marketing services and other because management considers these revenues to be unrelated to revenues from its natural gas and liquids production. Net marketing services and other primarily includes the cost of, and recoveries on, pipeline capacity releases and revenues for gathering services. Management further believes that adjusted operating revenues as presented provides useful information to investors for evaluating periodtoperiod earnings trends. Sales Volumes and Revenues (a) Includes Upper Dev [/INST] Positive. </s>

FULLER H B CO

2015-01-28

2014-11-29

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. We manage our business through four operating segments - Americas Adhesives, EIMEA (Europe, India, Middle East and Africa), Asia Pacific and Construction Products. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, flooring, textile, flexible packaging, graphic arts, envelope, automotive and electronics markets. The Construction Products operating segment provides floor preparation, grouts and mortars for tile setting as well as sealants and related products for heating, ventilation and air conditioning installations. We acquired the global industrial adhesives and synthetic polymers business of Forbo Holding AG on March 5, 2012. The Forbo industrial adhesives business acquired is referred to as the “acquired business” in the Management’s Discussion and Analysis. See Item 1. Business and Note 2 to the Consolidated Financial Statements. The integration of the acquired business involved a significant amount of restructuring and capital investment to optimize the new combined entity. In addition to this acquisition, we announced our intentions to take a series of actions in our existing EIMEA operating segment to improve the profitability and future growth prospects of this operating segment. We combined these two initiatives into a single project which we refer to as the “Business Integration Project”. We divested our Latin America Paints business on August 6, 2012. In accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification ASC 205-20, “Discontinued Operations” we have classified the results of this business as discontinued operations. See Item 1. Business and Note 2 to the Consolidated Financial Statements. Total Company: When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: • Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas • Global supply of and demand for raw materials • Economic growth rates, and • Currency exchange rates compared to the U.S. dollar We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impact the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in high-growth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With over 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. In 2014, we generated 42 percent of our net revenue in the United States and 34 percent in EIMEA. The pace of economic growth in these areas directly impacts certain industries to which we supply products. For example, adhesives-related revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as Construction Products and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other construction-related activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies strengthen against the dollar, our revenues and costs increase as the foreign currency-denominated financial statements translate into more dollars. The fluctuations of the Euro against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2014, the currency fluctuations had a negative impact on net revenue of $6.8 million as compared to 2013. Key financial results and transactions for 2014 included the following: • Net revenue increased 2.8 percent from 2013 primarily driven by a 3.5 percent increase in sales volume. • Gross profit margin decreased to 25.3 percent from 27.9 percent in 2013 and 27.4 percent in 2012. • Cash flow generated by operating activities from continuing operations was $29.7 million in 2014 as compared to $132.7 million in 2013 and $108.6 million in 2012. • We acquired ProSpec construction products business on September 3, 2014 for $26.2 million. The global economic conditions were mixed in 2014. Demand in North America saw the growth momentum built in the second half of 2013 weaken notably in the first quarter of 2014. However market conditions improved the rest of the year. The recovery in Europe remains weak though conditions stabilized during the year. We experienced continued growth in our Asian markets, particularly in China. Our total year organic sales growth, which we define as the combined variances from product pricing, sales volume and small acquisitions, was 3.1 percent for 2014 compared to 2013. In 2014 our diluted earnings per share from continuing operations was $0.97 per share compared to $1.87 per share in 2013 and $1.34 per share in 2012. The lower earnings per share from continuing operations in 2014 resulted from production inefficiencies related to the Business Integration Project, ERP system implementation costs in North America and higher special charges, net costs for the Business Integration Project. Special charges, net in 2014 were $51.5 million for costs related to the Business Integration Project. On an after-tax basis, the special charges, net resulted in a $45.2 million negative impact on net income and a negative $0.88 effect on diluted earnings per share. Special charges, net in 2013 were $45.1 million for costs related to the Business Integration Project. On an after-tax basis, the special charges, net resulted in a $35.3 million negative impact on net income and a negative $0.69 effect on diluted earnings per share. In 2012 we had special charges, net of $52.5 million for costs related to the Business Integration Project. On an after-tax basis, the special charges, net resulted in a $35.4 million negative impact on net income and a negative $0.70 effect on diluted earnings per share. See Note 5 to the Consolidated Financial Statements for more information. Project ONE: In December of 2012 our Board of Directors approved a multi-year project to replace and enhance our existing core information technology platforms. The scope for this project includes most of the basic transaction processing for the company including customer orders, procurement, manufacturing, and financial reporting. The project envisions harmonized business processes for all of our operating segments supported with one standard software configuration. The execution of this project, which we refer to as Project ONE, is being supported by internal resources and consulting services. During 2013 a project team was formed and the global blueprint for the software configuration was designed and built. In the latter half of 2013 and in the early months of 2014 the global blueprint was applied to the specific requirements of our North America adhesives business, the software was tested and the user groups were trained. On April 6, 2014 our North America adhesives business went live. The implementation process proved to be more difficult than we originally anticipated resulting in disruptions in our manufacturing network, lower productivity and deteriorated customer service levels. By the end of 2014 most of the problems associated with the software implementation had been remediated and the business was stable and running at capacity with productivity levels approaching the levels experienced prior to the new software implementation. In late 2014 we suspended any further implementation projects in other geographic regions until we complete the optimization of the current platform in North America. We are preparing a revised implementation plan that leverages the experiences of our first go-live event and reduces the risk of significant business interruption. We expect to start subsequent implementations in 2016. The original capital expenditure plan for Project ONE was approximately $60.0 million, of which $43.3 million was spent through November 29, 2014. Given the complexity of the initial implementation we anticipate that the total investment to complete the project will exceed our original estimate. We will have a revised estimate of the total project costs and the expected completion timetable later in 2015 when the revised implementation plan is complete. 2015 Outlook: Our key long term financial objectives remain unchanged: achieve organic revenue growth between 5 and 8 percent per year, increase our Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) margin to 15 percent, grow earnings per share by 15 percent per year and increase Return on Invested Capital (ROIC) to 15 percent. EBITDA is a non-GAAP financial measure defined on a consolidated basis as gross profit, less SG&A expense, plus depreciation expense, plus amortization expense. EBITDA excludes special charges, net. EBITDA margin is a non-GAAP financial measure defined as EBITDA divided by net revenue. ROIC is a non-GAAP financial measure defined as (gross profit less SG&A expense, less taxes at the effective tax rate plus income from equity method investments, calculated using trailing 12 month information) divided by (the sum of notes payable, current maturities of long-term debt, long-term debt, redeemable non-controlling interest and total equity). Our five-year plan introduced in the summer of 2011 (for fiscal years 2011 through 2015) anticipated that these financial targets could be achieved in 2015. Because we experienced some operational difficulties in 2014 we now expect that these long term goals will be achieved in 2016 at the earliest. In 2015 we expect organic revenue growth at the low end of our long-term growth targets of 5 to 8 percent. We expect our momentum in the Asia Pacific and Construction Products operating segments to again lead our growth in the coming year. We anticipate modest revenue growth in the Americas Adhesives and EIMEA operating segments, with EIMEA’s revenue performance expected to improve in the second half of 2015 following the completion of our Business Integration Project. We expect that the strengthening of the US dollar relative to the Euro will dampen our revenue growth rate in 2015 relative to 2014 by 3 percentage points or more. We expect our cost of raw materials to remain relatively flat compared to the prior year, with the potential for some improvement in input costs during the fiscal year as the benefit of lower crude oil prices are realized. Our gross profit margin is expected to increase in 2015, primarily driven by eliminating costs and inefficiencies related to the completion of the Business Integration Project in EIMEA and the absence of the incremental costs experienced in our North America adhesive business in 2014 related to the implementation of Project ONE. SG&A expenses should increase at a lower rate than the increase in net revenue. Overall, we expect our EBITDA margin to be approximately 13 percent for the full year. Our total capital expenditures will be reduced significantly in 2015 relative to 2014 reflecting the conclusion of the large investment phase of the Business Integration Project in EIMEA and the suspension of Project ONE. We expect total 2015 capital expenditures to be approximately $70.0 million. We expect that our 2016 capital expenditures will move toward normal levels, or about 2.5 percent of net revenue. Critical Accounting Policies and Significant Estimates: Management’s discussion and analysis of our results of operations and financial condition are based upon Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We believe the critical accounting policies and areas that require the most significant judgments and estimates to be used in the preparation of the Consolidated Financial Statements are pension and other postretirement plan assumptions; goodwill impairment assessment; long-lived assets recoverability; product, environmental and other litigation liabilities; and income tax accounting. Pension and Other Postretirement Plan Assumptions: We sponsor defined-benefit pension plans in both the U.S. and non-U.S. entities. Also in the U.S. we sponsor other postretirement plans for health care and life insurance benefits. Expenses and liabilities for the pension plans and other postretirement plans are actuarially calculated. These calculations are based on our assumptions related to the discount rate, expected return on assets, projected salary increases and health care cost trend rates. Note 10 to the Consolidated Financial Statements includes disclosure of assumptions employed in these measurements for both the non-U.S. and U.S. plans. The discount rate assumption is determined using an actuarial yield curve approach, which results in a discount rate that reflects the characteristics of the plan. The approach identifies a broad population of corporate bonds that meet the quality and size criteria for the particular plan. We use this approach rather than a specific index that has a certain set of bonds that may or may not be representative of the characteristics of our particular plan. A higher discount rate reduces the present value of the pension obligations. The discount rate for the U.S. pension plan was 4.10 percent at November 29, 2014, as compared to 4.77 percent at November 30, 2013 and 3.83 percent at December 1, 2012. Net periodic pension cost for a given fiscal year is based on assumptions developed at the end of the previous fiscal year. A discount rate reduction of 0.5 percentage points at November 29, 2014 would increase U.S. pension and other postretirement plan expense approximately $0.4 million (pre-tax) in fiscal 2015. Discount rates for non-U.S. plans are determined in a manner consistent with the U.S. plan. The expected long-term rate of return on plan assets assumption for the U.S. pension plan was 7.75 percent in 2014 compared to 7.75 percent for 2013 and 8.00 percent for 2012. Our expected long-term rate of return on U.S. plan assets was based on our target asset allocation assumption of 60 percent equities and 40 percent fixed-income. Management, in conjunction with our external financial advisors, determines the expected long-term rate of return on plan assets by considering the expected future returns and volatility levels for each asset class that are based on historical returns and forward looking observations. For 2014 the expected long-term rate of return on the target equities allocation was 8.5 percent and the expected long-term rate of return on the target fixed-income allocation was 5.0 percent. The total plan rate of return assumption included an estimate of the impact of diversification and the plan expense. For 2015, the expected long-term rate of return on assets will continue to be 7.75 percent with an expected long-term rate of return on the target equities allocation of 8.5 percent and an expected long-term rate of return on target fixed-income allocation of 5.0 percent. A change of 0.5 percentage points for the expected return on assets assumption would impact U.S. net pension and other postretirement plan expense by approximately $2.2 million (pre-tax). Management, in conjunction with our external financial advisors, uses the actual historical rates of return of the asset categories to assess the reasonableness of the expected long-term rate of return on plan assets. The most recent 10-year and 20-year historical equity returns are shown in the table below. Our expected rate of return on our total portfolio is consistent with the historical patterns observed over longer time frames. (*) Beginning in 2006, our target allocation migrated from 100 percent equities to our current allocation of 60 percent equities and 40 percent fixed-income. The historical actual rate of return for the fixed income of 9.2 percent is since inception (9 years). The expected long-term rate of return on plan assets assumption for non-U.S. pension plans was a weighted-average of 6.17 percent in 2014. The expected long-term rate of return on plan assets assumption used in each non-U.S. plan is determined on a plan-by-plan basis for each local jurisdiction and is based on expected future returns for the investment mix of assets currently in the portfolio for that plan. Management, in conjunction with our external financial advisors, develops expected rates of return for each plan, considers expected long-term returns for each asset category in the plan, reviews expectations for inflation for each local jurisdiction, and estimates the impact of active management of the plan’s assets. Our largest non-U.S. pension plans are in the United Kingdom and Germany. The expected long-term rate of return on plan assets for Germany was 5.75 percent and the historical rate of return since inception (17 years) for the total asset portfolio in Germany was 4.4 percent. The expected rate of return on our German portfolio of 5.75 percent assumes that market returns will improve in the future to be more in line with historical market patterns observed over longer time frames. In addition, we have modified our investment strategy for the German plan to include a more diversified pool of equity and fixed-income investments and, therefore, we currently expect the performance of the plan assets to improve going forward. The expected long-term rate of return on plan assets for the United Kingdom was 6.69 percent and the historical rate of return since inception (18 years) for the total asset portfolio in the United Kingdom was 7.1 percent. Management, in conjunction with our external financial advisors, uses actual historical returns of the asset portfolio to assess the reasonableness of the expected rate of return for each plan. Since both of these non-U.S. plans have been in existence for less than 20-years, the historical rate of return for each plan has been affected by a period of very poor market conditions by any longer term standards. The projected salary increase assumption is based on historic trends and comparisons to the external market. Higher rates of increase result in higher pension expenses. As this rate is also a long-term expected rate, it is less likely to change on an annual basis. In the U.S., we have used the rate of 4.50 percent for 2014, 4.50 percent for 2013 and 5.00 percent for 2012. Goodwill: Goodwill is the excess of cost of an acquired entity over the amounts assigned to assets acquired and liabilities assumed in a purchase business combination. Goodwill is assigned to reporting units at the date the goodwill is initially recorded. Once goodwill has been assigned to a reporting unit, it no longer retains its association with a particular acquisition, and all the activities within a reporting unit are available to support the value of goodwill. Accounting standards require us to test goodwill for impairment annually or more often if circumstances or events indicate a change in the estimated fair value may have occurred. The goodwill impairment analysis is a two-step process. The first step used to identify potential impairment involves comparing each reporting unit’s estimated fair value to its carrying value, including goodwill. We use a discounted cash flow approach to estimate the fair value of our reporting units. Our judgment is required in developing the assumptions for the discounted cash flow model. These assumptions include revenue growth rates, profit margin percentages, discount rates, perpetuity growth rates, future capital expenditures and working capital requirements. If the estimated fair value of a reporting unit exceeds its carrying value, goodwill is considered to not be impaired. If the carrying value exceeds estimated fair value, there is an indication of potential impairment and the second step is performed to measure the amount of impairment. The second step of the process involves the calculation of an implied fair value of goodwill for each reporting unit for which step one indicated impairment. The implied fair value of goodwill is determined in a manner similar to how goodwill is calculated in a business combination, by measuring the excess of the estimated fair value of the reporting unit as calculated in step one, over the estimated fair values of the individual assets, liabilities and identifiable intangibles as if the reporting unit was being acquired in a business combination. If the implied fair value of goodwill exceeds the carrying value of goodwill assigned to the reporting unit, there is no impairment. If the carrying value of goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss cannot exceed the carrying value of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted. In the fourth quarter of 2014, we conducted the required annual test of goodwill for impairment. We performed the goodwill impairment analysis on our reporting units by using a discount rate determined by management to result in the most representative fair value of the business as a whole. There were no indications of impairment in any of our reporting units. We also performed a sensitivity analysis by using a discount rate at the high end of our range to confirm the reasonableness of our goodwill impairment analysis. No indications of impairment in any of our reporting units were indicated by the sensitivity analysis. Of the goodwill balance of $256.0 million as of November 29, 2014, $71.3 million is allocated to the Americas Adhesives reporting unit and $20.8 million is allocated to the Construction Products reporting unit. In both of these reporting units, the calculated fair value substantially exceeded the carrying value of the net assets. The EIMEA reporting unit had a goodwill balance of $139.7 million as of November 29, 2014. The calculated fair value of this reporting unit exceeded its carrying value by approximately 74 percent. The goodwill balance in the Asia Pacific reporting unit is $24.2 million as of November 29, 2014. The calculated fair value exceeded its carrying value by approximately 59 percent. In both of these reporting units, the calculated fair value exceeded the carrying value by a reasonable margin. In 2014 our EIMEA reporting unit net revenue declined 1.8 percent over 2013, mainly due to reduced sales volume. Projected cash flows used in the fair value calculation in the fourth quarter of 2014 were based on no net revenue growth in 2015 and then growth in the years beyond 2015 in the low-single digits for the remaining years. Operating earnings for the EIMEA reporting unit are projected to grow primarily due to revenue growing at a higher rate than manufacturing and SG&A expenses. The Asia Pacific reporting unit had net revenue growth of 9.2 percent in 2014 compared to 2013. Projected cash flows used in the fair value calculation in the fourth quarter of 2014 were based on continued growth in 2015 of 11.0 percent. For years beyond 2015, net revenue projections assume continued growth in the high-single digits through 2019 with a leveling off in the mid-single digits. Operating earnings for the Asia Pacific reporting unit are projected to grow primarily due to revenue growing at a higher rate than SG&A expenses. If the economy or business environment falter and we are unable to achieve our assumed revenue growth rates or profit margin percentages, our projections used would need to be remeasured, which could impact the carrying value of our goodwill in one or more of our reporting units. See Note 6 to the Consolidated Financial Statements. Recoverability of Long-Lived Assets: The assessment of the recoverability of long-lived assets reflects our assumptions and estimates. Factors that we must estimate when performing impairment tests include sales volume, prices, inflation, currency exchange rates, tax rates and capital spending. Significant judgment is involved in estimating these factors, and they include inherent uncertainties. The measurement of the recoverability of these assets is dependent upon the accuracy of the assumptions used in making these estimates and how the estimates compare to the eventual future operating performance of the specific businesses to which the assets are attributed. Judgments made by us include the expected useful lives of long-lived assets. The ability to realize undiscounted cash flows in excess of the carrying amounts of such assets is affected by factors such as the ongoing maintenance and improvement of the assets, changes in economic conditions and changes in operating performance. Product, Environmental and Other Litigation Liabilities: As disclosed in Item 3. and in Note 1 and Note 12 to the Consolidated Financial Statements, we are subject to various claims, lawsuits and other legal proceedings. Reserves for loss contingencies associated with these matters are established when it is determined that a liability is probable and the amount can be reasonably estimated. The assessment of the probable liabilities is based on the facts and circumstances known at the time that the financial statements are being prepared. For cases in which it is determined that a liability is probable but only a range for the potential loss exists, the minimum amount of the range is recorded and subsequently adjusted as better information becomes available. For cases in which insurance coverage is available, the gross amount of the estimated liabilities is accrued, and a receivable is recorded for any probable estimated insurance recoveries. A discussion of environmental, product and other litigation liabilities is disclosed in Item 3. and Note 12 to the Consolidated Financial Statements. Based upon currently available facts, we do not believe that the ultimate resolution of any pending legal proceeding, individually or in the aggregate, will have a material adverse effect on our long-term financial condition. However, adverse developments and/or periodic settlements could negatively affect our results of operations or cash flows in one or more future quarters. Income Tax Accounting: As part of the process of preparing the Consolidated Financial Statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. The process involves estimating actual current tax expense along with assessing temporary differences resulting from differing treatment of items for book and tax purposes. These temporary differences result in deferred tax assets and liabilities, which are included in the Consolidated Balance Sheets. We record a valuation allowance to reduce our deferred tax assets to the amount that is more-likely-than-not to be realized. We have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance. Increases in the valuation allowance result in additional expense to be reflected within the tax provision in the Consolidated Statements of Income. As of November 29, 2014, the valuation allowance to reduce deferred tax assets totaled $16.4 million. We recognize tax benefits for tax positions for which it is more-likely-than-not that the tax position will be sustained by the applicable tax authority at the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement. We do not recognize a financial statement benefit for a tax position that does not meet the more-likely-than-not threshold. We believe that our liabilities for income taxes reflect the most likely outcome. It is difficult to predict the final outcome or the timing of the resolution of any particular tax position. Future changes in judgment related to the resolution of tax positions will impact earnings in the quarter of such change. We adjust our income tax liabilities related to tax positions in light of changing facts and circumstances. Settlement with respect to a tax position would usually require cash. Based upon our analysis of tax positions taken on prior year returns and expected tax positions to be taken for the current year tax returns, we have identified gross uncertain tax positions of $4.8 million as of November 29, 2014. We have not recorded U.S. deferred income taxes for certain of our non-U.S. subsidiaries undistributed earnings as such amounts are intended to be indefinitely reinvested outside of the U.S. Should we change our business strategies related to these non-U.S. subsidiaries, additional U.S. tax liabilities could be incurred. It is not practical to estimate the amount of these additional tax liabilities. See Note 8 to the Consolidated Financial Statements for further information on income tax accounting. Results of Operations Net revenue Net revenue in 2014 increased 2.8 percent from 2013. The 2013 net revenue was 8.5 percent higher than the net revenue in 2012. We review variances in net revenue in terms of changes related to product pricing, sales volume, changes in foreign currency exchange rates and major acquisitions. The pricing/sales volume variance and small acquisitions including ProSpec construction products, which was acquired in the fourth quarter of 2014, are viewed as organic growth. The following table shows the net revenue variance analysis for the past two years: Organic sales growth was 3.1 percent in 2014 compared to 2013. The 3.1 percent organic sales growth in 2014 was led by 18.7 percent growth in Construction Products, 11.2 percent growth in Asia Pacific and 2.4 percent growth in Americas Adhesives. The majority of the negative currency impact was driven by the weakening of the Australian dollar and the Canadian dollar against the U.S. dollar. Organic sales growth was 1.6 percent in 2013 compared to 2012. The 1.6 percent organic sales growth in 2013 was led by 7.8 percent growth in Construction Products, 6.5 percent growth in Asia Pacific and 1.6 percent growth in Americas Adhesives. The majority of the positive currency impact was driven by the strengthening of the Euro against the U.S. dollar. The acquired business added $121.8 million to net revenue in 2013 compared to 2012. Cost of sales Raw material costs as a percentage of net revenue increased 100 basis points in 2014 relative to 2013, reflecting increases in raw materials costs as well as changes in product pricing and sales mix. Other manufacturing costs as a percentage of revenue increased 160 basis points compared to last year mainly driven by cost associated with the implementation of our new ERP system as well as business integration costs that are not classified as special charges. As a result, cost of sales as a percentage of net revenue increased 260 basis points. The 7.9 percent increase in cost of sales for 2013 compared to 2012 was driven by the inclusion of the acquired business for the full year of 2013, offset by the recognition of the non-cash charge for the sale of inventories revalued at the date of the acquisition, which increased cost of sales by 20 basis points in 2012. Cost of sales as a percentage of net revenue decreased 50 basis points primarily driven by synergies from integrating the acquired business and benefits realized from the Business Integration Project. Raw material costs as a percentage of net revenue decreased 80 basis points relative to the prior year, reflecting material cost synergies and other profit improvement initiatives undertaken over the year. Other manufacturing costs as a percentage of revenue increased by 30 basis points compared to last year. Gross profit Gross profit in 2014 decreased $36.9 million compared to 2013 and gross profit margin declined 260 basis points. The increases in raw materials in addition to the cost associated with the implementation of our new ERP system as well as business integration costs that are not classified as special charges were the main factors to the gross profit reduction. Gross profit in 2013 increased $52.9 million compared to 2012 and gross profit margin improved 50 basis points. The synergies from integrating the acquired business and the recognition of the non-cash charge for the sale of inventories revalued at the date of the acquisition, which reduced gross profit margin 20 basis points in 2012, were the primary reasons for the margin improvement. Selling, general and administrative (SG&A) expenses SG&A expenses for 2014 increased $8.7 million or 2.3 percent compared to 2013. As a percentage of net revenue, SG&A expenses decreased 10 basis points due to ongoing cost control efforts offsetting higher spending for Project ONE. SG&A expenses for 2013 increased $20.0 million or 5.6 percent compared to 2012. The 50 basis point decrease in SG&A expense as a percentage of net revenue was driven by effective cost controls and the ongoing benefits of the Business Integration Project. We make SG&A expense plans at the beginning of each fiscal year and barring significant changes in business conditions or our outlook for the future, we maintain these spending plans for the entire year. Management routinely monitors our SG&A spending relative to these fiscal year plans for each operating segment and for the company overall. We feel it is important to maintain a consistent spending program in this area as many of the activities within the SG&A category such as the sales force, technology development, and customer service are critical elements of our business strategy. Special Charges, net The following table provides detail of special charges, net: The integration of the industrial adhesives business we acquired in March 2012 involves a significant amount of restructuring and capital investment to optimize the new combined entity. In addition to this acquisition, we announced our intentions to take a series of actions in our existing EIMEA operating segment to improve the profitability and future growth prospects of this operating segment. We combined these two initiatives into a single project which we refer to as the “Business Integration Project”. During the years ended November 29, 2014, November 30, 2013 and December 1, 2012, we incurred special charges, net of $51.5 million, $45.1 million and $52.5 million respectively, for costs related to the Business Integration Project. Acquisition and transformation related costs of $7.9 million for the year ended November 29, 2014 and $8.7 million for the year ended November 30, 2013 include costs related to organization consulting, financial advisory and legal services necessary to integrate the acquired business into our existing operating segments. For the year ended December 1, 2012 acquisition and transformation related costs of $18.2 million include $24.7 million of costs related to organization consulting, investment advisory, financial advisory, legal and valuation services necessary to acquire and integrate the acquired business and other costs related to the acquisition including an expense of $4.3 million to make a bridge loan available if needed and an expense of $0.8 million related to the purchase of a foreign currency option to hedge a portion of the acquisition purchase price. These costs were partially offset by a net gain of $11.6 million on forward currency contracts used to economically hedge the purchase price of the pending acquisition after the price was established. During the year ended November 29, 2014, we incurred workforce reduction costs of $3.2 million, cash facility exit costs of $25.2 million, non-cash facility exit costs of $6.9 million and other incremental transformation related costs of $8.3 million including the cost of personnel directly working on the integration. During the year ended November 30, 2013, we incurred workforce reduction costs of $9.8 million, cash facility exit costs of $11.8 million, non-cash facility exit costs of $6.1 million and other incremental transformation related costs of $8.7 million including the cost of personnel directly working on the integration. During the year ended December 1, 2012, we incurred workforce reduction costs of $28.1 million, cash facility exit costs of $1.0 million, non-cash facility exit costs of $3.2 million and other incremental transformation related costs of $2.0 million including the cost of personnel directly working on the integration. We present operating segment information consistent with how we organize our business internally, assess performance and make decisions regarding the allocation of resources. Segment operating income is defined as gross profit less selling, general and administrative expenses. Because this definition excludes special charges, we have not allocated special charges to the operating segments or included them in Management’s Discussion & Analysis of operating segment results. For informational purposes only, the following table provides the special charges, net attributable to each operating segment for the periods presented: The benefits of the Business Integration Project are expected to be substantial. We have plans to create annual cash cost savings and other cash pretax profit improvement benefits aggregating to $90.0 million when the various integration activities are complete. The Business Integration Project activities were expected to improve the EBITDA margin of the global business from just under 11 percent in 2011 to a target level of 15 percent by 2015. The achievement of the cost savings will be delayed due to project delays and higher than expected implementation costs. We now believe that the 15 percent EBITDA margin goal will be achieved in 2016 or shortly thereafter. We estimated the total costs of the Business Integration Project to be approximately $125.0 million. Primarily due to delays in completing the EIMEA portion of the project, we expect total project costs will exceed this estimate by approximately 30 percent. The following table provides detail of costs incurred inception-to-date as of November 29, 2014 for the Business Integration Project: The costs associated with the acquisition integration and the cash costs of the restructuring are incremental cash outlays that were funded with existing cash and cash generated from operations. Non-cash costs are primarily related to accelerated depreciation of long-lived assets. From the inception of the project we have focused on three key metrics which track the bulk of the Business Integration Project cost savings and profit improvement objectives: (1) cost savings achieved through workforce reductions, (2) cost reductions achieved through facility closures and consolidation and (3) the EBITDA margin of the business relative to our expected trend over the timeframe of the project. Since the project commenced over three years ago many changes have occurred in the project and within the underlying business. These changes make it difficult to accurately measure the cost savings according to the original metrics that we established. Therefore, going forward we will focus on the EBITDA margin goal of 15 percent as the performance metric for this project. For the year ended November 29, 2014, November 30, 2013 and December 1, 2012, we achieved EBITDA margin of 10.2 percent, 12.4 percent and 11.5 percent, respectively. Asset impairment charges In 2012, we recorded pre-tax asset impairment charges of $1.5 million to write down the value of two of our cost basis investments to fair value. Other income (expense), net Interest income was $0.4 million in 2014 compared to $0.7 million in 2013 and $1.7 million in 2012. The lower interest income in 2014 compared to 2013 was due to lower average cash balances held globally. The lower interest income in 2013 compared to 2012 was due to lower interest rates in EIMEA and a change in mix from cash held in countries with higher interest rates to countries with lower interest rates. Currency transaction and remeasurement losses were $2.5 million, $4.1 million and $1.2 million in 2014, 2013 and 2012, respectively. Gains on disposal of fixed assets were $2.8 million, $0.3 million and $0.6 million in 2014, 2013 and 2012, respectively. Interest expense Interest expense was $19.7 million in 2014 compared to $19.1 million in 2013 and $19.8 million in 2012. The higher interest expense in 2014 compared to 2013 was due to higher average debt balances, partially offset by higher capitalized interest on capital projects. The lower interest expense in 2013 compared to 2012 was due to higher capitalized interest on capital projects, partially offset by higher average debt balances. We capitalized interest of $2.7 million, $1.9 million and $0.2 million in 2014, 2013 and 2012, respectively. Income taxes Income tax expense in 2014 of $34.3 million includes $1.4 million of discrete tax benefits in both the U.S. and foreign jurisdictions. Income tax expense in 2013 of $39.9 million included $2.4 million of discrete tax benefits in both the U.S. and foreign jurisdictions. Excluding discrete items, the overall effective tax rate increased by 11.9 percentage points in 2014 as compared to 2013. The increase in the tax rate is principally due to a change in the geographic mix of pre-tax earnings and reduced tax benefit for special charges, net. Income tax expense in 2013 of $39.9 million includes $2.4 million of discrete tax benefits in both the U.S. and foreign jurisdictions. Income tax expense in 2012 of $30.5 million included $2.0 million of discrete tax expense in both the U.S. and foreign jurisdictions. Excluding discrete items, the overall effective tax rate increased by 3.5 percentage points in 2013 as compared to 2012. The increase in the tax rate is principally due to a change in the geographic mix of pre-tax earnings and reduced tax benefit for special charges, net. Income from equity method investments The income from equity method investments relates to our 50 percent ownership of the Sekisui-Fuller joint venture in Japan. Sekisui-Fuller’s net income measured in Japanese yen was higher in 2014 compared to 2013 and 2012, but the weakening of the yen in 2014 caused the net income in U.S. dollars to be lower. The results reflect the lower net income recorded in U.S. dollars in 2014 compared to 2013 and 2012. Income from equity method investments was negatively impacted in 2014 by a correction of an error in the carrying value of our investment in Sekisui-Fuller in the amount of $1.6 million. See Note 16 to the Consolidated Financial Statements for further information. Income from discontinued operations, net of tax The income from discontinued operations, net of tax, relates to the results of operations and the gain on the sale of the Central America Paints business, which we sold August 6, 2012. In 2013, in conjunction with filing the fiscal year 2012 tax return, we recorded a reduction in the income tax expense of $1.2 million related to the sale of the Central America Paints business. The $57.6 million in 2012 includes the after-tax gain on the sale of our Central America Paints business of $51.1 million. Net income attributable to non-controlling interests The net income attributable to non-controlling interests relates to the redeemable non-controlling interest in HBF Kimya. Net income attributable to H.B. Fuller Net income attributable to H.B. Fuller was $49.8 million in 2014 compared to $96.8 million in 2013 and $125.6 million in 2012. Fiscal year 2014 included $51.5 million of special charges, net ($45.2 million after-tax and a negative $0.88 effect on diluted earnings per share) for costs related to the Business Integration Project compared to $45.1 million ($35.3 million after-tax) in 2013 and $52.5 million ($35.4 million after-tax) in 2012. 2012 included $57.6 million of income from discontinued operations, net of tax, inclusive of an after-tax gain on the sale of discontinued operations of $51.1 million. Diluted earnings per share, from continuing operations, was $0.97 per share in 2014, $1.87 per share for 2013 and $1.34 per share for 2012. Operating Segment Results We are required to report segment information in the same way that we internally organize our business for assessing performance and making decisions regarding allocation of resources. For segment evaluation by the chief operating decision maker, segment operating income is defined as gross profit less SG&A expenses. Segment operating income excludes special charges, net and asset impairment charges. Inter-segment revenues are recorded at cost plus a markup for administrative costs. Corporate expenses are fully allocated to each operating segment. Our operations are managed through four reportable segments: Americas Adhesives, EIMEA, Asia Pacific and Construction Products. The tables below provide certain information regarding the net revenue and segment operating income of each of our operating segments. Net Revenue by Segment Segment Operating Income The following table provides a reconciliation of segment operating income to income from continuing operations before income taxes and income from equity method investments, as reported on the Consolidated Statements of Income. Americas Adhesives The following tables provide details of Americas Adhesives net revenue variances: Net revenue increased 2.0 percent in 2014 compared to 2013. The 2.4 percent increase in organic sales growth was attributable to a 3.3 percent increase in sales volume offset by a 0.9 percent decrease in pricing. The sales volume increase was driven by volume growth in several market segments and generally in line with end market conditions. Raw material cost as a percentage of net revenue increased 100 basis points as a result of increases in raw materials combined with price reductions. Manufacturing costs as a percentage of net revenue increased 150 basis points compared to 2013. The main driver for this increase is cost associated with the implementation of our new ERP system. Operating expenses as a percentage of net revenue were flat. As a result, segment operating income decreased 16.2 percent compared to 2013 and segment profit margin decreased 250 basis points. Net revenue increased 7.6 percent in 2013 compared to 2012. The 1.6 percent increase in organic sales growth was attributable to a 1.9 percent increase in volume offset by a 0.3 percent decrease in pricing. The acquired business added $51.7 million to net revenue. The sales volume increase was driven by changes in product mix as sales volume growth in several market segments was offset by declines in other market segments, generally in line with end market conditions. Segment operating income increased 9.7 percent compared to 2012 and segment profit margin increased by 30 basis points. Raw material cost as a percentage of net revenue decreased 90 basis points as a result of synergies from integrating the acquired business and other profit margin improvement initiatives in 2013. The margin benefit from lower raw material cost as a percentage of net revenue was partially offset by higher manufacturing and SG&A costs as a percentage of net revenue. EIMEA The following table provides details of the EIMEA net revenue variances: Net revenue decreased 1.8 percent in 2014 compared to 2013. Pricing increased 0.4 percent offset by a 2.5 percent decrease in sales volume. The stronger Euro partially offset by weaker Turkish lira, Indian rupee and Egyptian pound compared to the U.S. dollar resulted in a 0.3 percent increase in net revenue. Sales volume was down in core Europe reflecting the generally soft end market conditions across most of the region and the negative impact of deteriorated customer service levels due to the Business Integration Project. Sales volume growth was generated in the emerging markets, mainly in India and Turkey. Raw material cost as a percentage of net revenue increased 90 basis points in 2014 compared to 2013 primarily due to an increase in vinyl acetate monomer (VAM) costs in the second half of 2014. All other manufacturing costs as a percentage of net revenue were 190 basis points higher than last year mainly due to business integration costs that are not classified as special charges. Operating expenses as a percentage of net revenue were flat. In 2014, segment operating income decreased 40.8 percent and segment profit margin decreased 280 basis points compared to 2013. Net revenue increased 9.0 percent in 2013 compared to 2012. Pricing increased 1.5 percent offset by a 3.0 percent decrease in sales volume. The stronger Euro compared to the U.S. dollar resulted in a 1.5 percent increase in net revenue. The acquired business contributed $60.3 million of net revenue. Sales volume was down in core Europe reflecting the generally soft end market conditions across most of the region, especially in the southern region and for durable assembly type products which are associated with more cyclical end markets. In addition, we experienced some planned and unplanned volume losses due to negative impacts of the Business Integration Project. Volume growth was generated in the emerging markets of the region, especially Turkey, India and Russia. In 2013, segment operating income increased 49.4 percent and segment profit margin increased 190 basis points compared to 2012. Raw material cost as a percentage of net revenue decreased 130 basis points in 2013 compared to 2012. SG&A expenses as a percentage of net revenue which declined 100 basis points relative to the prior year, due primarily to the Business Integration Project, also contributed to the increase in segment profit margin. Asia Pacific The following table provides details of Asia Pacific net revenue variances: Net revenue for 2014 increased 9.2 percent compared to 2013. Organic growth was 11.2 percent driven mainly by volume growth while pricing was flat. Volume growth occurred in all Asia sub-regions as market conditions improved. Raw material costs as a percentage of net revenue increased 80 basis points in 2014 relative to the prior year. Manufacturing costs as a percentage of net revenue were flat in 2014 compared to 2013. SG&A expenses as a percentage of net revenue decreased 30 basis points compared to 2013. Segment operating income decreased 4.6% and segment profit margin decreased 50 basis points in 2014 compared to 2013. Net revenue for 2013 increased 10.7 percent compared to 2012. Organic growth was 6.5 percent reflecting an 8.3 percent increase in sales volume offset by a 1.8 percent decrease in pricing. Volume growth was driven mainly by China as market conditions improve in this region, however volume declined in both Australia and Southeast Asia compared to 2012 consistent with current market and economic conditions. Net revenue increased $9.8 million from the acquired business. Segment operating income increased $2.4 million and segment profit margin increased 70 basis points in 2013 compared to 2012. Raw material costs as a percentage of net revenue increased 90 basis points in 2013 compared to 2012. Manufacturing costs as a percentage of net revenue increased 20 basis points due to investments that we are making related to our electronics business. SG&A expenses as a percentage of net revenue decreased 170 basis points compared to 2012. Construction Products The following tables provide details of Construction Products net revenue variances: Net revenue increased 18.7 percent in 2014 driven by 20.4 percent increase in sales volume offset by a 1.7 percent decrease in pricing compared to 2013. The increase in sales volume was primarily attributed to continued market share gains with several key retail partners. Raw material cost as a percentage of net revenue increased by 190 basis points in 2014 relative to 2013 primarily due to changes in sales mix. Manufacturing cost as a percentage of net revenue increased by 240 basis points mainly due to lower productivity rates as new business was ramped up. Operating expenses as a percentage of net revenue decreased 90 basis points compared to 2013. Segment operating income decreased 39.1 percent and segment profit margin decreased 340 basis points compared to 2013. Net revenue increased 7.8 percent in 2013 driven by an 8.9 percent increase in sales volume offset by a 1.1 percent decrease in pricing compared to 2012. The increase in sales volume was primarily attributed to continued market share gains with several key retail partners. Segment operating income increased 31.3 percent and segment profit margin increased 120 basis points compared to 2012. Raw material cost as a percentage of net revenue declined by 20 basis points in 2013 relative to 2012 primarily due to changes in the mix of products sold. The improvement in segment profit margin was also driven by lower manufacturing and SG&A expenses as a percentage of net revenue as these expenses increased at a lower rate than net revenue growth. Financial Condition, Liquidity and Capital Resources Total cash and cash equivalents as of November 29, 2014 were $77.6 million as compared to $155.1 million as of November 30, 2013. Total long and short-term debt was $574.8 million as of November 29, 2014 and $492.9 million as of November 30, 2013. We believe that cash flows from operating activities will be adequate to meet our ongoing liquidity and capital expenditure needs. In addition, we believe we have the ability to obtain both short-term and long-term debt to meet our financing needs for the foreseeable future. Cash available in the United States has historically been sufficient and we expect it will continue to be sufficient to fund U.S. operations and U.S. capital spending and U.S. pension and other post retirement benefit contributions in addition to funding U.S. acquisitions, dividend payments, debt service and share repurchases as needed. For those international earnings considered to be reinvested indefinitely, we currently have no intention to, and plans do not indicate a need to, repatriate these funds for U.S. operations. Our credit agreements include restrictive covenants that, if not met, could lead to a renegotiation of our credit lines and a significant increase in our cost of financing. At November 29, 2014, we were in compliance with all covenants of our contractual obligations. • TTM = trailing 12 months • EBITDA for covenant purposes is defined as consolidated net income, plus (i) interest expense, (ii) taxes, (iii) depreciation and amortization, (iv) non-cash impairment losses, (v) extraordinary non-cash losses incurred other than in the ordinary course of business, (vi) nonrecurring extraordinary non-cash restructuring charges, (vii) [reserved] , (viii) cash expenses incurred during fiscal years 2013 through 2015 in connection with facilities consolidation, restructuring and integration, discontinuance of operations, work force reduction, sale or abandonment of assets other than inventory, and professional and other fees incurred in connection with the acquired business or the restructuring of the company’s Europe, India, Middle East and Africa operations, not to exceed (x) $39.8 million for the period beginning with the fiscal quarter ending November 30, 2013 through and including the fiscal quarter ending May 31, 2014 and (y) $20.0 million for the period beginning with the fiscal quarter ending August 30, 2014 through and including the fiscal quarter ending November 28, 2015, (ix) cash expenses related to the Tonsan acquisition for advisory services and for arranging financing for the acquired business (including the non-cash write-off of deferred financing costs and any loss or expense on foreign exchange transactions intended to hedge the purchase price for the acquired business) with cash expenses not to exceed $10.0 million, minus extraordinary non-cash gains incurred other than in the ordinary course of business. For the Total Indebtedness / TTM EBITDA ratio, TTM EBITDA is adjusted for the pro forma results from Material Acquisitions and Material Divestitures as if the acquisition or divestiture occurred at the beginning of the calculation period. Additional detail is provided in the Form 8-K dated October 31, 2014. We believe we have the ability to meet all of our contractual obligations and commitments in fiscal 2015. Net Financial Assets Of the $77.6 million in cash and cash equivalents as of November 29, 2014, $70.9 million was held outside the U.S. Of the $70.9 million of cash held outside the U.S., earnings on $63.1 million are indefinitely reinvested outside of the U.S. It is not practical for us to determine the U.S. tax implications of the repatriation of these funds. There are no contractual or regulatory restrictions on the ability of consolidated and unconsolidated subsidiaries to transfer funds in the form of cash dividends, loans or advances to us, except for: 1) a credit facility limitation restricting investments, loans, advances or capital contributions from the U.S. parent corporation, the Irish financing subsidiary, and the Construction Products subsidiary in excess of $100.0 million, 2) a credit facility limitation that provides total investments, loans, advances or guarantees not otherwise permitted in the credit agreement for all subsidiaries shall not exceed $125.0 million in the aggregate and 3) typical statutory restrictions, which prohibit distributions in excess of net capital or similar tests. The 2012 Forbo acquisition and any investments, loans, and advances established to consummate the Forbo acquisition are excluded from the credit facility limitations described above. Additionally, we have taken the income tax position that the majority of our cash in non-U.S. locations is indefinitely reinvested. We rely on operating cash flow, short-term borrowings and long-term debt to provide for the working capital needs of our operations. We believe that we have the ability to obtain both short-term and long-term debt to meet our financing needs for the foreseeable future. Debt Outstanding and Debt Capacity Notes Payable: Notes payable were $27.1 million at November 29, 2014. This amount mainly represented various short-term borrowings that were not part of committed lines. The weighted-average interest rates on these short-term borrowings were 11.3 percent in 2014 and 8.9 percent in 2013. Long-Term Debt: Long-term debt consisted of senior notes and term loans. The Series A and Series B senior notes bear a fixed interest rate of 5.13 percent and mature in fiscal year 2017. The Series C and Series D senior notes bear a fixed interest rate of 5.61 percent and mature in fiscal year 2020. The Series E senior notes bear a fixed interest rate of 4.12 percent and mature in fiscal year 2022. We are subject to prepayment penalties on our senior notes. As of November 29, 2014, “make-whole” premiums were estimated to be, if the entire debt were paid off, $50.5 million. We currently have no intention to prepay any senior notes. We executed interest rate swap agreements for the purpose of obtaining a floating rate of interest on $75.0 million of the $150.0 million senior notes. We have designated the $75.0 million of senior note debt as the hedged item in a fair value hedge. As required by applicable accounting standards, we recorded an asset for the fair value of the interest rate swaps (hedging instruments) totaling $4.7 million and recognized a liability of $4.7 million for the change in the fair value of the senior notes attributable to the change in the risk being hedged. This calculation resulted in $154.7 million being recorded in long-term debt related to these senior notes as of November 29, 2014. For further information related to long-term debt see Note 7 to Consolidated Financial Statements. On October 31, 2014, we entered into a credit agreement with a consortium of financial institutions under which we established a $300.0 million term loan that we can use to repay existing indebtedness, finance working capital needs, finance acquisitions, and for general corporate purposes. The term loan is committed financing that can be drawn at any time up to 270 days after October 31, 2014. At November 29, 2014, there was no balance drawn on the term loan. The interest rate on the term loan, if drawn, bears a floating interest rate at the London Interbank Offered Rate (LIBOR) plus 125 basis points and matures in 2019. There is no prepayment penalty on the term loan. See the discussion below regarding our lines of credit. On October 31, 2014 we amended various provisions of the Note Purchase Agreements Series A through E, including the covenant definition of Consolidated EBITDA. As part of these amendments, the interest rate on the debt may increase based on a ratings grid. Additional details on the Note Purchase Agreement amendments can be found in the 8-K dated October 31, 2014. Lines of Credit: We have a revolving credit agreement with a consortium of financial institutions at November 29, 2014. This credit agreement creates an unsecured multi-currency revolving credit facility that we can draw upon for general corporate purposes up to a maximum of $300.0 million. Interest is payable at LIBOR plus 1.075 percent. A facility fee of 0.175 percent is payable quarterly. The interest rate and the facility fee are based on a rating grid. The credit facility expires on October 31, 2019. As of November 29, 2014, we had drawn $143.0 million on our lines of credit. Goodwill and Other Intangible Assets As of November 29, 2014, goodwill totaled $256.0 million (14 percent of total assets) and other intangible assets, net of accumulated amortization, totaled $195.9 million (10 percent of total assets). The components of goodwill and other identifiable intangible assets, net of amortization, by segment at November 29, 2014 are as follows: Other finite-lived intangible assets are related to operating segment trademarks. Indefinite-lived intangible assets are related to EIMEA operating segment trademarks. Selected Metrics of Liquidity and Capital Resources Key metrics we monitor are net working capital as a percent of annualized net revenue, trade account receivable days sales outstanding (DSO), inventory days on hand, free cash flow and debt capitalization ratio. Current quarter net working capital (trade receivables, net of allowance for doubtful accounts plus inventory minus trade payables) divided by annualized net revenue. Trade receivables net of allowance for doubtful accounts multiplied by 56 (8 weeks) and divided by the net revenue for the last 2 months of the quarter. Total inventory multiplied by 56 and divided by cost of sales (excluding delivery costs) for the last 2 months of the quarter. Net cash provided by operations less purchased property, plant and equipment and dividends paid. Total debt divided by (total debt plus total stockholders’ equity). Another key metric we measure is the return on invested capital, or ROIC. The calculation is represented by total return divided by total invested capital. • Total return is defined as: gross profit less SG&A expenses, less taxes at the effective tax rate plus income from equity method investments. Total return is calculated using trailing 12 month information. • Total invested capital is defined as the sum of notes payable, current maturities of long-term debt, long-term debt, redeemable non-controlling interest and total equity. We believe ROIC provides a true measure of return on capital invested and is focused on the long term. The following table shows the ROIC calculation as of November 29, 2014 and November 30, 2013 based on the definition above: Summary of Cash Flows Cash Flows from Operating Activities from Continuing Operations Net income including non-controlling interest was $50.2 million in 2014, $97.2 million in 2013 and $125.9 million in 2012. Depreciation and amortization expense totaled $70.5 million in 2014 compared to $61.7 million in 2013 and $57.4 million in 2012. The higher depreciation and amortization expense in 2014 was directly related to the significant increase in capital expenditures in 2014 and 2013. Changes in net working capital (trade receivables, inventory and trade payables) accounted for a use of cash of $69.6 million, $2.8 million and $39.2 million in 2014, 2013 and 2012, respectively. Following is an assessment of each of the net working capital components: • Trade Receivables, net - Changes in trade receivables resulted in an $18.9 million use of cash in 2014 as compared to $7.3 million use of cash in 2013 and a $17.3 million use of cash in 2012. The larger use of cash in 2014 was partially related to higher net revenue and a one day higher DSO compared to 2013. The DSO was 56 days at November 29, 2014, 55 days at November 30, 2013 and 56 days at December 1, 2012. • Inventory - Changes in inventory resulted in a $36.2 million use of cash in 2014 as compared to a use of cash of $11.8 million in 2013 and a use of cash of $17.1 million in 2012. Inventory days on hand were 58 days at the end of 2014 as compared to 53 days at the end of 2013 and 53 days at the end of 2012, respectively. Inventory levels have increased to support the manufacturing transitions that are underway as part of the Business Integration Project and the implementation of our ERP system in North America. • Trade Payables - Changes in trade payables resulted in a use of cash of $14.5 million in 2014 and a source of cash of $16.3 million in 2013 and a use of cash of $4.8 million in 2012. The use of cash in 2014 compared to the source of cash in 2013 was primarily related to the timing of payments. Contributions to our pension and other postretirement benefit plans were $12.6 million, $6.8 million and $9.8 million in 2014, 2013 and 2012, respectively. Changes in deferred income taxes resulted in a source of cash of $4.2 million in 2014 compared to a source of cash of $9.6 million in 2013 and a use of cash of $16.8 million in 2012. The source of cash in deferred income taxes in 2014 compared to 2013 was primarily related to an increase in our minimum pension liability. Income taxes payable resulted in a use of cash of $0.1 million, a use of cash of $17.9 million and a source of cash of $15.2 million in 2014, 2013 and 2012, respectively. The 2014 change in income taxes payable was related to lower net income and the timing of U.S. estimated tax payments. Other assets was a use of cash of $41.7 million, $13.8 million and $4.3 million in 2014, 2013 and 2012, respectively. The larger use of cash in 2014 was primarily related to prepaid taxes other than income taxes. Accrued compensation was a use of cash of $28.1 million in 2014, a source of cash of $3.8 million in 2013 and a source of cash of $21.0 million in 2012. The use of cash in 2014 relates to the payments of severance related costs as part of our Business Integration Project and lower accruals for our employee incentive plans. Other operating activity was a source of cash of $33.3 million in 2014 a use of cash of $11.1 million in 2013 and a use of cash of $2.1 million in 2012. The source of cash in 2014 was primarily related to the impact of a stronger U.S. dollar on intercompany transactions. Income from discontinued operations, net of tax reduced cash flows from operating activities by $1.2 million and $57.6 million in 2013 and 2012, respectively. The $57.6 million in 2012 includes an after-tax gain on the sale of our Central America Paints business of $51.1 million. Cash Flows from Investing Activities from Continuing Operations Purchases of property plant and equipment were $139.8 million in 2014 as compared to $124.3 million in 2013 and $35.9 million in 2012. The increase in 2014 and 2013 was primarily related to capital expenditures for the Business Integration Project and our Project ONE ERP system. In 2014 we purchased the ProSpec construction products business for $26.2 million and adjusted the purchase price of Plexbond Quimica for $0.2 million. We acquired Plexbond Quimica, S.A. for $10.2 million in 2013. We acquired the global industrial adhesives business of Forbo Holding AG for $404.7 million and the outstanding shares of Engent, Inc. for $7.9 million in 2012. In 2013 an adjustment of the purchase price for the Forbo industrial adhesives business acquisition reduced cash used in investing activities by $1.6 million. In 2013 we purchased technology for the use in electronics markets for $2.4 million. See Note 2 to the Consolidated Financial Statements for further information on acquisitions. Cash Flows from Financing Activities from Continuing Operations Proceeds from long-term debt and repayment of long-term debt in 2014 were $560.0 million and $483.3 million, respectively and netted to a $76.7 million source of cash in 2014. Proceeds from long-term debt and repayment of long-term debt in 2013 were $107.0 million and $129.5 million, respectively. Proceeds from long-term debt in 2012 were $584.2 million of which $400.0 million was used for financing the acquisition of the acquired business. Included in the 2012 proceeds of long-term debt was our note purchase agreement under which we issued $250.0 million in aggregate principal amount of senior unsecured notes and a draw down of our $150.0 million term loan. Repayment of long-term debt in 2012 was $292.3 million which included prepayment of $80.0 million of long-term debt with proceeds from the sale of our Central America Paints business. Cash paid for dividends were $23.1 million, $19.3 million and $16.5 million in 2014, 2013 and 2012, respectively. Cash generated from the exercise of stock options was $6.9 million in 2014, $8.9 million in 2013 and $7.4 million in 2012. Repurchases of common stock were $15.5 million in 2014 compared to $17.6 million in 2013 and $4.3 million in 2012, including $12.3 million in 2014, $15.3 million in 2013 and $3.0 million in 2012 from our 2010 share repurchase program. Cash Flows from Discontinued Operations Cash flows from discontinued operations includes the proceeds from the sale of $118.5 million in 2012 and cash generated from operations and investing activities of the Central America Paints business. Contractual Obligations Due dates and amounts of contractual obligations follow: Some of our interest obligations on long-term debt are variable based on LIBOR. Interest payable for the variable portion is estimated based on a forward LIBOR curve. Pension contributions are only included for fiscal 2015. We have not determined our pension funding obligations beyond 2015 and thus, any potential future contributions have been excluded from the table. We expect to make cash outlays in the future related to uncertain tax positions. However, due to the uncertainty of the timing of future cash flows, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, gross unrecognized tax benefits of $4.8 million as of November 29, 2014, have been excluded from the contractual obligations table above. For further information related to unrecognized tax benefits see Note 8 to Consolidated Financial Statements. We expect 2015 capital expenditures to be approximately $70.0 million. Off-Balance Sheet Arrangements There are no relationships with any unconsolidated, special-purpose entities or financial partnerships established for the purpose of facilitating off-balance sheet financial arrangements. Recently Issued Accounting Pronouncements See Note 1 to the Consolidated Financial Statements for information concerning new accounting standards and the impact of the implementation of these standards on our financial statements. Forward-Looking Statements and Risk Factors The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of words like “plan,” “expect,” “aim,” “believe,” “project,” “anticipate,” “intend,” “estimate,” “will,” “should,” “could” (including the negative or variations thereof) and other expressions that indicate future events and trends. These plans and expectations are based upon certain underlying assumptions, including those mentioned with the specific statements. Such assumptions are in turn based upon internal estimates and analyses of current market conditions and trends, our plans and strategies, economic conditions and other factors. These plans and expectations and the assumptions underlying them are necessarily subject to risks and uncertainties inherent in projecting future conditions and results. Actual results could differ materially from expectations expressed in the forward-looking statements if one or more of the underlying assumptions and expectations proves to be inaccurate or is unrealized. In addition to the factors described in this report, Item 1A. Risk Factors identifies some of the important factors that could cause our actual results to differ materially from those in any such forward-looking statements. In order to comply with the terms of the safe harbor, we have identified these important factors which could affect our financial performance and could cause our actual results for future periods to differ materially from the anticipated results or other expectations expressed in the forward-looking statements. These factors should be considered, together with any similar risk factors or other cautionary language that may be made elsewhere in this Annual Report on Form 10-K. The list of important factors in Item 1A. Risk Factors does not necessarily present the risk factors in order of importance. This disclosure, including that under “Forward-Looking Statements and Risk Factors,” and other forward-looking statements and related disclosures made by us in this report and elsewhere from time to time, represents our best judgment as of the date the information is given. We do not undertake responsibility for updating any of such information, whether as a result of new information, future events, or otherwise, except as required by law. Investors are advised, however, to consult any further public company disclosures (such as in filings with the Securities and Exchange Commission or in our press releases) on related subjects.

<s>[INST] H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. We manage our business through four operating segments Americas Adhesives, EIMEA (Europe, India, Middle East and Africa), Asia Pacific and Construction Products. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, flooring, textile, flexible packaging, graphic arts, envelope, automotive and electronics markets. The Construction Products operating segment provides floor preparation, grouts and mortars for tile setting as well as sealants and related products for heating, ventilation and air conditioning installations. We acquired the global industrial adhesives and synthetic polymers business of Forbo Holding AG on March 5, 2012. The Forbo industrial adhesives business acquired is referred to as the “acquired business” in the Management’s Discussion and Analysis. See Item 1. Business and Note 2 to the Consolidated Financial Statements. The integration of the acquired business involved a significant amount of restructuring and capital investment to optimize the new combined entity. In addition to this acquisition, we announced our intentions to take a series of actions in our existing EIMEA operating segment to improve the profitability and future growth prospects of this operating segment. We combined these two initiatives into a single project which we refer to as the “Business Integration Project”. We divested our Latin America Paints business on August 6, 2012. In accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification ASC 20520, “Discontinued Operations” we have classified the results of this business as discontinued operations. See Item 1. Business and Note 2 to the Consolidated Financial Statements. Total Company: When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas Global supply of and demand for raw materials Economic growth rates, and Currency exchange rates compared to the U.S. dollar We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impact the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in highgrowth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With over 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. In 2014, we generated 42 percent of our net revenue in the United States and 34 percent in EIMEA. The pace of economic growth in these areas directly impacts certain industries to which we supply products. For example, adhesivesrelated revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as Construction Products and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other constructionrelated activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies strengthen against the dollar, our revenues and costs increase as the foreign currencydenominated financial statements translate into more dollars. The fluctuations of the Euro against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2014, the currency fluctuations had a negative impact on net revenue of $6.8 million as compared to 2013. Key financial results and transactions for 2014 included the following: Net revenue increased 2.8 percent from 2013 primarily driven by [/INST] Positive. </s>

FULLER H B CO

2016-01-27

2015-11-28

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. We manage our business through four operating segments - Americas Adhesives, EIMEA (Europe, India, Middle East and Africa), Asia Pacific and Construction Products. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, flooring, textile, flexible packaging, graphic arts, envelope, automotive and electronics markets. The Construction Products operating segment provides floor preparation, grouts and mortars for tile setting as well as sealants and related products for heating, ventilation and air conditioning installations. The integration of the industrial adhesives business we acquired in March 2012 involved a significant amount of restructuring and capital investment to optimize the new combined entity. In addition to this acquisition, we announced our intentions to take a series of actions in our existing EIMEA operating segment to improve the profitability and future growth prospects of this operating segment. We combined these two initiatives into a single project which we refer to as the Business Integration Project. Total Company: When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: ● Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas ● Global supply of and demand for raw materials ● Economic growth rates, and ● Currency exchange rates compared to the U.S. dollar We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impact the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in high-growth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With over 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. In 2015, we generated 43 percent of our net revenue in the United States and 29 percent in EIMEA. The pace of economic growth in these areas directly impacts certain industries to which we supply products. For example, adhesives-related revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as Construction Products and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other construction-related activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies weaken against the dollar, our revenues and costs decrease as the foreign currency-denominated financial statements translate into fewer dollars. The fluctuations of the Euro against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2015, the currency fluctuations had a negative impact on net revenue of approximately $126.0 million as compared to 2014. Key financial results and transactions for 2015 included the following: ● Net revenue decreased 1.0 percent from 2014 primarily driven by a 6.0 percent decrease in currency offset by a 4.5 percent increase in sales volume and a 0.5 percent increase in product pricing. ● Gross profit margin increased to 27.3 percent from 25.3 percent in 2014. ● Cash flow generated by operating activities from continuing operations was $210.5 million in 2015 as compared to $29.7 million in 2014 and $132.7 million in 2013. ● We acquired 95 percent of the equity of Tonsan Adhesive, Inc. on February 2, 2015 for $215.9 million. The global economic conditions were mixed in 2015. We experienced generally favorable end market conditions in Asian markets, particularly in China, and in the Construction Products related markets in North America. The end market conditions in China deteriorated in the second half of 2015 due to a reduced rate of growth. End market demand for our core adhesives products in the Americas and EIMEA were generally flat to slightly positive, with some end market segments up and others declining. Our total year constant currency sales growth, which we define as the combined variances from product pricing, sales volume and small acquisitions, increased 5.0 percent for 2015 compared to 2014. In 2015 our diluted earnings per share from continuing operations was $1.71 per share compared to $0.97 per share in 2014 and $1.87 per share in 2013. The higher earnings per share from continuing operations in 2015 compared to 2014 resulted from lower special charges, lower business integration costs that were not classified as special charges, lower raw material costs and lower production inefficiencies related to the Business Integration Project and ERP system implementation costs in North America. Special charges, net in 2015 were $4.7 million for costs related to the Business Integration Project. On an after-tax basis, the special charges, net resulted in a $4.7 million negative impact on net income and a negative $0.09 effect on diluted earnings per share. Special charges, net in 2014 were $51.5 million for costs related to the Business Integration Project. On an after-tax basis, the special charges, net resulted in a $45.2 million negative impact on net income and a negative $0.88 effect on diluted earnings per share. In 2013 we had special charges, net of $45.1 million for costs related to the Business Integration Project. On an after-tax basis, the special charges, net resulted in a $35.3 million negative impact on net income and a negative $0.69 effect on diluted earnings per share. See Note 5 to the Consolidated Financial Statements for more information. Project ONE: In December of 2012 our Board of Directors approved a multi-year project to replace and enhance our existing core information technology platforms. The scope for this project includes most of the basic transaction processing for the company including customer orders, procurement, manufacturing, and financial reporting. The project envisions harmonized business processes for all of our operating segments supported with one standard software configuration. The execution of this project, which we refer to as Project ONE, is being supported by internal resources and consulting services. During 2013 a project team was formed and the global blueprint for the software configuration was designed and built. In the latter half of 2013 and in the early months of 2014, the global blueprint was applied to the specific requirements of our North America adhesives business, the software was tested and the user groups were trained. On April 6, 2014, our North America adhesives business went live. The implementation process proved to be more difficult than we originally anticipated resulting in disruptions in our manufacturing network, lower productivity and deteriorated customer service levels. By the end of 2014, most of the problems associated with the software implementation had been remediated and the business was stable and running at capacity with productivity levels approaching the levels experienced prior to the new software implementation. In late 2014 we suspended any further implementation projects in other geographic regions until we complete the optimization of the current platform in North America. We are preparing a revised implementation plan that leverages the experiences of our first go-live event and reduces the risk of significant business interruption. We expect to start subsequent implementations in 2016. The original capital expenditure plan for Project ONE was approximately $60.0 million. In the fourth quarter of 2015, we received a cash settlement of $12.8 million as a result of an arbitration proceeding related to our initial implementation of Project ONE. Of this amount, $12.0 million was related to capital expenditures, which allowed us to reduce our total project-to-date capital expenditures to $31.3 million. Given the complexity of the initial implementation, we anticipate that the total investment to complete the project will exceed our original estimate. We will have a revised estimate of the total project costs and the expected completion timetable later in 2016 when the revised implementation plan is complete. Our current plan is to proceed with the second phase implementation in our Latin America region with the project commencing in the second half of 2016 and completion expected in early 2017. Subsequent phases of the global implementation will be evaluated following the completion of this second implementation. 2016 Outlook: Our key long term financial metrics remain unchanged: constant currency revenue growth, Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) margin, growth in earnings per share and Return on Invested Capital (ROIC). EBITDA is a non-GAAP financial measure defined on a consolidated basis as gross profit, less Selling, General and Administrative (SG&A) expense, plus depreciation expense, plus amortization expense. EBITDA excludes special charges, net. EBITDA margin is a non-GAAP financial measure defined as EBITDA divided by net revenue. ROIC is a non-GAAP financial measure defined as (gross profit less SG&A expense, less taxes at the effective tax rate plus income from equity method investments, calculated using trailing 12 month information) divided by (the sum of notes payable, current maturities of long-term debt, long-term debt, redeemable non-controlling interest and total equity). In 2016 we expect modest constant currency revenue growth of about 4 percent, mainly supported by continued growth in our Asia Pacific and Construction Products segments. Our Asia Pacific segment will benefit from a full year of the acquired Tonsan business as well as continued end market expansion, though at a slower rate. We anticipate slightly positive constant currency revenue growth in the Americas Adhesives and EIMEA operating segments. We expect that the strengthening of the US dollar relative to various currencies will dampen our revenue growth rate in 2016 relative to 2015 by up to 3 percentage points. Our gross profit margin is expected to increase in 2016, primarily driven by continuous productivity improvement in our manufacturing network, especially in Europe, plus the carry over benefit of lower raw material costs that were realized in the second half of 2015. SG&A expenses should increase at a rate in line with the increase in net revenue. Overall, we expect our EBITDA margin to be approximately 14 percent for the full year. We expect total 2016 capital expenditures to be approximately $60.0 million, slightly above our long term expectations of ongoing capital requirements of about 2 to 2.5 percent of net revenue. Critical Accounting Policies and Significant Estimates: Management’s discussion and analysis of our results of operations and financial condition are based upon the Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP). The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We believe the critical accounting policies and areas that require the most significant judgments and estimates to be used in the preparation of the Consolidated Financial Statements are pension and other postretirement plan assumptions; goodwill impairment assessment; long-lived assets recoverability; product, environmental and other litigation liabilities; and income tax accounting. Pension and Other Postretirement Plan Assumptions: We sponsor defined-benefit pension plans in both the U.S. and non-U.S. entities. Also in the U.S., we sponsor other postretirement plans for health care and life insurance benefits. Expenses and liabilities for the pension plans and other postretirement plans are actuarially calculated. These calculations are based on our assumptions related to the discount rate, expected return on assets, projected salary increases and health care cost trend rates. Note 10 to the Consolidated Financial Statements includes disclosure of assumptions employed in these measurements for both the non-U.S. and U.S. plans. The discount rate assumption is determined using an actuarial yield curve approach, which results in a discount rate that reflects the characteristics of the plan. The approach identifies a broad population of corporate bonds that meet the quality and size criteria for the particular plan. We use this approach rather than a specific index that has a certain set of bonds that may or may not be representative of the characteristics of our particular plan. A higher discount rate reduces the present value of the pension obligations. The discount rate for the U.S. pension plan was 4.30 percent at November 28, 2015, as compared to 4.10 percent at November 29, 2014 and 4.77 percent at November 30, 2013. Net periodic pension cost for a given fiscal year is based on assumptions developed at the end of the previous fiscal year. A discount rate reduction of 0.5 percentage points at November 28, 2015 would increase U.S. pension and other postretirement plan expense approximately $0.3 million (pre-tax) in fiscal 2016. Discount rates for non-U.S. plans are determined in a manner consistent with the U.S. plan. The expected long-term rate of return on plan assets assumption for the U.S. pension plan was 7.75 percent in 2015, 2014 and 2013. Our expected long-term rate of return on U.S. plan assets was based on our target asset allocation assumption of 60 percent equities and 40 percent fixed-income. Management, in conjunction with our external financial advisors, determines the expected long-term rate of return on plan assets by considering the expected future returns and volatility levels for each asset class that are based on historical returns and forward looking observations. For 2015 the expected long-term rate of return on the target equities allocation was 8.5 percent and the expected long-term rate of return on the target fixed-income allocation was 5.0 percent. The total plan rate of return assumption included an estimate of the effect of diversification and the plan expense. For 2016, the expected long-term rate of return on assets will continue to be 7.75 percent with an expected long-term rate of return on the target equities allocation of 8.5 percent and an expected long-term rate of return on target fixed-income allocation of 5.0 percent. A change of 0.5 percentage points for the expected return on assets assumption would impact U.S. net pension and other postretirement plan expense by approximately $2.0 million (pre-tax). Management, in conjunction with our external financial advisors, uses the actual historical rates of return of the asset categories to assess the reasonableness of the expected long-term rate of return on plan assets. The most recent 10-year and 20-year historical equity returns are shown in the table below. Our expected rate of return on our total portfolio is consistent with the historical patterns observed over longer time frames. (*) Beginning in 2006, our target allocation migrated from 100 percent equities to our current allocation of 60 percent equities and 40 percent fixed-income. The historical actual rate of return for the fixed income of 8.0 percent is since inception (9 years, 11 months). The expected long-term rate of return on plan assets assumption for non-U.S. pension plans was a weighted-average of 6.22 percent in 2015 compared to 6.17 percent in 2014 and 5.96 percent in 2013. The expected long-term rate of return on plan assets assumption used in each non-U.S. plan is determined on a plan-by-plan basis for each local jurisdiction and is based on expected future returns for the investment mix of assets currently in the portfolio for that plan. Management, in conjunction with our external financial advisors, develops expected rates of return for each plan, considers expected long-term returns for each asset category in the plan, reviews expectations for inflation for each local jurisdiction, and estimates the effect of active management of the plan’s assets. Our largest non-U.S. pension plans are in the United Kingdom and Germany. The expected long-term rate of return on plan assets for the United Kingdom was 6.75 percent and the expected long-term rate of return on plan assets for Germany was 5.75 percent. Management, in conjunction with our external financial advisors, uses actual historical returns of the asset portfolio to assess the reasonableness of the expected rate of return for each plan. The projected salary increase assumption is based on historic trends and comparisons to the external market. Higher rates of increase result in higher pension expenses. As this rate is also a long-term expected rate, it is less likely to change on an annual basis. In the U.S., we have used the rate of 4.50 percent for 2015, 2014 and 2013. Benefits under the U.S. Pension Plan were locked-in as of May 31, 2011 and no longer include compensation increases. The 4.50 percent rate is for the supplemental executive retirement plan only. Goodwill: Goodwill is the excess of cost of an acquired entity over the amounts assigned to assets acquired and liabilities assumed in a purchase business combination. Goodwill is assigned to reporting units at the date the goodwill is initially recorded. Once goodwill has been assigned to a reporting unit, it no longer retains its association with a particular acquisition, and all the activities within a reporting unit are available to support the value of goodwill. Accounting standards require us to test goodwill for impairment annually or more often if circumstances or events indicate a change in the estimated fair value may have occurred. The goodwill impairment analysis is a two-step process. The first step used to identify potential impairment involves comparing each reporting unit’s estimated fair value to its carrying value, including goodwill. We use a discounted cash flow approach to estimate the fair value of our reporting units. Our judgment is required in developing the assumptions for the discounted cash flow model. These assumptions include revenue growth rates, profit margin percentages, discount rates, perpetuity growth rates, future capital expenditures and working capital requirements. If the estimated fair value of a reporting unit exceeds its carrying value, goodwill is considered to not be impaired. If the carrying value exceeds estimated fair value, there is an indication of potential impairment and the second step is performed to measure the amount of impairment. The second step of the process, if required, involves the calculation of an implied fair value of goodwill for each reporting unit for which step one indicated impairment. The implied fair value of goodwill is determined in a manner similar to how goodwill is calculated in a business combination, by measuring the excess of the estimated fair value of the reporting unit as calculated in step one, over the estimated fair values of the individual assets, liabilities and identifiable intangibles as if the reporting unit was being acquired in a business combination. If the implied fair value of goodwill exceeds the carrying value of goodwill assigned to the reporting unit, there is no impairment. If the carrying value of goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss cannot exceed the carrying value of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted. In the fourth quarter of 2015, we conducted the required annual test of goodwill for impairment. We performed the goodwill impairment analysis on our reporting units by using a discount rate determined by management to result in the most representative fair value of the business as a whole. There were no indications of impairment in any of our reporting units. We also performed a sensitivity analysis by using a discount rate at the high end of our range to confirm the reasonableness of our goodwill impairment analysis. No indications of impairment in any of our reporting units were indicated by the sensitivity analysis. Of the goodwill balance of $354.2 million as of November 28, 2015, $67.1 million is allocated to the Americas Adhesives reporting unit, $122.6 million is allocated to the EIMEA reporting unit, $143.7 million is allocated to the Asia Pacific reporting unit and $20.8 million is allocated to the Construction Products reporting unit. In all four of these reporting units, the calculated fair value substantially exceeded the carrying value of the net assets. If the economy or business environment falter and we are unable to achieve our assumed revenue growth rates or profit margin percentages, our projections used would need to be remeasured, which could impact the carrying value of our goodwill in one or more of our reporting units. See Note 6 to the Consolidated Financial Statements. Recoverability of Long-Lived Assets: The assessment of the recoverability of long-lived assets reflects our assumptions and estimates. Factors that we must estimate when performing impairment tests include sales volume, prices, inflation, currency exchange rates, tax rates and capital spending. Significant judgment is involved in estimating these factors, and they include inherent uncertainties. The measurement of the recoverability of these assets is dependent upon the accuracy of the assumptions used in making these estimates and how the estimates compare to the eventual future operating performance of the specific businesses to which the assets are attributed. Judgments made by us include the expected useful lives of long-lived assets. The ability to realize undiscounted cash flows in excess of the carrying amounts of such assets is affected by factors such as the ongoing maintenance and improvement of the assets, changes in economic conditions and changes in operating performance. Product, Environmental and Other Litigation Liabilities: As disclosed in Item 3. Legal Proceedings and in Note 1 and Note 12 to the Consolidated Financial Statements, we are subject to various claims, lawsuits and other legal proceedings. Reserves for loss contingencies associated with these matters are established when it is determined that a liability is probable and the amount can be reasonably estimated. The assessment of the probable liabilities is based on the facts and circumstances known at the time that the financial statements are being prepared. For cases in which it is determined that a liability is probable but only a range for the potential loss exists, the minimum amount of the range is recorded and subsequently adjusted as better information becomes available. For cases in which insurance coverage is available, the gross amount of the estimated liabilities is accrued, and a receivable is recorded for any probable estimated insurance recoveries. A discussion of environmental, product and other litigation liabilities is disclosed in Item 3. Legal Proceedings and Note 12 to the Consolidated Financial Statements. Based upon currently available facts, we do not believe that the ultimate resolution of any pending legal proceeding, individually or in the aggregate, will have a material adverse effect on our long-term financial condition. However, adverse developments and/or periodic settlements could negatively affect our results of operations or cash flows in one or more future quarters. Income Tax Accounting: As part of the process of preparing the Consolidated Financial Statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. The process involves estimating actual current tax expense along with assessing temporary differences resulting from differing treatment of items for book and tax purposes. These temporary differences result in deferred tax assets and liabilities, which are included in the Consolidated Balance Sheets. We record a valuation allowance to reduce our deferred tax assets to the amount that is more-likely-than-not to be realized. We have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance. Increases in the valuation allowance result in additional expense to be reflected within the tax provision in the Consolidated Statements of Income. As of November 28, 2015, the valuation allowance to reduce deferred tax assets totaled $14.4 million. We recognize tax benefits for tax positions for which it is more-likely-than-not that the tax position will be sustained by the applicable tax authority at the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement. We do not recognize a financial statement benefit for a tax position that does not meet the more-likely-than-not threshold. We believe that our liabilities for income taxes reflect the most likely outcome. It is difficult to predict the final outcome or the timing of the resolution of any particular tax position. Future changes in judgment related to the resolution of tax positions will impact earnings in the quarter of such change. We adjust our income tax liabilities related to tax positions in light of changing facts and circumstances. Settlement with respect to a tax position would usually require cash. Based upon our analysis of tax positions taken on prior year returns and expected tax positions to be taken for the current year tax returns, we have identified gross uncertain tax positions of $4.9 million as of November 28, 2015. We have not recorded U.S. deferred income taxes for certain of our non-U.S. subsidiaries undistributed earnings as such amounts are intended to be indefinitely reinvested outside of the U.S. Should we change our business strategies related to these non-U.S. subsidiaries, additional U.S. tax liabilities could be incurred. It is not practical to estimate the amount of these additional tax liabilities. See Note 8 to the Consolidated Financial Statements for further information on income tax accounting. Acquisition Accounting: As we enter into business combinations we perform acquisition accounting requirements including the following: ● Identifying the acquirer, ● Determining the acquisition date, ● Recognizing and measuring the identifiable assets acquired and the liabilities assumed, and ● Recognizing and measuring goodwill or a gain from a bargain purchase We complete valuation procedures, and record the resulting fair value of the acquired assets and assumed liabilities based upon the valuation of the business enterprise and the tangible and intangible assets acquired. Enterprise value allocation methodology requires management to make assumptions and apply judgment to estimate the fair value of assets acquired and liabilities assumed. If estimates or assumptions used to complete the enterprise valuation and estimates of the fair value of the acquired assets and assumed liabilities significantly differed from assumptions made, the resulting difference could materially affect the fair value of net assets. The calculation of the fair value of the tangible assets, including property, plant and equipment utilizes the cost approach, which computes the cost to replace the asset, less accrued depreciation resulting from physical deterioration, functional obsolescence and external obsolescence. The calculation of the fair value of the identified intangible assets are determined using cash flow models following the income approach or a discounted market-based methodology approach. Significant inputs include estimated revenue growth rates, gross margins, operating expenses, estimated attrition rate, and a discount rate. Goodwill is recorded as the difference in the fair value of the acquired assets and assumed liabilities and the purchase price. Net revenue in 2015 decreased 1.0 percent from 2014. The 2014 net revenue was 2.8 percent higher than the net revenue in 2013. We review variances in net revenue in terms of changes related to product pricing, sales volume, changes in foreign currency exchange rates and major acquisitions. The pricing/sales volume variance and small acquisitions including Tonsan Adhesive, Inc., Continental Products Limited and ProSpec construction products are viewed as constant currency growth. The following table shows the net revenue variance analysis for the past two years: Constant currency growth was 5.0 percent in 2015 compared to 2014. The 5.0 percent constant currency growth in 2015 was driven by 39.8 percent growth in Asia Pacific, 23.8 percent growth in Construction Products offset by a 3.9 percent decrease in Americas Adhesives and 1.9 percent decrease in EIMEA. The majority of the negative currency impact was driven by the weakening of the Euro, Turkish lira, Canadian dollar and Australian dollar against the U.S. dollar. Constant currency growth was 3.1 percent in 2014 compared to 2013. The 3.1 percent constant currency growth in 2014 was driven by 18.7 percent growth in Construction Products, 11.2 percent growth in Asia Pacific and 2.4 percent growth in Americas Adhesives. The majority of the negative currency impact was driven by the devaluation of the Australian dollar and the Canadian dollar compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 200 basis points in 2015 compared to 2014, reflecting decreases in raw materials costs as well as changes in product pricing and sales mix. Other manufacturing costs as a percentage of revenue remained flat compared to last year. As a result, cost of sales as a percentage of net revenue decreased 200 basis points compared to 2014. Raw material costs as a percentage of net revenue increased 100 basis points in 2014 relative to 2013, reflecting increases in raw materials costs as well as changes in product pricing and sales mix. Other manufacturing costs as a percentage of revenue increased 160 basis points in 2014 compared to 2013 mainly driven by cost associated with the implementation of our ERP system as well as business integration costs that are not classified as special charges. As a result, cost of sales as a percentage of net revenue increased 260 basis points in 2014 compared to 2013. Gross profit in 2015 increased $34.7 million compared to 2014 and gross profit margin increased 200 basis points. The decrease in the cost of raw materials was the main factor for the increase in gross profit. Gross profit in 2014 decreased $36.9 million compared to 2013 and gross profit margin declined 260 basis points. The increases in raw materials in addition to the cost associated with the implementation of our ERP system as well as business integration costs that were not classified as special charges were the main factors to the gross profit reduction. Selling, general and administrative (SG&A) expenses SG&A expenses for 2015 increased $14.2 million or 3.7 percent compared to 2014. The added expense from the Tonsan acquisition partially offset by foreign currency exchange rates were the main drivers for the increase. SG&A expenses for 2014 increased $8.7 million or 2.3 percent compared to 2013. As a percentage of net revenue, SG&A expenses decreased 10 basis points in 2014 due to ongoing cost control efforts offsetting higher spending for Project ONE. We make SG&A expense plans at the beginning of each fiscal year and barring significant changes in business conditions or our outlook for the future, we maintain these spending plans for the entire year. Management routinely monitors our SG&A spending relative to these fiscal year plans for each operating segment and for the company overall. We feel it is important to maintain a consistent spending program in this area as many of the activities within the SG&A category such as the sales force, technology development, and customer service are critical elements of our business strategy. The following table provides detail of special charges, net: The integration of the industrial adhesives business we acquired in March 2012 involved a significant amount of restructuring and capital investment to optimize the new combined entity. In addition to this acquisition, we announced our intentions to take a series of actions in our existing EIMEA operating segment to improve the profitability and future growth prospects of this operating segment. We combined these two initiatives into a single project which we refer to as the Business Integration Project. During the years ended November 28, 2015, November 29, 2014 and November 30, 2013, we incurred special charges, net of $4.7 million, $51.5 million and $45.1 million, respectively, for costs related to the Business Integration Project. Acquisition and transformation related costs of 0.7 million for the year ended November 28, 2015, $7.9 million for the year ended November 29, 2014 and $8.7 million for the year ended November 30, 2013 include costs related to organization consulting, financial advisory and legal services necessary to integrate the acquired business into our existing operating segments. During the year ended November 28, 2015, we incurred cash facility exit costs of $2.2 million, non-cash facility exit costs of $1.5 million and other incremental transformation related costs of $0.3 million including the cost of personnel directly working on the integration. During the year ended November 29, 2014, we incurred workforce reduction costs of $3.2 million, cash facility exit costs of $25.2 million, non-cash facility exit costs of $6.9 million and other incremental transformation related costs of $8.3 million including the cost of personnel directly working on the integration. During the year ended November 30, 2013, we incurred workforce reduction costs of $9.8 million, cash facility exit costs of $11.8 million, non-cash facility exit costs of $6.1 million and other incremental transformation related costs of $8.7 million including the cost of personnel directly working on the integration. We present operating segment information consistent with how we organize our business internally, assess performance and make decisions regarding the allocation of resources. Segment operating income is defined as gross profit less selling, general and administrative expenses. Because this definition excludes special charges, we have not allocated special charges to the operating segments or included them in Management’s Discussion & Analysis of operating segment results. For informational purposes only, the following table provides the special charges, net attributable to each operating segment for the periods presented: We expect total project costs will be approximately $164.0 million. The following table provides detail of costs incurred inception-to-date as of November 28, 2015 for the Business Integration Project: Non-cash costs are primarily related to accelerated depreciation of long-lived assets. Currency transaction and remeasurement losses were $3.5 million, $2.5 million and $4.1 million in 2015, 2014 and 2013, respectively. Interest income was $0.5 million in 2015 compared to $0.4 million in 2014 and $0.7 million in 2013. Gains on disposal of fixed assets were $0.3 million, $2.8 million and $0.3 million in 2015, 2014 and 2013, respectively. Interest expense was $25.0 million in 2015 compared to $19.7 million in 2014 and $19.1 million in 2013. The higher interest expense in 2015 compared to 2014 was due to higher average debt balances resulting from the Tonsan acquisition and lower capitalized interest on capital projects, offset by lower average interest rates. The higher interest expense in 2014 compared to 2013 was due to higher average debt balances, partially offset by higher capitalized interest on capital projects. We capitalized interest of $0.1 million, $2.7 million and $1.9 million in 2015, 2014 and 2013, respectively. Income tax expense in 2015 of $55.9 million includes $0.2 million of discrete tax expense in both the U.S. and foreign jurisdictions. Income tax expense in 2014 of $34.3 million included $1.4 million of discrete tax benefits in both the U.S. and foreign jurisdictions. Excluding discrete items, the overall effective tax rate decreased by 4.9 percentage points in 2015 as compared to 2014. The decrease in the tax rate is principally due to a change in the geographic mix of pre-tax earnings and the reduction in special charges. The income from equity method investments relates to our 50 percent ownership of the Sekisui-Fuller joint venture in Japan. Sekisui-Fuller’s net income measured in Japanese yen was higher in 2015 compared to 2014 and 2013, but the weakening of the yen in 2015 and 2014 negatively impacted the net income in U.S. dollars. Income from equity method investments was negatively impacted in 2014 by a correction of an error in the carrying value of our investment in Sekisui-Fuller in the amount of $1.6 million. The income (loss) from discontinued operations, net of tax, relates to our Central America Paints business, which we sold in 2012. In 2015, in conjunction with the final settlement agreement, we increased our contingent consideration liability by $2.1 million and adjusted the related deferred income tax. In 2013, in conjunction with filing the 2012 tax return, we reduced our income tax expense $1.2 million, related to the sale of the Central America Paints business. See Note 2 to the Consolidated Financial Statements. The net income attributable to non-controlling interests relates to the redeemable non-controlling interest in H.B. Fuller Kimya Sanayi Ticaret A.S. (HBF Kimya). Net income attributable to H.B. Fuller ($ in millions) 2015 vs 2014 2014 vs 2013 Net income atAtributable to H.B. Fuller $ 86.7 $ 49.8 $ 96.8 74.2 % (48.6 )% Percent of net revenue 4.2 % 2.4 % 4.7 % Net income attributable to H.B. Fuller was $86.7 million in 2015 compared to $49.8 million in 2014 and $96.8 million in 2013. Fiscal year 2015 included $4.7 million of special charges, net ($4.7 million after-tax and a negative $0.09 effect on diluted earnings per share) for costs related to the Business Integration Project compared to $51.5 million ($45.2 million after-tax) in 2014 and $45.1 million ($35.3 million after-tax) in 2013. Diluted earnings per share, from continuing operations, was $1.71 per share in 2015, $0.97 per share for 2014 and $1.87 per share for 2013. Operating Segment Results We are required to report segment information in the same way that we internally organize our business for assessing performance and making decisions regarding allocation of resources. For segment evaluation by the chief operating decision maker, segment operating income is defined as gross profit less SG&A expenses. Segment operating income excludes special charges, net. Inter-segment revenues are recorded at cost plus a markup for administrative costs. Corporate expenses are fully allocated to each operating segment. Our operations are managed through four reportable segments: Americas Adhesives, EIMEA, Asia Pacific and Construction Products. The tables below provide certain information regarding the net revenue and segment operating income of each of our operating segments. Segment Operating Income The following table provides a reconciliation of segment operating income to income from continuing operations before income taxes and income from equity method investments, as reported on the Consolidated Statements of Income. Americas Adhesives The following tables provide details of Americas Adhesives net revenue variances: Net revenue decreased 4.8 percent in 2015 compared to 2014. The 3.9 percent decrease in constant currency growth was attributable to a 4.3 percent decrease in sales volume offset by a 0.4 percent increase in pricing. The sales volume decrease was driven by lower volume in several market segments and lost market share related to our ERP system implementation. Raw material costs as a percentage of net revenue decreased 280 basis points as a result of decreases in raw material costs following the drop in the global price of oil and natural gas. Other manufacturing costs as a percentage of net revenue decreased 50 basis points compared to 2014. Operating expenses were 3.0 percent lower compared to 2014. As a result, segment operating income increased 22.2 percent compared to 2014 and segment profit margin increased 320 basis points. Net revenue increased 2.0 percent in 2014 compared to 2013. The 2.4 percent increase in constant currency growth was attributable to a 3.3 percent increase in sales volume offset by a 0.9 percent decrease in pricing. The sales volume increase was driven by volume growth in several market segments and generally in line with end market conditions. Raw material cost as a percentage of net revenue increased 100 basis points as a result of increases in raw materials combined with price reductions. Manufacturing costs as a percentage of net revenue increased 150 basis points compared to 2013. The main driver for this increase is cost associated with the implementation of our ERP system. Operating expenses as a percentage of net revenue were flat. As a result, segment operating income decreased 16.2 percent compared to 2013 and segment profit margin decreased 250 basis points. EIMEA The following table provides details of the EIMEA net revenue variances: Net revenue decreased 15.9 percent in 2015 compared to 2014. Pricing increased 0.4 percent offset by a 2.3 percent decrease in sales volume. The negative currency effect of 14.0 percent was primarily the result of a weaker Euro, Turkish lira and Egyptian pound compared to the U.S. dollar. Sales volume was down in core Europe reflecting the generally soft end market conditions across most of the region and volume losses due to longer lead times caused by production inefficiencies related to the Business Integration Project. Sales volume growth was generated in the emerging markets, mainly in India, Middle East and Turkey. Raw material costs as a percentage of net revenue decreased 30 basis points in 2015 compared to 2014. Other manufacturing costs as a percentage of net revenue were 150 basis points higher than last year mainly due to lower sales. Operating expenses were 10.8 percent lower than 2014. In 2015, segment operating income decreased 61.1 percent and segment profit margin decreased 220 basis points compared to 2014. Net revenue decreased 1.8 percent in 2014 compared to 2013. Pricing increased 0.4 percent offset by a 2.5 percent decrease in sales volume. The stronger Euro partially offset by weaker Turkish lira, Indian rupee and Egyptian pound compared to the U.S. dollar resulted in a 0.3 percent increase in net revenue. Sales volume was down in core Europe reflecting the generally soft end market conditions across most of the region and the negative impact of deteriorated customer service levels due to the Business Integration Project. Sales volume growth was generated in the emerging markets, mainly in India and Turkey. Raw material costs as a percentage of net revenue increased 90 basis points in 2014 compared to 2013 primarily due to an increase in vinyl acetate monomer (VAM) costs in the second half of 2014. All other manufacturing costs as a percentage of net revenue were 190 basis points higher than last year mainly due to business integration costs that are not classified as special charges. Operating expenses as a percentage of net revenue were flat. In 2014, segment operating income decreased 40.8 percent and segment profit margin decreased 280 basis points compared to 2013. The following table provides details of Asia Pacific net revenue variances: Net revenue for 2015 increased 33.7 percent compared to 2014. Constant currency growth was 39.8 percent driven by 40.3 percent increase in sales volume offset by a decrease in pricing of 0.5 percent. The increase in sales volume occurred in all Asia sub-regions and included the addition of the Tonsan business acquired in the first quarter of 2015. The negative currency effect of 6.1 percent was primarily the result of a weaker Australian dollar compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 370 basis points in 2015 compared to 2014 primarily due to lower raw material costs following the drop in the global price of oil and natural gas and a change in sales mix. Other manufacturing costs as a percentage of net revenue were 40 basis points lower in 2015 compared to 2014. SG&A expenses as a percentage of net revenue increased 330 basis points compared to 2014 primarily from the added expense from the Tonsan acquisition. Segment operating income increased 84.3 percent and segment profit margin increased 130 basis points in 2015 compared to 2014. Net revenue for 2014 increased 9.2 percent compared to 2013. Constant currency growth was 11.2 percent driven mainly by volume growth while pricing was flat. Volume growth occurred in all Asia sub-regions as market conditions improved. Raw material costs as a percentage of net revenue increased 80 basis points in 2014 relative to the prior year. Manufacturing costs as a percentage of net revenue were flat in 2014 compared to 2013. SG&A expenses as a percentage of net revenue decreased 30 basis points compared to 2013. Segment operating income decreased 4.6% and segment profit margin decreased 50 basis points in 2014 compared to 2013. Construction Products The following tables provide details of Construction Products net revenue variances: Net revenue increased 23.8 percent in 2015 driven by 20.9 percent increase in sales volume and a 2.9 percent increase in pricing compared to 2014. The increase in sales volume was primarily attributed to continued market share gains with several key retail partners and the ProSpec acquisition in the fourth quarter of 2014. Raw material costs as a percentage of net revenue decreased 50 basis points in 2015 compared to 2014 primarily due to lower raw material costs and changes in sales mix. Other manufacturing costs as a percentage of net revenue decreased by 30 basis points. Operating expenses as a percentage of net revenue decreased 220 basis points compared to 2014 primarily due to increased sales volume. Segment operating income increased by $8.5 million, or 127.5 percent and segment profit margin increased 300 basis points compared to 2014. Net revenue increased 18.7 percent in 2014 driven by 20.4 percent increase in sales volume offset by a 1.7 percent decrease in pricing compared to 2013. The increase in sales volume was primarily attributed to continued market share gains with several key retail partners. Raw material costs as a percentage of net revenue increased by 190 basis points in 2014 relative to 2013 primarily due to changes in sales mix. Other manufacturing costs as a percentage of net revenue increased by 240 basis points mainly due to lower productivity rates as new business was ramped up. Operating expenses as a percentage of net revenue decreased 90 basis points compared to 2013. Segment operating income decreased 39.1 percent and segment profit margin decreased 340 basis points compared to 2013. Financial Condition, Liquidity and Capital Resources Total cash and cash equivalents as of November 28, 2015 were $119.2 million compared to $77.6 million as of November 29, 2014. Total long and short-term debt was $722.9 million as of November 28, 2015 and $574.8 million as of November 29, 2014. We believe that cash flows from operating activities will be adequate to meet our ongoing liquidity and capital expenditure needs. In addition, we believe we have the ability to obtain both short-term and long-term debt to meet our financing needs for the foreseeable future. Cash available in the United States has historically been sufficient and we expect it will continue to be sufficient to fund U.S. operations and U.S. capital spending and U.S. pension and other postretirement benefit contributions in addition to funding U.S. acquisitions, dividend payments, debt service and share repurchases as needed. For those international earnings considered to be reinvested indefinitely, we currently have no intention to, and plans do not indicate a need to, repatriate these funds for U.S. operations. Our credit agreements and note purchase agreements include restrictive covenants that, if not met, could lead to a renegotiation of our credit lines and a significant increase in our cost of financing. At November 28, 2015, we were in compliance with all covenants of our contractual obligations as shown in the following table: ● TTM = trailing 12 months ● EBITDA for covenant purposes is defined as consolidated net income, plus (i) interest expense, (ii) taxes, (iii) depreciation and amortization, (iv) non-cash impairment losses, (v) extraordinary non-cash losses incurred other than in the ordinary course of business, (vi) nonrecurring extraordinary non-cash restructuring charges, (vii) [reserved] , (viii) cash expenses incurred during fiscal years 2013 through 2015 in connection with facilities consolidation, restructuring and integration, discontinuance of operations, work force reduction, sale or abandonment of assets other than inventory, and professional and other fees incurred in connection with the acquired business or the restructuring of the company’s Europe, India, Middle East and Africa operations, not to exceed (x) $39.8 million for the period beginning with the fiscal quarter ending November 30, 2013 through and including the fiscal quarter ending May 31, 2014 and (y) $20.0 million for the period beginning with the fiscal quarter ending August 30, 2014 through and including the fiscal quarter ending November 28, 2015, (ix) cash expenses related to the Tonsan acquisition for advisory services and for arranging financing for the acquired business (including the non-cash write-off of deferred financing costs and any loss or expense on foreign exchange transactions intended to hedge the purchase price for the acquired business) with cash expenses not to exceed $10.0 million, minus extraordinary non-cash gains incurred other than in the ordinary course of business. For the Total Indebtedness / TTM EBITDA ratio, TTM EBITDA is adjusted for the pro forma results from Material Acquisitions and Material Divestitures as if the acquisition or divestiture occurred at the beginning of the calculation period. Additional detail is provided in the Form 8-K dated October 31, 2014. ● Pursuant to the Credit Agreement dated October 31, 2014, the company elected to increase the Total Indebtedness / TTM EBITDA ratio to a maximum of 3.75 to 1.00 for four quarters beginning with the first fiscal quarter ending February 28, 2015. The maximum ratio will return to 3.50 to 1.00 in the first fiscal quarter ending February 27, 2016. We believe we have the ability to meet all of our contractual obligations and commitments in fiscal 2016. Net Financial Assets Of the $119.2 million in cash and cash equivalents as of November 28, 2015, $83.1 million was held outside the U.S. Of the $83.1 million of cash held outside the U.S., earnings on $74.7 million are indefinitely reinvested outside of the U.S. It is not practical for us to determine the U.S. tax implications of the repatriation of these funds. There are no contractual or regulatory restrictions on the ability of consolidated and unconsolidated subsidiaries to transfer funds in the form of cash dividends, loans or advances to us, except for: 1) a credit facility limitation restricting investments, loans, advances or capital contributions from the U.S. parent corporation, the Irish financing subsidiary, and the Construction Products subsidiary in excess of $100.0 million, 2) a credit facility limitation that provides total investments, loans, advances or guarantees not otherwise permitted in the credit agreement for all subsidiaries shall not exceed $125.0 million in the aggregate and 3) typical statutory restrictions, which prohibit distributions in excess of net capital or similar tests. The 2012 Forbo acquisition, the 2015 Tonsan acquisition and any investments, loans, and advances established to consummate the Forbo and Tonsan acquisitions are excluded from the credit facility limitations described above. Additionally, we have taken the income tax position that the majority of our cash in non-U.S. locations is indefinitely reinvested. We rely on operating cash flow, short-term borrowings and long-term debt to provide for the working capital needs of our operations. We believe that we have the ability to obtain both short-term and long-term debt to meet our financing needs for the foreseeable future. Debt Outstanding and Debt Capacity Notes Payable: Notes payable were $30.8 million at November 28, 2015 and $27.1 million at November 29, 2014. These amounts mainly represented various foreign subsidiaries’ short-term borrowings that were not part of committed lines. The weighted-average interest rates on these short-term borrowings were 8.1 percent in 2015 and 11.3 percent in 2014. Long-Term Debt: Long-term debt consisted of senior notes and term loans. The Series A and Series B senior notes bear a fixed interest rate of 5.13 percent and mature in fiscal year 2017. The Series C and Series D senior notes bear a fixed interest rate of 5.61 percent and mature in fiscal year 2020. The Series E senior notes bear a fixed interest rate of 4.12 percent and mature in fiscal year 2022. We are subject to prepayment penalties on our senior notes. As of November 28, 2015, make-whole premiums were estimated to be, if the entire debt were paid off, $42.6 million. We currently have no intention to prepay any senior notes. We executed interest rate swap agreements for the purpose of obtaining a floating rate of interest on $75.0 million of the $150.0 million senior notes. We have designated the $75.0 million of senior note debt as the hedged item in a fair value hedge. As required by applicable accounting standards, we recorded an asset for the fair value of the interest rate swaps (hedging instruments) totaling $3.4 million and recognized a liability of $3.4 million for the change in the fair value of the senior notes attributable to the change in the risk being hedged. This calculation resulted in $153.4 million being recorded in long-term debt related to these senior notes as of November 28, 2015. For further information related to long-term debt see Note 7 to the Consolidated Financial Statements. On October 31, 2014, we entered into a credit agreement with a consortium of financial institutions under which we established a $300.0 million term loan that we can use to repay existing indebtedness, finance working capital needs, finance acquisitions, and for general corporate purposes. At November 28, 2015, there was a balance of $288.8 million drawn on the term loan. The interest rate on the term loan bears a floating interest rate at the London Interbank Offered Rate (LIBOR) plus 125 basis points and matures in 2019. There is no prepayment penalty on the term loan. See the discussion below regarding our lines of credit. On October 31, 2014 we amended various provisions of the Note Purchase Agreements Series A through E, including the covenant definition of Consolidated EBITDA. As part of these amendments, the interest rate on the debt may increase based on a ratings grid. Additional details on the Note Purchase Agreement amendments can be found in the 8-K dated October 31, 2014. Lines of Credit: We have a revolving credit agreement with a consortium of financial institutions at November 28, 2015. This credit agreement creates an unsecured multi-currency revolving credit facility that we can draw upon for general corporate purposes up to a maximum of $300.0 million. Interest is payable at LIBOR plus 1.075 percent. A facility fee of 0.175 percent is payable quarterly. The interest rate and the facility fee are based on a rating grid. The credit facility expires on October 31, 2019. As of November 28, 2015, our lines of credit were undrawn. Goodwill and Other Intangible Assets As of November 28, 2015, goodwill totaled $354.2 million (17 percent of total assets) and other intangible assets, net of accumulated amortization, totaled $213.0 million (10 percent of total assets). The components of goodwill and other identifiable intangible assets, net of amortization, by segment at November 28, 2015 are as follows: 1 Other finite-lived intangible assets are related to operating segment trademarks. 2 Indefinite-lived intangible assets are related to EIMEA operating segment trademarks. Selected Metrics of Liquidity and Capital Resources Key metrics we monitor are net working capital as a percent of annualized net revenue, trade account receivable days sales outstanding (DSO), inventory days on hand, free cash flow and debt capitalization ratio. 1 Current quarter net working capital (trade receivables, net of allowance for doubtful accounts plus inventory minus trade payables) divided by annualized net revenue. 2 Trade receivables net of allowance for doubtful accounts multiplied by 56 (8 weeks) and divided by the net revenue for the last 2 months of the quarter. 3 Total inventory multiplied by 56 and divided by cost of sales (excluding delivery costs) for the last 2 months of the quarter. 4 Net cash provided by operations less purchased property, plant and equipment and dividends paid. 5 Total debt divided by (total debt plus total stockholders’ equity). Another key metric we measure is the return on invested capital, or ROIC. The calculation is represented by total return divided by total invested capital. ● Total return is defined as: gross profit less SG&A expenses, less taxes at the effective tax rate plus income from equity method investments. Total return is calculated using trailing 12 month information. ● Total invested capital is defined as the sum of notes payable, current maturities of long-term debt, long-term debt, redeemable non-controlling interest and total equity. We believe ROIC provides a true measure of return on capital invested and is focused on the long term. The following table shows the ROIC calculation as of November 28, 2015 and November 29, 2014 based on the definition above: Summary of Cash Flows Cash Flows from Operating Activities from Continuing Operations Net income including non-controlling interest was $87.1 million in 2015, $50.2 million in 2014 and $97.2 million in 2013. Depreciation and amortization expense totaled $75.3 million in 2015 compared to $70.5 million in 2014 and $61.7 million in 2013. The higher depreciation and amortization expense in 2015 was directly related to the significant increase in capital expenditures in 2014 and 2013. Changes in net working capital (trade receivables, inventory and trade payables) accounted for a use of cash of $10.8 million, $69.6 million and $2.8 million in 2015, 2014 and 2013, respectively. Following is an assessment of each of the net working capital components: ● Trade Receivables, net - Changes in trade receivables resulted in a $12.0 use of cash in 2015 compared to $18.9 million use of cash in 2014 and a $7.3 million use of cash in 2013. The smaller use of cash in 2015 was partially related to lower net revenue compared to 2014. The DSO was 60 days at November 28, 2015, 56 days at November 29, 2014 and 55 days at November 30, 2013. ● Inventory - Changes in inventory resulted in a $4.6 million use of cash in 2015 compared to a use of cash of $36.2 million in 2014 and a use of cash of $11.8 million in 2013. Inventory days on hand were 60 days at the end of 2015 compared to 58 days at the end of 2014 and 53 days at the end of 2013. In 2015 inventory levels returned to a more normal level. In 2014, inventory levels increased to support the manufacturing transition as part of the Business Integration Project and the implementation of our ERP system in North America. ● Trade Payables - Changes in trade payables resulted in a source of cash of $5.8 million in 2015 compared to a use of cash of $14.5 million in 2014 and a source of cash of $16.3 million in 2013. The source of cash in 2015 compared to the use of cash in 2014 was primarily related to the timing of payments. Contributions to our pension and other postretirement benefit plans were $4.6 million, $12.6 million and $6.8 million in 2015, 2014 and 2013, respectively. Changes in deferred income taxes resulted in a source of cash of $6.6 million in 2015 compared to a source of cash of $4.2 million in 2014 and a source of cash of $9.6 million in 2013. Income taxes payable resulted in a use of cash of $1.4 million, $0.1 million and $17.9 million in 2015, 2014 and 2013, respectively. Other assets was a source of cash of $12.0 million, a use of cash of $41.7 million and a use of cash of $13.8 million in 2015, 2014 and 2013, respectively. The source of cash in 2015 was primarily related to the decrease in prepaid taxes other than income taxes. Accrued compensation was a source of cash of $6.0 million in 2015, a use of cash of $28.1 million in 2014 and a source of cash of $3.8 million in 2013. The source of cash in 2015 relates to lower payouts for our employee incentive plans and higher accruals. The use of cash in 2014 relates to the payments of severance related costs as part of our Business Integration Project. Other operating activity was a source of cash of $22.6 million in 2015, a source of cash of $33.3 million in 2014 and a use of cash of $11.1 million in 2013. The source of cash in 2015 and 2014 were primarily related to the impact of a stronger U.S. dollar on certain foreign transactions. Income (loss) from discontinued operations, net of tax were $1.3 million loss in 2015 and income of $1.2 million in 2013. Cash Flows from Investing Activities from Continuing Operations Purchases of property plant and equipment were $58.6 million in 2015 compared to $139.8 million in 2014 and $124.3 million in 2013. The decrease in 2015 was primarily related to reduced capital expenditures for the Business Integration Project and Project ONE ERP system compared to 2014 and 2013. In 2015 we received a cash settlement of $12.8 million as a result of an arbitration proceeding related to our initial implementation of Project ONE, of which $12.0 was recorded as a reduction of the ERP system asset. In 2015 we acquired Tonsan Adhesive, Inc. for $215.9 million and Continental Products Limited for $1.6 million. In 2014 we purchased the ProSpec construction products business for $26.2 million and adjusted the purchase price of Plexbond Quimica for $0.2 million. We acquired Plexbond Quimica, S.A. for $10.2 million in 2013 and reduced the purchase price for the 2012 industrial adhesives business acquisition by $1.6 million. See Note 2 to the Consolidated Financial Statements for further information on acquisitions. Cash Flows from Financing Activities from Continuing Operations Proceeds from long-term debt in 2015 were $357.0 million. Included in the $357.0 million of proceeds is $300.0 million from our October 31, 2014 term loan which was drawn in conjunction with the acquisition of Tonsan Adhesive, Inc. Repayment of long-term debt in 2015 was $211.3 million. In 2014 proceeds from long-term debt were $560.0 million and repayment of long-term debt was 483.3 million. Proceeds from long-term debt and repayment of long-term debt in 2013 was $107.0 million and $129.5 million, respectively. Cash paid for dividends were $25.7 million, $23.1 million and $19.3 million in 2015, 2014 and 2013, respectively. Cash generated from the exercise of stock options were $4.6 million in 2015, $6.9 million in 2014 and $8.9 million in 2013. Repurchases of common stock were $19.3 million in 2015 compared to $15.5 million in 2014 and $17.6 million in 2013, including $17.1 million in 2015, $12.3 million in 2014 and $15.3 million in 2013 from our 2010 share repurchase program. Cash flows from discontinued operations includes the 2015 settlement payment of the contingent consideration of the Central America Paints business, that was sold in 2012, less the related deferred income taxes. In 2013, in conjunction with filing the 2012 tax return, we reduced our income tax liability related to the sale of the Central America Paints business. See Note 2 to the Consolidated Financial Statements for further information. Contractual Obligations Due dates and amounts of contractual obligations follow: 1 Some of our interest obligations on long-term debt are variable based on LIBOR. Interest payable for the variable portion is estimated based on a forward LIBOR curve. 2 Pension contributions are only included for fiscal 2016. We have not determined our pension funding obligations beyond 2016 and thus, any potential future contributions have been excluded from the table. We expect to make cash outlays in the future related to uncertain tax positions. However, due to the uncertainty of the timing of future cash flows, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, gross unrecognized tax benefits of $4.9 million as of November 28, 2015 have been excluded from the contractual obligations table above. For further information related to unrecognized tax benefits see Note 8 to the Consolidated Financial Statements. We expect 2016 capital expenditures to be approximately $60.0 million. Off-Balance Sheet Arrangements There are no relationships with any unconsolidated, special-purpose entities or financial partnerships established for the purpose of facilitating off-balance sheet financial arrangements. Recently Issued Accounting Pronouncements See Note 1 to the Consolidated Financial Statements for information concerning new accounting standards and the impact of the implementation of these standards on our financial statements. Forward-Looking Statements and Risk Factors The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of words like "plan," "expect," "aim," "believe," "project," "anticipate," "intend," "estimate," "will," "should," "could" (including the negative or variations thereof) and other expressions that indicate future events and trends. These plans and expectations are based upon certain underlying assumptions, including those mentioned with the specific statements. Such assumptions are in turn based upon internal estimates and analyses of current market conditions and trends, our plans and strategies, economic conditions and other factors. These plans and expectations and the assumptions underlying them are necessarily subject to risks and uncertainties inherent in projecting future conditions and results. Actual results could differ materially from expectations expressed in the forward-looking statements if one or more of the underlying assumptions and expectations proves to be inaccurate or is unrealized. In addition to the factors described in this report, Item 1A. Risk Factors identifies some of the important factors that could cause our actual results to differ materially from those in any such forward-looking statements. In order to comply with the terms of the safe harbor, we have identified these important factors which could affect our financial performance and could cause our actual results for future periods to differ materially from the anticipated results or other expectations expressed in the forward-looking statements. These factors should be considered, together with any similar risk factors or other cautionary language that may be made elsewhere in this Annual Report on Form 10-K. The list of important factors in Item 1A. Risk Factors does not necessarily present the risk factors in order of importance. This disclosure, including that under Forward-Looking Statements and Risk Factors, and other forward-looking statements and related disclosures made by us in this report and elsewhere from time to time, represents our best judgment as of the date the information is given. We do not undertake responsibility for updating any of such information, whether as a result of new information, future events, or otherwise, except as required by law. Investors are advised, however, to consult any further public company disclosures (such as in filings with the SEC or in our press releases) on related subjects.

<s>[INST] H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. We manage our business through four operating segments Americas Adhesives, EIMEA (Europe, India, Middle East and Africa), Asia Pacific and Construction Products. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, flooring, textile, flexible packaging, graphic arts, envelope, automotive and electronics markets. The Construction Products operating segment provides floor preparation, grouts and mortars for tile setting as well as sealants and related products for heating, ventilation and air conditioning installations. The integration of the industrial adhesives business we acquired in March 2012 involved a significant amount of restructuring and capital investment to optimize the new combined entity. In addition to this acquisition, we announced our intentions to take a series of actions in our existing EIMEA operating segment to improve the profitability and future growth prospects of this operating segment. We combined these two initiatives into a single project which we refer to as the Business Integration Project. Total Company: When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas Global supply of and demand for raw materials Economic growth rates, and Currency exchange rates compared to the U.S. dollar We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impact the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in highgrowth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With over 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. In 2015, we generated 43 percent of our net revenue in the United States and 29 percent in EIMEA. The pace of economic growth in these areas directly impacts certain industries to which we supply products. For example, adhesivesrelated revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as Construction Products and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other constructionrelated activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies weaken against the dollar, our revenues and costs decrease as the foreign currencydenominated financial statements translate into fewer dollars. The fluctuations of the Euro against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2015, the currency fluctuations had a negative impact on net revenue of approximately $126.0 million as compared to 2014. Key financial results and transactions for 2015 included the following: Net revenue decreased 1.0 percent from 2014 primarily driven by a 6.0 percent decrease in currency offset by a 4.5 percent increase in sales volume and a 0.5 percent increase in product pricing. Gross profit margin increased to 27.3 percent from 25.3 percent in 2014. Cash flow generated by operating activities from continuing operations was $210.5 million in 2015 as compared to $29.7 million in 2014 and $132.7 million in 2013. We acquired 95 percent of the equity of Tonsan Adhesive, Inc. on February 2, 2015 for $215.9 million. The global [/INST] Positive. </s>

FULLER H B CO

2017-01-31

2016-12-03

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. We manage our business through five operating segments - Americas Adhesives, EIMEA (Europe, India, Middle East and Africa), Asia Pacific, Construction Products and Engineering Adhesives. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, flooring, textile, flexible packaging, graphic arts, and envelope markets. The Construction Products operating segment provides floor preparation, grouts and mortars for tile setting as well as sealants and related products for heating, ventilation and air conditioning installations. The Engineering Adhesives operating segment provides high-performance adhesives to the transportation, electronics, medical, clean energy, appliance and heavy machinery markets. Total Company When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: ● Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas ● Global supply of and demand for raw materials ● Economic growth rates, and ● Currency exchange rates compared to the U.S. dollar We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impacts the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in high-growth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With over 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. In 2016, we generated 42 percent of our net revenue in the United States and 29 percent in EIMEA. The pace of economic growth in these areas directly impacts certain industries to which we supply products. For example, adhesives-related revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as construction products and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other construction-related activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies weaken against the dollar, our revenues and costs decrease as the foreign currency-denominated financial statements translate into fewer dollars. The fluctuations of the Euro against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2016, the currency fluctuations had a negative impact on net revenue of approximately $38 million as compared to 2015. Key financial results and transactions for 2016 included the following: ● Net revenue increased 0.5 percent from 2015 primarily driven by a 3.9 percent increase in sales volume offset by a 1.8 percent decrease in currency and a 1.6 percent decrease in product pricing. ● Gross profit margin increased to 29.1 percent from 27.3 percent in 2015. ● Every five or six years we have a 53rd week in our fiscal year. 2016 was a 53-week year which increased our revenue and costs by approximately 2 percent. ● Cash flow generated by operating activities from continuing operations was $195.7 million in 2016 as compared to $210.5 million in 2015 and $29.7 million in 2014. ● We acquired Advanced Adhesives on April 29, 2016 for $10.4 million and Cyberbond on June 8, 2016 for $42.5 million. The global economic conditions showed little to no improvement in 2016. Our total year constant currency sales growth, which we define as the combined variances from product pricing, sales volume and small acquisitions, increased 2.3 percent for 2016 compared to 2015. In 2016, our diluted earnings per share from continuing operations was $2.42 per share compared to $1.71 per share in 2015 and $0.97 per share in 2014. The higher earnings per share from continuing operations in 2016 compared to 2015 resulted from higher sales volume, lower raw material costs and lower special charges. Project ONE In December of 2012 our Board of Directors approved a multi-year project to replace and enhance our existing core information technology platforms. The scope for this project includes most of the basic transaction processing for the company including customer orders, procurement, manufacturing, and financial reporting. The project envisions harmonized business processes for all of our operating segments supported with one standard software configuration. The execution of this project, which we refer to as Project ONE, is being supported by internal resources and consulting services. During 2013 a project team was formed and the global blueprint for the software configuration was designed and built. In the latter half of 2013 and in the early months of 2014, the global blueprint was applied to the specific requirements of our North America adhesives business, the software was tested and the user groups were trained. On April 6, 2014, our North America adhesives business went live. The implementation process proved to be more difficult than we originally anticipated resulting in disruptions in our manufacturing network, lower productivity and deteriorated customer service levels. By the end of 2014, most of the problems associated with the software implementation had been remediated and the business was stable and running at capacity with productivity levels approaching the levels experienced prior to the new software implementation. In late 2014, we suspended any further implementation projects in other geographic regions until we complete the optimization of the current platform in North America. We are preparing a revised implementation plan that leverages the experiences of our first go-live event and reduces the risk of significant business interruption. We expect to start subsequent implementations in 2017. The original capital expenditure plan for Project ONE was approximately $60.0 million. In the fourth quarter of 2015 we received a cash settlement of $12.8 million as a result of an arbitration proceeding related to our initial implementation of Project ONE. Of this amount, $12.0 million was related to capital expenditures, which allowed us to reduce our total project-to-date capital expenditures to $31.3 million. Given the complexity of the initial implementation, we anticipate that the total investment to complete the project will exceed our original estimate. We will have a revised estimate of the total project costs and the expected completion timetable later in 2017 when the revised implementation plan is complete. Our current plan is to proceed with the second phase implementation in our Latin America region with the project commencing in the first half of 2017 and completion expected in 2018. Subsequent phases of the global implementation will be evaluated following the completion of this second implementation. Restructuring Plan On December 7, 2016, the Company approved a restructuring plan (the “Plan”) related to organizational changes and other actions to optimize operations. In implementing the Plan, the Company expects to incur costs of approximately $17.0 million to $20.0 million ($13.0 million to $16.0 million after-tax) which includes (i) cash expenditures of approximately $13.0 million ($11.0 million after-tax) for severance and related employee costs globally and (ii) $4.0 million to $7.0 million ($3.0 million to $5.0 million after-tax) related to the optimization of production facilities, streamlining of processes and accelerated depreciation of long-lived assets. Approximately $15.0 million to $16.0 million ($12.0 million to $13.0 million after-tax) of the costs are expected to be cash costs. The Plan will be implemented beginning in the first quarter of 2017 and is currently expected to be completed by mid-year of fiscal 2018. The restructuring costs will be spread across the next several quarters as the measures are implemented with the majority of the costs occurring in fiscal 2017. Critical Accounting Policies and Significant Estimates Management’s discussion and analysis of our results of operations and financial condition are based upon the Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We believe the critical accounting policies and areas that require the most significant judgments and estimates to be used in the preparation of the Consolidated Financial Statements are pension and other postretirement plan assumptions; goodwill impairment assessment; long-lived assets recoverability; product, environmental and other litigation liabilities, income tax accounting and acquisition accounting. Pension and Other Postretirement Plan Assumptions We sponsor defined-benefit pension plans in both the U.S. and non-U.S. entities. Also in the U.S., we sponsor other postretirement plans for health care and life insurance benefits. Expenses and liabilities for the pension plans and other postretirement plans are actuarially calculated. These calculations are based on our assumptions related to the discount rate, expected return on assets, projected salary increases and health care cost trend rates. Note 10 to the Consolidated Financial Statements includes disclosure of assumptions employed in these measurements for both the non-U.S. and U.S. plans. The discount rate assumption is determined using an actuarial yield curve approach, which results in a discount rate that reflects the characteristics of the plan. The approach identifies a broad population of corporate bonds that meet the quality and size criteria for the particular plan. We use this approach rather than a specific index that has a certain set of bonds that may or may not be representative of the characteristics of our particular plan. A higher discount rate reduces the present value of the pension obligations. The discount rate for the U.S. pension plan was 4.10 percent at December 3, 2016, as compared to 4.30 percent at November 28, 2015 and 4.10 percent at November 29, 2014. Net periodic pension cost for a given fiscal year is based on assumptions developed at the end of the previous fiscal year. A discount rate reduction of 0.5 percentage points at December 3, 2016 would increase U.S. pension and other postretirement plan expense approximately $0.2 million (pre-tax) in fiscal 2017. Discount rates for non-U.S. plans are determined in a manner consistent with the U.S. plan. The expected long-term rate of return on plan assets assumption for the U.S. pension plan was 7.75 percent in 2016, 2015 and 2014. Our expected long-term rate of return on U.S. plan assets was based on our target asset allocation assumption of 60 percent equities and 40 percent fixed-income. Management, in conjunction with our external financial advisors, determines the expected long-term rate of return on plan assets by considering the expected future returns and volatility levels for each asset class that are based on historical returns and forward looking observations. For 2016, the expected long-term rate of return on the target equities allocation was 8.75 percent and the expected long-term rate of return on the target fixed-income allocation was 5.0 percent. The total plan rate of return assumption included an estimate of the effect of diversification and the plan expense. For 2017, the expected long-term rate of return on assets will continue to be 7.75 percent with an expected long-term rate of return on the target equities allocation of 8.5 percent and an expected long-term rate of return on target fixed-income allocation of 5.0 percent. A change of 0.5 percentage points for the expected return on assets assumption would impact U.S. net pension and other postretirement plan expense by approximately $2.0 million (pre-tax). Management, in conjunction with our external financial advisors, uses the actual historical rates of return of the asset categories to assess the reasonableness of the expected long-term rate of return on plan assets. The most recent 10-year and 20-year historical equity returns are shown in the table below. Our expected rate of return on our total portfolio is consistent with the historical patterns observed over longer time frames. (*) Beginning in 2006, our target allocation migrated from 100 percent equities to our current allocation of 60 percent equities and 40 percent fixed-income. The historical actual rate of return for the fixed income of 8.0 percent is since inception (10 years, 11 months). The expected long-term rate of return on plan assets assumption for non-U.S. pension plans was a weighted-average of 6.20 percent in 2016 compared to 6.22 percent in 2015 and 6.17 percent in 2014. The expected long-term rate of return on plan assets assumption used in each non-U.S. plan is determined on a plan-by-plan basis for each local jurisdiction and is based on expected future returns for the investment mix of assets currently in the portfolio for that plan. Management, in conjunction with our external financial advisors, develops expected rates of return for each plan, considers expected long-term returns for each asset category in the plan, reviews expectations for inflation for each local jurisdiction, and estimates the effect of active management of the plan’s assets. Our largest non-U.S. pension plans are in the United Kingdom and Germany. The expected long-term rate of return on plan assets for the United Kingdom was 6.75 percent and the expected long-term rate of return on plan assets for Germany was 5.75 percent. Management, in conjunction with our external financial advisors, uses actual historical returns of the asset portfolio to assess the reasonableness of the expected rate of return for each plan. The projected salary increase assumption is based on historic trends and comparisons to the external market. Higher rates of increase result in higher pension expenses. As this rate is also a long-term expected rate, it is less likely to change on an annual basis. In the U.S., we have used the rate of 4.50 percent for 2016, 2015 and 2014. Benefits under the U.S. Pension Plan were locked-in as of May 31, 2011 and no longer include compensation increases. The 4.50 percent rate is for the supplemental executive retirement plan only. Projected salary increase assumption for non-U.S. plans are determined in a manner consistent with the U.S. plans. Goodwill Goodwill is the excess of cost of an acquired entity over the amounts assigned to assets acquired and liabilities assumed in a purchase business combination. Goodwill is assigned to reporting units at the date the goodwill is initially recorded. Once goodwill has been assigned to a reporting unit, it no longer retains its association with a particular acquisition, and all the activities within a reporting unit are available to support the value of goodwill. Accounting standards require us to test goodwill for impairment annually or more often if circumstances or events indicate a change in the estimated fair value may have occurred. The goodwill impairment analysis is a two-step process. The first step used to identify potential impairment involves comparing each reporting unit’s estimated fair value to its carrying value, including goodwill. We use a discounted cash flow approach to estimate the fair value of our reporting units. Our judgment is required in developing the assumptions for the discounted cash flow model. These assumptions include revenue growth rates, profit margin percentages, discount rates, perpetuity growth rates, future capital expenditures and working capital requirements. If the estimated fair value of a reporting unit exceeds its carrying value, goodwill is considered to not be impaired. If the carrying value exceeds estimated fair value, there is an indication of potential impairment and the second step is performed to measure the amount of impairment. The second step of the process, if required, involves the calculation of an implied fair value of goodwill for each reporting unit for which step one indicated impairment. The implied fair value of goodwill is determined in a manner similar to how goodwill is calculated in a business combination, by measuring the excess of the estimated fair value of the reporting unit as calculated in step one, over the estimated fair values of the individual assets, liabilities and identifiable intangibles as if the reporting unit was being acquired in a business combination. If the implied fair value of goodwill exceeds the carrying value of goodwill assigned to the reporting unit, there is no impairment. If the carrying value of goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss cannot exceed the carrying value of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted. In the fourth quarter of 2016, we conducted the required annual test of goodwill for impairment. We performed the goodwill impairment analysis by using a discount rate determined by management to result in the most representative fair value of the business as a whole. Based on this analysis, it was determined that the goodwill allocated to the EIMEA Construction reporting unit was impaired. As a result, a goodwill impairment charge of $0.8 million was recorded as of 2016. There were no indications of impairment for any of the remaining reporting units. Of the goodwill balance of $366.2 million as of December 3, 2016, $98.9 million is allocated to the EIMEA reporting unit. The calculated fair value of this reporting unit exceeded its carrying value by approximately 60 percent. The goodwill balance in the Tonsan reporting unit as of December 3, 2016 is $114.4 million. The calculated fair value of this reporting unit exceeded its carrying value by approximately 30 percent. For both of these reporting units, the Company believes the calculated fair value exceeds the carrying value by a reasonable margin. For the remaining reporting units, the calculated fair value substantially exceeded the carrying value of the net assets. If the economy or business environment falter and we are unable to achieve our assumed revenue growth rates or profit margin percentages, our projections used would need to be remeasured, which could impact the carrying value of our goodwill in one or more of our reporting units. See Note 6 to the Consolidated Financial Statements. Recoverability of Long-Lived Assets The assessment of the recoverability of long-lived assets reflects our assumptions and estimates. Factors that we must estimate when performing impairment tests include sales volume, prices, inflation, currency exchange rates, tax rates and capital spending. Significant judgment is involved in estimating these factors, and they include inherent uncertainties. The measurement of the recoverability of these assets is dependent upon the accuracy of the assumptions used in making these estimates and how the estimates compare to the eventual future operating performance of the specific businesses to which the assets are attributed. Judgments made by us include the expected useful lives of long-lived assets. The ability to realize undiscounted cash flows in excess of the carrying amounts of such assets is affected by factors such as the ongoing maintenance and improvement of the assets, changes in economic conditions and changes in operating performance. Product, Environmental and Other Litigation Liabilities As disclosed in Item 3. Legal Proceedings and in Note 1 and Note 12 to the Consolidated Financial Statements, we are subject to various claims, lawsuits and other legal proceedings. Reserves for loss contingencies associated with these matters are established when it is determined that a liability is probable and the amount can be reasonably estimated. The assessment of the probable liabilities is based on the facts and circumstances known at the time that the financial statements are being prepared. For cases in which it is determined that a liability is probable but only a range for the potential loss exists, the minimum amount of the range is recorded and subsequently adjusted as better information becomes available. For cases in which insurance coverage is available, the gross amount of the estimated liabilities is accrued, and a receivable is recorded for any probable estimated insurance recoveries. A discussion of environmental, product and other litigation liabilities is disclosed in Item 3. Legal Proceedings and Note 12 to the Consolidated Financial Statements. Based upon currently available facts, we do not believe that the ultimate resolution of any pending legal proceeding, individually or in the aggregate, will have a material adverse effect on our long-term financial condition. However, adverse developments and/or periodic settlements could negatively affect our results of operations or cash flows in one or more future quarters. Contingent Consideration Liability Concurrent with a business acquisition, we entered into an agreement that requires us to pay the sellers a certain amount based upon a formula related to the entity’s gross profit in 2018. We use the income approach in calculating the fair value of this contingent consideration liability using a real option model. The significant judgments and assumptions utilized in the calculation of the contingent consideration liability include revenue growth rates, profit margin percentages, volatility and discount rate, which are sensitive to change. The change in fair value of the contingent consideration liability each reporting period is recorded in SG&A expenses in the Consolidated Statements of Income. See Notes 2 and 13 to the Consolidated Financial Statements for additional information. Income Tax Accounting As part of the process of preparing the Consolidated Financial Statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. The process involves estimating actual current tax expense along with assessing temporary differences resulting from differing treatment of items for book and tax purposes. These temporary differences result in deferred tax assets and liabilities, which are included in the Consolidated Balance Sheets. We record a valuation allowance to reduce our deferred tax assets to the amount that is more-likely-than-not to be realized. We have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance. Increases in the valuation allowance result in additional expense to be reflected within the tax provision in the Consolidated Statements of Income. As of December 3, 2016, the valuation allowance to reduce deferred tax assets totaled $11.9 million. We recognize tax benefits for tax positions for which it is more-likely-than-not that the tax position will be sustained by the applicable tax authority at the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement. We do not recognize a financial statement benefit for a tax position that does not meet the more-likely-than-not threshold. We believe that our liabilities for income taxes reflect the most likely outcome. It is difficult to predict the final outcome or the timing of the resolution of any particular tax position. Future changes in judgment related to the resolution of tax positions will impact earnings in the quarter of such change. We adjust our income tax liabilities related to tax positions in light of changing facts and circumstances. Settlement with respect to a tax position would usually require cash. Based upon our analysis of tax positions taken on prior year returns and expected tax positions to be taken for the current year tax returns, we have identified gross uncertain tax positions of $4.2 million as of December 3, 2016. We have not recorded U.S. deferred income taxes for certain of our non-U.S. subsidiaries undistributed earnings as such amounts are intended to be indefinitely reinvested outside of the U.S. Should we change our business strategies related to these non-U.S. subsidiaries, additional U.S. tax liabilities could be incurred. It is not practical to estimate the amount of these additional tax liabilities. See Note 8 to the Consolidated Financial Statements for further information on income tax accounting. Acquisition Accounting As we enter into business combinations we perform acquisition accounting requirements including the following: ● Identifying the acquirer, ● Determining the acquisition date, ● Recognizing and measuring the identifiable assets acquired and the liabilities assumed, and ● Recognizing and measuring goodwill or a gain from a bargain purchase We complete valuation procedures, and record the resulting fair value of the acquired assets and assumed liabilities based upon the valuation of the business enterprise and the tangible and intangible assets acquired. Enterprise value allocation methodology requires management to make assumptions and apply judgment to estimate the fair value of assets acquired and liabilities assumed. If estimates or assumptions used to complete the enterprise valuation and estimates of the fair value of the acquired assets and assumed liabilities significantly differed from assumptions made, the resulting difference could materially affect the fair value of net assets. The calculation of the fair value of the tangible assets, including property, plant and equipment utilizes the cost approach, which computes the cost to replace the asset, less accrued depreciation resulting from physical deterioration, functional obsolescence and external obsolescence. The calculation of the fair value of the identified intangible assets are determined using cash flow models following the income approach or a discounted market-based methodology approach. Significant inputs include estimated revenue growth rates, gross margins, operating expenses, estimated attrition rate, and a discount rate. Goodwill is recorded as the difference in the fair value of the acquired assets and assumed liabilities and the purchase price. Results of Operations Net revenue Net revenue in 2016 increased 0.5 percent from 2015. The 2015 net revenue was 1.0 percent lower than the net revenue in 2014. We review variances in net revenue in terms of changes related to product pricing, sales volume, changes in foreign currency exchange rates and large acquisitions. The pricing/sales volume variance and small acquisitions including Cyberbond, Advanced Adhesives, Tonsan Adhesive, Inc., Continental Products Limited and ProSpec construction products are viewed as constant currency growth. The following table shows the net revenue variance analysis for the past two years: Constant currency growth was 2.3 percent in 2016 compared to 2015. The 2.3 percent constant currency growth in 2016 was driven by 27.3 percent growth in Engineering Adhesives, 8.5 percent growth in Asia Pacific and 2.0 percent growth in EIMEA, offset by a 5.8 percent decrease in Construction Products and 2.7 percent decrease in Americas Adhesives. The negative 1.8 percent currency impact was primarily driven by the devaluation of the Chinese renminbi, Euro, Egyptian pound, Turkish lira, Canadian dollar, Indian rupee, Australian dollar and Malaysian ringgit compared to the U.S. dollar. Constant currency growth was 5.0 percent in 2015 compared to 2014. The 5.0 percent constant currency growth in 2015 was driven by 101.6 percent growth in Engineering Adhesives, 17.6 percent growth in Construction Products and 3.8 percent growth in Asia Pacific offset by a 4.3 percent decrease in Americas Adhesives and 2.0 percent decrease in EIMEA. The majority of the negative currency impact was driven by the weakening of the Euro, Turkish lira, Canadian dollar and Australian dollar against the U.S. dollar. Cost of sales Raw material costs as a percentage of net revenue decreased 220 basis points in 2016 compared to 2015 due to lower raw material costs, sales mix and the 2015 impact of valuing inventories acquired in the Tonsan Adhesive, Inc. acquisition at fair value. Other manufacturing costs as a percentage of revenue increased 40 basis points compared to 2015. As a result, cost of sales as a percentage of net revenue decreased 180 basis points compared to 2015. Raw material costs as a percentage of net revenue decreased 200 basis points in 2015 compared to 2014, reflecting decreases in raw materials costs as well as changes in product pricing and sales mix. Other manufacturing costs as a percentage of revenue remained flat compared to 2014. As a result, cost of sales as a percentage of net revenue decreased 200 basis points compared to 2014. Gross profit Gross profit in 2016 increased $41.8 million compared to 2015 and gross profit margin increased 180 basis points. The decrease in the cost of raw materials was the main factor for the increase in gross profit. Gross profit in 2015 increased $34.7 million compared to 2014 and gross profit margin increased 200 basis points. The decrease in the cost of raw materials was the main factor for the increase in gross profit. Selling, general and administrative expenses Selling, general and administration (“SG&A”) expenses for 2016 increased $10.0 million or 2.5 percent compared to 2015. The increase is mainly due to higher personnel costs related to increased headcount, a full year of Tonsan operations for 2016 and incremental expenses coming from newly acquired businesses compared to 2015. This increase is partially offset by lower expenses related to general spending reductions, foreign currency exchange rate benefits on spending outside the U.S. and the mark to market adjustment related to the Tonsan contingent consideration liability. SG&A expenses for 2015 increased $14.2 million or 3.7 percent compared to 2014. The added expense from the Tonsan acquisition partially offset by foreign currency exchange rates were the main drivers for the increase. We make SG&A expense plans at the beginning of each fiscal year and barring significant changes in business conditions or our outlook for the future, we maintain these spending plans for the entire year. Management routinely monitors our SG&A spending relative to these fiscal year plans for each operating segment and for the company overall. We feel it is important to maintain a consistent spending program in this area as many of the activities within the SG&A category such as the sales force, technology development, and customer service are critical elements of our business strategy. Special Charges, net The following table provides detail of special charges, net: The integration of the industrial adhesives business we acquired in March 2012 involved a significant amount of restructuring and capital investment to optimize the new combined entity. In addition to this acquisition, we announced our intentions to take a series of actions in our existing EIMEA operating segment to improve the profitability and future growth prospects of this operating segment. We combined these two initiatives into a single project which we refer to as the Business Integration Project. During the years ended December 3, 2016, November 28, 2015 and November 29, 2014, we incurred special charges, net of $(0.2) million, $4.7 million and $51.5 million, respectively, for costs related to the Business Integration Project. Acquisition and transformation related costs of $0.2 million for the year ended December 3, 2016, $0.7 million for the year ended November 28, 2015 and $7.9 million for the year ended November 29, 2014 include costs related to organization consulting, financial advisory and legal services necessary to integrate the acquired business into our existing operating segments. During the year ended December 3, 2016, we incurred cash facility exit costs of $1.3 million, non-cash facility exit costs of $1.7 million and other incremental transformation related costs of $0.2 million including the cost of personnel directly working on the integration. Also included in facility exit costs for 2016 is a $3.6 million gain on the sale of our production facility located in Wels, Austria, of which the sale closed during the third quarter of 2016. During the year ended November 28, 2015, we incurred cash facility exit costs of $2.2 million, non-cash facility exit costs of $1.5 million and other incremental transformation related costs of $0.3 million including the cost of personnel directly working on the integration. During the year ended November 29, 2014, we incurred workforce reduction costs of $3.2 million, cash facility exit costs of $25.2 million, non-cash facility exit costs of $6.9 million and other incremental transformation related costs of $8.3 million including the cost of personnel directly working on the integration. We present operating segment information consistent with how we organize our business internally, assess performance and make decisions regarding the allocation of resources. Segment operating income is defined as gross profit less selling, general and administrative expenses. Because this definition excludes special charges, we have not allocated special charges to the operating segments or included them in Management’s Discussion & Analysis of operating segment results. For informational purposes only, the following table provides the special charges, net attributable to each operating segment for the periods presented: We expect total project costs will be approximately $164.0 million. The following table provides detail of costs incurred inception-to-date as of December 3, 2016 for the Business Integration Project: Non-cash costs are primarily related to accelerated depreciation of long-lived assets. Other income (expense), net Currency transaction and remeasurement losses were $9.5 million, $3.5 million and $2.5 million in 2016, 2015 and 2014, respectively. Interest income was $2.0 million in 2016 compared to $0.5 million in 2015 and $0.4 million in 2014. Gain or (loss) on disposal of fixed assets were ($.8) million, $0.3 million and $2.8 million in 2016, 2015 and 2014, respectively. Interest expense Interest expense was $27.4 million in 2016 compared to $25.0 million in 2015 and $19.7 million in 2014. The higher interest expense in 2016 compared to 2015 was due to higher LIBOR rates on floating rate debt held in the U.S. and larger local currency balances at higher interest rates. The higher interest expense in 2015 compared to 2014 was due to higher average debt balances resulting from the Tonsan acquisition and lower capitalized interest on capital projects, offset by lower average interest rates. We capitalized interest of $0.8 million, $0.1 million and $2.7 million in 2016, 2015 and 2014, respectively. Income taxes Income tax expense in 2016 of $50.4 million includes $2.6 million of discrete tax benefits in both the U.S. and foreign jurisdictions. Income tax expense in 2015 of $55.9 million included $0.2 million of discrete tax expense in both the U.S. and foreign jurisdictions. Income tax expense in 2014 of $34.3 million included $1.4 million of discrete tax benefits in both the U.S. and foreign jurisdictions. Excluding discrete items, the overall effective tax rate decreased by 8.5 percentage points in 2016 as compared to 2015 and 4.9 percentage points in 2015 as compared to 2014. The decrease in the tax rate is principally due to a change in the geographic mix of pre-tax earnings and the reduction in special charges. Income from equity method investments The income from equity method investments relates to our 50 percent ownership of the Sekisui-Fuller joint venture in Japan. The higher income for 2016 compared to 2015 is related to higher net income in the joint venture and the impact of a stronger Japanese yen. Sekisui-Fuller’s net income measured in Japanese yen was higher in 2015 compared to 2014, but the weakening of the yen in 2015 negatively impacted the net income in U.S. dollars. Income from equity method investments was negatively impacted in 2014 by a correction of an error in the carrying value of our investment in Sekisui-Fuller in the amount of $1.6 million. Income (loss) from discontinued operations, net of tax The income (loss) from discontinued operations, net of tax, relates to our Central America Paints business, which we sold in 2012. In 2015, in conjunction with the final settlement agreement, we increased our contingent consideration liability by $2.1 million and adjusted the related deferred income tax. Net income attributable to non-controlling interests The net income attributable to non-controlling interests relates to the redeemable non-controlling interest in H.B. Fuller Kimya Sanayi Ticaret A.S. (HBF Kimya). Net income attributable to H.B. Fuller Net income attributable to H.B. Fuller was $124.1 million in 2016 compared to $86.7 million in 2015 and $49.8 million in 2014. Fiscal year 2016 included $(0.2) million of special charges, net ($0.1 million after-tax) for costs related to the Business Integration Project compared to $4.7 million ($4.7 million after-tax) in 2015 and $51.5 million ($45.2 million after-tax) in 2014. Diluted earnings per share, from continuing operations, was $2.42 per share in 2016, $1.71 per share for 2015 and $0.97 per share for 2014. Operating Segment Results We are required to report segment information in the same way that we internally organize our business for assessing performance and making decisions regarding allocation of resources. For segment evaluation by the chief operating decision maker, segment operating income is defined as gross profit less SG&A expenses. Segment operating income excludes special charges, net. Inter-segment revenues are recorded at cost plus a markup for administrative costs. Corporate expenses are fully allocated to each operating segment. Through the fourth quarter of 2015, our business was reported in four operating segments: Americas Adhesives, Europe, India, Middle East and Africa (EIMEA), Asia Pacific and Construction Products. Changes in our management reporting structure during the first quarter of 2016 required us to conduct an operating segment assessment in accordance with Accounting Standards Codification Topic 280, Segment Reporting, to determine our reportable segments. As a result of this assessment, we now have five reportable segments: Americas Adhesives, EIMEA, Asia Pacific, Construction Products and Engineering Adhesives. Prior period segment information has been recast retrospectively to reflect our new operating segments. The tables below provide certain information regarding the net revenue and segment operating income of each of our operating segments. Net Revenue by Segment Segment Operating Income The following table provides a reconciliation of segment operating income to income from continuing operations before income taxes and income from equity method investments, as reported on the Consolidated Statements of Income. Americas Adhesives The following tables provide details of Americas Adhesives net revenue variances: Net revenue decreased 3.0 percent in 2016 compared to 2015. The 2.7 percent decrease in constant currency growth was attributable to a 0.2 percent increase in sales volume offset by a 2.9 percent decrease in product pricing. The 0.3 percent negative currency effect was due to the weaker Canadian dollar compared to the U.S. dollar. The sales volume increase was driven by modest market share gains partially offset by general end-market weakness in Latin America and unfavorable sales mix. As a percentage of net revenue, raw material costs decreased 150 basis points mainly due to reductions in raw material costs. Other manufacturing costs as a percentage of net revenue increased 40 basis points in 2016 compared to 2015. Segment operating income decreased 1.4 percent and segment operating margin as a percentage of net revenue increased 20 basis points in 2016 compared to 2015. Net revenue decreased 5.3 percent in 2015 compared to 2014. The 4.3 percent decrease in constant currency growth was attributable to a 4.7 percent decrease in sales volume offset by a 0.4 percent increase in pricing. The sales volume decrease was driven by lower volume in several market segments and lost market share related to our ERP system implementation. Raw material costs as a percentage of net revenue decreased 290 basis points as a result of decreases in raw material costs following the drop in the global price of oil and natural gas. Other manufacturing costs as a percentage of net revenue decreased 60 basis points compared to 2014. Segment operating income increased 20.8 percent compared to 2014 and segment profit margin increased 330 basis points. EIMEA The following table provides details of the EIMEA net revenue variances: Net revenue decreased 0.8 percent in 2016 compared to 2015. The 2.0 percent increase in constant currency growth was attributable to a 3.0 percent increase in sales volume offset by a 1.0 percent decrease in product pricing. Sales volume growth was primarily related to the hygiene market, with strong growth in the emerging markets, as well as growth in core Europe. The 2.8 percent negative currency effect was primarily the result of a weaker Euro, Egyptian pound, Turkish lira and Indian rupee compared to the U.S. dollar. Raw material cost as a percentage of net revenue decreased 300 basis points in 2016 compared to 2015 primarily due to lower raw material costs. Other manufacturing costs as a percentage of net revenue were 100 basis points lower than 2015 primarily due to improved production efficiencies, lower freight costs and favorable currency impacts. Segment operating income increased 165.4 percent and segment operating margin increased 460 basis points compared to 2015. Net revenue decreased 15.7 percent in 2015 compared to 2014. The 2.0 percent decrease in constant currency growth was attributable to a 1.6 percent decrease in sales volume and a 0.4 percent decrease in product pricing. Sales volume was down in core Europe reflecting the generally soft end market conditions across most of the region and volume losses due to longer lead times caused by production inefficiencies related to the Business Integration Project. Sales volume growth was generated in the emerging markets, mainly in India, Middle East and Turkey. The negative currency effect of 13.7 percent was primarily the result of a weaker Euro, Turkish lira and Egyptian pound compared to the U.S. dollar. Raw material costs as a percentage of net revenue was flat in 2015 compared to 2014. Other manufacturing costs as a percentage of net revenue were 160 basis points higher in 2015 compared to 2014 mainly due to lower sales. In 2015, segment operating income decreased 54.5 percent and segment profit margin decreased 230 basis points compared to 2014. Asia Pacific The following table provides details of Asia Pacific net revenue variances: Net revenue in 2016 increased 4.8 percent compared to 2015. The 8.5 percent increase in constant currency growth was attributable to a 10.8 percent increase in sales volume partially offset by a 2.3 percent decrease in product pricing. Most of the growth compared to 2015 is driven by the acquisition of Advanced Adhesives that occurred during the second quarter of 2016, as well as growth in Southeast Asia and Greater China. Negative currency effects of 3.7 percent compared to 2015 were primarily driven by the weaker Chinese renminbi, Australian dollar and Malaysian ringgit compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 140 basis points compared to 2015 due to lower raw material costs and changes in sales mix, partially offset by the impact of valuing inventories related to the Advanced Adhesives acquisition at fair value. Other manufacturing costs as a percentage of net revenue increased 110 basis points compared to 2015, primarily due to the acquisition of Advanced Adhesives and the costs to rationalize certain production capabilities in Southeast Asia. Segment operating income increased 19 percent and segment operating margin increased 80 basis points compared to 2015. Net revenue for 2015 decreased 1.5 percent compared to 2014. Constant currency growth was 3.8 percent driven by 4.0 percent increase in sales volume offset by a decrease in pricing of 0.2 percent. The increase in sales volume occurred in all Asia sub-regions. The negative currency effect of 5.3 percent was primarily the result of a weaker Australian dollar compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 300 basis points in 2015 compared to 2014 primarily due to lower raw material costs following the drop in the global price of oil and natural gas and a change in sales mix. Other manufacturing costs as a percentage of net revenue were 80 basis points higher in 2015 compared to 2014. Segment operating income increased 55.2 percent and segment profit margin increased 200 basis points in 2015 compared to 2014. Construction Products The following tables provide details of Construction Products net revenue variances: Net revenue decreased 6.0 percent in 2016 compared to 2015. The 5.8 percent decrease in constant currency growth was driven by a 6.7 percent decrease in sales volume offset by a 0.9 percent increase in product pricing. The decrease in sales volume was primarily attributed to lower export revenue, inventory rebalancing with certain channel partners and a strong fiscal 2015 driven by market share gains with certain retail partners. The increase in pricing is mainly due to price increases related to certain product lines in multiple channels. Negative currency effects of 0.2 percent compared to 2015 were primarily driven by the weaker Australian dollar compared to the U.S. dollar. Raw material cost as a percentage of net revenue was 210 basis points lower in 2016 compared to 2015 primarily due to changes in product mix and lower raw material costs. Other manufacturing costs as a percentage of net revenue were 360 basis points higher in 2016 compared to 2015 mainly due to higher supply chain costs as we complete the facility upgrade and expansion project. Segment operating income decreased 76.3 percent and segment profit margin decreased 370 basis points in 2016 compared to 2015. Net revenue increased 14.9 percent in 2015 compared to 2014. The 17.6 percent increase in constant currency growth was driven by a 14.9 percent increase in sales volume and a 2.7 percent increase in product pricing. The increase in sales volume was primarily attributed to market share gains with several key retail partners and the ProSpec acquisition in the fourth quarter of 2014. Negative currency effects of 2.7 percent compared to 2015 were primarily driven by the weaker Australian dollar and Euro compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 160 basis points in 2015 compared to 2014 primarily due to lower raw material costs and changes in sales mix. Other manufacturing costs as a percentage of net revenue decreased by 10 basis points. Operating expenses as a percentage of net revenue decreased 280 basis points compared to 2014 primarily due to increased sales volume. Segment operating income increased by $11.0 million and segment profit margin increased 380 basis points compared to 2014. Engineering Adhesives The following tables provide details of Engineering Adhesives net revenue variances: Net revenue increased 22.7 percent in 2016 compared to 2015. The 27.3 percent increase in constant currency growth was driven by a 27.9 percent increase in sales volume offset by a 0.6 percent decrease in product pricing. The increase in sales volume was partially attributed to a full year of the Tonsan business, which was acquired late in the first quarter of 2015, as well as the acquisition of Cyberbond that occurred during the third quarter of 2016. Negative currency effects of 4.6 percent compared to 2015 were primarily driven by the weaker Chinese renminbi and Euro compared to the U.S. dollar. Raw material cost as a percentage of net revenue was 390 basis points lower in 2016 compared to 2015 primarily due to the impact of valuing inventories related to the Tonsan acquisition at fair value, lower raw material costs and changes in product mix associated with the acquisition of Tonsan. Other manufacturing costs as a percentage of net revenue were 40 basis points higher in 2016 compared to 2015 primarily due to the impact of a full year of the Tonsan business and the Cyberbond acquisition. Operating expense as a percentage of net revenue decreased 320 basis points compared to 2015, partially due to the net mark to market adjustment related to the Tonsan contingent consideration liability offest by the Cyberbond acquisition. Segment operating income increased $16.5 million and segment operating margin increased 670 basis points in 2016 compared to 2015. Net revenue increased 93.4 percent in 2015 compared to 2014. The 101.6 percent increase in constant currency growth was driven by a 98.1 percent increase in sales volume and a 3.5 percent increase in product pricing. The increase in sales volume was primarily attributed to the Tonsan acquisition, which occurred in the first quarter of 2015. Negative currency effects of 8.2 percent compared to 2014 were primarily driven by the weaker Chinese renminbi and Euro compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 400 basis points in 2015 compared to 2014 primarily due to lower raw material costs and changes in sales mix. Other manufacturing costs as a percentage of net revenue decreased by 260 basis points. Operating expenses as a percentage of net revenue increased 590 basis points compared to 2014 primarily due to increased sales volume and the net mark to market adjustment related to the Tonsan contingent consideration liability. Segment operating income increased $1.2 million and segment profit margin increased 70 basis points compared to 2014. Financial Condition, Liquidity and Capital Resources Total cash and cash equivalents as of December 3, 2016 were $142.2 million compared to $119.2 million as of November 28, 2015. Total long and short-term debt was $705.6 million as of December 3, 2016 and $722.9 million as of November 28, 2015. We believe that cash flows from operating activities will be adequate to meet our ongoing liquidity and capital expenditure needs. In addition, we believe we have the ability to obtain both short-term and long-term debt to meet our financing needs for the foreseeable future. Cash available in the United States has historically been sufficient and we expect it will continue to be sufficient to fund U.S. operations and U.S. capital spending and U.S. pension and other postretirement benefit contributions in addition to funding U.S. acquisitions, dividend payments, debt service and share repurchases as needed. For those international earnings considered to be reinvested indefinitely, we currently have no intention to, and plans do not indicate a need to, repatriate these funds for U.S. operations. Our credit agreements and note purchase agreements include restrictive covenants that, if not met, could lead to a renegotiation of our credit lines and a significant increase in our cost of financing. At December 3, 2016, we were in compliance with all covenants of our contractual obligations as shown in the following table: ● TTM = trailing 12 months ● EBITDA for covenant purposes is defined as consolidated net income, plus interest expense, taxes, depreciation and amortization, non-cash impairment losses, extraordinary non-cash losses incurred other than in the ordinary course of business, nonrecurring extraordinary non-cash restructuring charges, cash expenses related to the Tonsan acquisition for advisory services and for arranging financing for the acquired business with cash expenses not to exceed $10.0 million, minus extraordinary non-cash gains incurred other than in the ordinary course of business. For the Total Indebtedness / TTM EBITDA ratio, TTM EBITDA is adjusted for the pro forma results from Material Acquisitions and Material Divestitures as if the acquisition or divestiture occurred at the beginning of the calculation period. Additional detail is provided in the Form 8-K dated October 31, 2014. We believe we have the ability to meet all of our contractual obligations and commitments in fiscal 2017. Net Financial Assets Of the $142.2 million in cash and cash equivalents as of December 3, 2016, $114.7 million was held outside the U.S. Of the $114.7 million of cash held outside the U.S., earnings on $103.8 million are indefinitely reinvested outside of the U.S. It is not practical for us to determine the U.S. tax implications of the repatriation of these funds. There are no contractual or regulatory restrictions on the ability of consolidated and unconsolidated subsidiaries to transfer funds in the form of cash dividends, loans or advances to us, except for: 1) a credit facility limitation restricting investments, loans, advances or capital contributions from the U.S. parent corporation, the Irish financing subsidiary, and the Construction Products subsidiary in excess of $100.0 million, 2) a credit facility limitation that provides total investments, loans, advances or guarantees not otherwise permitted in the credit agreement for all subsidiaries shall not exceed $125.0 million in the aggregate and 3) typical statutory restrictions, which prohibit distributions in excess of net capital or similar tests. The 2012 Forbo acquisition, the 2015 Tonsan acquisition and any investments, loans, and advances established to consummate the Forbo and Tonsan acquisitions are excluded from the credit facility limitations described above. Additionally, we have taken the income tax position that the majority of our cash in non-U.S. locations is indefinitely reinvested. We rely on operating cash flow, short-term borrowings and long-term debt to provide for the working capital needs of our operations. We believe that we have the ability to obtain both short-term and long-term debt to meet our financing needs for the foreseeable future. Debt Outstanding and Debt Capacity Notes Payable Notes payable were $37.3 million at December 3, 2016 and $30.8 million at November 28, 2015. These amounts mainly represented various foreign subsidiaries’ short-term borrowings that were not part of committed lines. The weighted-average interest rates on these short-term borrowings were 13.7 percent in 2016 and 8.1 percent in 2015. Long-Term Debt Long-term debt consisted of senior notes and term loans. The Series A and Series B senior notes bear a fixed interest rate of 5.13 percent and mature in fiscal year 2017. The Series C and Series D senior notes bear a fixed interest rate of 5.61 percent and mature in fiscal year 2020. The Series E senior notes bear a fixed interest rate of 4.12 percent and mature in fiscal year 2022. We are subject to prepayment penalties on our senior notes. As of December 3, 2016, make-whole premiums were estimated to be, if the entire debt were paid off, $33.1 million. We currently have no intention to prepay any senior notes. We executed interest rate swap agreements for the purpose of obtaining a floating rate of interest on $75.0 million of the $150.0 million senior notes. We have designated the $75.0 million of senior note debt as the hedged item in a fair value hedge. As required by applicable accounting standards, we recorded an asset for the fair value of the interest rate swaps (hedging instruments) totaling $1.6 million and recognized a liability of $1.6 million for the change in the fair value of the senior notes attributable to the change in the risk being hedged. This calculation resulted in $101.4 million being recorded in long-term debt and $50.2 million being recorded in current portion of long-term debt related to these senior notes as of December 3, 2016. For further information related to long-term debt see Note 7 to the Consolidated Financial Statements. On October 31, 2014, we entered into a credit agreement with a consortium of financial institutions under which we established a $300.0 million term loan that we can use to repay existing indebtedness, finance working capital needs, finance acquisitions, and for general corporate purposes. At December 3, 2016, there was a balance of $266.3 million drawn on the term loan. The interest rate on the term loan bears a floating interest rate at the London Interbank Offered Rate (LIBOR) plus 125 basis points and matures in 2019. There is no prepayment penalty on the term loan. See the discussion below regarding our lines of credit. On October 31, 2014 we amended various provisions of the Note Purchase Agreements Series A through E, including the covenant definition of Consolidated EBITDA. As part of these amendments, the interest rate on the debt may increase based on a ratings grid. Additional details on the Note Purchase Agreement amendments can be found in the 8-K dated October 31, 2014. Lines of Credit We have a revolving credit agreement with a consortium of financial institutions at December 3, 2016. This credit agreement creates an unsecured multi-currency revolving credit facility that we can draw upon for general corporate purposes up to a maximum of $300.0 million. Interest is payable at LIBOR plus 1.075 percent. A facility fee of 0.175 percent is payable quarterly. The interest rate and the facility fee are based on a rating grid. The credit facility expires on October 31, 2019. As of December 3, 2016, our lines of credit were undrawn. Goodwill and Other Intangible Assets As of December 3, 2016, goodwill totaled $366.2 million (18 percent of total assets) and other intangible assets, net of accumulated amortization, totaled $205.4 million (10 percent of total assets). The components of goodwill and other identifiable intangible assets, net of amortization, by segment at December 3, 2016 are as follows: 1 Other finite-lived intangible assets are related to operating segment trademarks. 2 Indefinite-lived intangible assets are related to EIMEA operating segment trademarks. Selected Metrics of Liquidity and Capital Resources Key metrics we monitor are net working capital as a percent of annualized net revenue, trade account receivable days sales outstanding (DSO), inventory days on hand, free cash flow and debt capitalization ratio. 1 Current quarter net working capital (trade receivables, net of allowance for doubtful accounts plus inventory minus trade payables) divided by annualized net revenue (current quarter, adjusted for extra week, multiplied by 4). 2 Trade receivables net of allowance for doubtful accounts multiplied by 63 (9 weeks) for 2016 and 56 (8 weeks) for 2015 and divided by the net revenue for the last 2 months of the quarter. 3 Total inventory multiplied by 63 for 2016 and 56 for 2015 and divided by cost of sales (excluding delivery costs) for the last 2 months of the quarter. 4 Net cash provided by operations less purchased property, plant and equipment and dividends paid. 5 Total debt divided by (total debt plus total stockholders’ equity). Summary of Cash Flows Cash Flows from Operating Activities from Continuing Operations Net income including non-controlling interest was $124.4 million in 2016, $87.1 million in 2015 and $50.2 million in 2014. Depreciation and amortization expense totaled $77.7 million in 2016 compared to $75.3 million in 2015 and $70.5 million in 2014. The higher depreciation and amortization expense in 2016 was directly related to the significant increase in capital expenditures in 2014 and intangible assets acquired in acquisitions. Changes in net working capital (trade receivables, inventory and trade payables) accounted for a use of cash of $13.9 million, $10.8 million and $69.6 million in 2016, 2015 and 2014, respectively. Following is an assessment of each of the net working capital components: ● Trade Receivables, net - Changes in trade receivables resulted in a $1.9 million source of cash in 2016 compared to $12.0 million use of cash in 2015 and $18.9 million use of cash in 2014. The source of cash in 2016 was related to higher net revenue and collection of receivables compared to the use of cash in 2015. The 2015 smaller use of cash was partially related to lower net revenue compared to 2014. The DSO was 57 days at December 3, 2016, 60 days at November 28, 2015 and 56 days at November 29, 2014. ● Inventory - Changes in inventory resulted in a $3.5 million use of cash in 2016 compared to a $4.6 million use of cash in 2015 and a $36.2 million use of cash of in 2014. In 2016, inventory levels decreased slightly from 2015 related to normal activity. In 2015 inventory levels returned to a more normal level from 2014 when inventory had increased to support the manufacturing transition as part of the Business Integration Project and the implementation of our ERP system in North America. Inventory days on hand were 60 days at the end of 2016 compared to 60 days at the end of 2015 and 58 days at the end of 2014. ● Trade Payables - Changes in trade payables resulted in a $12.3 million use of cash in 2016 compared to a $5.8 million source of cash in 2015 and a $14.5 million use of cash in 2014. Both comparisons were primarily related to the timing of payments. Contributions to our pension and other postretirement benefit plans were $6.6 million, $4.6 million and $12.6 million in 2016, 2015 and 2014, respectively. Income taxes payable resulted in a $1.7 million, $1.4 million and $0.1 million use of cash in 2016, 2015 and 2014, respectively. Other assets resulted in an $8.4 million use of cash, a $12.0 million source of cash and a $41.7 million use of cash in 2016, 2015 and 2014, respectively. Accrued compensation was a $0.9 million and $6.0 million source of cash in 2016 and 2015, respectively, and a $28.1 million use of cash in 2014. The source of cash in 2016 relates to lower payouts for our employee incentive plans and in 2015 relates to lower payouts for our employee incentive plans and higher accruals. The use of cash in 2014 relates to the payments of severance related costs as part of our Business Integration Project. Other operating activity was a $29.5 million, $22.6 million and $33.3 million source of cash in 2016, 2015 and 2014, respectively. This reflects the impact of a stronger U.S. dollar on certain foreign transactions in 2016, 2015 and 2014. Loss from discontinued operations, net of tax was $1.3 million in 2015. Cash Flows from Investing Activities from Continuing Operations Purchases of property plant and equipment were $63.3 million in 2016 compared to $58.6 million in 2015 and $139.8 million in 2014. The increase in 2016 relates to building a new plant in Indonesia and the Construction Products expansion project offset by lower capital expenditures for the Business Integration project. The decrease in 2015 was primarily related to reduced capital expenditures for the Business Integration Project and Project ONE ERP system compared to 2014. In 2015 we received a cash settlement of $12.8 million as a result of an arbitration proceeding related to our initial implementation of Project ONE, of which $12.0 million was recorded as a reduction of the ERP system asset. In 2016, we acquired Cyberbond for $42.2 million, net of cash acquired and Advanced Adhesives for $10.4 million, net of cash acquired. In 2015, we acquired Tonsan Adhesive, Inc. for $215.9 million and Continental Products Limited for $1.6 million. In 2014, we purchased the ProSpec construction products business for $26.2 million and adjusted the purchase price of Plexbond Quimica for $0.2 million. See Note 2 to the Consolidated Financial Statements for further information on acquisitions. Cash Flows from Financing Activities from Continuing Operations Repayment of long-term debt in 2016 was $22.5 million. There were no proceeds from long term debt borrowing in 2016. In 2015 proceeds from long-term debt were $357.0 million. Included in the $357.0 million of proceeds is $300.0 million from our October 31, 2014 term loan which was drawn in conjunction with the acquisition of Tonsan Adhesive, Inc. Repayment of long-term debt in 2015 was $211.3 million. In 2014 proceeds from long-term debt were $560.0 million and repayment of long-term debt was $483.3 million. Cash paid for dividends were $27.5 million, $25.7 million and $23.1 million in 2016, 2015 and 2014, respectively. Cash generated from the exercise of stock options were $11.3 million in 2016, $4.6 million in 2015 and $6.9 million in 2014. Repurchases of common stock were $23.2 million in 2016 compared to $19.3 million in 2015 and $15.5 million in 2014, including $20.9 million in 2016, $17.1 million in 2015 and $12.3 million in 2014 from our 2010 share repurchase program. Cash Flows from Discontinued Operations Cash flows from discontinued operations includes the 2015 settlement payment of the contingent consideration of the Central America Paints business, that was sold in 2012, less the related deferred income taxes. See Note 2 to the Consolidated Financial Statements for further information. Contractual Obligations Due dates and amounts of contractual obligations follow: 1 Some of our interest obligations on long-term debt are variable based on LIBOR. Interest payable for the variable portion is estimated based on a forward LIBOR curve. 2 Pension contributions are only included for fiscal 2017. We have not determined our pension funding obligations beyond 2017 and thus, any potential future contributions have been excluded from the table. 3 This amount includes the forward purchase contract of $11.2 million and the contingent consideration liability of $4.7 million related to the Tonsan acquisition. We expect to make cash outlays in the future related to uncertain tax positions. However, due to the uncertainty of the timing of future cash flows, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, gross unrecognized tax benefits of $4.2 million as of December 3, 2016 have been excluded from the contractual obligations table above. For further information related to unrecognized tax benefits see Note 8 to the Consolidated Financial Statements. We expect 2017 capital expenditures to be approximately $60.0 million. Off-Balance Sheet Arrangements There are no relationships with any unconsolidated, special-purpose entities or financial partnerships established for the purpose of facilitating off-balance sheet financial arrangements. Recently Issued Accounting Pronouncements See Note 1 to the Consolidated Financial Statements for information concerning new accounting standards and the impact of the implementation of these standards on our financial statements. Forward-Looking Statements and Risk Factors The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of words like "plan," "expect," "aim," "believe," "project," "anticipate," "intend," "estimate," "will," "should," "could" (including the negative or variations thereof) and other expressions that indicate future events and trends. These plans and expectations are based upon certain underlying assumptions, including those mentioned with the specific statements. Such assumptions are in turn based upon internal estimates and analyses of current market conditions and trends, our plans and strategies, economic conditions and other factors. These plans and expectations and the assumptions underlying them are necessarily subject to risks and uncertainties inherent in projecting future conditions and results. Actual results could differ materially from expectations expressed in the forward-looking statements if one or more of the underlying assumptions and expectations proves to be inaccurate or is unrealized. In addition to the factors described in this report, Item 1A. Risk Factors identifies some of the important factors that could cause our actual results to differ materially from those in any such forward-looking statements. In order to comply with the terms of the safe harbor, we have identified these important factors which could affect our financial performance and could cause our actual results for future periods to differ materially from the anticipated results or other expectations expressed in the forward-looking statements. These factors should be considered, together with any similar risk factors or other cautionary language that may be made elsewhere in this Annual Report on Form 10-K. The list of important factors in Item 1A. Risk Factors does not necessarily present the risk factors in order of importance. This disclosure, including that under Forward-Looking Statements and Risk Factors, and other forward-looking statements and related disclosures made by us in this report and elsewhere from time to time, represents our best judgment as of the date the information is given. We do not undertake responsibility for updating any of such information, whether as a result of new information, future events, or otherwise, except as required by law. Investors are advised, however, to consult any further public company disclosures (such as in filings with the SEC or in our press releases) on related subjects.

<s>[INST] H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. We manage our business through five operating segments Americas Adhesives, EIMEA (Europe, India, Middle East and Africa), Asia Pacific, Construction Products and Engineering Adhesives. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, flooring, textile, flexible packaging, graphic arts, and envelope markets. The Construction Products operating segment provides floor preparation, grouts and mortars for tile setting as well as sealants and related products for heating, ventilation and air conditioning installations. The Engineering Adhesives operating segment provides highperformance adhesives to the transportation, electronics, medical, clean energy, appliance and heavy machinery markets. Total Company When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas Global supply of and demand for raw materials Economic growth rates, and Currency exchange rates compared to the U.S. dollar We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impacts the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in highgrowth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With over 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. In 2016, we generated 42 percent of our net revenue in the United States and 29 percent in EIMEA. The pace of economic growth in these areas directly impacts certain industries to which we supply products. For example, adhesivesrelated revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as construction products and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other constructionrelated activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies weaken against the dollar, our revenues and costs decrease as the foreign currencydenominated financial statements translate into fewer dollars. The fluctuations of the Euro against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2016, the currency fluctuations had a negative impact on net revenue of approximately $38 million as compared to 2015. Key financial results and transactions for 2016 included the following: Net revenue increased 0.5 percent from 2015 primarily driven by a 3.9 percent increase in sales volume offset by a 1.8 percent decrease in currency and a 1.6 percent decrease in product pricing. Gross profit margin increased to 29.1 percent from 27.3 percent in 2015. Every five or six years we have a 53rd week in our fiscal year. 2016 was a 53week year which increased our revenue and costs by approximately 2 percent. Cash flow generated by operating activities from continuing operations was $195.7 million in 2016 as compared to $210.5 million in 2015 and $29.7 million in 2014. We acquired Advanced Adhesives on April 29, 2016 for $10.4 million and Cyberbond on June 8, 2016 for $42.5 million. The global economic conditions showed little to no improvement in 2016. Our [/INST] Positive. </s>

FULLER H B CO

2018-01-31

2017-12-02

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. We manage our business through six operating segments - Americas Adhesives, EIMEA (Europe, India, Middle East and Africa), Asia Pacific, Construction Products, Engineering Adhesives and Royal Adhesives. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, flooring, textile, flexible packaging, graphic arts and envelope markets. The Construction Products operating segment provides floor preparation, grouts and mortars for tile setting, and adhesives for soft flooring as well as sealants and related products for heating, ventilation and air conditioning installations. The Engineering Adhesives operating segment provides high-performance adhesives to the transportation, electronics, medical, clean energy, appliance and heavy machinery markets. The Royal Adhesives operating segment produces and supplies specialty adhesives, sealants, coatings, polymers, tapes, encapsulants and additives to the aerospace and defense, automotive, recreational vehicle, bus, truck and trailer, marine, assembly, electrical/electronic, filter, printing, flexible packaging, laminating, graphic arts, solar/renewable energy, personal care, home furnishings, roofing and flooring markets. Total Company When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: ● Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas, ● Global supply of and demand for raw materials, ● Economic growth rates, and ● Currency exchange rates compared to the U.S. dollar. We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impacts the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in high-growth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With over 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. In 2017, we generated 42 percent of our net revenue in the United States and 28 percent in EIMEA. The pace of economic growth in these areas directly impacts certain industries to which we supply products. For example, adhesives-related revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as construction products and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other construction-related activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies weaken against the dollar, our revenues and costs decrease as the foreign currency-denominated financial statements translate into fewer dollars. The fluctuations of the Euro and the Chinese renminbi against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2017, currency fluctuations had a negative impact on net revenue of approximately $46 million as compared to 2016. Key financial results and transactions for 2017 included the following: ● Net revenue increased 10.1 percent from 2016 primarily driven by a 11.9 percent increase in sales volume, including a 7.7 percent increase due to acquisitions, and 0.8 percent in product pricing offset by a 2.2 percent decrease in currency and a 0.4 percent decrease due to unfavorable sales mix. ● Gross profit margin decreased to 26.2 percent from 29.1 percent in 2016 primarily due to higher raw material costs and the impact of acquired businesses including the inventory step up related to our recent acquisitions. ● We acquired Adecol for $44.7 million, Royal Adhesives for $1,622.7 million and Wisdom Adhesives for $123.5 million. Inclusion of the acquired businesses increased net revenue by $161.7 million. ● Cash flow generated by operating activities from continuing operations was $138.2 million in 2017 as compared to $195.7 million in 2016 and $210.5 million in 2015. Our total year constant currency sales growth, which we define as the combined variances from sales volume, product pricing, sales mix and business acquisitions, increased 12.3 percent for 2017 compared to 2016. The inclusion of a 53rd week in 2016 negatively impacted 2017 constant currency sales growth by approximately 2.0 percent. In 2017, our diluted earnings per share from continuing operations was $1.13 per share compared to $2.42 per share in 2016 and $1.71 per share in 2015. The lower earnings per share from continuing operations in 2017 compared to 2016 was due to an increase in transaction costs related to acquisitions, including make-whole costs associated with the early repayment of certain outstanding debt obligations, and the implementation of the 2017 Restructuring Plan. Project ONE In December of 2012, our Board of Directors approved a multi-year project to replace and enhance our existing core information technology platforms. The scope for this project includes most of the basic transaction processing for the company including customer orders, procurement, manufacturing, and financial reporting. The project envisions harmonized business processes for all of our operating segments supported with one standard software configuration. The execution of this project, which we refer to as Project ONE, is being supported by internal resources and consulting services. During 2013, a project team was formed and the global blueprint for the software configuration was designed and built. In the latter half of 2013 and in the early months of 2014, the global blueprint was applied to the specific requirements of our North America adhesives business, the software was tested and the user groups were trained. On April 6, 2014, our North America adhesives business went live. The implementation process proved to be more difficult than we originally anticipated resulting in disruptions in our manufacturing network, lower productivity and deteriorated customer service levels. By the end of 2014, most of the problems associated with the software implementation had been remediated and the business was stable and running at capacity with productivity levels approaching the levels experienced prior to the new software implementation. In 2017, we re-initiated Project ONE and began the implementation of our ERP system in Argentina. The project work was completed at the end of fiscal 2017 and the system went live at the beginning of fiscal 2018. We expect full implementation of our ERP system in Latin America in early 2019, followed by continued implementation in North America (including our acquired businesses and Construction Products business), EIMEA and Asia Pacific. Total expenditures for Project ONE are estimated to be $125 to $150 million, of which 50-60% is expected to be capital expenditures. Our total project-to-date expenditures are approximately $50 million, of which approximately $33 million are capital expenditures. Given the complexity of the implementation, the total investment to complete the project may exceed our estimate. Restructuring Plan On December 7, 2016, the Company approved a restructuring plan (the “2017 Restructuring Plan”) related to organizational changes and other actions to optimize operations. In implementing the 2017 Restructuring Plan, we expect to incur pre-tax costs of approximately $20.0 million which includes severance and related employee costs and costs related to the optimization of production facilities, streamlining of processes, rationalization of product offerings and accelerated depreciation of long-lived assets. The 2017 Restructuring Plan was implemented in the first quarter of 2017 and is currently expected to be completed by mid-year of fiscal 2018. During the year ended December 2, 2017, we recorded a pre-tax charge of $18.0 million related to the 2017 Restructuring Plan. Federal Income Tax Reform On December 22, 2017, the President of the United States signed into law H.R. 1, originally known as the “Tax Cuts and Jobs Act”, hereafter referred to as “U.S. Tax Reform”. The Company is in the process of determining the impact to the financial statements of all aspects of U.S. Tax Reform and will reflect the impact of such reform in the financial statements during the period in which such amounts can be reasonably estimated. U.S. Tax Reform includes a number of provisions, including the lowering of the U.S. corporate tax rate from 35 percent to 21 percent, effective January 1, 2018, which will result in a blended federal tax rate for fiscal year 2018. There are also provisions that may partially offset the benefit of such rate reduction, such as the repeal of the deduction for domestic production activities. U.S. Tax Reform also includes international provisions, which generally establish a territorial-style system for taxing foreign-source income of domestic multinational corporations. Financial statement impacts will include adjustments for the re-measurement of deferred tax assets (liabilities) and the accrual for deemed repatriation tax on unremitted foreign earnings and profits. The Company anticipates that the impact of U.S. Tax Reform may be material to the income tax expense on the Consolidated Statement of Income and related income tax balances on the Consolidated Balance Sheet and Statement of Cash Flow. Critical Accounting Policies and Significant Estimates Management’s discussion and analysis of our results of operations and financial condition are based upon the Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We believe the critical accounting policies and areas that require the most significant judgments and estimates to be used in the preparation of the Consolidated Financial Statements are pension and other postretirement plan assumptions; goodwill impairment assessment; long-lived assets recoverability; product, environmental and other litigation liabilities; accounting for our contingent consideration liability; income tax accounting; and acquisition accounting. Pension and Other Postretirement Plan Assumptions We sponsor defined-benefit pension plans in both the U.S. and non-U.S. entities. Also in the U.S., we sponsor other postretirement plans for health care and life insurance benefits. Expenses and liabilities for the pension plans and other postretirement plans are actuarially calculated. These calculations are based on our assumptions related to the discount rate, expected return on assets, projected salary increases and health care cost trend rates. Note 10 to the Consolidated Financial Statements includes disclosure of assumptions employed in these measurements for both the non-U.S. and U.S. plans. The discount rate assumption is determined using an actuarial yield curve approach, which results in a discount rate that reflects the characteristics of the plan. The approach identifies a broad population of corporate bonds that meet the quality and size criteria for the particular plan. We use this approach rather than a specific index that has a certain set of bonds that may or may not be representative of the characteristics of our particular plan. A higher discount rate reduces the present value of the pension obligations. The discount rate for the U.S. pension plan was 3.73 percent at December 2, 2017, as compared to 4.10 percent at December 3, 2016 and 4.30 percent at November 28, 2015. Net periodic pension cost for a given fiscal year is based on assumptions developed at the end of the previous fiscal year. A discount rate reduction of 0.5 percentage points at December 2, 2017 would increase U.S. pension and other postretirement plan expense approximately $0.1 million (pre-tax) in fiscal 2018. Discount rates for non-U.S. plans are determined in a manner consistent with the U.S. plans. The expected long-term rate of return on plan assets assumption for the U.S. pension plan was 7.75 percent in 2017, 2016 and 2015. Our expected long-term rate of return on U.S. plan assets was based on our target asset allocation assumption of 60 percent equities and 40 percent fixed-income. Management, in conjunction with our external financial advisors, determines the expected long-term rate of return on plan assets by considering the expected future returns and volatility levels for each asset class that are based on historical returns and forward looking observations. For 2017, the expected long-term rate of return on the target equities allocation was 8.5 percent and the expected long-term rate of return on the target fixed-income allocation was 5.0 percent. The total plan rate of return assumption included an estimate of the effect of diversification and the plan expense. For 2018, the expected long-term rate of return on assets will continue to be 7.75 percent with an expected long-term rate of return on the target equities allocation of 8.2 percent and an expected long-term rate of return on target fixed-income allocation of 5.6 percent. A change of 0.5 percentage points for the expected return on assets assumption would impact U.S. net pension and other postretirement plan expense by approximately $2.3 million (pre-tax). Management, in conjunction with our external financial advisors, uses the actual historical rates of return of the asset categories to assess the reasonableness of the expected long-term rate of return on plan assets. The most recent 10-year and 20-year historical equity returns are shown in the table below. Our expected rate of return on our total portfolio is consistent with the historical patterns observed over longer time frames. * Beginning in 2006, our target allocation migrated from 100 percent equities to our current allocation of 60 percent equities and 40 percent fixed-income. The historical actual rate of return for the fixed income of 8.1 percent is since inception (11 years, 11 months). The expected long-term rate of return on plan assets assumption for non-U.S. pension plans was a weighted-average of 6.21 percent in 2017 compared to 6.20 percent in 2016 and 6.22 percent in 2015. The expected long-term rate of return on plan assets assumption used in each non-U.S. plan is determined on a plan-by-plan basis for each local jurisdiction and is based on expected future returns for the investment mix of assets currently in the portfolio for that plan. Management, in conjunction with our external financial advisors, develops expected rates of return for each plan, considers expected long-term returns for each asset category in the plan, reviews expectations for inflation for each local jurisdiction, and estimates the effect of active management of the plan’s assets. Our largest non-U.S. pension plans are in the United Kingdom and Germany. The expected long-term rate of return on plan assets for the United Kingdom was 6.75 percent and the expected long-term rate of return on plan assets for Germany was 5.75 percent. Management, in conjunction with our external financial advisors, uses actual historical returns of the asset portfolio to assess the reasonableness of the expected rate of return for each plan. The projected salary increase assumption is based on historic trends and comparisons to the external market. Higher rates of increase result in higher pension expenses. As this rate is also a long-term expected rate, it is less likely to change on an annual basis. In the U.S., we have used the rate of 4.50 percent for 2017, 2016 and 2015. Benefits under the U.S. Pension Plan were locked-in as of May 31, 2011 and no longer include compensation increases. The 4.50 percent rate is for the supplemental executive retirement plan only. Projected salary increase assumptions for non-U.S. plans are determined in a manner consistent with the U.S. plans. Goodwill Goodwill is the excess of cost of an acquired entity over the amounts assigned to assets acquired and liabilities assumed in a purchase business combination. Goodwill is assigned to reporting units at the date the goodwill is initially recorded. Once goodwill has been assigned to a reporting unit, it no longer retains its association with a particular acquisition, and all the activities within a reporting unit are available to support the value of goodwill. Accounting standards require us to test goodwill for impairment annually or more often if circumstances or events indicate a change in the estimated fair value may have occurred. The goodwill impairment analysis is a two-step process. The first step used to identify potential impairment involves comparing each reporting unit’s estimated fair value to its carrying value, including goodwill. We use a discounted cash flow approach to estimate the fair value of our reporting units. Our judgment is required in developing the assumptions for the discounted cash flow model. These assumptions include revenue growth rates, profit margin percentages, discount rates, perpetuity growth rates, future capital expenditures and working capital requirements. If the estimated fair value of a reporting unit exceeds its carrying value, goodwill is considered to not be impaired. If the carrying value exceeds estimated fair value, there is an indication of potential impairment and the second step is performed to measure the amount of impairment. The second step of the process, if required, involves the calculation of an implied fair value of goodwill for each reporting unit for which step one indicated impairment. The implied fair value of goodwill is determined in a manner similar to how goodwill is calculated in a business combination, by measuring the excess of the estimated fair value of the reporting unit as calculated in step one, over the estimated fair values of the individual assets, liabilities and identifiable intangibles as if the reporting unit was being acquired in a business combination. If the implied fair value of goodwill exceeds the carrying value of goodwill assigned to the reporting unit, there is no impairment. If the carrying value of goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss cannot exceed the carrying value of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted. In the fourth quarter of 2017, we conducted the required annual test of goodwill for impairment. We performed the goodwill impairment analysis by using a discount rate determined by management to result in the most representative fair value of the business as a whole. There were no indications of impairment in any of our remaining reporting units. Of the goodwill balance of $1,336.7 million as of December 2, 2017, $108.0 million is allocated to the EIMEA reporting unit. The calculated fair value of this reporting unit exceeded its carrying value by approximately 60 percent. The goodwill balance in the Tonsan reporting unit as of December 2, 2017 is $119.0 million. The calculated fair value of this reporting unit exceeded its carrying value by approximately 60 percent. The goodwill balance in the Construction Products reporting unit as of December 2, 2017 is $20.8 million. The calculated fair value of this reporting unit exceeded it carrying value by approximately 90 percent. For all of these reporting units, the Company believes the calculated fair value exceeds the carrying value by a reasonable margin. For the remaining reporting units assessed in our annual impairment test, the calculated fair value substantially exceeded the carrying value of the net assets. If the economy or business environment falter and we are unable to achieve our assumed revenue growth rates or profit margin percentages, our projections used would need to be remeasured, which could impact the carrying value of our goodwill in one or more of our reporting units. See Note 5 to the Consolidated Financial Statements. Recoverability of Long-Lived Assets The assessment of the recoverability of long-lived assets reflects our assumptions and estimates. Factors that we must estimate when performing impairment tests include sales volume, prices, inflation, currency exchange rates, tax rates and capital spending. Significant judgment is involved in estimating these factors, and they include inherent uncertainties. The measurement of the recoverability of these assets is dependent upon the accuracy of the assumptions used in making these estimates and how the estimates compare to the eventual future operating performance of the specific businesses to which the assets are attributed. Judgments made by us include the expected useful lives of long-lived assets. The ability to realize undiscounted cash flows in excess of the carrying amounts of such assets is affected by factors such as the ongoing maintenance and improvement of the assets, changes in economic conditions and changes in operating performance. Product, Environmental and Other Litigation Liabilities As disclosed in Item 3. Legal Proceedings and in Note 1 and Note 14 to the Consolidated Financial Statements, we are subject to various claims, lawsuits and other legal proceedings. Reserves for loss contingencies associated with these matters are established when it is determined that a liability is probable and the amount can be reasonably estimated. The assessment of the probable liabilities is based on the facts and circumstances known at the time that the financial statements are being prepared. For cases in which it is determined that a liability is probable but only a range for the potential loss exists, the minimum amount of the range is recorded and subsequently adjusted as better information becomes available. For cases in which insurance coverage is available, the gross amount of the estimated liabilities is accrued, and a receivable is recorded for any probable estimated insurance recoveries. A discussion of environmental, product and other litigation liabilities is disclosed in Item 3. Legal Proceedings and Note 14 to the Consolidated Financial Statements. Based upon currently available facts, we do not believe that the ultimate resolution of any pending legal proceeding, individually or in the aggregate, will have a material adverse effect on our long-term financial condition. However, adverse developments and/or periodic settlements could negatively affect our results of operations or cash flows in one or more future quarters. Contingent Consideration Liability Concurrent with a business acquisition, we entered into an agreement that requires us to pay the sellers a certain amount based upon a formula related to the entity’s gross profit in 2018. We use the income approach in calculating the fair value of this contingent consideration liability using a real option model. The significant judgments and assumptions utilized in the calculation of the contingent consideration liability include revenue growth rates, profit margin percentages, volatility and discount rate, which are sensitive to change. The change in fair value of the contingent consideration liability each reporting period is recorded in selling, general and administration expenses in the Consolidated Statements of Income. See Note 2 and Note 13 for additional information. Income Tax Accounting As part of the process of preparing the Consolidated Financial Statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. The process involves estimating actual current tax expense along with assessing temporary differences resulting from differing treatment of items for book and tax purposes. These temporary differences result in deferred tax assets and liabilities, which are included in the Consolidated Balance Sheets. We record a valuation allowance to reduce our deferred tax assets to the amount that is more-likely-than-not to be realized. We have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance. Increases in the valuation allowance result in additional expense to be reflected within the tax provision in the Consolidated Statements of Income. As of December 2, 2017, the valuation allowance to reduce deferred tax assets totaled $9.3 million. We recognize tax benefits for tax positions for which it is more-likely-than-not that the tax position will be sustained by the applicable tax authority at the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement. We do not recognize a financial statement benefit for a tax position that does not meet the more-likely-than-not threshold. We believe that our liabilities for income taxes reflect the most likely outcome. It is difficult to predict the final outcome or the timing of the resolution of any particular tax position. Future changes in judgment related to the resolution of tax positions will impact earnings in the quarter of such change. We adjust our income tax liabilities related to tax positions in light of changing facts and circumstances. Settlement with respect to a tax position would usually require cash. Based upon our analysis of tax positions taken on prior year returns and expected tax positions to be taken for the current year tax returns, we have identified gross uncertain tax positions of $8.9 million as of December 2, 2017. We have not recorded U.S. deferred income taxes for certain of our non-U.S. subsidiaries undistributed earnings as such amounts are intended to be indefinitely reinvested outside of the U.S. Should we change our business strategies related to these non-U.S. subsidiaries, additional U.S. tax liabilities could be incurred. It is not practical to estimate the amount of these additional tax liabilities. See Note 11 to the Consolidated Financial Statements for further information on income tax accounting. Acquisition Accounting As we enter into business combinations, we perform acquisition accounting requirements including the following: ● Identifying the acquirer, ● Determining the acquisition date, ● Recognizing and measuring the identifiable assets acquired and the liabilities assumed, and ● Recognizing and measuring goodwill or a gain from a bargain purchase. We complete valuation procedures, and record the resulting fair value of the acquired assets and assumed liabilities based upon the valuation of the business enterprise and the tangible and intangible assets acquired. Enterprise value allocation methodology requires management to make assumptions and apply judgment to estimate the fair value of assets acquired and liabilities assumed. If estimates or assumptions used to complete the enterprise valuation and estimates of the fair value of the acquired assets and assumed liabilities significantly differed from assumptions made, the resulting difference could materially affect the fair value of net assets. The calculation of the fair value of the tangible assets, including property, plant and equipment utilizes the cost approach, which computes the cost to replace the asset, less accrued depreciation resulting from physical deterioration, functional obsolescence and external obsolescence. The calculation of the fair value of the identified intangible assets are determined using cash flow models following the income approach or a discounted market-based methodology approach. Significant inputs include estimated revenue growth rates, gross margins, operating expenses, estimated attrition rate, and a discount rate. Goodwill is recorded as the difference in the fair value of the acquired assets and assumed liabilities and the purchase price. Net revenue in 2017 increased 10.1 percent from 2016. Every five or six years we have a 53rd week in our fiscal year. 2016 was a 53-week year which contributed approximately 2.0 percent to net revenue in 2016, primarily related to volume. The 2016 net revenue was 0.5 percent higher than the net revenue in 2015. In analyzing our results of operations from period to period, we review variances in net revenue in terms of changes related to sales volume, product pricing, sales mix, business acquisitions and changes in foreign currency exchange rates. The impact of sales volume, product pricing, sales mix and acquisitions including Royal Adhesives, Adecol, Wisdom, Cyberbond, L.L.C., Advanced Adhesives and Tonsan are viewed as constant currency growth. The following table shows the net revenue variance analysis for the past two years: Constant currency growth was 12.3 percent in 2017 compared to 2016. The inclusion of a 53rd week in 2016 negatively impacted 2017 constant currency sales growth by approximately 2.0 percent. The 12.3 percent constant currency growth in 2017 was driven by 19.8 percent growth in Engineering Adhesives, 10.9 percent growth in Asia Pacific, 10.5 percent growth in Americas Adhesives, and 7.2 percent growth in EIMEA, offset by a 7.2 percent decrease in Construction Products. Constant currency growth in 2017 also includes 3.7 percent growth attributable to the acquisition of Royal Adhesives. The negative 2.2 percent currency impact was primarily driven by the devaluation of the Egyptian pound, Turkish lira, Chinese renminbi, Argentinian peso, Mexican peso and Malaysian ringgit partially offset by a stronger Euro, Indian rupee and Australian dollar compared to the U.S. dollar. Constant currency growth was 2.3 percent in 2016 compared to 2015. The 2016 sales volume included approximately 2.0 percent in incremental net revenue related to the 53rd week. The 2.3 percent constant currency growth in 2016 was driven by 27.3 percent growth in Engineering Adhesives, 8.5 percent growth in Asia Pacific and 2.0 percent growth in EIMEA, offset by a 5.8 percent decrease in Construction Products and 2.7 percent decrease in Americas Adhesives. The negative 1.8 percent currency impact was primarily driven by the devaluation of the Chinese renminbi, Euro, Egyptian pound, Turkish lira, Canadian dollar, Indian rupee, Australian dollar and Malaysian ringgit compared to the U.S. dollar. Raw material costs as a percentage of net revenue increased 240 basis points in 2017 compared to 2016 due to higher raw material costs and the impact of acquired businesses including the inventory step up related to our recent acquisitions. Other manufacturing costs as a percentage of revenue increased 70 basis points compared to 2016 driven primarily by the impact of acquired businesses and the implementation of the 2017 Restructuring Plan. As a result, cost of sales as a percentage of net revenue increased 290 basis points compared to 2016. Raw material costs as a percentage of net revenue decreased 220 basis points in 2016 compared to 2015 due to lower raw material costs, sales mix and the 2015 impact of valuing inventories acquired in the Tonsan Adhesive, Inc. acquisition at fair value. Other manufacturing costs as a percentage of revenue increased 40 basis points compared to 2015. As a result, cost of sales as a percentage of net revenue decreased 180 basis points compared to 2015. Gross profit in 2017 decreased $6.6 million compared to 2016 and gross profit margin decreased 290 basis points. The decrease in gross profit margin was primarily due to higher raw material costs, the impact of acquired businesses and the implementation of the 2017 Restructuring Plan. Gross profit in 2016 increased $41.8 million compared to 2015 and gross profit margin increased 180 basis points. The decrease in the cost of raw materials was the main factor for the increase in gross profit. Selling, general and administration (“SG&A”) expenses for 2017 increased $69.4 million or 17.0 percent compared to 2016. The increase is mainly due to the impact of acquired businesses, transaction costs related to acquisitions and higher variable compensation, partially offset by lower expenses related to general spending reductions and foreign currency exchange rate benefits on spending outside the U.S. SG&A expenses for 2016 increased $10.0 million or 2.5 percent compared to 2015. The increase is mainly due to higher personnel costs related to increased headcount, a full year of Tonsan operations for 2016 and incremental expenses coming from newly acquired businesses compared to 2015. This increase is partially offset by lower expenses related to general spending reductions, foreign currency exchange rate benefits on spending outside the U.S. and the mark to market adjustment related to the Tonsan contingent consideration liability. We make SG&A expense plans at the beginning of each fiscal year and barring significant changes in business conditions or our outlook for the future, we maintain these spending plans for the entire year. Management routinely monitors our SG&A spending relative to these fiscal year plans for each operating segment and for the company overall. We feel it is important to maintain a consistent spending program in this area as many of the activities within the SG&A category such as the sales force, technology development, and customer service are critical elements of our business strategy. The following table provides detail of special charges, net: The integration of the industrial adhesives business we acquired in March 2012 involved a significant amount of restructuring and capital investment to optimize the new combined entity. In addition to this acquisition, we announced our intentions to take a series of actions in our existing EIMEA operating segment to improve the profitability and future growth prospects of this operating segment. We combined these two initiatives into a single project which we refer to as the Business Integration Project. The Business Integration Project was substantially complete at the end of 2016, and no special charges, net were incurred during the year ended December 2, 2017. We incurred special charges, net of $(0.2) million and $4.7 million for costs related to the Business Integration Project during the years ended December 3, 2016 and November 28, 2015, respectively. Acquisition and transformation related costs of $0.2 million for the year ended December 3, 2016 and $0.7 million for the year ended November 28, 2015 include costs related to organization consulting, financial advisory and legal services necessary to integrate the acquired business into our existing operating segments. During the year ended December 3, 2016, we incurred cash facility exit costs of $1.3 million, non-cash facility exit costs of $1.7 million and other incremental transformation related costs of $0.2 million including the cost of personnel directly working on the integration. Also included in facility exit costs for 2016 is a $3.6 million gain on the sale of our production facility located in Wels, Austria. During the year ended November 28, 2015, we incurred cash facility exit costs of $2.2 million, non-cash facility exit costs of $1.5 million and other incremental transformation related costs of $0.3 million including the cost of personnel directly working on the integration. Other expense, net Other expense, net includes currency transaction and remeasurement losses of $2.4 million, $9.5 million and $3.5 million in 2017, 2016 and 2015, respectively. Interest income was $3.9 million in 2017 compared to $2.0 million in 2016 and $0.5 million in 2015. Gain (loss) on disposal of fixed assets was nil, ($0.8) million and $0.3 million in 2017, 2016 and 2015, respectively. Other expense, net for 2017 also includes $25.5 million of expense related to make-whole costs associated with the early repayment of certain outstanding debt obligations which were refinanced upon entering into the Term Loan B Credit Agreement (as described in Note 6 to our Consolidated Financial Statements). Interest expense Interest expense was $43.7 million in 2017 compared to $27.4 million in 2016 and $25.0 million in 2015. The higher interest expense in 2017 compared to 2016 was due primarily to higher U.S. debt balances from the issuance of our Term Loan B Credit Agreement and the Public Notes (as described in Note 6 to our Consolidated Financial Statements) and the write-off of capitalized debt issuance costs on repaid debt facilities. The higher interest expense in 2016 compared to 2015 was due to higher LIBOR rates on floating rate debt held in the U.S. and larger local currency balances at higher interest rates. We capitalized interest of $0.3 million, $0.8 million and $0.1 million in 2017, 2016 and 2015, respectively. Income taxes Income tax expense in 2017 of $9.1 million includes $4.1 million of discrete tax benefits in both the U.S. and foreign jurisdictions, primarily related to the release of the valuation allowance in Brazil in conjunction with the Adecol acquisition. Income tax expense in 2016 of $50.4 million includes $2.6 million of discrete tax benefits in both the U.S. and foreign jurisdictions. Income tax expense in 2015 of $55.9 million included $0.2 million of discrete tax expense in both the U.S. and foreign jurisdictions. Excluding discrete items, the overall effective tax rate decreased by 9.2 percentage points in 2017 as compared to 2016 and decreased by 8.5 percentage points in 2016 as compared to 2015. The decrease in the tax rate is principally due to a pre-tax loss in the U.S. and a decrease in the effective rate outside the U.S. due to a change in the geographic mix of pre-tax earnings. Income from equity method investments The income from equity method investments relates to our 50 percent ownership of the Sekisui-Fuller joint venture in Japan. The higher income for 2017 compared to 2016 relates to higher net income in our joint venture. The higher income for 2016 compared to 2015 is related to higher net income in our joint venture and the impact of a stronger Japanese yen. Loss from discontinued operations, net of tax The loss from discontinued operations, net of tax, relates to our Central America Paints business, which we sold in 2012. In 2015, in conjunction with the final settlement agreement, we increased our contingent consideration liability by $2.1 million and adjusted the related deferred income tax. Net income attributable to non-controlling interests The net income attributable to non-controlling interests related to the redeemable non-controlling interest in H.B. Fuller Kimya Sanayi Ticaret A.S. (HBF Kimya). During fiscal 2017, we purchased the remaining shares from the non-controlling shareholder. Net income attributable to H.B. Fuller Net income attributable to H.B. Fuller was $58.2 million in 2017 compared to $124.1 million in 2016 and $86.7 million in 2015. Diluted earnings per share, from continuing operations, was $1.13 per share in 2017, $2.42 per share for 2016 and $1.71 per share for 2015. Operating Segment Results We are required to report segment information in the same way that we internally organize our business for assessing performance and making decisions regarding allocation of resources. For segment evaluation by the chief operating decision maker, segment operating income is defined as gross profit less SG&A expenses. Segment operating income excludes special charges, net. Inter-segment revenues are recorded at cost plus a markup for administrative costs. Corporate expenses are fully allocated to each operating segment. The acquisition of Royal Adhesives during the fourth quarter of 2017 resulted in the addition of another reportable segment. We have six reportable segments for the year ended December 2, 2017: Americas Adhesives, EIMEA, Asia Pacific, Construction Products, Engineering Adhesives and Royal Adhesives. The tables below provide certain information regarding the net revenue and segment operating income of each of our operating segments. Net Revenue by Segment Segment Operating Income (Loss) The following table provides a reconciliation of segment operating income to income from continuing operations before income taxes and income from equity method investments, as reported in the Consolidated Statements of Income. Americas Adhesives The following tables provide details of Americas Adhesives net revenue variances: Net revenue increased 10.2 percent in 2017 compared to 2016. The 10.5 percent increase in constant currency growth was attributable to an 11.7 percent increase in sales volume, including an 8.2 percent increase due to the Wisdom Adhesives acquisition and a 0.5 percent increase due to the Adecol acquisition offset by an unfavorable 0.8 percent decrease in sales mix and a 0.4 percent decrease in product pricing. The 0.3 percent negative currency effect was due to the weaker Argentinian peso and Mexican peso, offset by the stronger Brazilian real and Canadian dollar compared to the U.S. dollar. As a percentage of net revenue, raw material costs increased 300 basis points mainly due to higher raw material costs and the inventory step up related to the Wisdom and Adecol acquisitions. Other manufacturing costs as a percentage of net revenue increased 170 basis points, primarily due to the acquisition and integration of Wisdom Adhesives. Operating expense as a percentage of net revenue decreased 20 basis points. Segment operating income decreased 21.4 percent and segment operating margin as a percentage of net revenue decreased 450 basis points in 2017 compared to 2016. Net revenue decreased 3.0 percent in 2016 compared to 2015. The 2.7 percent decrease in constant currency growth was attributable to a 0.2 percent increase in sales volume offset by a 2.9 percent decrease in product pricing. The 0.3 percent negative currency effect was due to the weaker Canadian dollar compared to the U.S. dollar. The sales volume increase was driven by modest market share gains partially offset by general end-market weakness in Latin America and unfavorable sales mix. As a percentage of net revenue, raw material costs decreased 150 basis points mainly due to reductions in raw material costs. Other manufacturing costs as a percentage of net revenue increased 40 basis points in 2016 compared to 2015. Segment operating income decreased 1.4 percent and segment operating margin as a percentage of net revenue increased 20 basis points in 2016 compared to 2015. EIMEA The following table provides details of the EIMEA net revenue variances: Net revenue increased 0.6 percent in 2017 compared to 2016. The 7.2 percent increase in constant currency growth was attributable to a 4.5 percent increase in product pricing, a 2.6 percent increase in sales volume and a 0.1 percent increase due to favorable sales mix. Sales volume growth was primarily related to the hygiene and durable assembly markets. In addition, we had strong growth in the emerging markets. The 6.6 percent negative currency effect was primarily the result of a weaker Egyptian pound and Turkish lira offset by a stronger Euro and Indian rupee compared to the U.S. dollar. Raw material costs as a percentage of net revenue increased 160 basis points in 2017 compared to 2016 primarily due to higher raw material costs offset by higher product pricing. Other manufacturing costs as a percentage of net revenue decreased 10 basis points in 2017 compared to 2016. Operating expense as a percentage of net revenue increased 30 basis points. Segment operating income decreased 25.5 percent and segment operating margin decreased 190 basis points compared to 2016. Net revenue decreased 0.8 percent in 2016 compared to 2015. The 2.0 percent increase in constant currency growth was attributable to a 3.0 percent increase in sales volume offset by a 1.0 percent decrease in product pricing. Sales volume growth was primarily related to the hygiene market, with strong growth in the emerging markets, as well as growth in core Europe. The 2.8 percent negative currency effect was primarily the result of a weaker Euro, Egyptian pound, Turkish lira and Indian rupee compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 300 basis points in 2016 compared to 2015 primarily due to lower raw material costs. Other manufacturing costs as a percentage of net revenue were 100 basis points lower than 2015 primarily due to improved production efficiencies, lower freight costs and favorable currency impacts. Segment operating income increased 165.4 percent and segment operating margin increased 460 basis points compared to 2015. Asia Pacific The following table provides details of Asia Pacific net revenue variances: Net revenue in 2017 increased 9.3 percent compared to 2016. The 10.9 percent increase in constant currency growth was attributable to a 12.0 percent increase in sales volume, including a 2.8 percent increase due to the Advanced Adhesives acquisition, partially offset by a 0.6 percent decrease in product pricing and a 0.5 percent decrease due to unfavorable sales mix. Organic constant currency growth was primarily driven by volume growth in Greater China. Negative currency effects of 1.6 percent compared to 2016 were primarily driven by the weaker Chinese renminbi and Malaysian ringgit compared to the U.S. dollar, partially offset by a stronger Australian dollar. Raw material costs as a percentage of net revenue increased 150 basis points compared to 2016, primarily due to higher raw material costs. Other manufacturing costs as a percentage of net revenue decreased 50 basis points compared to 2016. Operating expense as a percentage of net revenue decreased 40 basis points. Segment operating income decreased 0.6 percent and segment operating margin decreased 60 basis points compared to 2016. Net revenue in 2016 increased 4.8 percent compared to 2015. The 8.5 percent increase in constant currency growth was attributable to a 10.8 percent increase in sales volume partially offset by a 2.3 percent decrease in product pricing. Most of the growth compared to 2015 is driven by the acquisition of Advanced Adhesives that occurred during the second quarter of 2016, as well as growth in Southeast Asia and Greater China. Negative currency effects of 3.7 percent compared to 2015 were primarily driven by the weaker Chinese renminbi, Australian dollar and Malaysian ringgit compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 140 basis points compared to 2015 due to lower raw material costs and changes in sales mix, partially offset by the impact of valuing inventories related to the Advanced Adhesives acquisition at fair value. Other manufacturing costs as a percentage of net revenue increased 110 basis points compared to 2015, primarily due to the acquisition of Advanced Adhesives and the costs to rationalize certain production capabilities in Southeast Asia. Segment operating income increased 19 percent and segment operating margin increased 80 basis points compared to 2015. Construction Products The following tables provide details of Construction Products net revenue variances: Net revenue decreased 7.0 percent in 2017 compared to 2016. The 7.2 percent decrease in constant currency growth was driven by a 6.9 percent decrease in sales volume and a 0.3 percent decrease due to unfavorable sales mix. The sales volume decline was due to lower service levels related to the facility upgrade and expansion project. Positive currency effects of 0.2 percent compared to 2016 were primarily driven by the stronger Australian dollar compared to the U.S. dollar. Raw material costs as a percentage of net revenue was 140 basis points lower in 2017 compared to 2016 primarily due to lower raw material costs. Other manufacturing costs as a percentage of net revenue were 280 basis points higher in 2017 compared to 2016 due to inefficiencies related to the facility upgrade and expansion project. Operating expense as a percentage of net revenue increased 30 basis points. Segment operating income (loss) decreased 133.3 percent and segment profit margin decreased 180 basis points in 2017 compared to 2016. Net revenue decreased 6.0 percent in 2016 compared to 2015. The 5.8 percent decrease in constant currency growth was driven by a 6.7 percent decrease in sales volume offset by a 0.9 percent increase in product pricing. The decrease in sales volume was primarily attributed to lower export revenue, inventory rebalancing with certain channel partners and a strong fiscal 2015 driven by market share gains with certain retail partners. The increase in pricing is mainly due to price increases related to certain product lines in multiple channels. Negative currency effects of 0.2 percent compared to 2015 were primarily driven by the weaker Australian dollar compared to the U.S. dollar. Raw material costs as a percentage of net revenue was 210 basis points lower in 2016 compared to 2015 primarily due to changes in product mix and lower raw material costs. Other manufacturing costs as a percentage of net revenue were 360 basis points higher in 2016 compared to 2015 mainly due to higher supply chain costs as we complete the facility upgrade and expansion project. Segment operating income decreased 76.3 percent and segment profit margin decreased 370 basis points in 2016 compared to 2015. Engineering Adhesives The following tables provide details of Engineering Adhesives net revenue variances: Net revenue increased 18.0 percent in 2017 compared to 2016. The 19.8 percent increase in constant currency growth was driven by a 21.4 percent increase in sales volume including a 3.2 percent increase due to the acquisition of Cyberbond, L.L.C., partially offset by a 1.2 percent decrease in product pricing and a 0.5 percent decrease due to unfavorable sales mix. Organic constant currency growth was driven by strong performance in the electronics and Tonsan markets. Negative currency effects of 1.8 percent compared to 2016 were primarily driven by the weaker Chinese renminbi partially offset by a stronger Euro and Indian rupee compared to the U.S. dollar. Raw material costs as a percentage of net revenue was 200 basis points higher in 2017 compared to 2016 due to unfavorable sales mix and higher raw material costs. Other manufacturing costs as a percentage of net revenue were 90 basis points lower in 2017 compared to 2016 primarily due to higher sales volume. Operating expense as a percentage of net revenue decreased 110 basis points compared to 2016, partially due to the net mark to market adjustment related to the Tonsan contingent consideration liability. Segment operating income decreased 17.2 percent and segment operating margin decreased 10 basis points in 2017 compared to 2016. Net revenue increased 22.7 percent in 2016 compared to 2015. The 27.3 percent increase in constant currency growth was driven by a 27.9 percent increase in sales volume offset by a 0.6 percent decrease in product pricing. The increase in sales volume was partially attributed to a full year of the Tonsan business, which was acquired late in the first quarter of 2015, as well as the acquisition of Cyberbond, L.L.C. that occurred during the third quarter of 2016. Negative currency effects of 4.6 percent compared to 2015 were primarily driven by the weaker Chinese renminbi and Euro compared to the U.S. dollar. Raw material costs as a percentage of net revenue was 390 basis points lower in 2016 compared to 2015 primarily due to the impact of valuing inventories related to the Tonsan acquisition at fair value, lower raw material costs and changes in product mix associated with the acquisition of Tonsan. Other manufacturing costs as a percentage of net revenue were 40 basis points higher in 2016 compared to 2015 primarily due to the impact of a full year of the Tonsan business and the Cyberbond, L.L.C. acquisition. Operating expense as a percentage of net revenue decreased 320 basis points compared to 2015, partially due to the net mark to market adjustment related to the Tonsan contingent consideration liability offset by the Cyberbond, L.L.C. acquisition. Segment operating income increased $16.5 million and segment operating margin increased 670 basis points in 2016 compared to 2015. Royal Adhesives Royal Adhesives was acquired during the fourth quarter of 2017. As a result, there is no comparable financial information for this segment for the years ended December 3, 2016 and November 28, 2015. Segment operating income for the year ended December 2, 2017 includes $32.1 million of transaction costs incurred by the Company related to the Royal Adhesives acquisition and $10.8 million of inventory step up expense. Financial Condition, Liquidity and Capital Resources Total cash and cash equivalents as of December 2, 2017 were $194.4 million compared to $142.2 million as of December 3, 2016. Total long and short-term debt was $2,451.9 million as of December 2, 2017 and $703.3 million as of December 3, 2016. We believe that cash flows from operating activities will be adequate to meet our ongoing liquidity and capital expenditure needs. In addition, we believe we have the ability to obtain both short-term and long-term debt to meet our financing needs for the foreseeable future. Cash available in the United States has historically been sufficient and we expect it will continue to be sufficient to fund U.S. operations and U.S. capital spending and U.S. pension and other postretirement benefit contributions in addition to funding U.S. acquisitions, dividend payments, debt service and share repurchases as needed. For those international earnings considered to be reinvested indefinitely, we currently have no intention to, and plans do not indicate a need to, repatriate these funds for U.S. operations. Our credit agreements include restrictive covenants that, if not met, could lead to a renegotiation of our credit lines and a significant increase in our cost of financing. At December 2, 2017, we were in compliance with all covenants of our contractual obligations as shown in the following table: ● TTM = trailing 12 months ● EBITDA for covenant purposes is defined as consolidated net income, plus interest expense, expense for taxes paid or accrued, depreciation and amortization, certain non-cash impairment losses, extraordinary non-cash losses incurred other than in the ordinary course of business, nonrecurring extraordinary non-cash restructuring charges and the non-cash impact of purchase accounting, expenses related to the Royal Adhesives acquisition not to exceed $40.0 million, one-time costs incurred in connection with prepayment premiums and make-whole amounts under certain agreements, certain “run rate” cost savings and synergies in connection with the Royal Adhesives acquisition not to exceed 15% of Consolidated EBITDA, expenses relating to the integration of Royal Adhesives during the fiscal years ending in 2017, 2018 and 2019 not exceeding $30 million in aggregate, restructuring expenses that began prior to the Royal Adhesives acquisition incurred in fiscal years ending in 2017 and 2018 not exceeding $28 million in aggregate, and non-capitalized charges relating to the SAP implementation during fiscal years ending in 2017 through 2021 not exceeding $13 million in any single fiscal year, minus extraordinary non-cash gains. For the Total Indebtedness / TTM EBITDA ratio, TTM EBITDA is adjusted for the pro forma results from Material Acquisitions and Material Divestitures as if the acquisition or divestiture occurred at the beginning of the calculation period. The full definition is set forth in the Term Loan B Credit Agreement and the Amended Revolving Credit Agreement, and can be found in the Company’s 8-K filings dated October 20, 2017 and 8-K dated November 17, 2017, respectively. We believe we have the ability to meet all of our contractual obligations and commitments in fiscal 2018. Net Financial Assets (Liabilities) Of the $194.4 million in cash and cash equivalents as of December 2, 2017, $172.1 million was held outside the U.S. Of the $172.1 million of cash held outside the U.S., earnings on $161.7 million are indefinitely reinvested outside of the U.S. It is not practical for us to determine the U.S. tax implications of the repatriation of these funds. There are no contractual or regulatory restrictions on the ability of consolidated and unconsolidated subsidiaries to transfer funds in the form of cash dividends, loans or advances to us, except for: 1) a credit facility limitation restricting investments, loans, advances or capital contributions from Loan Parties to non-Loan Parties in excess of $100.0 million, 2) a credit facility limitation that provides total investments, loans, advances or guarantees not otherwise permitted in the credit agreement for all subsidiaries shall not exceed $125.0 million in the aggregate, 3) a credit facility limitation that provides total investments, dividends, and distributions shall not exceed the Available Amount defined in these agreements, and 4) typical statutory restrictions, which prohibit distributions in excess of net capital or similar tests. The Royal Adhesives acquisition and any investments, loans, and advances established to consummate the Royal Adhesives acquisition, are excluded from the credit facility limitations described above. Additionally, we have taken the income tax position that the majority of our cash in non-U.S. locations is indefinitely reinvested. Debt Outstanding and Debt Capacity Notes Payable Notes payable were $31.5 million at December 2, 2017 and $37.3 million at December 3, 2016. These amounts mainly represented various foreign subsidiaries’ short-term borrowings that were not part of committed lines. The weighted-average interest rates on these short-term borrowings were 11.0 percent in 2017 and 13.7 percent in 2016. Long-Term Debt Long-term debt consisted of a secured term loan (“Term Loan B”) and an unsecured public note (“Public Notes”). The Term Loan B bears a floating interest rate at the London Interbank Offered Rate (LIBOR) plus 2.25 percent (3.53 percent at December 2, 2017) and matures in fiscal year 2024. The Public Notes bear interest at 4.00 percent fixed interest and matures in fiscal year 2027. We are subject to a par call of 1.00 percent except within three months of maturity date. We currently have no intention to prepay the Public Notes. Additional details on the Public Notes and the Term Loan B Credit Agreement can be found in the 8-K dated February 9, 2017 and the 8-K dated October 20, 2017, respectively. We executed interest rate swap agreements for the purpose of obtaining a fixed interest rate on $1,050,000 of the $2,150,000 Term Loan B. We have designated forecasted interest payments resulting from the variability of 1-month LIBOR in relation to $1,050,000 of the Term Loan B as the hedged item in cash flow hedges. The combined fair value of the interest rate swaps in total was an asset of $3,104 at December 2, 2017 and was included in other liabilities in the Consolidated Balance Sheets. We are applying the shortcut method in accounting for these interest rate swaps as changes in the fair value of the interest rate swap are expected to offset the changes in cash flows (i.e. changes in interest rate payments) attributable to fluctuations in LIBOR rates on the interest payments associated with the $1,050,000 tranche of variable rate Term Loan B, resulting in no ineffectiveness. We entered into interest rate swap agreements for the purpose of obtaining a floating rate on $150,000 of our $300,000 Public Notes. We have designated the $150,000 of public debt as the hedged item in a fair value hedge. The combined fair value of the interest rate swaps in total was a liability of $2,121 at December 2, 2017 and was included in other liabilities in the Consolidated Balance Sheets. The swaps were designated for hedge accounting treatment as fair value hedges. We are applying the shortcut method in accounting for these interest rate swaps as we expect that the changes in the fair value of the swap will offset the changes in the fair value of the Public Notes resulting in no ineffectiveness. As a result of applying the shortcut method, the change in the fair value of the interest rate swap and an equivalent amount for the change in the fair value of the debt will be reflected in other income (expense), net and no ineffectiveness will be recognized in our Condensed Consolidated Statements of Income. Lines of Credit We have a revolving credit agreement with a consortium of financial institutions at December 2, 2017. This credit agreement creates a secured multi-currency revolving credit facility that we can draw upon to repay existing indebtedness, finance working capital needs, finance acquisitions, and for general corporate purposes up to a maximum of $400.0 million. Interest on the revolving credit facility is payable at LIBOR plus 2.00 percent (3.27 percent at December 2, 2017). A facility fee of 0.30 percent of the unused commitment under the revolving credit facility is payable quarterly. The interest rate and the facility fee are based on a leverage grid. The credit facility expires on April 12, 2022. As of December 2, 2017, our lines of credit were undrawn. Additional details on the revolving credit agreement can be found in the 8-K dated November 17, 2017. For further information related to debt outstanding and debt capacity, see Note 6 to the Consolidated Financial Statements. Goodwill and Other Intangible Assets As of December 2, 2017, goodwill totaled $1,336.7 million (31 percent of total assets) and other intangible assets, net of accumulated amortization, totaled $1,001.8 million (23 percent of total assets). The components of goodwill and other identifiable intangible assets, net of amortization, by segment at December 2, 2017 are as follows: 1 Other finite-lived intangible assets are related to operating segment trademarks. 2 Indefinite-lived intangible assets are related to EIMEA operating segment trademarks. Selected Metrics of Liquidity and Capital Resources Key metrics we monitor are net working capital as a percent of annualized net revenue, trade account receivable days sales outstanding (DSO), inventory days on hand, free cash flow and debt capitalization ratio. 1 Current quarter net working capital (trade receivables, net of allowance for doubtful accounts plus inventory minus trade payables) divided by annualized net revenue (current quarter, adjusted for extra week, multiplied by 4). 2 Trade receivables net of allowance for doubtful accounts multiplied by 56 (8 weeks) for 2017 and 63 (9 weeks) for 2016 and divided by the net revenue for the last 2 months of the quarter. 3 Total inventory multiplied by 56 for 2017 and 63 for 2016 and divided by cost of sales (excluding delivery costs) for the last 2 months of the quarter. 4 Net cash provided by operations less purchased property, plant and equipment and dividends paid. 5 Total debt divided by (total debt plus total stockholders’ equity). Summary of Cash Flows Cash Flows from Operating Activities from Continuing Operations Net income including non-controlling interest was $58.3 million in 2017, $124.4 million in 2016 and $87.3 million in 2015. Depreciation and amortization expense totaled $87.4 million in 2017 compared to $77.7 million in 2016 and $75.3 million in 2015. The higher depreciation and amortization expense in 2017 was directly related to the intangible assets acquired in acquisitions. Changes in net working capital (trade receivables, inventory and trade payables) accounted for a source of cash of $7.0 million and a use of cash of $13.9 million and $10.8 million in 2017, 2016 and 2015, respectively. Following is an assessment of each of the net working capital components: ● Trade Receivables, net - Changes in trade receivables resulted in a $26.8 million use of cash in 2017 compared to $1.9 million source of cash in 2016 and $12.0 million use of cash in 2015. The use of cash in 2017 was related to higher net revenue compared to 2016. The source of cash in 2016 was related to higher collection of receivables somewhat offset by higher net revenue compared to the use of cash in 2015. The DSO was 61 days at December 2, 2017, 57 days at December 3, 2016 and 60 days at November 28, 2015. ● Inventory - Changes in inventory resulted in a $10.6 million use of cash in 2017 compared to a $3.5 million use of cash in 2016 and a $4.6 million use of cash of in 2015. In 2017, inventory levels increased due to higher raw material costs and to maintain service levels while integrating our acquisitions. In 2016, inventory levels decreased slightly from 2015 related to normal activity. Inventory days on hand were 59 days at the end of 2017 compared to 60 days at the end of 2016 and 60 days at the end of 2015. ● Trade Payables - Changes in trade payables resulted in a $44.4 million source of cash in 2017 compared to a $12.3 million use of cash in 2016 and a $5.8 million source of cash in 2015. Both comparisons were primarily related to the timing of payments. Contributions to our pension and other postretirement benefit plans were $4.7 million, $6.6 million and $4.6 million in 2017, 2016 and 2015, respectively. Income taxes payable resulted in a $15.0 million, $1.7 million and $1.4 million use of cash in 2017, 2016 and 2015, respectively. Other assets resulted in a $13.0 million use of cash in 2017, an $8.4 million use of cash in 2016 and a $12.0 million source of cash in 2015. Accrued compensation was a $12.2 million, $0.9 million and a $6.0 million source of cash in 2017, 2016 and 2015, respectively. The source of cash in 2017 relates to higher accruals for our employee incentive plans and the source of cash in 2016 relates to lower payouts for our employee incentive plans. Other operating activity was a $8.8 million use of cash in 2017 and a source of cash in $29.5 million and $22.6 million in 2016 and 2015, respectively. This reflects the impact of a stronger U.S. dollar on certain foreign transactions in 2017, 2016 and 2015. Cash Flows from Investing Activities from Continuing Operations Purchases of property plant and equipment were $54.9 million in 2017 compared to $63.3 million in 2016 and $58.6 million in 2015. The increase in 2016 relates to building a new plant in Indonesia and the Construction Products expansion project offset by lower capital expenditures for the Business Integration project. In 2015 we received a cash settlement of $12.8 million as a result of an arbitration proceeding related to our initial implementation of Project ONE, of which $12.0 million was recorded as a reduction of the ERP system asset. In 2017, we acquired Adecol for $44.7 million, net of cash acquired, Royal Adhesives for $1,622.7 million, net of cash acquired and Wisdom for $123.5 million, net of cash acquired. In 2016, we acquired Cyberbond, L.L.C. for $42.2 million, net of cash acquired and Advanced Adhesives for $10.4 million, net of cash acquired. In 2015, we acquired Tonsan Adhesive, Inc. for $215.9 million and Continental Products Limited for $1.6 million. See Note 2 to the Consolidated Financial Statements for further information on acquisitions. Cash Flows from Financing Activities from Continuing Operations In 2017 we repaid $1,079.3 million and borrowed $2,856.3 million of debt in conjunction with our acquisition of Royal Adhesives. In 2017, we paid $24.2 million of debt issuance costs. In 2016, there was $22.5 million of repayments of long-term debt and no proceeds from long term debt borrowing. In 2015 proceeds from long-term debt were $357.0 million. Included in the $357.0 million of proceeds is $300.0 million from our October 31, 2014 Term Loan A which was drawn in conjunction with the acquisition of Tonsan Adhesive, Inc. Repayment of long-term debt in 2015 was $211.3 million. See Note 6 of the Consolidated Financial Statements for further discussion of debt borrowings and repayments. Cash paid for dividends were $29.6 million, $27.5 million and $25.7 million in 2017, 2016 and 2015, respectively. Cash generated from the exercise of stock options were $17.7 million in 2017, $11.3 million in 2016 and $4.6 million in 2015. Repurchases of common stock were $21.8 million in 2017 compared to $23.2 million in 2016 and $19.3 million in 2015, including $19.1 million in 2017, $20.9 million in 2016 and $17.1 million in 2015 from our share repurchase program. Contractual Obligations Due dates and amounts of contractual obligations follow: 1 Some of our interest obligations on long-term debt are variable based on LIBOR. Interest payable for the variable portion is estimated based on a forward LIBOR curve. 2 Pension contributions are only included for fiscal 2018. We have not determined our pension funding obligations beyond 2018 and thus, any potential future contributions have been excluded from the table. 3 Represents the fair value of our foreign exchange contracts and cash flow hedges with a payable position to the counterparty as of December 2, 2017, based on fair market values as of that date. Future changes in market values will impact the amount of cash ultimately paid or received to settle those instruments in the future. 4 This amount includes the forward purchase contract of $12.0 million and the contingent consideration liability of $0.5 million related to the Tonsan acquisition. We are subject to mandatory prepayments in the first quarter of each fiscal year equal to 50 percent of Excess Cash Flow, as defined in the Term Loan B Credit Agreement, of the prior fiscal year less any voluntary prepayments made during that fiscal year. The Excess Cash Flow Percentage (“ECF Percentage”) shall be reduced to 25 percent when our Secured Leverage Ratio is below 4.25:1.00 and to 0 percent when our Secured Leverage Ratio is below 3.75:1.00. The first measurement period is fiscal year 2018 and the first prepayment is due in the first fiscal quarter of 2019. We have not estimated the prepayment for the first quarter of fiscal year 2019 or for future years in the table above, and have listed only the scheduled amortization payments. We expect to make cash outlays in the future related to uncertain tax positions. However, due to the uncertainty of the timing of future cash flows, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, gross unrecognized tax benefits of $8.9 million as of December 2, 2017 have been excluded from the contractual obligations table above. For further information related to unrecognized tax benefits see Note 11 to the Consolidated Financial Statements. We expect 2018 capital expenditures to be approximately $90.0 million. Off-Balance Sheet Arrangements There are no relationships with any unconsolidated, special-purpose entities or financial partnerships established for the purpose of facilitating off-balance sheet financial arrangements. Forward-Looking Statements and Risk Factors The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of words like "plan," "expect," "aim," "believe," "project," "anticipate," "intend," "estimate," "will," "should," "could" (including the negative or variations thereof) and other expressions that indicate future events and trends. These plans and expectations are based upon certain underlying assumptions, including those mentioned with the specific statements. Such assumptions are in turn based upon internal estimates and analyses of current market conditions and trends, our plans and strategies, economic conditions and other factors. These plans and expectations and the assumptions underlying them are necessarily subject to risks and uncertainties inherent in projecting future conditions and results. Actual results could differ materially from expectations expressed in the forward-looking statements if one or more of the underlying assumptions and expectations proves to be inaccurate or is unrealized. In addition to the factors described in this report, Item 1A. Risk Factors identifies some of the important factors that could cause our actual results to differ materially from those in any such forward-looking statements. In order to comply with the terms of the safe harbor, we have identified these important factors which could affect our financial performance and could cause our actual results for future periods to differ materially from the anticipated results or other expectations expressed in the forward-looking statements. These factors should be considered, together with any similar risk factors or other cautionary language that may be made elsewhere in this Annual Report on Form 10-K. The list of important factors in Item 1A. Risk Factors does not necessarily present the risk factors in order of importance. This disclosure, including that under Forward-Looking Statements and Risk Factors, and other forward-looking statements and related disclosures made by us in this report and elsewhere from time to time, represents our best judgment as of the date the information is given. We do not undertake responsibility for updating any of such information, whether as a result of new information, future events, or otherwise, except as required by law. Investors are advised, however, to consult any further public company disclosures (such as in filings with the SEC or in our press releases) on related subjects.

<s>[INST] H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. We manage our business through six operating segments Americas Adhesives, EIMEA (Europe, India, Middle East and Africa), Asia Pacific, Construction Products, Engineering Adhesives and Royal Adhesives. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, flooring, textile, flexible packaging, graphic arts and envelope markets. The Construction Products operating segment provides floor preparation, grouts and mortars for tile setting, and adhesives for soft flooring as well as sealants and related products for heating, ventilation and air conditioning installations. The Engineering Adhesives operating segment provides highperformance adhesives to the transportation, electronics, medical, clean energy, appliance and heavy machinery markets. The Royal Adhesives operating segment produces and supplies specialty adhesives, sealants, coatings, polymers, tapes, encapsulants and additives to the aerospace and defense, automotive, recreational vehicle, bus, truck and trailer, marine, assembly, electrical/electronic, filter, printing, flexible packaging, laminating, graphic arts, solar/renewable energy, personal care, home furnishings, roofing and flooring markets. Total Company When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas, Global supply of and demand for raw materials, Economic growth rates, and Currency exchange rates compared to the U.S. dollar. We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impacts the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in highgrowth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With over 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. In 2017, we generated 42 percent of our net revenue in the United States and 28 percent in EIMEA. The pace of economic growth in these areas directly impacts certain industries to which we supply products. For example, adhesivesrelated revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as construction products and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other constructionrelated activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies weaken against the dollar, our revenues and costs decrease as the foreign currencydenominated financial statements translate into fewer dollars. The fluctuations of the Euro and the Chinese renminbi against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2017, currency fluctuations had a negative impact on net revenue of approximately $46 million as compared to 2016. Key financial results and transactions for 2017 included the following: Net revenue increased 10.1 percent from 2016 primarily driven by a 11.9 percent increase in sales volume, including a 7.7 percent increase due to acquisitions, and 0.8 percent in product pricing offset by a 2.2 percent decrease in currency and a 0.4 percent decrease due to unfavorable sales mix. Gross profit margin decreased to 26.2 percent from 29.1 percent in 2016 primarily due to higher raw material costs and [/INST] Negative. </s>

FULLER H B CO

2019-01-28

2018-12-01

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. For the year ended December 2, 2017, we had six reportable segments: Americas Adhesives, EIMEA, Asia Pacific, Construction Adhesives, Engineering Adhesives and Royal Adhesives. As of the beginning of fiscal 2018, in connection with the integration of the operations of Royal Adhesives with the Company’s other segments, we modified our operating segment structure by allocating the Royal Adhesives segment into each of the five other segments. We began reporting results in five segments for the quarter ended March 3, 2018: Americas Adhesives, EIMEA, Asia Pacific, Construction Adhesives and Engineering Adhesives. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, insulating glass, flooring, textile, flexible packaging, graphic arts and envelope markets. The Construction Adhesives operating segment provides floor preparation, grouts and mortars for tile setting, and adhesives for soft flooring, and pressure-sensitive adhesives, tapes and sealants for the commercial roofing industry as well as sealants and related products for heating, ventilation and air conditioning installations. The Engineering Adhesives operating segment provides high-performance adhesives to the transportation, electronics, medical, clean energy, aerospace and defense, appliance and heavy machinery markets. Total Company When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: ● Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas, ● Global supply of and demand for raw materials, ● Economic growth rates, and ● Currency exchange rates compared to the U.S. dollar We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impacts the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in high-growth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With approximately 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. The pace of economic growth directly impacts certain industries to which we supply products. For example, adhesives-related revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as Construction Adhesives and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other construction-related activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies weaken against the U.S. dollar, our revenues and costs decrease as the foreign currency-denominated financial statements translate into fewer U.S. dollars. The fluctuations of the Euro and the Chinese renminbi against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2018, currency fluctuations had a negative impact on net revenue of approximately $2.0 million as compared to 2017. Key financial results and transactions for 2018 included the following: ● Net revenue increased 31.9 percent from 2017 primarily driven by a 28.3 percent increase due to acquisitions, a 3.4 percent increase in product pricing, and a 0.6 percent increase due to favorable sales mix. Positive drivers of growth were partially offset by a 0.3 percent decrease in sales volume and a 0.1 percent decrease due to currency fluctuations. ● Gross profit margin increased to 27.5 percent from 26.2 percent in 2018 primarily due to favorable product pricing, the impact of the Royal Adhesives acquisition and lower restructuring plan costs. Positive drivers of growth were partially offset by higher raw material costs. ● Cash flow generated by operating activities was $253.3 million in 2018 as compared to $140.8 million in 2017 and $195.7 million in 2016. Our total year constant currency sales growth, which we define as the combined variances from sales volume, product pricing, sales mix and business acquisitions, increased 32.0 percent for 2018 compared to 2017. In 2018, our diluted earnings per share was $3.29 compared to $1.15 in 2017 and $2.37 in 2016. The higher earnings per share in 2018 compared to 2017 was due to higher net revenue, lower transaction costs related to acquisitions, and one time discrete items related to U.S. Tax Reform, which were partially offset by higher operating expenses mainly due to the impact of acquired businesses and higher interest expense due to higher U.S. debt balances at higher interest rates from the issuance of new debt in 2017. The lower earnings per share in 2017 compared to 2016 was due to an increase in transaction costs related to acquisitions, including make-whole costs associated with the early repayment of certain outstanding debt obligations, and the implementation of the 2017 Restructuring Plan. Change in Accounting Principle In the fourth quarter of 2018, we elected to change our method of accounting for certain inventories in the United States within the Company’s Americas Adhesives and Construction Adhesives segments from the last-in, first-out method (“LIFO”) to weighted-average cost. We have retrospectively adjusted the Consolidated Financial Statements for all periods presented to reflect this change. Project ONE In December 2012, our Board of Directors approved a multi-year project to replace and enhance our existing core information technology platforms. The scope for this project includes most of the basic transaction processing for the company including customer orders, procurement, manufacturing, and financial reporting. The project envisions harmonized business processes for all of our operating segments supported with one standard software configuration. The execution of this project, which we refer to as Project ONE, is being supported by internal resources and consulting services. The North America adhesives business went live in 2014. In 2017, we began the Project ONE implementation in our Latin America adhesives business, and implementation for all countries, with the exception of Brazil, has been completed as of the end of 2018. During 2019 and beyond, we will continue implementation in North America, EIMEA (Europe, India, Middle East and Africa) and Asia Pacific. Total expenditures for Project ONE are estimated to be $195 to $210 million, of which 50-55% is expected to be capital expenditures. Our total project-to-date expenditures are approximately $73 million, of which approximately $38 million are capital expenditures. Given the complexity of the implementation, the total investment to complete the project may exceed our estimate. Restructuring Plans Royal Adhesives Restructuring Plan During the first quarter of 2018, we approved a restructuring plan consisting of consolidation plans, organizational changes and other actions related to the integration of the operations of Royal Adhesives with the operations of the Company (the “Royal Adhesives Restructuring Plan”). In implementing the Royal Adhesives Restructuring Plan, we expect to incur costs of approximately $20.0 million, which includes (i) cash expenditures of approximately $12.0 million for severance and related employee costs globally and (ii) other costs of approximately $8.0 million related to the optimization of production facilities, streamlining of processes and accelerated depreciation of long-lived assets. Approximately $14.0 million of the costs are expected to be cash costs. For the year ending December 1, 2018, we incurred costs of $6.7 million under this plan. The Royal Adhesives Restructuring Plan was implemented in the first quarter of 2018 and is currently expected to be completed by the end of fiscal year 2020. 2017 Restructuring Plan During the first quarter of 2017, we approved a restructuring plan (the “2017 Restructuring Plan”) related to organizational changes and other actions to optimize operations. In implementing the 2017 Restructuring Plan, we incurred costs of $20.2 million as of December 1, 2018 which included cash expenditures of approximately $11.3 million for severance and related employee costs globally and $8.9 million related to the optimization of production facilities, streamlining of processes and accelerated depreciation of long-lived assets. Approximately $15.8 million of the costs were cash costs. The 2017 Restructuring Plan is substantially complete. Federal Income Tax Reform On December 22, 2017, the President of the United States signed into law H.R. 1, originally known as the “Tax Cuts and Jobs Act”, hereafter referred to as “U.S. Tax Reform”. Since the passing of U.S. Tax Reform, additional guidance in the form of notices and proposed regulations which interpret various aspects of U.S. Tax Reform have been issued. As of the filing of this document, additional guidance is expected. Changes could be made to the proposed regulations as they become finalized, future legislation could be enacted, more regulations and notices could be issued, all of which may impact our financial results. We will continue to monitor all of these changes and will reflect the impact as appropriate in future financial statements. Many state and local tax jurisdictions are still determining how they will interpret elements of U.S. Tax Reform. Final state and local governments’ conformity and legislation or guidance relating to U.S. Tax Reform may impact our financial results. Given the varying effective dates of specific components of U.S. Tax Reform coupled with our fiscal year end, we will be required to consider additional elements of U.S. Tax Reform, including the significant changes related to taxation of international operations that we were not subject to during our fiscal year ended December 1, 2018. Such elements will be included for our fiscal year ended November 30, 2019. Critical Accounting Policies and Significant Estimates Management’s discussion and analysis of our results of operations and financial condition are based upon the Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We believe the critical accounting policies and areas that require the most significant judgments and estimates to be used in the preparation of the Consolidated Financial Statements relate to pension and other postretirement plans; goodwill impairment; long-lived assets recoverability; valuation of product, environmental and other litigation liabilities; valuation of deferred tax assets and accuracy of tax contingencies; and valuation of acquired assets and liabilities. Pension and Other Postretirement Plan Assumptions We sponsor defined-benefit pension plans in both the U.S. and non-U.S. entities. Also in the U.S., we sponsor other postretirement plans for health care and life insurance benefits. Expenses and liabilities for the pension plans and other postretirement plans are actuarially calculated. These calculations are based on our assumptions related to the discount rate, expected return on assets, projected salary increases and health care cost trend rates. Note 10 to the Consolidated Financial Statements includes disclosure of assumptions employed in these measurements for both the non-U.S. and U.S. plans. The discount rate assumption is determined using an actuarial yield curve approach, which results in a discount rate that reflects the characteristics of the plan. The approach identifies a broad population of corporate bonds that meet the quality and size criteria for the particular plan. We use this approach rather than a specific index that has a certain set of bonds that may or may not be representative of the characteristics of our particular plan. A higher discount rate reduces the present value of the pension obligations. The discount rate for the U.S. pension plan was 4.51 percent at December 1, 2018, as compared to 3.73 percent at December 2, 2017 and 4.10 percent at December 3, 2016. Net periodic pension cost for a given fiscal year is based on assumptions developed at the end of the previous fiscal year. A discount rate reduction of 0.5 percentage points at December 1, 2018 would decrease U.S. pension and other postretirement plan expense less than $0.1 million (pre-tax) in fiscal 2019. Discount rates for non-U.S. plans are determined in a manner consistent with the U.S. plans. The expected long-term rate of return on plan assets assumption for the U.S. pension plan was 7.75 percent in 2018, 2017 and 2016. Our expected long-term rate of return on U.S. plan assets was based on our target asset allocation assumption of 60 percent equities and 40 percent fixed-income. Management, in conjunction with our external financial advisors, determines the expected long-term rate of return on plan assets by considering the expected future returns and volatility levels for each asset class that are based on historical returns and forward looking observations. For 2018, the expected long-term rate of return on the target equities allocation was 8.25 percent and the expected long-term rate of return on the target fixed-income allocation was 5.6 percent. The total plan rate of return assumption included an estimate of the effect of diversification and the plan expense. For 2019, the expected long-term rate of return on assets will be 7.50 percent with an expected long-term rate of return on the target equities allocation of 8.2 percent and an expected long-term rate of return on target fixed-income allocation of 5.6 percent. A change of 0.5 percentage points for the expected return on assets assumption would impact U.S. net pension and other postretirement plan expense by approximately $2.1 million (pre-tax). Management, in conjunction with our external financial advisors, uses the actual historical rates of return of the asset categories to assess the reasonableness of the expected long-term rate of return on plan assets. The most recent 10-year and 20-year historical equity returns are shown in the table below. Our expected rate of return on our total portfolio is consistent with the historical patterns observed over longer time frames. * Beginning in 2006, our target allocation migrated from 100 percent equities to our current allocation of 60 percent equities and 40 percent fixed-income. The historical actual rate of return for the fixed income of 7.0 percent is since inception (12 years, 11 months). The expected long-term rate of return on plan assets assumption for non-U.S. pension plans was a weighted-average of 6.20 percent in 2018 compared to 6.21 percent in 2017 and 6.20 percent in 2016. The expected long-term rate of return on plan assets assumption used in each non-U.S. plan is determined on a plan-by-plan basis for each local jurisdiction and is based on expected future returns for the investment mix of assets currently in the portfolio for that plan. Management, in conjunction with our external financial advisors, develops expected rates of return for each plan, considers expected long-term returns for each asset category in the plan, reviews expectations for inflation for each local jurisdiction, and estimates the effect of active management of the plan’s assets. Our largest non-U.S. pension plans are in the United Kingdom and Germany. The expected long-term rate of return on plan assets for the United Kingdom was 6.75 percent and the expected long-term rate of return on plan assets for Germany was 5.75 percent. Management, in conjunction with our external financial advisors, uses actual historical returns of the asset portfolio to assess the reasonableness of the expected rate of return for each plan. The projected salary increase assumption is based on historic trends and comparisons to the external market. Higher rates of increase result in higher pension expenses. As this rate is also a long-term expected rate, it is less likely to change on an annual basis. In the U.S., we have used the rate of 4.50 percent for 2018, 2017 and 2016. Benefits under the U.S. Pension Plan were locked-in as of May 31, 2011 and no longer include compensation increases. The 4.50 percent rate is for the supplemental executive retirement plan only. Projected salary increase assumptions for non-U.S. plans are determined in a manner consistent with the U.S. plans. Goodwill Goodwill is the excess of cost of an acquired entity over the amounts assigned to assets acquired and liabilities assumed in a purchase business combination. Goodwill is allocated to our reporting units, which are our operating segments or one level below our operating segments (the component level). Reporting units are determined by the discrete financial information available for the component and whether it is regularly reviewed by segment management. Components are aggregated into a single reporting unit if they share similar economic characteristics. Our reporting units are as follows: Americas Adhesives, EIMEA, Asia Pacific, Flooring, Roofing, Specialty Construction, Engineering Adhesives and Tonsan. We evaluate our goodwill for impairment annually as of the end of our third quarter or earlier upon the occurrence of substantive unfavorable changes in economic conditions, industry trends, costs, cash flows, or ongoing declines in market capitalization. For fiscal 2018, we performed an initial quantitative goodwill impairment test as of the end of the third quarter which resulted in no indicators of impairment for any of our reporting units. However, upon the decrease of our stock price and management’s reassessment of its long-term business plan during the fourth quarter of 2018, we updated our quantitative goodwill impairment test as of December 1, 2018. The quantitative impairment test requires judgment, including the identification of reporting units, the assignment of assets, liabilities and goodwill to reporting units, and the determination of fair value of each reporting unit. The impairment test requires the comparison of the fair value of each reporting unit with its carrying amount, including goodwill. In performing the impairment test, we determined the fair value of our reporting units by using discounted cash flow (“DCF”) analyses. Determining fair value requires the Company to make judgments about appropriate discount rates, perpetual growth rates and the amount and timing of expected future cash flows. The cash flows employed in the DCF analysis for each reporting unit are based on the reporting unit's budget, long-term business plan, and recent operating performance. Discount rate assumptions are based on an assessment of the risk inherent in the future cash flows of the respective reporting unit and market conditions. Given the inherent uncertainty in determining the assumptions underlying a DCF analysis, actual results may differ from those used in our valuations. In assessing the reasonableness of the determined fair values, we also reconciled the aggregate determined fair value of the Company to the Company's market capitalization, which, at the date of our fourth quarter 2018 impairment test, included an 11% control premium. For the fourth quarter 2018 test, the fair value of the reporting units exceeded the respective carrying values by 16% to 122% ("headroom"). Significant assumptions used in the DCF included long-term growth rates and discount rates that ranged from 9.0% to 10.8%. An increase in the discount and decrease in the long-term growth rates of 0.5% would result in the fair value of the reporting units exceeding their respective carrying values by 5% to 104%. The Roofing reporting unit, which had headroom of 18%, and EIMEA reporting unit, which had headroom of 16%, were the only reporting units with fair value in excess of carrying value of less than 20%. As of December 1, 2018, the carrying value of goodwill assigned to the Roofing and EIMEA reporting units were $175.0 and $190.2 million, respectively. Management will continue to monitor these reporting units for changes in the business environment that could impact recoverability. The recoverability of goodwill is dependent upon the continued growth of cash flows from our business activities. If the economy or business environment falter and we are unable to achieve our assumed revenue growth rates or profit margin percentages, our projections used would need to be remeasured, which could impact the carrying value of our goodwill in one or more of our reporting units. Most significantly, for our Roofing reporting unit, a decrease in the planned volume revenue growth would negatively impact the fair value of the reporting unit and the calculation of excess carrying value. For our EIMEA reporting unit, not achieving cost savings due to plant consolidation efforts currently underway would negatively impact the fair value of the reporting unit and the calculation of excess carrying value. See Note 5 to the Consolidated Financial Statements for further information regarding goodwill. Recoverability of Long-Lived Assets The assessment of the recoverability of long-lived assets reflects our assumptions and estimates. Factors that we must estimate when performing impairment tests include sales volume, prices, inflation, currency exchange rates, tax rates and capital spending. Significant judgment is involved in estimating these factors, and they include inherent uncertainties. The measurement of the recoverability of these assets is dependent upon the accuracy of the assumptions used in making these estimates and how the estimates compare to the eventual future operating performance of the specific businesses to which the assets are attributed. Judgments made by us include the expected useful lives of long-lived assets. The ability to realize undiscounted cash flows in excess of the carrying amounts of such assets is affected by factors such as the ongoing maintenance and improvement of the assets, changes in economic conditions and changes in operating performance. Product, Environmental and Other Litigation Liabilities As disclosed in Item 3. Legal Proceedings and in Note 1 and Note 14 to the Consolidated Financial Statements, we are subject to various claims, lawsuits and other legal proceedings. Reserves for loss contingencies associated with these matters are established when it is determined that a liability is probable and the amount can be reasonably estimated. The assessment of the probable liabilities is based on the facts and circumstances known at the time that the financial statements are being prepared. For cases in which it is determined that a liability is probable but only a range for the potential loss exists, the minimum amount of the range is recorded and subsequently adjusted as better information becomes available. For cases in which insurance coverage is available, the gross amount of the estimated liabilities is accrued, and a receivable is recorded for any probable estimated insurance recoveries. A discussion of environmental, product and other litigation liabilities is disclosed in Item 3. Legal Proceedings and Note 14 to the Consolidated Financial Statements. Based upon currently available facts, we do not believe that the ultimate resolution of any pending legal proceeding, individually or in the aggregate, will have a material adverse effect on our long-term financial condition. However, adverse developments and/or periodic settlements could negatively affect our results of operations or cash flows in one or more future quarters. Income Tax Accounting As part of the process of preparing the Consolidated Financial Statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. The process involves estimating actual current tax expense along with assessing temporary differences resulting from differing treatment of items for book and tax purposes. These temporary differences result in deferred tax assets and liabilities, which are included in the Consolidated Balance Sheets. We record a valuation allowance to reduce our deferred tax assets to the amount that is more-likely-than-not to be realized. We have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance. Increases in the valuation allowance result in additional expense to be reflected within the tax provision in the Consolidated Statements of Income. As of December 1, 2018, the valuation allowance to reduce deferred tax assets totaled $14.1 million. We recognize tax benefits for tax positions for which it is more-likely-than-not that the tax position will be sustained by the applicable tax authority at the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement. We do not recognize a financial statement benefit for a tax position that does not meet the more-likely-than-not threshold. We believe that our liabilities for income taxes reflect the most likely outcome. It is difficult to predict the final outcome or the timing of the resolution of any particular tax position. Future changes in judgment related to the resolution of tax positions will impact earnings in the quarter of such change. We adjust our income tax liabilities related to tax positions in light of changing facts and circumstances. Settlement with respect to a tax position would usually require cash. Based upon our analysis of tax positions taken on prior year returns and expected tax positions to be taken for the current year tax returns, we have identified gross uncertain tax positions of $8.4 million as of December 1, 2018. We have not recorded U.S. deferred income taxes for certain of our non-U.S. subsidiaries undistributed earnings as such amounts are intended to be indefinitely reinvested outside of the U.S. Should we change our business strategies related to these non-U.S. subsidiaries, additional U.S. tax liabilities could be incurred. It is not practical to estimate the amount of these additional tax liabilities. See Note 11 to the Consolidated Financial Statements for further information on income tax accounting. Acquisition Accounting As we enter into business combinations, we perform acquisition accounting requirements including the following: ● Identifying the acquirer, ● Determining the acquisition date, ● Recognizing and measuring the identifiable assets acquired and the liabilities assumed, and ● Recognizing and measuring goodwill or a gain from a bargain purchase We complete valuation procedures and record the resulting fair value of the acquired assets and assumed liabilities based upon the valuation of the business enterprise and the tangible and intangible assets acquired. Enterprise value allocation methodology requires management to make assumptions and apply judgment to estimate the fair value of assets acquired and liabilities assumed. If estimates or assumptions used to complete the enterprise valuation and estimates of the fair value of the acquired assets and assumed liabilities significantly differed from assumptions made, the resulting difference could materially affect the fair value of net assets. The calculation of the fair value of the tangible assets, including property, plant and equipment, utilizes the cost approach, which computes the cost to replace the asset, less accrued depreciation resulting from physical deterioration, functional obsolescence and external obsolescence. The calculation of the fair value of the identified intangible assets are determined using cash flow models following the income approach or a discounted market-based methodology approach. Significant inputs include estimated revenue growth rates, gross margins, operating expenses, and estimated attrition, royalty and discount rates. Goodwill is recorded as the difference in the fair value of the acquired assets and assumed liabilities and the purchase price. Net revenue in 2018 increased 31.9 percent from 2017. The 2017 net revenue was 10.1 percent higher than the net revenue in 2016. Every five or six years we have a 53rd week in our fiscal year. 2016 was a 53-week year which contributed approximately 2.0 percent to net revenue in 2016, primarily related to volume. In analyzing our results of operations from period to period, we review variances in net revenue in terms of changes related to sales volume, product pricing, sales mix, business acquisitions and changes in foreign currency exchange rates. The impact of sales volume, product pricing, sales mix and acquisitions including Royal Adhesives, Adecol and Wisdom, Cyberbond, L.L.C. and Advanced Adhesives are viewed as constant currency growth. The following table shows the net revenue variance analysis for the past two years: Constant currency growth was 32.0 percent in 2018 compared to 2017. The 32.0 percent constant currency growth in 2018 was driven by 71.4 percent growth in Construction Adhesives, 57.1 percent growth in Engineering Adhesives, 29.9 percent growth in EIMEA, 21.2 percent growth in Americas Adhesives and 5.1 percent growth in Asia Pacific. Constant currency growth in 2018 includes 28.3 percent growth attributable to the acquisition of Royal Adhesives and Adecol. The negative 0.1 percent currency impact was primarily driven by a weaker Brazilian real, Argentinian peso, Australian dollar, Canadian dollar and Turkish lira offset by a stronger Mexican peso, Chinese renminbi and Euro compared to the U.S. dollar. Constant currency growth was 12.3 percent in 2017 compared to 2016. The inclusion of a 53rd week in 2016 negatively impacted 2017 constant currency sales growth by approximately 2.0 percent. The 12.3 percent constant currency growth in 2017 was driven by 24.2 percent growth in Engineering Adhesives, 12.6 percent growth in Americas Adhesives, 9.5 percent growth in Asia Pacific, 4.3 percent growth in EIMEA and 1.5 percent growth in Construction Adhesives. Constant currency growth in 2017 includes 3.7 percent growth attributable to the acquisition of Royal Adhesives. The negative 2.2 percent currency impact was primarily driven by a weaker Egyptian pound, Turkish lira, Chinese renminbi, Argentinian peso, Mexican peso and Malaysian ringgit partially offset by a stronger Euro, Indian rupee and Australian dollar compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 130 basis points in 2018 compared to 2017 due to an increase in product pricing and the impact of the Royal Adhesives acquisition. Other manufacturing costs as a percentage of net revenue was flat compared to 2017. As a result, cost of sales as a percentage of net revenue decreased 130 basis points compared to 2017. Raw material costs as a percentage of net revenue increased 240 basis points in 2017 compared to 2016 due to higher raw material costs and the impact of acquired businesses including the inventory step up related to our recent acquisitions. Other manufacturing costs as a percentage of revenue increased 40 basis points compared to 2016 driven primarily by the impact of acquired businesses and the implementation of the 2017 Restructuring Plan. As a result, cost of sales as a percentage of net revenue increased 270 basis points compared to 2016. Gross profit in 2018 increased $231.8 million compared to 2017 and gross profit margin increased 130 basis points. The increase in gross profit margin was primarily due to favorable product pricing and the impact of the Royal Adhesives acquisition and lower restructuring plan costs. Gross profit in 2017 decreased $0.7 million compared to 2016 and gross profit margin decreased 270 basis points. The decrease in gross profit margin was primarily due to higher raw material costs, the impact of acquired businesses and the implementation of the 2017 Restructuring Plan. Selling, general and administration (“SG&A”) expenses for 2018 increased $105.1 million or 22.0 percent compared to 2017. The increase is mainly due to the impact of acquired businesses and the impact of unfavorable foreign currency exchange rates on spending outside the U.S. SG&A expenses for 2017 increased $69.4 million or 17.0 percent compared to 2016. The increase is mainly due to the impact of acquired businesses, transaction costs related to acquisitions and higher variable compensation, partially offset by lower expenses related to general spending reductions and the impact of favorable foreign currency exchange rates on spending outside the U.S. Acquisition and transformation related costs of $0.2 million for the year ended December 3, 2016 include costs related to organization consulting, financial advisory and legal services necessary to integrate the industrial adhesives business we acquired in March 2012 into our existing operating segments. During the year ended December 3, 2016, we incurred cash facility exit costs of $1.3 million, non-cash facility exit costs of $1.7 million and other incremental transformation related costs of $0.2 million. Also included in facility exit costs for 2016 is a $3.6 million gain on the sale of our production facility located in Wels, Austria. Other income (expense), net includes foreign currency transaction losses of $4.5 million, $2.4 million and $9.5 million in 2018, 2017 and 2016, respectively. Gain (loss) on disposal of fixed assets was $3.1 million, nil and ($0.8) million in 2018, 2017 and 2016, respectively. Other income (expense), net for 2017 also included $25.5 million of expense related to make-whole costs associated with the early repayment of certain outstanding debt obligations which were refinanced upon entering into the Term Loan B Credit Agreement (as described in Note 6 to our Consolidated Financial Statements). Interest expense was $111.0 million, $43.7 million and $27.4 million for 2018, 2017 and 2016, respectively. The higher interest expense in 2018 compared to 2017 was due primarily to higher U.S. debt balances at higher interest rates from the issuance of our 4.000% Notes and higher LIBOR rates on floating rate debt held in the U.S. The higher interest expense in 2017 compared to 2016 was due to higher U.S. debt balances from the issuance of our Term Loan B Credit Agreement and the Public Notes and the write-off of capitalized debt issuance costs on repaid debt facilities. We capitalized interest of $0.3 million, $0.3 million and $0.8 million in 2018, 2017 and 2016, respectively. Interest income was $11.7 million, $3.9 million and $2.0 million in 2018, 2017 and 2016, respectively. Interest income in 2018 was higher due to our cross-currency swap cash flow hedges that were entered into at the end of 2017 in conjunction with the Royal Adhesives acquisition. The income tax benefit in 2018 of $6.4 million includes $49.0 million of discrete tax benefits in both the U.S. and foreign jurisdictions, primarily related to the impact of U.S. Tax Reform. Income tax expense in 2017 of $9.8 million includes $4.1 million of discrete tax benefits in both the U.S. and foreign jurisdictions, primarily related to the release of the valuation allowance in Brazil in conjunction with the Adecol acquisition. Income tax expense in 2016 of $48.9 million included $2.6 million of discrete tax benefits in both the U.S. and foreign jurisdictions. Excluding discrete items, the overall effective tax rate increased by 4.2 percentage points in 2018 as compared to 2017 and decreased by 8.5 percentage points in 2017 as compared to 2016. The increase in the tax rate is principally due to an increase in the effective rate outside the U.S. due to a change in the geographic mix of pre-tax earnings, as well as withholding tax expense in foreign jurisdictions. The income from equity method investments relates to our 50 percent ownership of the Sekisui-Fuller joint venture in Japan. The lower income for 2018 compared to 2017 relates to lower net income in our joint venture. The higher income for 2017 compared to 2016 relates to higher net income in our joint venture. The net income attributable to non-controlling interests related to the redeemable non-controlling interest in H.B. Fuller Kimya Sanayi Ticaret A.S. (HBF Kimya). During fiscal 2017, we purchased the remaining shares from the non-controlling shareholder. Net income attributable to H.B. Fuller was $171.2 million in 2018 compared to $59.4 million in 2017 and $121.7 million in 2016. Diluted earnings per share was $3.29 per share in 2018, $1.15 per share for 2017 and $2.37 per share for 2016. Operating Segment Results We are required to report segment information in the same way that we internally organize our business for assessing performance and making decisions regarding allocation of resources. For segment evaluation by the chief operating decision maker, segment operating income is defined as gross profit less SG&A expenses. Segment operating income excludes special charges, net. Inter-segment revenues are recorded at cost plus a markup for administrative costs. Corporate expenses are fully allocated to each operating segment. For the year ended December 2, 2017, we had six reportable segments: Americas Adhesives, EIMEA, Asia Pacific, Construction Adhesives, Engineering Adhesives and Royal Adhesives. As of the beginning of fiscal 2018, in connection with the integration of the operations of Royal Adhesives with the Company’s other segments, we modified our operating segment structure by allocating the Royal Adhesives segment into each of the five other segments. We began reporting results in five segments for the quarter ended March 3, 2018: Americas Adhesives, EIMEA, Asia Pacific, Construction Adhesives and Engineering Adhesives. The tables below provide certain information regarding the net revenue and segment operating income (loss) of each of our operating segments. The following table provides a reconciliation of segment operating income to income before income taxes and income from equity method investments, as reported in the Consolidated Statements of Income. Net revenue increased 21.2 percent in 2018 compared to 2017. The 23.9 percent increase in constant currency growth was attributable to an 18.7 percent increase in sales volume, including a 22.1 percent increase due to the Royal Adhesives, Adecol and Wisdom acquisitions, a 3.8 percent increase in product pricing and a 1.4 percent increase in sales mix. The 2.7 negative currency effect was primarily due to the weaker Brazilian real and Argentinian peso compared to the U.S. dollar. As a percentage of net revenue, raw material costs decreased 90 basis points mainly due to an increase in product pricing and the impact of acquired businesses. Other manufacturing costs as a percentage of net revenue increased 90 basis points, primarily due to higher delivery costs and the impact of acquired businesses. Operating expense as a percentage of net revenue decreased 50 basis points. Segment operating income increased 26.5 percent and segment operating margin as a percentage of net revenue increased 50 basis points in 2018 compared to 2017. Net revenue increased 12.6 percent in 2017 compared to 2016. The 12.8 percent increase in constant currency growth was attributable to a 14.0 percent increase in sales volume, including an 11.1 percent increase due to the Royal Adhesives, Adecol and Wisdom acquisitions, offset by an unfavorable 0.8 percent decrease in sales mix and a 0.4 percent decrease in product pricing. The 0.2 percent negative currency effect was due to the weaker Argentinian peso and Mexican peso, offset by the stronger Brazilian real and Canadian dollar compared to the U.S. dollar. As a percentage of net revenue, raw material costs increased 320 basis points mainly due to higher raw material costs and the inventory step up related to the Wisdom, Adecol and Royal Adhesives acquisitions. Other manufacturing costs as a percentage of net revenue increased 120 basis points, primarily due to the acquisition and integration of Wisdom Adhesives. SG&A expenses as a percentage of net revenue increased 70 basis points due to the impact of the Royal Adhesives acquisition. Segment operating income decreased 25.2 percent and segment operating margin as a percentage of net revenue decreased 510 basis points in 2017 compared to 2016. The following table provides details of the EIMEA net revenue variances: Net revenue increased 29.9 percent in 2018 compared to 2017. The 28.2 percent increase in constant currency growth was attributable to a 23.4 percent increase in sales volume, including a 24.3 percent increase due to the Royal acquisition, a 4.4 percent increase in product pricing and a 0.4 percent increase in sales mix. The 1.7 percent positive currency effect was primarily the result of a stronger Euro and British pound offset by a weaker Turkish lira and Indian rupee compared to the U.S. dollar. Raw material costs as a percentage of net revenue increased 20 basis points. Other manufacturing costs as a percentage of net revenue decreased 40 basis points in 2018 compared to 2017. Operating expense as a percentage of net revenue decreased 190 basis points due to lower restructuring plan costs. Segment operating income increased 113.3 percent and segment operating margin as a percentage of net revenue increased 210 basis points in 2018 compared to 2017. Net revenue increased 4.3 percent in 2017 compared to 2016. The 10.9 percent increase in constant currency growth was attributable to a 6.3 percent increase in sales volume, including a 3.7 percent increase due to the Royal Adhesives acquisition, a 4.5 percent increase in product pricing and a 0.1 percent increase due to favorable sales mix. Sales volume growth was primarily related to the hygiene and durable assembly markets. In addition, we had strong growth in the emerging markets. The 6.6 percent negative currency effect was primarily the result of a weaker Egyptian pound and Turkish lira offset by a stronger Euro and Indian rupee compared to the U.S. dollar. Raw material costs as a percentage of net revenue increased 250 basis points primarily due to higher raw material costs and the impact of the Royal Adhesives acquisition offset by higher product pricing. Other manufacturing costs as a percentage of net revenue was flat in 2017 compared to 2016. Operating expense as a percentage of net revenue increased 160 basis points due to the acquisition of Royal Adhesives. Segment operating income decreased 53.1 percent and segment operating margin decreased 410 basis points compared to 2016. Net revenue in 2018 increased 5.1 percent compared to 2017. The 3.3 percent increase in constant currency growth was attributable to a 2.4 percent increase in sales volume, including a 1.5 percent increase due to the Royal Adhesives acquisition, and a 1.4 percent increase in product pricing, partially offset by a 0.5 decrease due to unfavorable sales mix. Positive currency effects of 1.8 percent compared to 2017 were primarily driven by the stronger Chinese renminbi and Malaysian ringgit offset by the weaker Australian dollar and Indonesian rupiah compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 60 basis points compared to 2017 primarily due to an increase in product pricing. Other manufacturing costs as a percentage of net revenue decreased 50 basis points compared to 2017. Operating expense as a percentage of net revenue increased 20 basis points. Segment operating income increased 21.6 percent and segment operating margin increased 90 basis points compared to 2017. Net revenue in 2017 increased 9.5 percent compared to 2016. The 11.1 percent increase in constant currency growth was attributable to a 12.1 percent increase in sales volume, including a 3.0 percent increase due to the Advanced Adhesives and Royal Adhesives acquisitions, partially offset by a 0.5 percent decrease in product pricing and a 0.5 percent decrease due to unfavorable sales mix. Constant currency growth was primarily driven by volume growth in Greater China. Negative currency effects of 1.6 percent compared to 2016 were primarily driven by the weaker Chinese renminbi and Malaysian ringgit compared to the U.S. dollar, partially offset by a stronger Australian dollar. Raw material costs as a percentage of net revenue increased 180 basis points compared to 2016, primarily due to higher raw material costs. Other manufacturing costs as a percentage of net revenue decreased 60 basis points compared to 2016. Operating expense as a percentage of net revenue decreased 40 basis points. Segment operating income decreased 3.9 percent and segment operating margin decreased 80 basis points compared to 2016. NMP = Non-meaningful percentage Net revenue increased 71.4 percent in 2018 compared to 2017. The 71.2 percent increase in constant currency growth was driven by a 72.2 percent increase in sales volume, including a 72.4 percent increase due to the Royal Adhesives acquisition, partially offset by a 1.0 percent decrease due to unfavorable sales mix. The positive currency effect of 0.2 percent compared to 2017 was due to the stronger Euro and Australian dollar compared to the U.S. dollar. Raw material costs as a percentage of net revenue was flat compared to 2017. Other manufacturing costs as a percentage of net revenue were 680 basis points lower in 2018 compared to 2017 primarily due to improved operating efficiencies related to the completion of the facility upgrade and expansion project and lower restructuring plan costs. SG&A expenses as a percentage of net revenue decreased by 560 basis points in 2018 compared to 2017 due to increased sales volume. Net revenue increased 1.5 percent in 2017 compared to 2016. The 1.3 percent increase in constant currency growth was driven by a 1.6 percent increase in sales volume, including an 8.5 percent increase due to the Royal Adhesives acquisition, offset by a 6.9 percent decrease in sales volume and a 0.3 percent decrease due to unfavorable sales mix. The sales volume decline was due to lower service levels related to the facility upgrade and expansion project. Positive currency effects of 0.2 percent compared to 2016 were primarily driven by the stronger Australian dollar compared to the U.S. dollar. Raw material cost as a percentage of net revenue was 30 basis points higher in 2017 compared to 2016. Other manufacturing costs as a percentage of net revenue were 180 basis points higher in 2017 compared to 2016 due to inefficiencies related to the facility upgrade and expansion project. Operating expense as a percentage of net revenue increased 420 basis points due to the impact of the Royal Adhesives acquisition. Segment operating income (loss) decreased 493.9 percent and segment profit margin decreased 630 basis points in 2017 compared to 2016. Net revenue increased 57.1 percent in 2018 compared to 2017. The 54.6 percent increase in constant currency growth was driven by a 49.1 percent increase in sales volume, including a 39.9 percent increase due to the acquisition of Royal Adhesives, a 4.8 percent increase in product pricing and a 0.7 percent increase due to favorable sales mix. Sales volume growth was primarily driven by strong performance in the Tonsan and automotive markets. Positive currency effects of 2.5 percent were primarily driven by the stronger Chinese renminbi, Euro and British pound offset by the weaker Turkish lira and Brazilian real compared to the U.S. dollar. Raw material costs as a percentage of net revenue were 260 basis points lower in 2018 compared to 2017 due to increased product pricing and the impact of the Royal Adhesives acquisition partially offset by higher raw material costs. Other manufacturing costs as a percentage of net revenue were 280 basis points higher in 2018 compared to 2017 due to the impact of the Royal Adhesives acquisition. Operating expense as a percentage of net revenue decreased 500 basis points compared to 2017 primarily due to higher sales volume and the impact of the Royal Adhesives acquisition. Segment operating income increased 198.8 percent and segment operating margin increased 480 basis points in 2018 compared to 2017. Net revenue increased 24.2 percent in 2017 compared to 2016. The 26.0 percent increase in constant currency growth was driven by a 27.7 percent increase in sales volume, including a 9.5 percent increase due to the acquisitions of Cyberbond, L.L.C. and Royal Adhesives, partially offset by a 1.2 percent decrease in product pricing and a 0.5 percent decrease due to unfavorable sales mix. Constant currency growth was driven by strong performance in the electronics and Tonsan markets. Negative currency effects of 1.8 percent compared to 2016 were primarily driven by the weaker Chinese renminbi partially offset by a stronger Euro and Indian rupee compared to the U.S. dollar. Raw material cost as a percentage of net revenue increased 160 basis points in 2017 compared to 2016 due to unfavorable sales mix, higher raw material costs and the impact of the Royal Adhesives acquisition. Other manufacturing costs as a percentage of net revenue decreased 30 basis points in 2017 compared to 2016. Operating expense as a percentage of net revenue increased 50 basis points compared to 2016 due to the impact of acquisitions, partially offset by the net mark to market adjustment related to the Tonsan contingent consideration liability. Segment operating income decreased 6.9 percent and segment operating margin decreased 180 basis points in 2017 compared to 2016. Financial Condition, Liquidity and Capital Resources Total cash and cash equivalents as of December 1, 2018 were $150.8 million compared to $194.4 million as of December 2, 2017. Total long and short-term debt was $2,247.5 million as of December 1, 2018 and $2,451.9 million as of December 2, 2017. We believe that cash flows from operating activities will be adequate to meet our ongoing liquidity and capital expenditure needs. In addition, we believe we have the ability to obtain both short-term and long-term debt to meet our financing needs for the foreseeable future. Cash available in the United States has historically been sufficient and we expect it will continue to be sufficient to fund U.S. operations and U.S. capital spending and U.S. pension and other postretirement benefit contributions in addition to funding U.S. acquisitions, dividend payments, debt service and share repurchases as needed. For those international earnings considered to be reinvested indefinitely, we currently have no intention to, and plans do not indicate a need to, repatriate these funds for U.S. operations. Our credit agreements include restrictive covenants that, if not met, could lead to a renegotiation of our credit lines and a significant increase in our cost of financing. At December 1, 2018, we were in compliance with all covenants of our contractual obligations as shown in the following table: ● TTM = trailing 12 months ● EBITDA for covenant purposes is defined as consolidated net income, plus interest expense, expense for taxes paid or accrued, depreciation and amortization, certain non-cash impairment losses, extraordinary non-cash losses incurred other than in the ordinary course of business, nonrecurring extraordinary non-cash restructuring charges and the non-cash impact of purchase accounting, expenses related to the Royal Adhesives acquisition not to exceed $40.0 million, one-time costs incurred in connection with prepayment premiums and make-whole amounts under certain agreements, certain “run rate” cost savings and synergies in connection with the Royal Adhesives acquisition not to exceed 15% of Consolidated EBITDA, expenses relating to the integration of Royal Adhesives during the fiscal years ending in 2017, 2018 and 2019 not exceeding $30 million in aggregate, restructuring expenses that began prior to the Royal Adhesives acquisition incurred in fiscal years ending in 2017 and 2018 not exceeding $28 million in aggregate, and non-capitalized charges relating to the SAP implementation during fiscal years ending in 2017 through 2021 not exceeding $13 million in any single fiscal year, minus extraordinary non-cash gains. For the Total Indebtedness / TTM EBITDA ratio, TTM EBITDA is adjusted for the pro forma results from Material Acquisitions and Material Divestitures as if the acquisition or divestiture occurred at the beginning of the calculation period. The full definition is set forth in the Term Loan B Credit Agreement and the Amended Revolving Credit Agreement, and can be found in the Company’s 8-K filings dated October 20, 2017 and November 17, 2017, respectively. We believe we have the ability to meet all of our contractual obligations and commitments in fiscal 2019. Of the $150.8 million in cash and cash equivalents as of December 1, 2018, $145.2 million was held outside the U.S. Of the $145.2 million of cash held outside the U.S., earnings on $137.8 million are indefinitely reinvested outside of the U.S. It is not practical for us to determine the U.S. tax implications of the repatriation of these funds. There are no contractual or regulatory restrictions on the ability of consolidated and unconsolidated subsidiaries to transfer funds in the form of cash dividends, loans or advances to us, except for: 1) a credit facility limitation restricting investments, loans, advances or capital contributions from Loan Parties to non-Loan Parties in excess of $100.0 million, 2) a credit facility limitation that provides total investments, loans, advances or guarantees not otherwise permitted in the credit agreement for all subsidiaries shall not exceed $125.0 million in the aggregate, 3) a credit facility limitation that provides total investments, dividends, and distributions shall not exceed the Available Amount defined in these agreements, and 4) typical statutory restrictions, which prohibit distributions in excess of net capital or similar tests. The Royal Adhesives acquisition and any investments, loans, and advances established to consummate the Royal Adhesives acquisition, are excluded from the credit facility limitations described above. Additionally, we have taken the income tax position that the majority of our cash in non-U.S. locations is indefinitely reinvested. Debt Outstanding and Debt Capacity Notes Payable Notes payable were $14.8 million at December 1, 2018 and $31.5 million at December 2, 2017. These amounts mainly represented various foreign subsidiaries’ short-term borrowings that were not part of committed lines. The weighted-average interest rates on these short-term borrowings were 9.6 percent in 2018 and 11.0 percent in 2017. Long-Term Debt Long-term debt consisted of a secured term loan (“Term Loan B”) and an unsecured public note (“Public Notes”). The Term Loan B bears a floating interest rate at LIBOR plus 2.00 percent (4.30 percent at December 1, 2018) and matures in fiscal year 2024. The Public Notes bear interest at 4.00 percent fixed interest and mature in fiscal year 2027. We are subject to a par call of 1.00 percent except within three months of maturity date. We currently have no intention to prepay the Public Notes. Additional details on the Public Notes and the Term Loan B Credit Agreement can be found in the 8-K dated February 9, 2017 and the 8-K dated October 20, 2017, respectively. We executed interest rate swap agreements for the purpose of obtaining a fixed interest rate on $1,450.0 million of the $2,150.0 million Term Loan B. We have designated forecasted interest payments resulting from the variability of 1-month LIBOR in relation to $1,450.0 million of the Term Loan B as the hedged item in cash flow hedges. The combined fair value of the interest rate swaps in total was an asset of $28.9 million at December 1, 2018 and was included in other assets in the Consolidated Balance Sheets. We are applying the hypothetical derivative method to assess hedge effectiveness for these interest rate swaps. Changes in the fair value of a hypothetically perfect swap with terms that match the critical terms of our $1,450.0 million variable rate Term Loan B are compared with the change in the fair value of the swaps. We entered into interest rate swap agreements for the purpose of obtaining a floating rate on $150.0 million of our $300.0 million Public Notes. We have designated the $150.0 million of public debt as the hedged item in a fair value hedge. The combined fair value of the interest rate swaps in total was a liability of $8.7 million at December 1, 2018 and was included in other liabilities in the Consolidated Balance Sheets. The swaps were designated for hedge accounting treatment as fair value hedges. We are applying the hypothetical derivative method to assess hedge effectiveness for these interest rate swaps. Changes in the fair value of a hypothetically perfect swap with terms that match the critical terms of our $150.0 million fixed rate Public Notes are compared with the change in the fair value of the swaps. Lines of Credit We have a revolving credit agreement with a consortium of financial institutions at December 1, 2018. This credit agreement creates a secured multi-currency revolving credit facility that we can draw upon to repay existing indebtedness, finance working capital needs, finance acquisitions, and for general corporate purposes up to a maximum of $400.0 million. Interest on the revolving credit facility is payable at LIBOR plus 2.00 percent (4.35 percent at December 1, 2018). A facility fee of 0.30 percent of the unused commitment under the revolving credit facility is payable quarterly. The interest rate and the facility fee are based on a leverage grid. The credit facility expires on April 12, 2022. As of December 1, 2018, our lines of credit were undrawn. Additional details on the revolving credit agreement can be found in the 8-K dated November 17, 2017. For further information related to debt outstanding and debt capacity, see Note 6 to the Consolidated Financial Statements. Uncertainty relating to the LIBOR phase out at the end of 2021 may adversely impact the value of, and our obligations under, our Term Loan B, Public Notes and revolving credit facility. See the applicable discussion under Risk Factors. Goodwill and Other Intangible Assets As of December 1, 2018, goodwill totaled $1,305.2 million (31 percent of total assets) and other intangible assets, net of accumulated amortization, totaled $ 908.2 million (22 percent of total assets). The components of goodwill and other identifiable intangible assets, net of amortization, by segment at December 1, 2018 are as follows: Selected Metrics of Liquidity and Capital Resources Key metrics we monitor are net working capital as a percent of annualized net revenue, trade accounts receivable days sales outstanding (DSO), inventory days on hand, free cash flow after dividends and debt capitalization ratio. 1 Current quarter net working capital (trade receivables, net of allowance for doubtful accounts plus inventory minus trade payables) divided by annualized net revenue (current quarter multiplied by 4). 2 Trade receivables net of allowance for doubtful accounts multiplied by 56 (8 weeks) and divided by the net revenue for the last 2 months of the quarter. 3 Total inventory multiplied by 56 and divided by cost of sales (excluding delivery costs) for the last 2 months of the quarter. 4 Net cash provided by operations less purchased property, plant and equipment and dividends paid. See reconciliation to Net cash provided by operating activities below. 5 Total debt divided by (total debt plus total stockholders’ equity). Free cash flow after dividends, a non-GAAP financial measure, is defined as net cash provided by operating activities less purchased property, plant and equipment and dividends paid. Free cash flow after dividends is an integral financial measure used by the Company to assess its ability to generate cash in excess of its operating needs, therefore, the Company believes this financial measure provides useful information to investors. The following table reflects the manner in which free cash flow after dividends is determined and provides a reconciliation of free cash flow after dividends to net cash provided by operating activities, the most directly comparable financial measure calculated and reported in accordance with U.S. GAAP. Net income including non-controlling interest was $171.2 million in 2018, $59.5 million in 2017 and $121.9 million in 2016. Depreciation and amortization expense totaled $145.1 million in 2018 compared to $87.3 million in 2017 and $77.7 million in 2016. The higher depreciation and amortization expense in 2018 and 2017 was directly related to the intangible assets acquired in acquisitions. Changes in net working capital (trade receivables, inventory and trade payables) accounted for a use of cash of $31.1 million, a source of cash of $8.9 million and a use of cash of $17.9 million in 2018, 2017 and 2016, respectively. Following is an assessment of each of the net working capital components: ● Trade Receivables, net - Changes in trade receivables resulted in a $39.4 million use of cash in 2018 compared to $26.8 million use of cash in 2017 and $1.9 million source of cash in 2016. The use of cash in 2018 was related to higher net revenue and an increase in trade receivables compared to 2017. The use of cash in 2017 compared to a source of cash in 2016 was related to higher net revenue compared to 2016. The DSO was 56 days at December 1, 2018, 61 days at December 2, 2017 and 57 days at December 3, 2016. ● Inventory - Changes in inventory resulted in a $17.1 million use of cash in 2018 compared to an $8.7 million use of cash in 2017 and a $7.5 million use of cash of in 2016. In 2018 and 2017, inventory levels increased due to higher raw material costs and to maintain service levels while integrating our acquisitions. Inventory days on hand were 60 days at the end of 2018 compared to 59 days at the end of 2017 and 60 days at the end of 2016. ● Trade Payables - Changes in trade payables resulted in a $25.4 million source of cash in 2018 compared to a $44.4 million source of cash in 2017 and a $12.3 million use of cash in 2016. Both comparisons were primarily related to the timing of payments. Contributions to our pension and other postretirement benefit plans were $6.6 million, $4.7 million and $6.6 million in 2018, 2017 and 2016, respectively. Income taxes payable resulted in a $4.0 million source of cash in 2018 and a $15.0 million and $1.7 million use of cash in 2017 and 2016, respectively. Other assets resulted in a $35.2 million use of cash in 2018, a $13.0 million use of cash in 2017 and an $8.4 million use of cash 2016, respectively. Accrued compensation was a $0.3 million use of cash in 2018 and a $12.2 million and $0.9 million source of cash in 2017 and 2016, respectively. The use of cash in 2018 relates to lower accruals for our employee incentive plans and the source of cash in 2017 relates to higher accruals for our employee incentive plans. Other operating activity was a $78.5 million source of cash in 2018 an $11.1 million use of cash in 2017 and a $34.4 million source of cash in and 2016, respectively. This reflects the impact of a stronger U.S. dollar on certain foreign transactions in 2018, 2017 and 2016. Purchases of property, plant and equipment were $68.3 million in 2018 compared to $54.9 million in 2017 and $63.3 million in 2016. The increase in 2018 relates to higher purchases due to our acquisitions in 2017. In 2016, purchases of property, plant and equipment included expenditures related to a new plant in Indonesia and the Construction Adhesives expansion project. In 2018, we received $3.5 million of cash resulting in an adjustment to the purchase price of Royal Adhesives and Adecol. In 2017, we acquired Adecol for $44.7 million, net of cash acquired, Royal Adhesives for $1,622.7 million, net of cash acquired and Wisdom for $123.5 million, net of cash acquired. In 2016, we acquired Cyberbond, L.L.C. for $42.2 million, net of cash acquired and Advanced Adhesives for $10.4 million, net of cash acquired. See Note 2 to the Consolidated Financial Statements for further information on acquisitions. In 2018, we had $185.8 million of repayments of long-term debt and no proceeds from long-term debt borrowing. In 2017, we repaid $1,079.3 million and borrowed $2,856.3 million of debt in conjunction with our acquisition of Royal Adhesives and we paid $24.2 million of debt issuance costs. In 2016, there was $22.5 million of repayments of long-term debt and no proceeds from long-term debt borrowing. See Note 6 of the Consolidated Financial Statements for further discussion of debt borrowings and repayments. Cash paid for dividends were $31.1 million, $29.6 million and $27.5 million in 2018, 2017 and 2016, respectively. Cash generated from the exercise of stock options were $6.2 million in 2018, $17.7 million in 2017 and $11.3 million in 2016. Repurchases of common stock were $4.7 million in 2018 compared to $21.8 million in 2017 and $23.2 million in 2016, including $19.1 million in 2017 and $20.9 million in 2016 from our share repurchase program. There were no repurchases from our share repurchase program in 2018. 1 Some of our interest obligations on long-term debt are variable based on LIBOR. Interest payable for the variable portion is estimated based on a forward LIBOR curve. 2 Pension contributions are only included for fiscal 2019. We have not determined our pension funding obligations beyond 2019 and thus, any potential future contributions have been excluded from the table. 3 Represents the fair value of our foreign exchange contracts with a payable position to the counterparty as of December 1, 2018, based on fair market values as of that date. Future changes in market values will impact the amount of cash ultimately paid or received to settle those instruments in the future. 4 This amount includes the forward purchase contract of $9.9 million and the contingent consideration liability of $3.6 million related to the Tonsan acquisition. We are subject to mandatory prepayments in the first quarter of each fiscal year equal to 50% of Excess Cash Flow, as defined in the Term Loan B Credit Agreement, of the prior fiscal year less any voluntary prepayments made during that fiscal year. The Excess Cash Flow Percentage (ECF Percentage) shall be reduced to 25% when our Secured Leverage Ratio is below 4.25:1.00 and to 0% when our Secured Leverage Ratio is below 3.75:1.00. The first measurement period is fiscal year 2018 and the first prepayment was satisfied through amounts prepaid during fiscal year 2018. We have estimated the 2019 prepayment and is shown in the table above as due in less than one year. We expect to make cash outlays in the future related to uncertain tax positions. However, due to the uncertainty of the timing of future cash flows, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, gross unrecognized tax benefits of $8.4 million as of December 1, 2018 have been excluded from the contractual obligations table above. For further information related to unrecognized tax benefits see Note 11 to the Consolidated Financial Statements. We expect 2019 capital expenditures to be approximately $100.0 million. Off-Balance Sheet Arrangements There are no relationships with any unconsolidated, special-purpose entities or financial partnerships established for the purpose of facilitating off-balance sheet financial arrangements. Forward-Looking Statements and Risk Factors The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of words like "plan," "expect," "aim," "believe," "project," "anticipate," "intend," "estimate," "will," "should," "could" (including the negative or variations thereof) and other expressions that indicate future events and trends. These plans and expectations are based upon certain underlying assumptions, including those mentioned with the specific statements. Such assumptions are in turn based upon internal estimates and analyses of current market conditions and trends, our plans and strategies, economic conditions and other factors. These plans and expectations and the assumptions underlying them are necessarily subject to risks and uncertainties inherent in projecting future conditions and results. Actual results could differ materially from expectations expressed in the forward-looking statements if one or more of the underlying assumptions and expectations proves to be inaccurate or is unrealized. In addition to the factors described in this report, Item 1A. Risk Factors identifies some of the important factors that could cause our actual results to differ materially from those in any such forward-looking statements. In order to comply with the terms of the safe harbor, we have identified these important factors which could affect our financial performance and could cause our actual results for future periods to differ materially from the anticipated results or other expectations expressed in the forward-looking statements. These factors should be considered, together with any similar risk factors or other cautionary language that may be made elsewhere in this Annual Report on Form 10-K. The list of important factors in Item 1A. Risk Factors does not necessarily present the risk factors in order of importance. This disclosure, including that under Forward-Looking Statements and Risk Factors, and other forward-looking statements and related disclosures made by us in this report and elsewhere from time to time, represents our best judgment as of the date the information is given. We do not undertake responsibility for updating any of such information, whether as a result of new information, future events, or otherwise, except as required by law. Investors are advised, however, to consult any further public company disclosures (such as in filings with the SEC or in our press releases) on related subjects.

<s>[INST] H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. For the year ended December 2, 2017, we had six reportable segments: Americas Adhesives, EIMEA, Asia Pacific, Construction Adhesives, Engineering Adhesives and Royal Adhesives. As of the beginning of fiscal 2018, in connection with the integration of the operations of Royal Adhesives with the Company’s other segments, we modified our operating segment structure by allocating the Royal Adhesives segment into each of the five other segments. We began reporting results in five segments for the quarter ended March 3, 2018: Americas Adhesives, EIMEA, Asia Pacific, Construction Adhesives and Engineering Adhesives. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, insulating glass, flooring, textile, flexible packaging, graphic arts and envelope markets. The Construction Adhesives operating segment provides floor preparation, grouts and mortars for tile setting, and adhesives for soft flooring, and pressuresensitive adhesives, tapes and sealants for the commercial roofing industry as well as sealants and related products for heating, ventilation and air conditioning installations. The Engineering Adhesives operating segment provides highperformance adhesives to the transportation, electronics, medical, clean energy, aerospace and defense, appliance and heavy machinery markets. Total Company When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas, Global supply of and demand for raw materials, Economic growth rates, and Currency exchange rates compared to the U.S. dollar We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impacts the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in highgrowth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With approximately 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. The pace of economic growth directly impacts certain industries to which we supply products. For example, adhesivesrelated revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as Construction Adhesives and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other constructionrelated activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies weaken against the U.S. dollar, our revenues and costs decrease as the foreign currencydenominated financial statements translate into fewer U.S. dollars. The fluctuations of the Euro and the Chinese renminbi against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2018, currency fluctuations had a negative impact on net revenue of approximately $2.0 million as compared to 2017. Key financial results and transactions for 2018 included the following: Net revenue increased 31.9 percent from 2017 primarily driven by a 28.3 percent increase due to acquisitions, a 3.4 percent increase in product pricing, and a 0.6 percent increase due to favorable sales mix. Positive drivers of growth were partially offset by a 0.3 percent decrease in sales volume and a 0.1 percent decrease due to currency fluctuations. Gross profit margin increased to 27.5 percent from 26. [/INST] Positive. </s>

FULLER H B CO

2020-01-24

2019-11-30

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. We have five reportable segments: Americas Adhesives, EIMEA, Asia Pacific, Construction Adhesives and Engineering Adhesives. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, insulating glass, flooring, textile, flexible packaging, graphic arts and envelope markets. The Construction Adhesives operating segment provides floor preparation, grouts and mortars for tile setting, and adhesives for soft flooring, and pressure-sensitive adhesives, tapes and sealants for the commercial roofing industry as well as sealants and related products for heating, ventilation and air conditioning installations. The Engineering Adhesives operating segment provides high-performance adhesives to the transportation, electronics, medical, clean energy, aerospace and defense, appliance and heavy machinery markets. Total Company When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: ● Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas, ● Global supply of and demand for raw materials, ● Economic growth rates, and ● Currency exchange rates compared to the U.S. dollar We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impacts the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in high-growth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With approximately 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. The pace of economic growth directly impacts certain industries to which we supply products. For example, adhesives-related revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as Construction Adhesives and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other construction-related activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies weaken against the U.S. dollar, our revenues and costs decrease as the foreign currency-denominated financial statements translate into fewer U.S. dollars. The fluctuations of the Euro and the Chinese renminbi against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2019, currency fluctuations had a negative impact on net revenue of approximately $100.0 million as compared to 2018. Key financial results and transactions for 2019 included the following: ● Net revenue decreased 4.7 percent from 2018 primarily driven by a 3.3 percent decrease due to currency fluctuations, a 2.1 percent decrease in sales volume and a 0.3 percent decrease due to the divestiture of our surfactants and thickeners business. Negative drivers of growth were partially offset by a 1.0 percent increase in product pricing. ● Gross profit margin increased to 27.9 percent from 27.2 percent in 2018 primarily due to favorable product pricing and lower raw material costs. Positive drivers of growth were partially offset by lower sales volumes. ● Cash flow generated by operating activities was $269.2 million in 2019 as compared to $253.3 million in 2018 and $166.3 million in 2017. Our total year organic sales growth, which we define as the combined variances from sales volume and product pricing, decreased 1.1 percent for 2019 compared to 2018. In 2019, our diluted earnings per share was $ 2.52 compared to $3.29 in 2018 and $1.15 in 2017. The lower earnings per share in 2019 compared to 2018 was due to lower net revenue and higher income tax expense, which were partially offset by lower operating costs and the gain on the sale of our surfactants and thickeners business. The higher earnings per share in 2018 compared to 2017 was due to higher net revenue, lower transaction costs related to acquisitions, and one time discrete items related to U.S. Tax Reform, which were partially offset by higher operating expenses mainly due to the impact of acquired businesses and higher interest expense due to higher U.S. debt balances at higher interest rates from the issuance of new debt in 2017. Changes in Accounting Principles In the fourth quarter of 2018, we elected to change our method of accounting for certain inventories in the United States within the Company’s Americas Adhesives and Construction Adhesives segments from the last-in, first-out method (“LIFO”) to weighted-average cost. We have retrospectively adjusted the Consolidated Financial Statements as of and for the year ended December 2, 2017 to reflect this change. In the first quarter of 2019, we adopted a new accounting standard related to revenue recognition which requires us to recognize the amount of revenue to which we expect to be entitled for the transfer of promised goods or services to customers. Prior periods were not restated for this adoption. In the first quarter of 2019, we also adopted a new accounting standard related to the classification of pension expense which requires us to include only the service component of pension expense in operating expenses with the other components included in non-operating expenses. We have retrospectively adjusted the Consolidated Statements of Income for the years ended December 1, 2018 and December 2, 2017 to reflect this change. Project ONE In December 2012, our Board of Directors approved a multi-year project to replace and enhance our existing core information technology platforms. The scope for this project includes most of the basic transaction processing for the company including customer orders, procurement, manufacturing, and financial reporting. The project envisions harmonized business processes for all of our operating segments supported with one standard software configuration. The execution of this project, which we refer to as Project ONE, is being supported by internal resources and consulting services. The North America adhesives business went live in 2014. In 2017, we began the Project ONE implementation and upgrade of our ERP system in our Latin America adhesives business and, with the exception of Brazil, was completed as of the end of 2018. During 2019, other entities in our North America adhesives business went live and in 2020 and beyond, we will continue implementation in North America, EIMEA and Asia Pacific. Total expenditures for Project ONE are estimated to be $195 to $210 million, of which 50-55% is expected to be capital expenditures. Our total project-to-date expenditures are approximately $79 million, of which approximately $41 million are capital expenditures. Given the complexity of the implementation, the total investment to complete the project may exceed our estimate. Restructuring Plans 2020 Restructuring Plan During the fourth quarter of 2019, we approved a restructuring plan related to organizational changes and other actions to optimize operations in connection with the realignment of the Company into three global business units (“2020 Restructuring Plan”). In implementing the 2020 Restructuring Plan, we expect to incur costs of approximately $9.0 million to $11.0 million ($7.1 million to $8.7 million after-tax), which includes (i) cash expenditures of approximately $6.0 million to $8.0 million ($4.8 million to $6.4 million after tax) for severance and related employee costs globally and (ii) $3.0 million ($2.3 million after-tax) related to streamlining of processes and other restructuring-related costs. All restructuring costs are expected to be cash costs. For the year ending November 30, 2019, we incurred costs of $10.1 million under this plan. The 2020 Restructuring Plan was implemented in the fourth quarter of 2019 and is currently expected to be completed by mid-year of fiscal year 2021. Royal Adhesives Restructuring Plan During the first quarter of 2018, we approved a restructuring plan consisting of consolidation plans, organizational changes and other actions related to the integration of the operations of Royal Adhesives with the operations of the Company (the “Royal Adhesives Restructuring Plan”). In implementing the Royal Adhesives Restructuring Plan, we have incurred costs of approximately $10.4 million, which includes (i) cash expenditures of approximately $6.2 million for severance and related employee costs globally and (ii) other costs of approximately $4.2 million related to the optimization of production facilities, streamlining of processes and accelerated depreciation of long-lived assets. Approximately $7.9 million of the costs were cash costs. The Royal Adhesives Restructuring Plan was implemented in the first quarter of 2018 and is substantially complete. Critical Accounting Policies and Significant Estimates Management’s discussion and analysis of our results of operations and financial condition are based upon the Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We believe the critical accounting policies and areas that require the most significant judgments and estimates to be used in the preparation of the Consolidated Financial Statements relate to pension and other postretirement plans; goodwill impairment; long-lived assets recoverability; valuation of product, environmental and other litigation liabilities; valuation of deferred tax assets and accuracy of tax contingencies; and valuation of acquired assets and liabilities. Pension and Other Postretirement Plan Assumptions We sponsor defined-benefit pension plans in both the U.S. and non-U.S. entities. Also in the U.S., we sponsor other postretirement plans for health care and life insurance benefits. Expenses and liabilities for the pension plans and other postretirement plans are actuarially calculated. These calculations are based on our assumptions related to the discount rate, expected return on assets, projected salary increases and health care cost trend rates. Note 11 to the Consolidated Financial Statements includes disclosure of assumptions employed in these measurements for both the non-U.S. and U.S. plans. The discount rate assumption is determined using an actuarial yield curve approach, which results in a discount rate that reflects the characteristics of the plan. The approach identifies a broad population of corporate bonds that meet the quality and size criteria for the particular plan. We use this approach rather than a specific index that has a certain set of bonds that may or may not be representative of the characteristics of our particular plan. A higher discount rate reduces the present value of the pension obligations. The discount rate for the U.S. pension plan was 3.19 percent at November 30, 2019, as compared to 4.51 percent at December 1, 2018 and 3.73 percent at December 2, 2017. Net periodic pension cost for a given fiscal year is based on assumptions developed at the end of the previous fiscal year. A discount rate change of 0.5 percentage points at November 30, 2019 would impact U.S. pension and other postretirement plan (income) expense by approximately $0.2 million (pre-tax) in fiscal 2020. Discount rates for non-U.S. plans are determined in a manner consistent with the U.S. plans. The expected long-term rate of return on plan assets assumption for the U.S. pension plan was 7.50 percent in 2019 and 7.75 in 2018 and 2017. Our expected long-term rate of return on U.S. plan assets was based on our target asset allocation assumption of 60 percent equities and 40 percent fixed-income. Management, in conjunction with our external financial advisors, determines the expected long-term rate of return on plan assets by considering the expected future returns and volatility levels for each asset class that are based on historical returns and forward looking observations. For 2019, the expected long-term rate of return on the target equities allocation was 8.00 percent and the expected long-term rate of return on the target fixed-income allocation was 4.45 percent. The total plan rate of return assumption included an estimate of the effect of diversification and the plan expense. For 2020, the expected long-term rate of return on assets will be 7.50 percent with an expected long-term rate of return on the target equities allocation of 8.00 percent and an expected long-term rate of return on target fixed-income allocation of 4.45 percent. A change of 0.5 percentage points for the expected return on assets assumption would impact U.S. net pension and other postretirement plan expense by approximately $2.4 million (pre-tax). Management, in conjunction with our external financial advisors, uses the actual historical rates of return of the asset categories to assess the reasonableness of the expected long-term rate of return on plan assets. The most recent 10-year and 20-year historical equity returns are shown in the table below. Our expected rate of return on our total portfolio is consistent with the historical patterns observed over longer time frames. * Beginning in 2006, our target allocation migrated from 100 percent equities to our current allocation of 60 percent equities and 40 percent fixed-income. The historical actual rate of return for the fixed income of 8.2 percent is since inception (13 years, 11 months). The expected long-term rate of return on plan assets assumption for non-U.S. pension plans was a weighted-average of 6.21 percent in 2019 compared to 6.20 percent in 2018 and 6.21 percent in 2017. The expected long-term rate of return on plan assets assumption used in each non-U.S. plan is determined on a plan-by-plan basis for each local jurisdiction and is based on expected future returns for the investment mix of assets currently in the portfolio for that plan. Management, in conjunction with our external financial advisors, develops expected rates of return for each plan, considers expected long-term returns for each asset category in the plan, reviews expectations for inflation for each local jurisdiction, and estimates the effect of active management of the plan’s assets. Our largest non-U.S. pension plans are in the United Kingdom and Germany. The expected long-term rate of return on plan assets for the United Kingdom was 6.75 percent and the expected long-term rate of return on plan assets for Germany was 5.75 percent. Management, in conjunction with our external financial advisors, uses actual historical returns of the asset portfolio to assess the reasonableness of the expected rate of return for each plan. The projected salary increase assumption is based on historic trends and comparisons to the external market. Higher rates of increase result in higher pension expenses. As this rate is also a long-term expected rate, it is less likely to change on an annual basis. In the U.S., we have used the rate of 4.50 percent for 2019, 2018 and 2017. Benefits under the U.S. Pension Plan were locked-in as of May 31, 2011 and no longer include compensation increases. The 4.50 percent rate is for the supplemental executive retirement plan only. Projected salary increase assumptions for non-U.S. plans are determined in a manner consistent with the U.S. plans. Goodwill Goodwill is the excess of cost of an acquired entity over the amounts assigned to assets acquired and liabilities assumed in a purchase business combination. Goodwill is allocated to our reporting units, which are our operating segments or one level below our operating segments (the component level). Reporting units are determined by the discrete financial information available for the component and whether it is regularly reviewed by segment management. Components are aggregated into a single reporting unit if they share similar economic characteristics. Our reporting units are as follows: Americas Adhesives, EIMEA, Asia Pacific, Flooring, Roofing, Specialty Construction, Engineering Adhesives and Tonsan. We evaluate our goodwill for impairment annually during the fourth quarter or earlier upon the occurrence of substantive unfavorable changes in economic conditions, industry trends, costs, cash flows, or ongoing declines in market capitalization. The quantitative impairment test requires judgment, including the identification of reporting units, the assignment of assets, liabilities and goodwill to reporting units, and the determination of fair value of each reporting unit. The impairment test requires the comparison of the fair value of each reporting unit with its carrying amount, including goodwill. In performing the impairment test, we determined the fair value of our reporting units by using discounted cash flow (“DCF”) analyses. Determining fair value requires the Company to make judgments about appropriate discount rates, perpetual growth rates and the amount and timing of expected future cash flows. The cash flows employed in the DCF analysis for each reporting unit are based on the reporting unit's budget, long-term business plan, and recent operating performance. Discount rate assumptions are based on an assessment of the risk inherent in the future cash flows of the respective reporting unit and market conditions. Given the inherent uncertainty in determining the assumptions underlying a DCF analysis, actual results may differ from those used in our valuations. In assessing the reasonableness of the determined fair values, we also reconciled the aggregate determined fair value of the Company to the Company's market capitalization, which, at the date of our 2019 impairment test, included a 33 percent control premium. For the 2019 impairment test, the fair value of the reporting units exceeded the respective carrying values by 8 percent to 109 percent ("headroom"). Significant assumptions used in the DCF analysis included long-term growth rates and discount rates that ranged from 7.8 percent to 9.9 percent. An increase in the discount rate and decrease in the long-term growth rates of 0.5 percent would result in the fair value of Flooring falling below its carrying value by 6 percent. The fair value of the remaining reporting units would exceed their respective carrying values by 10 percent to 83 percent. The Flooring and EIMEA reporting units had headroom of 8 percent and 21 percent, respectively. The remaining reporting units had significant fair value in excess of carrying value. As of November 30, 2019, the carrying values of goodwill assigned to the Flooring and EIMEA reporting units were $73.9 million and $151.6 million, respectively. Management will continue to monitor these reporting units for changes in the business environment that could impact recoverability. The recoverability of goodwill is dependent upon the continued growth of cash flows from our business activities. If the economy or business environment falter and we are unable to achieve our assumed revenue growth rates or profit margin percentages, our projections used would need to be remeasured, which could impact the carrying value of our goodwill in one or more of our reporting units. Most significantly, for our Flooring and EIMEA reporting units, a decrease in the planned volume revenue growth would negatively impact the fair value of the reporting units and the calculation of excess carrying value. See Note 5 to the Consolidated Financial Statements for further information regarding goodwill. Recoverability of Long-Lived Assets The assessment of the recoverability of long-lived assets reflects our assumptions and estimates. Factors that we must estimate when performing impairment tests include sales volume, prices, inflation, currency exchange rates, tax rates and capital spending. Significant judgment is involved in estimating these factors, and they include inherent uncertainties. The measurement of the recoverability of these assets is dependent upon the accuracy of the assumptions used in making these estimates and how the estimates compare to the eventual future operating performance of the specific businesses to which the assets are attributed. Judgments made by us include the expected useful lives of long-lived assets. The ability to realize undiscounted cash flows in excess of the carrying amounts of such assets is affected by factors such as the ongoing maintenance and improvement of the assets, changes in economic conditions and changes in operating performance. Product, Environmental and Other Litigation Liabilities As disclosed in Item 3. Legal Proceedings and in Note 1 and Note 15 to the Consolidated Financial Statements, we are subject to various claims, lawsuits and other legal proceedings. Reserves for loss contingencies associated with these matters are established when it is determined that a liability is probable and the amount can be reasonably estimated. The assessment of the probable liabilities is based on the facts and circumstances known at the time that the financial statements are being prepared. For cases in which it is determined that a liability is probable but only a range for the potential loss exists, the minimum amount of the range is recorded and subsequently adjusted as better information becomes available. For cases in which insurance coverage is available, the gross amount of the estimated liabilities is accrued, and a receivable is recorded for any probable estimated insurance recoveries. A discussion of environmental, product and other litigation liabilities is disclosed in Item 3. Legal Proceedings and Note 15 to the Consolidated Financial Statements. Based upon currently available facts, we do not believe that the ultimate resolution of any pending legal proceeding, individually or in the aggregate, will have a material adverse effect on our long-term financial condition. However, adverse developments and/or periodic settlements could negatively affect our results of operations or cash flows in one or more future quarters. Income Tax Accounting As part of the process of preparing the Consolidated Financial Statements, we are required to estimate income taxes in each of the jurisdictions in which we operate. The process involves estimating actual current tax expense along with assessing temporary differences resulting from differing treatment of items for book and tax purposes. These temporary differences result in deferred tax assets and liabilities, which are included in the Consolidated Balance Sheets. We record a valuation allowance to reduce our deferred tax assets to the amount that is more-likely-than-not to be realized. We have considered future taxable income and ongoing tax planning strategies in assessing the need for the valuation allowance. Increases in the valuation allowance result in additional expense to be reflected within the tax provision in the Consolidated Statements of Income. As of November 30, 2019, the valuation allowance to reduce deferred tax assets totaled $15.0 million. We recognize tax benefits for tax positions for which it is more-likely-than-not that the tax position will be sustained by the applicable tax authority at the largest amount of tax benefit that is greater than fifty percent likely of being realized upon ultimate settlement. We do not recognize a financial statement benefit for a tax position that does not meet the more-likely-than-not threshold. We believe that our liabilities for income taxes reflect the most likely outcome. It is difficult to predict the final outcome or the timing of the resolution of any particular tax position. Future changes in judgment related to the resolution of tax positions will impact earnings in the quarter of such change. We adjust our income tax liabilities related to tax positions in light of changing facts and circumstances. Settlement with respect to a tax position would usually require cash. Based upon our analysis of tax positions taken on prior year returns and expected tax positions to be taken for the current year tax returns, we have identified gross uncertain tax positions of $8.9 million as of November 30, 2019. We have not recorded U.S. deferred income taxes for certain of our non-U.S. subsidiaries undistributed earnings as such amounts are intended to be indefinitely reinvested outside of the U.S. Should we change our business strategies related to these non-U.S. subsidiaries, additional U.S. tax liabilities could be incurred. It is not practical to estimate the amount of these additional tax liabilities. See Note 12 to the Consolidated Financial Statements for further information on income tax accounting. Acquisition Accounting As we enter into business combinations, we perform acquisition accounting requirements including the following: ● Identifying the acquirer, ● Determining the acquisition date, ● Recognizing and measuring the identifiable assets acquired and the liabilities assumed, and ● Recognizing and measuring goodwill or a gain from a bargain purchase We complete valuation procedures and record the resulting fair value of the acquired assets and assumed liabilities based upon the valuation of the business enterprise and the tangible and intangible assets acquired. Enterprise value allocation methodology requires management to make assumptions and apply judgment to estimate the fair value of assets acquired and liabilities assumed. If estimates or assumptions used to complete the enterprise valuation and estimates of the fair value of the acquired assets and assumed liabilities significantly differed from assumptions made, the resulting difference could materially affect the fair value of net assets. The calculation of the fair value of the tangible assets, including property, plant and equipment, utilizes the cost approach, which computes the cost to replace the asset, less accrued depreciation resulting from physical deterioration, functional obsolescence and external obsolescence. The calculation of the fair value of the identified intangible assets are determined using cash flow models following the income approach or a discounted market-based methodology approach. Significant inputs include estimated revenue growth rates, gross margins, operating expenses, and estimated attrition, royalty and discount rates. Goodwill is recorded as the difference in the fair value of the acquired assets and assumed liabilities and the purchase price. Results of Operations Net revenue We review variances in net revenue in terms of changes related to sales volume, product pricing, business acquisitions and divestitures (M&A) and changes in foreign currency exchange rates. The following table shows the net revenue variance analysis the past two years: Organic growth was a negative 1.1 percent in 2019 compared to 2018. The 1.1 percent negative organic growth in 2019 was driven by a 12.0 percent decrease in Construction Adhesives and a 2.7 percent decrease in EIMEA, partially offset by 4.2 percent growth in Engineering Adhesives, 1.1 percent growth in Americas Adhesives and 1.1 percent growth in Asia Pacific. The decrease is predominately driven by a decrease in sales volume. There was a 0.3 percent decrease due to the divestiture of our surfactants and thickeners business during fiscal 2019. The negative 3.3 percent currency impact was primarily driven by a weaker Euro, Chinese renminbi, Argentinian peso, Brazilian real and Turkish lira compared to the U.S. dollar. Organic growth was 3.7 percent in 2018 compared to 2017. The 3.7 percent organic growth in 2018 was driven by a 14.7 percent growth in Engineering Adhesives, 4.1 percent growth in EIMEA, 2.0 percent growth in Asia Pacific and 1.4 percent growth in Americas Adhesives, offset by a 1.1 percent decrease in Construction Adhesives. There was a 28.3 percent increase due to the acquisition of Royal Adhesives and Adecol. The negative 0.1 percent currency impact was primarily driven by a weaker Brazilian real, Argentinian peso, Australian dollar, Canadian dollar and Turkish lira offset by a stronger Mexican peso, Chinese renminbi and Euro compared to the U.S. dollar. Cost of sales Cost of sales in 2019 compared to 2018 decreased 70 basis points as a percentage of net revenue. Raw material cost as a percentage of net revenue decreased 160 basis points in 2019 compared to 2018 primarily due to an increase in product pricing and lower raw material costs. Other manufacturing costs as a percentage of net revenue increased 90 basis points in 2019 compared to 2018 primarily due to the impact of lower sales volume and higher manufacturing waste and scrap costs. Cost of sales in 2018 compared to 2017 decreased 120 basis points as a percentage of net revenue. Raw material costs as a percentage of net revenue decreased 130 basis points in 2018 compared to 2017 due to an increase in product pricing and the impact of the Royal Adhesives acquisition. Other manufacturing costs as a percentage of net revenue increased 10 basis points in 2018 compared to 2017. Gross profit Gross profit in 2019 decreased 2.6 percent and gross profit margin increased 70 basis points compared to 2018. The increase in gross profit margin was primarily due to increased product pricing and lower raw material costs partially offset by lower sales volume and higher manufacturing waste and scrap costs. Gross profit in 2018 increased 38.3 percent and gross profit margin increased 120 basis points compared to 2017. The increase in gross profit margin was primarily due to increased product pricing and the impact of the Royal Adhesives acquisition and lower restructuring plan costs. Selling, general and administrative expenses SG&A expenses for 2019 decreased $9.4 million, or 1.6 percent, compared to 2018. The decrease is primarily due to general spending reductions and the favorable impact of foreign currency exchange rates on spending outside the U.S. SG&A expenses for 2018 increased $110.8 million or 23.1 percent compared to 2017. The increase is mainly due to the impact of acquired businesses and the impact of unfavorable foreign currency exchange rates on spending outside the U.S. Other income (expense), net Other income (expense), net includes foreign transaction losses of $1.2 million, $4.5 million and $2.4 million in 2019, 2018 and 2017, respectively. Gains on disposal of assets were $24.1 million, $3.1 million and nil in 2019, 2018 and 2017, respectively. Defined benefit pension benefit was $13.7 million, $16.9 million and $8.5 million in 2019, 2018 and 2017, respectively. Other income of $1.3 million, $2.6 million and $0.2 million was also included in 2019, 2018 and 2017, respectively. Additionally, 2017 includes $25.5 million of expense related to make-whole costs associated with the early repayment of certain outstanding debt obligations which were refinanced upon entering into the Term Loan B Credit Agreement. Interest expense Interest expense in 2019 compared to 2018 was lower due to lower U.S. debt balances. Interest expense in 2018 compared to 2017 was higher due primarily to higher U.S. debt balances at higher interest rates from the issuance of our 4.000% Notes and higher LIBOR rates on floating rate debt held in the U.S. We capitalized $0.4 million of interest expense in 2019 and $0.3 million of interest expense in each of 2018 and 2017. Interest income Interest income in 2019 and 2018 was higher due to our cross-currency swap cash flow hedges that were entered into at the end of 2017 in conjunction with the Royal Adhesives acquisition. Income tax benefit (expense) Income tax expense of $49.4 million in 2019 includes $12.4 million of discrete tax expense related to the sale of the surfactants and thickeners business and return to accrual adjustments. Excluding the discrete tax expense of $12.4 million, the overall effective tax rate was 24.9 percent. The decrease in the overall effective tax rate for 2019 compared to 2018, excluding the impact of discrete items, is primarily due to the geographic mix of earnings. The income tax benefit in 2018 of $6.4 million includes $49.0 million of discrete tax benefits in both the U.S. and foreign jurisdictions, primarily related to the impact of U.S. Tax Reform. Excluding the discrete tax benefits of $49.0 million, the overall effective tax rate was 27.2 percent. The increase in the overall effective tax rate for 2018 compared to 2017, excluding the impact of discrete items, is primarily due to the geographic mix of earnings, as well as withholding tax expense in foreign jurisdictions. Income tax expense in 2017 of $9.8 million includes $4.1 million of discrete tax benefits in both the U.S. and foreign jurisdictions, primarily related to the release of the valuation allowance in Brazil in conjunction with the Adecol acquisition. Excluding the discrete tax benefits, the overall effective tax rate was 23.0 percent. Income from equity method investments The income from equity method investments relates to our 50 percent ownership of the Sekisui-Fuller joint venture in Japan. The lower income for 2019 compared to 2018 and 2018 compared to 2017 relates to lower net income in our joint venture. Net income attributable to H.B. Fuller Net income attributable to H.B. Fuller was $130.8 million in 2019 compared to $171.2 million in 2018 and $59.4 million in 2017. Diluted earnings per share was $2.52 per share in 2019, $3.29 per share for 2018 and $1.15 per share for 2017. Operating Segment Results We are required to report segment information in the same way that we internally organize our business for assessing performance and making decisions regarding allocation of resources. For segment evaluation by the chief operating decision maker, segment operating income is defined as gross profit less SG&A expenses. Inter-segment revenues are recorded at cost plus a markup for administrative costs. Corporate expenses are fully allocated to each operating segment. We have five reportable segments: Americas Adhesives, EIMEA, Asia Pacific, Construction Adhesives and Engineering Adhesives. As of the beginning of 2019, we realigned certain customers across operating segments. Prior period segment information has been recast retrospectively to reflect the realignments. The tables below provide certain information regarding the net revenue and segment operating income of each of our operating segments. Net Revenue by Segment Segment Operating Income (Loss) The following table provides a reconciliation of segment operating income to income before income taxes and income from equity method investments, as reported in the Consolidated Statements of Income. Americas Adhesives The following tables provide details of Americas Adhesives net revenue variances: Net revenue decreased 2.7 percent in 2019 compared to 2018. The 1.1 percent increase in organic growth was attributable to increased product pricing, partially offset by a decrease in sales volume. There was a 1.0 percent decrease due to the divestiture of our surfactants and thickeners business in fiscal 2019. The negative currency effect was due to the weaker Argentinian peso, Brazilian real, Canadian dollar and Colombian peso compared to the U.S. dollar. As a percentage of net revenue, raw material costs decreased 30 basis points. Other manufacturing costs as a percentage of net revenue increased 30 basis points. SG&A expenses as a percentage of net revenue increased 40 basis points in 2019 as compared to 2018. Segment operating income decreased 6.9 percent and segment operating margin as a percentage of net revenue decreased 40 basis points in 2019 as compared to 2018. Net revenue increased 16.5 percent in 2018 compared to 2017. The 1.4 percent increase in organic growth was attributable to increased product pricing offset by a decrease in sales volume. There was a 17.4 percent increase due to the Royal Adhesives, Adecol and Wisdom acquisitions. The negative currency effect was primarily due to the weaker Brazilian real and Argentinian peso compared to the U.S. dollar. As a percentage of net revenue, raw material costs decreased 60 basis points primarily due to increased product pricing and the impact of acquired businesses. Other manufacturing costs as a percentage of net revenue increased 70 basis points primarily due to higher delivery costs and the impact of acquired businesses. SG&A expense as a percentage of net revenue decreased 10 basis points. Segment operating income increased 16.7 percent and segment operating margin as a percentage of net revenue was flat in 2018 compared to 2017. EIMEA The following table provides details of the EIMEA net revenue variances: Net revenue decreased 8.1 percent in 2019 compared to 2018. The 2.7 percent decrease in organic growth was attributable to a decrease in sales volume, partially offset by increased product pricing. The negative currency effect was primarily the result of a weaker Euro and Turkish lira compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 170 basis points due to lower raw material costs and favorable product mix. Other manufacturing costs as a percentage of net revenue increased 80 basis points due to lower sales volume. SG&A expenses as a percentage of net revenue increased 160 basis points primarily due to higher restructuring plan costs and lower net revenue. Segment operating income decreased 24.7 percent and segment operating margin decreased 70 basis points compared to 2018. Net revenue increased 23.6 percent in 2018 compared to 2017. The 4.1 percent increase in organic growth was attributable to increased product pricing offset by a decrease in sales volume. There was an 18.0 percent increase due to the Royal Adhesives acquisition. The positive currency effect was primarily the result of a stronger Euro and British pound offset by a weaker Turkish lira and Indian rupee compared to the U.S. dollar. Raw material costs as a percentage of net revenue increased 80 basis points primarily due to higher raw material costs offset by increased product pricing. Other manufacturing costs as a percentage of net revenue decreased 60 basis points in 2018 compared to 2017 primarily due to lower restructuring plan costs and the impact of the Royal Adhesives acquisition. SG&A expense as a percentage of net revenue decreased 140 basis points due to lower restructuring plan costs. Segment operating income increased 72.1 percentand segment operating margin as a percentage of net revenue increased 120 basis points in 2018 compared to 2017. Asia Pacific The following table provides details of Asia Pacific net revenue variances: Net revenue in 2019 decreased 2.4 percent compared to 2018. The 1.1 percent increase in organic growth was attributable to an increase in sales volume and product pricing. The negative currency effect was primarily the result of a weaker Chinese renminbi and Australian dollar compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 270 basis points primarily due to increased product pricing and lower raw material costs. Other manufacturing costs as a percentage of net revenue increased 20 basis points. SG&A expenses as a percentage of net revenue increased 80 basis points primarily due to lower net revenue. Segment operating income increased 24.9 percent and segment operating margin increased 170 basis points compared to 2018. Net revenue in 2018 increased 5.1 percent compared to 2017. The 2.0 percent increase in organic growth was attributable to an increase in product pricing and sales volume. There was a 1.5 percent increase due to the Royal Adhesives acquisition. The positive currency effect was primarily driven by the stronger Chinese renminbi and Malaysian ringgit offset by the weaker Australian dollar and Indonesian rupiah compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 60 basis points compared to 2017 primarily due to an increase in product pricing. Other manufacturing costs as a percentage of net revenue decreased 50 basis points compared to 2017. SG&A expense as a percentage of net revenue increased 30 basis points. Segment operating income increased 18.8 percent and segment operating margin increased 80 basis points in 2018 compared to 2017. Construction Adhesives NMP = Non-meaningful percentage The following tables provide details of Construction Adhesives net revenue variances: Net revenue decreased 12.6 percent in 2019 compared to 2018. The 12.0 percent decrease in organic growth was attributable to lower sales volume partially offset by increased product pricing. The negative currency effect was due to the weaker Australian dollar compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 70 basis points primarily due to increased product pricing and lower raw material costs. Other manufacturing costs as a percentage of net revenue increased 220 basis points primarily due to higher production costs, the impact of lower sales volume and higher manufacturing waste and scrap costs. SG&A expenses as a percentage of net revenue increased 220 basis points due to lower sales volume and higher restructuring plan costs. Segment operating income decreased 60.5 percent and segment operating margin decreased 370 basis points compared to 2018. Net revenue increased 73.5 percent in 2018 compared to 2017. The 1.1 percent decrease in organic growth was attributable to a decrease in sales volume. There was a 74.5 percent increase due to the Royal Adhesives acquisition. The positive currency effect was due to the stronger Euro and Australian dollar compared to the U.S. dollar. Raw material costs as a percentage of net revenue increased 70 basis points compared to 2017 primarily due to higher raw material costs. Other manufacturing costs as a percentage of net revenue decreased 660 basis points primarily due to improved operating efficiencies related to the completion of the facility upgrade and expansion project and lower restructuring plan costs. SG&A expenses as a percentage of net revenue decreased by 670 basis points in 2018 compared to 2017 due to increased sales volume. Segment operating margin increased 1,260 basis points compared to 2017. Engineering Adhesives The following tables provide details of Engineering Adhesives net revenue variances: Net revenue increased 0.9 percent in 2019 compared to 2018. The 4.2 percent increase in organic growth was attributable to an increase in sales volume, partially offset by decreased product pricing. Sales volume growth was primarily driven by strong performance in the electronics and new energy markets. The negative currency effect was due to a weaker Chinese renminbi and Euro compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 380 basis points due to favorable product mix and lower raw material costs. Other manufacturing costs as a percentage of net revenue increased 220 basis points due to higher production and integration costs. SG&A expense as a percentage of net revenue decreased 120 basis points due to lower compensation costs. Segment operating income increased 26.5 percent and segment operating margin increased 280 basis points compared to 2018. Net revenue increased 79.2 percent in 2018 compared to 2017. The 14.7 percent increase in organic growth is attributable to an increase in sales volume and product pricing. Sales volume growth was primarily driven by strong performance in the Tonsan and automotive markets. There was a 62.3 percent increase due to the acquisition of Royal Adhesives. The positive currency effects were primarily driven by the stronger Chinese renminbi, Euro and British pound offset by the weaker Turkish lira and Brazilian real compared to the U.S. dollar. Raw material costs as a percentage of net revenue decreased 350 basis points due to increased product pricing and the impact of the Royal Adhesives acquisition partially offset by higher raw material costs. Other manufacturing costs as a percentage of net revenue increased 400 basis points primarily due to the impact of the Royal Adhesives acquisition. SG&A expense as a percentage of net revenue decreased 570 basis points compared to 2017 primarily due to higher sales volume and the impact of the Royal Adhesives acquisition. Segment operating income increased 241.9 percent and segment operating margin increased 520 basis points in 2018 compared to 2017. Financial Condition, Liquidity and Capital Resources Total cash and cash equivalents as of November 30, 2019 were $112.2 million compared to $150.8 million as of December 1, 2018. Total long and short-term debt was $1,979.1 million as of November 30, 2019 and $2,247.5 million as of December 1, 2018. We believe that cash flows from operating activities will be adequate to meet our ongoing liquidity and capital expenditure needs. In addition, we believe we have the ability to obtain both short-term and long-term debt to meet our financing needs for the foreseeable future. Cash available in the United States has historically been sufficient and we expect it will continue to be sufficient to fund U.S. operations, U.S. capital spending and U.S. pension and other postretirement benefit contributions in addition to funding U.S. acquisitions, dividend payments, debt service and share repurchases as needed. For those international earnings considered to be reinvested indefinitely, we currently have no intention to, and plans do not indicate a need to, repatriate these funds for U.S. operations. Our credit agreements include restrictive covenants that, if not met, could lead to a renegotiation of our credit lines and a significant increase in our cost of financing. At November 30, 2019, we were in compliance with all covenants of our contractual obligations as shown in the following table: ● TTM = trailing 12 months ● EBITDA for covenant purposes is defined as consolidated net income, plus interest expense, expense for taxes paid or accrued, depreciation and amortization, certain non-cash impairment losses, extraordinary non-cash losses incurred other than in the ordinary course of business, nonrecurring extraordinary non-cash restructuring charges and the non-cash impact of purchase accounting, expenses related to the Royal Adhesives acquisition not to exceed $40.0 million, expenses relating to the integration of Royal Adhesives during the fiscal years ending in 2017, 2018 and 2019 not exceeding $30 million in aggregate, restructuring expenses that began prior to the Royal Adhesives acquisition incurred in fiscal years ending in 2017 and 2018 not exceeding $28 million in aggregate, and non-capitalized charges relating to the SAP implementation during fiscal years ending in 2017 through 2021 not exceeding $13 million in any single fiscal year, minus extraordinary non-cash gains. For the Total Indebtedness / TTM EBITDA ratio, TTM EBITDA is adjusted for the pro forma results from Material Acquisitions and Material Divestitures as if the acquisition or divestiture occurred at the beginning of the calculation period. The full definition is set forth in the Term Loan B Credit Agreement and the Amended Revolving Credit Agreement, and can be found in the Company’s 8-K filings dated October 20, 2017 and November 17, 2017, respectively. We believe we have the ability to meet all of our contractual obligations and commitments in fiscal 2020. Net Financial Assets (Liabilities) Of the $112.2 million in cash and cash equivalents as of November 30, 2019, $97.9 million was held outside the U.S. Of the $97.9 million of cash held outside the U.S., earnings on $91.9 million are indefinitely reinvested outside of the U.S. It is not practical for us to determine the U.S. tax implications of the repatriation of these funds. There are no contractual or regulatory restrictions on the ability of consolidated and unconsolidated subsidiaries to transfer funds in the form of cash dividends, loans or advances to us, except for: 1) a credit facility limitation restricting investments, loans, advances or capital contributions from Loan Parties to non-Loan Parties in excess of $100.0 million, 2) a credit facility limitation that provides total investments, loans, advances or guarantees not otherwise permitted in the credit agreement for all subsidiaries shall not exceed $125.0 million in the aggregate, 3) a credit facility limitation that provides total investments, dividends, and distributions shall not exceed the Available Amount defined in these agreements, all three of which do not apply once our secured leverage ratio drops below 4.0x and 4) typical statutory restrictions, which prohibit distributions in excess of net capital or similar tests. The Royal Adhesives acquisition and any investments, loans, and advances established to consummate the Royal Adhesives acquisition, are excluded from the credit facility limitations described above. Additionally, we have taken the income tax position that the majority of our cash in non-U.S. locations is indefinitely reinvested. Debt Outstanding and Debt Capacity Notes Payable Notes payable were $15.7 million at November 30, 2019 and $14.8 million at December 1, 2018. These amounts primarily represented various foreign subsidiaries’ short-term borrowings that were not part of committed lines. The weighted-average interest rates on these short-term borrowings were 8.9 percent in 2019 and 9.6 percent in 2018. Long-Term Debt Long-term debt consisted of a secured term loan (“Term Loan B”) and an unsecured public note (“Public Notes”). The Term Loan B bears a floating interest rate at LIBOR plus 2.00 percent (3.72 percent at November 30, 2019) and matures in fiscal year 2024. The Public Notes bear interest at 4.00 percent fixed interest and mature in fiscal year 2027. We are subject to a par call of 1.00 percent except within three months of maturity date. We currently have no intention to prepay the Public Notes. Additional details on the Public Notes and the Term Loan B Credit Agreement can be found in Form 8-K dated February 9, 2017 and Form 8-K dated October 20, 2017, respectively. We executed interest rate swap agreements for the purpose of obtaining a fixed interest rate on $1,350.0 million of the $2,150.0 million Term Loan B. We have designated forecasted interest payments resulting from the variability of 1-month LIBOR in relation to $1,350.0 million of the Term Loan B as the hedged item in cash flow hedges. The combined fair value of the interest rate swaps in total was a liability of $17.6 million at November 30, 2019 and was included in other liabilities in the Consolidated Balance Sheets. We are applying the hypothetical derivative method to assess hedge effectiveness for these interest rate swaps. Changes in the fair value of a hypothetically perfect swap with terms that match the critical terms of our $1,350.0 million variable rate Term Loan B are compared with the change in the fair value of the swaps. We entered into interest rate swap agreements for the purpose of obtaining a floating rate on $150.0 million of our $300.0 million Public Notes. We have designated the $150.0 million of public debt as the hedged item in a fair value hedge. The combined fair value of the interest rate swaps in total was an asset of $5.7 million at November 30, 2019 and was included in other assets in the Consolidated Balance Sheets. The swaps were designated for hedge accounting treatment as fair value hedges. We are applying the hypothetical derivative method to assess hedge effectiveness for these interest rate swaps. Changes in the fair value of a hypothetically perfect swap with terms that match the critical terms of our $150.0 million fixed rate Public Notes are compared with the change in the fair value of the swaps. Lines of Credit We have a revolving credit agreement with a consortium of financial institutions at November 30, 2019. This credit agreement creates a secured multi-currency revolving credit facility that we can draw upon to repay existing indebtedness, finance working capital needs, finance acquisitions, and for general corporate purposes up to a maximum of $400.0 million. Interest on the revolving credit facility is payable at LIBOR plus 2.00 percent (3.70 percent at November 30, 2019). A facility fee of 0.30 percent of the unused commitment under the revolving credit facility is payable quarterly. The interest rate and the facility fee are based on a leverage grid. The credit facility expires on April 12, 2022. As of November 30, 2019, our lines of credit were undrawn. Additional details on the revolving credit agreement can be found in the 8-K dated November 17, 2017. For further information related to debt outstanding and debt capacity, see Note 6 to the Consolidated Financial Statements. Uncertainty relating to the LIBOR phase out at the end of 2021 may adversely impact the value of, and our obligations under, our Term Loan B, Public Notes and revolving credit facility. See the applicable discussion under Risk Factors. Goodwill and Other Intangible Assets As of November 30, 2019, goodwill totaled $1,281.8 million (32 percent of total assets) and other intangible assets, net of accumulated amortization, totaled $799.4 million (20 percent of total assets). The components of goodwill and other identifiable intangible assets, net of amortization, by segment at November 30, 2019 are as follows: Selected Metrics of Liquidity and Capital Resources Key metrics we monitor are net working capital as a percent of annualized net revenue, trade account receivable days sales outstanding (DSO), inventory days on hand, free cash flow after dividends and debt capitalization ratio. 1 Current quarter net working capital (trade receivables, net of allowance for doubtful accounts plus inventory minus trade payables) divided by annualized net revenue (current quarter, multiplied by 4). 2 Trade receivables net of allowance for doubtful accounts multiplied by 56 (8 weeks) and divided by the net revenue for the last 2 months of the quarter. 3 Total inventory multiplied by 56 and divided by cost of sales (excluding delivery costs) for the last 2 months of the quarter. 4 Net cash provided by operations less purchased property, plant and equipment and dividends paid. See reconciliation to Net cash provided by operating activities below. 5 Total debt divided by (total debt plus total stockholders’ equity). Free cash flow after dividends, a non-GAAP financial measure, is defined as net cash provided by operating activities less purchased property, plant and equipment and dividends paid. Free cash flow after dividends is an integral financial measure used by the Company to assess its ability to generate cash in excess of its operating needs, therefore, the Company believes this financial measure provides useful information to investors. The following table reflects the manner in which free cash flow after dividends is determined and provides a reconciliation of free cash flow after dividends to net cash provided by operating activities, the most directly comparable financial measure calculated and reported in accordance with U.S. GAAP. Reconciliation of “Net cash provided by operating activities” to "Free cash flow after dividends" Cash Flows from Operating Activities Summary of Cash Flows Cash Flows from Operating Activities Net income including non-controlling interest was $130.8 million in 2019, $171.2 million in 2018 and $59.5 million in 2017. Depreciation and amortization expense totaled $141.2 million in 2019 compared to $145.1 million in 2018 and $87.3 million in 2017. The higher depreciation and amortization expense in 2019 and 2018 was directly related to the assets acquired in our business acquisitions. Changes in net working capital (trade receivables, inventory and trade payables) accounted for a source of cash of $5.5 million, a use of cash of $31.1 million and a source of cash of $8.9 million in 2019, 2018 and 2017, respectively. Following is an assessment of each of the net working capital components: ● Trade Receivables, net - Changes in trade receivables resulted in a $25.6 million use of cash in 2019 compared to a $39.4 million and $26.8 million use of cash in 2018 and 2017, respectively. The lower use of cash in 2019 compared to 2018 was related to lower net revenue and lower trade receivables compared to the prior year. The higher use of cash in 2018 was related to higher net revenue and an increase in trade receivables compared to 2017. The DSO was 59 days at November 30, 2019, 56 days at December 1, 2018 and 61 days at December 2, 2017. ● Inventory - Changes in inventory resulted in a $19.6 million source of cash in 2019 compared to a $17.1 million and an $8.7 million use of cash in 2018 and 2017, respectively. The source of cash in 2019 compared to the use of cash in 2018 was due to higher raw material costs and higher inventory to maintain service levels while integrating our acquisitions in 2018. Inventory days on hand were 58 days at the end of 2019 compared to 60 days at the end of 2018 and 59 days at the end of 2017. ● Trade Payables - Changes in trade payables resulted in an $11.5 million, $25.4 million and $44.4 million source of cash in 2019, 2018 and 2017, respectively. Changes between all years were primarily related to the timing of payments, and extension of payment terms globally. Contributions to our pension and other postretirement benefit plans were $8.1 million, $6.6 million and $4.7 million in 2019, 2018 and 2017, respectively. Income taxes payable resulted in a $21.0 million and $4.0 million source of cash in 2019 and 2018, respectively, and a $15.0 million use of cash in 2017. Other assets resulted in an $18.3 million, $35.2 million and $13.0 million use of cash in 2019, 2018 and 2017, respectively. Accrued compensation was a $1.3 million source of cash in 2019, a $0.3 million use of cash in 2018 and a $12.2 million source of cash in 2017. The source of cash in 2019 and 2017 relates to higher accruals for our employee incentive plans while the use of cash in 2018 relates to lower accruals. Other operating activity was a $37.5 million and a $81.5 million source of cash in 2019 and 2018, respectively, and an $14.4 million use of cash in and 2017. This reflects the impact of a stronger U.S. dollar on certain foreign transactions in 2019, 2018 and 2017. Cash Flows from Investing Activities Purchases of property plant and equipment were $62.0 million in 2019 compared to $68.3 million in 2018 and $54.9 million in 2017. The higher purchases in 2019 and 2018 compared to 2017 relates to higher purchases due to our acquisitions in 2017. Proceeds from the sale of property, plant and equipment were $11.1 million in 2019 compared to $2.9 million in 2018 and $0.7 million in 2017. The higher proceeds in 2019 were due to the sale of certain properties. In 2019, we acquired Ramapo Sales and Marketing, Inc. for $8.3 million and paid a $9.9 million contingent consideration payment for our 2015 acquisition of Tonsan Adhesive, Inc. In 2019, we also received $70.3 million of cash related to the sale of our surfactants and thickeners business. In addition, we received payment of a government grant and expended cash related to the building of a plant in China of $8.9 million and $2.8 million, respectively. In 2018, we received $3.5 million of cash resulting in an adjustment to the purchase price of Royal Adhesives and Adecol. In 2017, we acquired Adecol for $44.7 million, net of cash acquired, Royal Adhesives for $1,622.7 million, net of cash acquired and Wisdom for $123.5 million, net of cash acquired. See Note 2 to the Consolidated Financial Statements for further information on acquisitions. Cash Flows from Financing Activities In 2019 and 2018, we repaid $288.6 million and $185.8 million of long-term debt, respectively. In 2017, we repaid $1,079.3 million and borrowed $2,856.3 million of debt in conjunction with our acquisition of Royal Adhesives and we paid $49.7 million of debt issuance, prepayment and extinguishment costs. See Note 6 of the Consolidated Financial Statements for further discussion of debt borrowings and repayments. Cash paid for dividends were $32.4 million, $31.1 million and $29.6 million in 2019, 2018 and 2017, respectively. Cash generated from the exercise of stock options were $10.9 million, $6.2 million and $17.7 million in 2019, 2018 and 2017, respectively. Repurchases of common stock were $3.0 million in 2019 compared to $4.7 million in 2018 and $21.8 million in 2017, including $19.1 million in 2017 from our share repurchase program. There were no repurchases from our share repurchase program in 2019 and 2018. Contractual Obligations Due dates and amounts of contractual obligations are as follows: 1 Some of our interest obligations on long-term debt are variable based on LIBOR. Interest payable for the variable portion is estimated based on a forward LIBOR curve. 2 Pension contributions are only included for fiscal 2020. We have not determined our pension funding obligations beyond 2020 and thus, any potential future contributions have been excluded from the table. 3 Represents the fair value of our foreign exchange contracts with a payable position to the counterparty as of November 30, 2019, based on fair market values as of that date. Future changes in market values will impact the amount of cash ultimately paid or received to settle those instruments in the future. We are subject to mandatory prepayments in the first quarter of each fiscal year equal to 50% of Excess Cash Flow, as defined in the Term Loan B Credit Agreement, of the prior fiscal year less any voluntary prepayments made during that fiscal year. The Excess Cash Flow Percentage (ECF Percentage) shall be reduced to 25% when our Secured Leverage Ratio is below 4.25:1.00 and to 0% when our Secured Leverage Ratio is below 3.75:1.00. The prepayment for the 2019 measurement period was satisfied through amounts prepaid during 2019. We have estimated the 2020 prepayment as shown in the table above and have classified it as current portion of long-term debt. We expect to make cash outlays in the future related to uncertain tax positions. However, due to the uncertainty of the timing of future cash flows, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, gross unrecognized tax benefits of $8.9 million as of November 30, 2019 have been excluded from the contractual obligations table above. For further information related to unrecognized tax benefits, see Note 12 to the Consolidated Financial Statements. We expect 2020 capital expenditures to be approximately $85.0 million. Off-Balance Sheet Arrangements There are no relationships with any unconsolidated, special-purpose entities or financial partnerships established for the purpose of facilitating off-balance sheet financial arrangements. Forward-Looking Statements and Risk Factors The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements may be identified by the use of words like "plan," "expect," "aim," "believe," "project," "anticipate," "intend," "estimate," "will," "should," "could" (including the negative or variations thereof) and other expressions that indicate future events and trends. These plans and expectations are based upon certain underlying assumptions, including those mentioned with the specific statements. Such assumptions are in turn based upon internal estimates and analyses of current market conditions and trends, our plans and strategies, economic conditions and other factors. These plans and expectations and the assumptions underlying them are necessarily subject to risks and uncertainties inherent in projecting future conditions and results. Actual results could differ materially from expectations expressed in the forward-looking statements if one or more of the underlying assumptions and expectations proves to be inaccurate or is unrealized. In addition to the factors described in this report, Item 1A. Risk Factors identifies some of the important factors that could cause our actual results to differ materially from those in any such forward-looking statements. In order to comply with the terms of the safe harbor, we have identified these important factors which could affect our financial performance and could cause our actual results for future periods to differ materially from the anticipated results or other expectations expressed in the forward-looking statements. These factors should be considered, together with any similar risk factors or other cautionary language that may be made elsewhere in this Annual Report on Form 10-K. The list of important factors in Item 1A. Risk Factors does not necessarily present the risk factors in order of importance. This disclosure, including that under Forward-Looking Statements and Risk Factors, and other forward-looking statements and related disclosures made by us in this report and elsewhere from time to time, represents our best judgment as of the date the information is given. We do not undertake responsibility for updating any of such information, whether as a result of new information, future events, or otherwise, except as required by law. Investors are advised, however, to consult any further public company disclosures (such as in filings with the SEC or in our press releases) on related subjects.

<s>[INST] H.B. Fuller Company is a global formulator, manufacturer and marketer of adhesives and other specialty chemical products. We have five reportable segments: Americas Adhesives, EIMEA, Asia Pacific, Construction Adhesives and Engineering Adhesives. The Americas Adhesives, EIMEA and Asia Pacific operating segments manufacture and supply adhesives products in the assembly, packaging, converting, nonwoven and hygiene, performance wood, insulating glass, flooring, textile, flexible packaging, graphic arts and envelope markets. The Construction Adhesives operating segment provides floor preparation, grouts and mortars for tile setting, and adhesives for soft flooring, and pressuresensitive adhesives, tapes and sealants for the commercial roofing industry as well as sealants and related products for heating, ventilation and air conditioning installations. The Engineering Adhesives operating segment provides highperformance adhesives to the transportation, electronics, medical, clean energy, aerospace and defense, appliance and heavy machinery markets. Total Company When reviewing our financial statements, it is important to understand how certain external factors impact us. These factors include: Changes in the prices of our raw materials that are primarily derived from refining crude oil and natural gas, Global supply of and demand for raw materials, Economic growth rates, and Currency exchange rates compared to the U.S. dollar We purchase thousands of raw materials, the majority of which are petroleum/natural gas derivatives. The price of these derivatives impacts the cost of our raw materials. However, the supply of and demand for key raw materials has a greater impact on our costs. As demand increases in highgrowth areas, the supply of key raw materials may tighten, resulting in certain materials being put on allocation. Natural disasters, such as hurricanes, also can have an impact as key raw material producers are shut down for extended periods of time. We continually monitor capacity utilization figures, market supply and demand conditions, feedstock costs and inventory levels, as well as derivative and intermediate prices, which affect our raw materials. With approximately 75 percent of our cost of sales accounted for by raw materials, our financial results are extremely sensitive to changing costs in this area. The pace of economic growth directly impacts certain industries to which we supply products. For example, adhesivesrelated revenues from durable goods customers in areas such as appliances, furniture and other woodworking applications tend to fluctuate with the overall economic activity. In business components such as Construction Adhesives and insulating glass, revenues tend to move with more specific economic indicators such as housing starts and other constructionrelated activity. The movement of foreign currency exchange rates as compared to the U.S. dollar impacts the translation of the foreign entities’ financial statements into U.S. dollars. As foreign currencies weaken against the U.S. dollar, our revenues and costs decrease as the foreign currencydenominated financial statements translate into fewer U.S. dollars. The fluctuations of the Euro and the Chinese renminbi against the U.S. dollar have the largest impact on our financial results as compared to all other currencies. In 2019, currency fluctuations had a negative impact on net revenue of approximately $100.0 million as compared to 2018. Key financial results and transactions for 2019 included the following: Net revenue decreased 4.7 percent from 2018 primarily driven by a 3.3 percent decrease due to currency fluctuations, a 2.1 percent decrease in sales volume and a 0.3 percent decrease due to the divestiture of our surfactants and thickeners business. Negative drivers of growth were partially offset by a 1.0 percent increase in product pricing. Gross profit margin increased to 27.9 percent from 27.2 percent in 2018 primarily due to favorable product pricing and lower raw material costs. Positive drivers of growth were partially offset by lower sales volumes. Cash flow generated by operating activities was $269.2 million in 2019 as compared to $253.3 million in 2018 and $166.3 million in 2017. Our total year organic sales growth, which we define as the combined variances from sales volume and product pricing, decreased 1.1 percent for [/INST] Positive. </s>

VALSPAR CORP

2015-12-18

2015-10-30

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Dollars in thousands, except per share amounts) Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Unless otherwise noted, transactions, trends and other factors significantly impacting our financial condition, results of operations and liquidity are discussed in order of magnitude. In addition, unless expressly stated otherwise, the comparisons presented in this MD&A refer to the same period in the prior year. Our MD&A is presented in seven sections: • Overview • Results of Operations • Financial Condition • Non-GAAP Financial Measures • Critical Accounting Estimates • Off-Balance Sheet Arrangements • Forward-Looking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. OVERVIEW The Valspar Corporation is a global leader in the paints and coatings industry. We develop, manufacture and distribute a broad range of coatings, paints and related products and we operate our business in two reportable segments: Coatings and Paints. Our Coatings segment aggregates our industrial and packaging product lines. Our Paints segment aggregates our consumer paints and automotive refinish product lines. See Note 15 in Notes to Consolidated Financial Statements for further information on our reportable segments. We operate in over 25 countries, and approximately 46% of our total net sales in 2015 was generated outside of the U.S. In the discussions of our operating results, we sometimes refer to the impact of changes in foreign currency exchange rates or the impact of foreign currency exchange rate fluctuations, which are references to the differences between the foreign currency exchange rates we use to translate international operating results from local currencies into U.S. dollars for reporting purposes. The impact of foreign currency exchange rate fluctuations is calculated as the difference between current period activity translated using the current period’s currency exchange rates and the comparable prior-year period’s currency exchange rates. We use this method to calculate the impact of changes in foreign currency exchange rates for all countries where the functional currency is not the U.S. dollar. We have a 4-4-5 week accounting cycle with the fiscal year ending on the Friday on or immediately preceding October 31. Fiscal years 2015 and 2013 included 52 weeks while fiscal year 2014 included 53 weeks. Our fundamental business objective is to create long-term value for our stockholders. We intend to accomplish this by: • Focusing on Customer Success by delivering coatings products and solutions that add value for our customers; • Building Strong Brands and Distribution Partners by investing in brands that are well recognized in the markets in which we operate and building differentiated distribution networks in key markets; • Developing Differentiated Technologies by investing in technologies that enhance our competitive position and add value for our customers; • Driving Industry-Leading Innovation by developing unique products and services that differentiate us in the marketplace with our customers; and • Attracting and Developing the Best People by creating a world class team with deep expertise and stockholder value orientation. In addition to creating value for our stockholders, we are committed to: • Adhering to our values, engaging in ethical business conduct and doing business with integrity; • Improving the safety and reducing the environmental footprint of our business and the products we manufacture while also delivering solutions that enable our customers to meet their safety and environmental objectives; and • Demonstrating our corporate citizenship by supporting the communities in which we work and live through volunteer efforts and philanthropy. The following discussion of results of operations and financial condition should be read in the context of this overview. RESULTS OF OPERATIONS Overview Net sales in 2015 were $4,392,622 compared to $4,625,624 in 2014. The decline was primarily due to the impact of foreign currency exchange and lower sales in our Consumer Paints product line due to a change in product line offering at a key North America customer that took effect in the first quarter of 2015. Additionally, fiscal year 2015 included one fewer week than fiscal year 2014 (53rd week). This decline was partially offset by net new business in our Coatings segment and the acquisition of the performance coating businesses of Quest Specialty Chemicals (Quest) in our Paints segment. Our raw material costs were approximately 80% of our cost of goods sold. Raw material costs in our industries declined in 2015. Gross profit as a percent of sales increased to 35.3% from 33.3% in the prior year driven by improved productivity and favorable price/cost comparison. Operating expenses as a percentage of net sales increased to 21.7% from 21.2%. Net income as a percent of sales of 9.1% increased from 7.5% in the prior year primarily due to improved gross margin and the benefit from a pre-tax gain on sale of certain assets of a non-strategic specialty product line. Restructuring Fiscal year 2015 restructuring expenses, included the following: (i) actions in the Coatings and Paints segments to rationalize manufacturing operations in the Australia region, (ii) actions to consolidate administrative operations in the Europe region, and (iii) initiatives in the Paints segment to improve our North American cost structure through non-manufacturing headcount reductions and other activities to rationalize our manufacturing operations. Most of these restructuring activities are expected to be completed within the next 12 months. Total pre-tax restructuring charges were $21,569 or $0.18 per share in fiscal year 2015. Included in fiscal year 2015 restructuring charges were $2,842 non-cash pre-tax asset impairment charges. Fiscal year 2014 restructuring expenses, relating primarily to initiatives that began in fiscal year 2013, included the following: (i) actions in the Paints segment to consolidate manufacturing and distribution operations following the acquisition of Ace Hardware Corporation’s paint manufacturing business, ongoing profit improvement plans in Australia, and other actions in Asia, (ii) actions in our Coatings segment to consolidate manufacturing operations in Europe following the acquisition of the Inver Group, and other actions to rationalize manufacturing operations and lower operating expenses, (iii) overall initiatives to improve our global cost structure, including non-manufacturing headcount reductions, and (iv) in the fourth quarter of 2014, activities initiated to rationalize manufacturing operations in the Coatings segment in the Australia region. These restructuring activities resulted in pre-tax charges of $41,139 or $0.34 per share for fiscal year 2014, including non-cash pre-tax asset impairment charges of $11,141. See Note 18 in Notes to Consolidated Financial Statements for further information on restructuring. See reconciliation in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Non-GAAP Financial Measures” for more information on the per share impact of restructuring charges. Financial Results 2015 vs. 2014 The following tables present selected financial data for the years ended October 30, 2015 and October 31, 2014. • Consolidated Net Sales - Consolidated net sales for the year decreased 5.0%, including a negative impact of 5.0% from foreign currency. Lower sales in our Consumer Paints product line due to a change in product line offering at a key North America customer that took effect in the first quarter of 2015 and the 53rd week in 2014, were primarily offset by net new business in our Coatings segment and the acquisition of Quest in our Paints segment. • Coatings Segment Net Sales - Our Coatings segment net sales for the year decreased 3.4%, including a negative impact of 6.0% from foreign currency. Excluding foreign currency exchange, the increase was due to new business, partially offset by the impact of the 53rd week in 2014. • Paints Segment Net Sales - Our Paints segment net sales for the year decreased 8.0%, including a negative impact of 4.0% from foreign currency. Excluding foreign currency exchange, the decrease in net sales was driven primarily by a change in our product line offering at a North America home improvement channel customer that took effect in the first quarter of 2015, a change in price/mix and the 53rd week in 2014, partially offset by the acquisition of Quest in the third quarter of 2015 and volume growth outside the U.S due to new business. Paints segment sales in North America in fiscal year 2015 have declined versus the previous year primarily due to an adjustment in our product line offering by a significant customer in the home improvement channel. This customer informed us that in fiscal year 2015 they were discontinuing one of the several products that we supply. The impact of this adjustment on the fiscal year 2015 net sales was significant, and we expect net sales in North America to be approximately $40,000 lower than the prior year period through the first half of fiscal year 2016 as a result of this adjustment. The total net impact of this adjustment on fiscal year 2015 net sales was approximately $150,000. We took actions to mitigate a portion of the effect on our business of this expected sales decline, including reductions in operating expenses as well as restructuring activities in the Paints segment (see Note 18 in the Consolidated Financial Statements for more information on restructuring activities). • Other and Administrative Net Sales - The Other and Administrative category includes the following product lines: resins, furniture protection plans and colorants. Other and Administrative net sales increased 0.3%, including a negative impact of 2.5% from foreign currency. Excluding foreign currency exchange, the increased sales was primarily due to furniture protection plans and resins. • Gross Profit - The gross profit rate increased 2.0 percentage points. The increase in gross profit rate was primarily driven by improved productivity, favorable price/cost comparison and lower restructuring charges, partially offset by acquisition-related charges from Quest. Productivity includes procurement efficiencies, product reformulations and benefits from previously completed restructuring actions. Cost/price comparison reflects the impact of market changes in raw material costs, offset by changes in product pricing and promotions. Restructuring charges of $14,007 or 0.3% of net sales and $28,471 or 0.6% of net sales were included in the 2015 and 2014 periods, respectively. Acquisition-related charges of $4,428 or 0.1% of net sales were included in fiscal year 2015. Includes research and development, selling, general and administrative, restructuring and acquisition-related costs. For breakout see Consolidated Statements of Operations. • Consolidated Operating Expenses (dollars) - Consolidated operating expenses decreased $27,734 or 2.8% including a favorable impact of 5.0% from foreign currency. Excluding foreign currency exchange, dollars in fiscal year 2015 increased primarily due to investments to support our growth initiatives, Quest operating expenses and higher bad debt expense, partially offset by lower incentive compensation accruals and lower restructuring charges. Restructuring charges of $7,562 or 0.2% of net sales and $12,668 or 0.3% of net sales were included in the 2015 and 2014 periods, respectively. Acquisition-related charges of $892 were included in fiscal year 2015. EBIT is defined as earnings before interest and taxes. • Consolidated EBIT - EBIT for 2015 increased $87,937 or 15.8% or 2.7 percentage points as a percent of net sales from the prior year. Fiscal year 2015 results included a pre-tax gain on sale of certain assets of a non-strategic specialty product line of $48,001. Restructuring charges were $21,569 or 0.5% of net sales, compared to $41,139 or 0.9% of net sales in fiscal year 2014. Acquisition-related charges of $5,320 or 0.1% of net sales were included in fiscal year 2015. Foreign currency exchange had a negative impact of $23,001 on EBIT. The effect of foreign currency exchange on Consolidated EBIT in 2015 may not be indicative of the effect of foreign currency exchange in subsequent quarters or fiscal years. • Coatings Segment EBIT - EBIT as a percent of net sales increased 4.3 percentage points from the prior year. The increase was primarily due to the gain on sale of certain assets of a non-strategic specialty product offering of $48,001, improved productivity, favorable price/cost comparison and lower restructuring charges, partially offset by higher operating expense. Restructuring charges for the 2015 and 2014 periods were $9,574 or 0.4% of net sales and $28,902 or 1.1% of net sales, respectively. • Paints Segment EBIT - EBIT as a percent of net sales decreased 0.2 percentage points from the prior year. The decrease was driven by the effect of lower volumes in our Consumer Product line in North America and acquisition-related charges from the Quest acquisition, partially offset by improved productivity. Restructuring charges for 2015 and 2014 periods were $11,913 or 0.7% of net sales and $11,934 or 0.7% of net sales, respectively. Acquisition-related charges of $5,320 or 0.3% were included in fiscal year 2015. • Other and Administrative EBIT - Other and Administrative EBIT includes corporate expenses. EBIT as a percent of net sales increased 5.3 percentage points from the prior year primarily due to lower operating expenses and improved operating performance. Restructuring charges of $82 or 0.0% of net sales and $303 or 0.1% of net sales were included in the 2015 and 2014 periods, respectively. • Interest Expense - Interest expense increased in fiscal year 2015 primarily due to higher average debt levels and higher average interest rates. • Effective Tax Rate - The lower 2015 effective tax rate was primarily due to the U.S. foreign tax credit and the sale of a specialty product offering in a foreign location, which is taxed at a lower rate than the U.S. federal statutory rate, partially offset by a reversal of valuation allowances in 2014, which did not recur in 2015. Financial Results 2014 vs. 2013 The following tables present selected financial data for the years ended October 31, 2014 and October 25, 2013. • Consolidated Net Sales - Consolidated net sales for the year increased 10.3%, including a positive impact of 4.9% from the fiscal year 2013 acquisitions of the Inver Group and the paint manufacturing business of Ace Hardware (Ace paints), a positive impact of 1.0% from the 53rd week in fiscal year 2014 and a negative impact of 0.7% from foreign currency. The remaining increase in sales of 5.1% was due to new business across all significant product lines and growth of existing business in our consumer product lines. • Coatings Segment Net Sales - Our Coatings segment net sales for the year increased 13.8%, including a positive impact of 8.8% from our Inver Group acquisition, a positive impact of 1.1% from the 53rd week in fiscal year 2014 and a negative impact of 0.6% from foreign currency. The remaining increase in sales of 4.5% was due to volume growth driven by new business in all product lines, partially offset by continued weakness in our North America general industrial product line. • Paints Segment Net Sales - Our Paints segment net sales for the year increased 6.9%, including a positive impact of 0.8% from the 53rd week in fiscal 2014, a positive impact of 0.5% from our Ace paints acquisitions and a negative impact of 1.1% from foreign currency. The remaining increase in sales of 6.7% reflects new business in all regions and growth in our North America home improvement channel. • Other and Administrative Net Sales - The Other and Administrative category includes the following product lines: resins, furniture protection plans and colorants. Other and Administrative net sales increased 0.3%, including a positive impact of 1.4% from the 53rd week in fiscal 2014 and a negative impact of 0.5% from foreign currency. The offsetting decrease of 1.6% was primarily due to decreased sales of resins. • Gross Profit - The gross profit rate increased 0.9 percentage points. This was primarily due to improved productivity, favorable price/cost comparison and leverage from increased volumes, partially offset by investments in strategic acquisitions, which had lower initial margins. Restructuring charges of $28,471 or 0.6% of net sales and $21,916 or 0.5% of net sales were included in the 2014 and 2013 periods, respectively. There were no acquisition-related charges in 2014 compared to $513, or 0.01% of net sales in 2013. Includes research and development, selling, general and administrative, restructuring and acquisition-related costs. For breakout see Consolidated Statements of Operations. • Consolidated Operating Expenses (dollars) - Consolidated operating expenses increased $113,503 or 13.1% compared to the prior year primarily due to investments to support our growth initiatives, the effect of our Inver Group acquisition and higher incentive compensation. Restructuring charges of $12,668 or 0.3% of net sales and $14,517 or 0.3% of net sales were included in the 2014 and 2013 periods, respectively. There were no acquisition-related charges in 2014, compared to $1,729 or 0.04% of net sales in 2013. EBIT is defined as earnings before interest and taxes. • Consolidated EBIT - EBIT for 2014 increased $68,659 or 14.1% from the prior year. Fiscal year 2014 results included restructuring charges of $41,139 or 0.9% of net sales, compared to $36,433 or 0.9% of net sales in fiscal year 2013. There were no acquisition-related charges in fiscal year 2014, compared to charges of $2,242 or 0.1% of net sales in fiscal year 2013. Foreign currency exchange fluctuation had an immaterial effect on Consolidated and segment EBIT. • Coatings Segment EBIT - EBIT as a percent of net sales increased 0.6 percentage points from the prior year, primarily due to improved productivity, including the benefits from previously completed restructuring actions, leverage from higher volumes and a favorable price/cost comparison, partially offset by higher restructuring charges and the effect of the Inver Group acquisition. Restructuring charges for the 2014 and 2013 periods were $28,902 or 1.1% of net sales and $19,492 or 0.9% of net sales, respectively. There were no acquisition-related charges in 2014 period, compared to $2,242 or 0.1% of net sales in 2013. • Paints Segment EBIT - EBIT as a percent of net sales increased 0.6 percentage points from the prior year, primarily due to improved sales mix, productivity, including the benefits from previously completed restructuring actions, and lower restructuring charges, partially offset by investments to support our growth initiatives. Restructuring charges for the 2014 and 2013 periods were $11,934 or 0.7% of net sales and $14,953 or 0.9% of net sales, respectively. • Other and Administrative EBIT - Other and Administrative EBIT includes corporate expenses. EBIT as a percent of net sales decreased 6.2 percentage points from the prior year primarily due to higher incentive compensation accruals, partially offset by lower restructuring charges. EBIT included restructuring charges of $303 or 0.1% of net sales and $1,988 or 0.9% of net sales in the 2014 and 2013 periods, respectively. • Interest Expense - Interest expense increased slightly in fiscal year 2014 primarily due to a higher average debt balance, partially offset by lower average interest rates. • Effective Tax Rate - The lower 2014 effective tax rate was primarily due to favorable changes in geographical mix of earnings. FINANCIAL CONDITION Cash Flow Cash flow provided by operations was $383,200 in 2015, compared to $347,104 in 2014 and $398,504 in 2013. Cash flow provided by operations in 2015 increased due to higher net income, improvements in inventory and lower restructuring payments, partially offset by increased incentive compensation payments from prior year performance and higher income tax payments. In 2015, we used cash flow from operations and net proceeds from issuance of debt and bank borrowings and cash on hand to fund $346,680 for acquisitions of businesses, net of cash, $322,420 in share repurchases and $97,126 in capital expenditures. We used cash on hand and proceeds from stock options exercised to fund $96,890 in dividend payments. Debt and Capital Resources Our debt classified as current was $334,153 at October 30, 2015 compared to $606,356 at October 31, 2014. Total debt was $2,041,086 at October 30, 2015 and $1,556,391 at October 31, 2014. The increase in total debt from October 31, 2014 was primarily due to borrowings to fund the Quest acquisition, share repurchases, and capital expenditures, partially offset by cash provided by operations. The ratio of total debt to capital was 70.5% at October 30, 2015, compared to 60.6% at October 31, 2014. Average debt outstanding during 2015 was $1,908,101 at a weighted average interest rate of 4.26% versus $1,608,935 at 4.06% last year. Interest expense for 2015 was $81,348 compared to $65,330 in 2014. On August 3, 2015, we retired $150,000 of Senior Notes in accordance with their scheduled maturity using commercial paper and our revolving credit facility. On July 27, 2015, we issued $350,000 of unsecured Senior Notes that mature on January 15, 2026 with a coupon rate of 3.95%. The net proceeds of the issuance were approximately $345,000. The public offering was made pursuant to a registration statement filed with the U.S. Securities and Exchange Commission (SEC). We used the net proceeds from this offering for the repayment of borrowings under the term loan credit facility that was entered into on May 29, 2015. On May 29, 2015, we entered into a $350,000 term loan credit agreement with a syndicate of banks with a maturity date of November 29, 2016. This facility was used to provide funding for the acquisition of Quest. See Note 2 in the Consolidated Financial Statements for further information on the acquisition. This facility was repaid and terminated on July 29, 2015 primarily using the net proceeds from the unsecured Senior Notes issued in July 2015. On January 21, 2015, we issued $250,000 of unsecured Senior Notes that mature on February 1, 2025 with a coupon rate of 3.30%, and $250,000 of unsecured Senior Notes that mature on February 1, 2045 with a coupon rate of 4.40%. The net proceeds of both issuances were approximately $492,000 in the aggregate. The public offering was made pursuant to a registration statement filed with the SEC. We used the net proceeds to repay short-term borrowings under our commercial paper program and credit facility in the first quarter of 2015. We maintain an unsecured revolving credit facility with a syndicate of banks. On December 16, 2013, we entered into an amended and restated $750,000 credit facility with a syndicate of banks with a maturity date of December 14, 2018. Under certain circumstances we have the option to increase this credit facility to $1,000,000. In July 2013, we entered into a U.S. dollar equivalent unsecured committed revolving bilateral credit facility, expiring July 2014. In July 2014, this facility was extended for one year to July 2015. We paid off and terminated the bilateral credit facility in December 2014. In certain geographies we have accepted bankers' acceptance drafts and commercial acceptance drafts as payment from customers. When we sell these instruments with recourse to a financial institution, we record them as short-term borrowings from the time they are sold until they reach maturity. These instruments are classified as short-term debt and the balance outstanding was $0 at October 30, 2015 and $23,838 at October 31, 2014. As of October 30, 2015 and October 31, 2014, our bank facilities consisted of the following: Our bank syndicate facility includes $327,869 and $388,876 of commercial paper as of October 30, 2015 and October 31, 2014, respectively, along with $100,000 of revolving credit facility borrowings as of October 31, 2014. We have a $450,000 commercial paper program backed by our $750,000 credit facility, as amended and restated. We maintain uncommitted bank lines of credit to meet short-term funding needs in certain of our international locations. These arrangements are reviewed periodically for renewal and modification. Our credit facilities have covenants that require us to maintain certain financial ratios. We were in compliance with these covenants as of October 30, 2015. Our debt covenants do not limit, nor are they reasonably likely to limit, our ability to obtain additional debt or equity financing. As of October 30, 2015, we had total committed liquidity of $608,092, comprised of $185,961 in cash and cash equivalents and $422,131 in unused committed bank credit facilities, compared to $389,327 of total committed liquidity as of October 31, 2014. At October 30, 2015 we had unused lines of committed and uncommitted credit available from banks of $513,490. Our cash and cash equivalent balances consist of high quality, short-term money market instruments and cash held by our international subsidiaries that are used to fund those subsidiaries’ day-to-day operating needs. Those balances have also been used to finance international acquisitions. Our investment policy on excess cash is to preserve principal. As of October 30, 2015, $181,370 of the $185,961 of cash (on the Consolidated Balance Sheets) was held by foreign subsidiaries. If these funds were repatriated to the U.S. we would be required to accrue and pay income taxes. No provision has been made for U.S. federal income taxes on certain undistributed earnings of foreign subsidiaries that we intend to permanently invest or that may be remitted substantially tax-fee. We believe cash flow from operations, existing lines of credit, access to credit facilities and access to debt and capital markets will be sufficient to meet our domestic and international liquidity needs. In the current market conditions, we have demonstrated continued access to capital markets. We have committed liquidity and cash reserves in excess of our anticipated funding requirements. We use derivative instruments with a number of counterparties principally to manage interest rate and foreign currency exchange risks. We evaluate the financial stability of each counterparty and spread the risk among several financial institutions to limit our exposure. We will continue to monitor counterparty risk on an ongoing basis. We do not have any credit-risk related contingent features in our derivative contracts as of October 30, 2015. We paid common stock dividends of $96,890 or $1.20 per share in 2015, an increase of 15.4% per share over 2014 common stock dividends of $87,427 or $1.04 per share. We have continuing authorization to purchase shares of our common stock for general corporate purposes. We repurchased 3,891,545 shares totaling $322,420 in 2015 compared to 4,705,081 shares totaling $349,181 in 2014 and 5,889,945 shares totaling $378,141 in 2013. On November 21, 2014, the Board approved a new share repurchase program, with no expiration date, authorizing us to purchase up to $1.5 billion of outstanding shares of common stock. This new program was effective immediately and replaced the previous repurchase authorization. As of October 30, 2015, $1,193,764 remained available for purchase under our repurchase authorization. We are involved in various claims relating to environmental and waste disposal matters at a number of current and former plant sites. We engage or participate in remedial and other environmental compliance activities at certain of these sites. At other sites, we have been named as a potentially responsible party (PRP) under federal and state environmental laws for the remediation of hazardous waste. We analyze each individual site, considering the number of parties involved, the level of potential liability or contribution by us relative to the other parties, the nature and magnitude of the wastes involved, the method and extent of remediation, the potential insurance coverage, the estimated legal and consulting expense with respect to each site, and the time period over which any costs would likely be incurred. Based on the above analysis, we estimate the remediation or other clean-up costs and related claims for each site. The estimates are based in part on discussions with other PRPs, governmental agencies and engineering firms. We accrue appropriate reserves for potential environmental liabilities when the amount of the costs that will be incurred can be reasonably determined. Accruals are reviewed and adjusted as additional information becomes available. While uncertainties exist with respect to the amounts and timing of our ultimate environmental liabilities, management believes it is neither probable nor reasonably possible that such liabilities, individually or in the aggregate, will have a material adverse effect on our financial condition, results of operations or cash flows. We are involved in a variety of legal claims and proceedings relating to personal injury, product liability, warranties, customer contracts, employment, trade practices, environmental and other legal matters that arise in the normal course of business. These claims and proceedings include cases where we are one of a number of defendants in proceedings alleging that the plaintiffs suffered injuries or contracted diseases from exposure to chemicals or other ingredients used in the production of some of our products or waste disposal. We are also subject to claims related to the performance of our products. We believe these claims and proceedings are in the ordinary course for a business of the type and size in which we are engaged. While we are unable to predict the ultimate outcome of these claims and proceedings, we believe it is neither probable nor reasonably possible that the costs and liabilities of such matters, individually or in the aggregate, will have a material adverse effect on our financial condition, results of operations or cash flows. Under various agreements, we are obligated to make future cash payments in fixed amounts. These include payments under our multi-currency credit facilities, senior notes, capital leases, employee benefit plans, non-cancelable operating leases with initial or remaining terms in excess of one year, capital expenditures, commodity purchase commitments, telecommunication commitments, IT commitments, and marketing commitments. Some of our interest charges are variable and are assumed at current rates. Contractual Obligations The following table summarizes our contractual obligations as of October 30, 2015 for the fiscal years ending in October: We expect to make cash outlays in the future related to uncertain tax positions. However, due to the uncertainty of the timing of future cash flows, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, unrecognized tax benefits of $15,600 as of October 30, 2015, have been excluded from the contractual obligations table above. For further information related to unrecognized tax benefits, see Note 12 in Notes to Consolidated Financial Statements. NON-GAAP FINANCIAL MEASURES This section includes financial information prepared in accordance with accounting principles generally accepted in the United States (GAAP), as well as certain non-GAAP financial measures such as adjusted gross profit, adjusted operating expense, adjusted earnings before interest and taxes (EBIT), adjusted net income and adjusted net income per common share - diluted. Generally, a non-GAAP financial measure is a numerical measure of financial performance that excludes (or includes) amounts that are included in (or excluded from) the most directly comparable measure calculated and presented in accordance with GAAP. The non-GAAP financial measures should be viewed as a supplement to, and not a substitute for, financial measures presented in accordance with GAAP. Non-GAAP measures as presented herein may not be comparable to similarly titled measures used by other companies. We believe that the non-GAAP financial measures provide meaningful information to assist investors in understanding our financial results and assessing prospects for future performance without regard to restructuring and acquisition-related charges. We believe adjusted gross profit, adjusted operating expense, adjusted EBIT, adjusted net income and adjusted net income per common share - diluted are important indicators of our operations because they exclude items that we believe may not be indicative of or are unrelated to our core operating results and provide a baseline for analyzing trends in our underlying business. To measure adjusted gross profit, adjusted operating expense and adjusted EBIT, we remove the impact of before-tax restructuring, acquisition-related charges and gain on sale of certain assets. Adjusted net income and adjusted net income per common share - diluted are calculated by removing the after-tax impact of restructuring, acquisition-related charges and gain on sale of certain assets from our calculated net income and net income per common share - diluted. Since non-GAAP financial measures are not standardized, it may not be possible to compare these financial measures with other companies’ non-GAAP financial measures. These non-GAAP financial measures are an additional way to view aspects of our operations that, when viewed with our GAAP results and the reconciliations to corresponding GAAP financial measures below, provide a more complete understanding of our business. We strongly encourage investors and shareholders to review our financial statements and publicly filed reports in their entirety and not to rely on any single financial measure. The following table reconciles gross profit, operating expense, EBIT, net income and net income per common share - diluted (GAAP financial measures) to adjusted gross profit, adjusted operating expense, adjusted EBIT, adjusted net income and adjusted net income per common share - diluted (non-GAAP financial measures) for the periods presented: The tax effect of restructuring, acquisition-related charges and gain on sale of certain assets is calculated using the effective tax rate of the jurisdiction in which the charges were incurred.See Note 18 in Notes to Consolidated Financial Statements for further information on restructuring. CRITICAL ACCOUNTING ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with generally accepted accounting principles in the United States (GAAP). The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of any contingent assets and liabilities at the date of the financial statements. We regularly review our estimates and assumptions, which are based on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following areas are affected by significant judgments and estimates used in the preparation of our Consolidated Financial Statements and that the judgments and estimates are reasonable: Revenue Recognition Our revenue from product sales is recognized at the time the product is delivered or title has passed, a sales agreement is in place, pricing is fixed or determinable and collection is reasonably assured. Discounts provided to customers at the point of sale are recognized as reductions in revenue as the products are sold. We offer promotional and rebate programs to our customers. These programs require estimates of customer participation and performance and are recorded at the time of sale as deductions from revenue. We also offer consumer programs to promote the sale of our products and record them as a reduction in revenue at the time the consumer offer is made using estimated redemption and participation. Revenues exclude sales taxes collected from our customers. Additionally, in the U.S., we sell extended furniture protection plans for which revenue is deferred and recognized over the life of the contract. An actuarial study utilizing historical claims data is used to forecast claim payments over the contract period and revenue is recognized based on the forecasted claims payments. Actual claims costs are reflected in earnings in the period incurred. Anticipated losses on programs in progress are charged to earnings when identified. Differences between estimated and actual results, which have been insignificant historically, are recognized as a change in management estimate in a subsequent period. Valuation of Goodwill and Indefinite-Lived Intangible Assets Goodwill represents the excess of cost over the fair value of identifiable net assets of businesses acquired. Other intangible assets consist of customer lists and relationships, purchased technology and patents and trademarks. Evaluating goodwill for impairment involves the determination of the fair value of our reporting units in which we have recorded goodwill. A reporting unit is an operating segment or a component of an operating segment for which discrete financial information is available and reviewed by management on a regular basis. We have determined that we have four separate reporting units with goodwill. Goodwill for each of our reporting units is reviewed for impairment at least annually using a two-step process, as we have chosen not to perform a qualitative assessment for impairment. In the first step, we compare the fair value of each reporting unit to its carrying value, including goodwill. We use the following four material assumptions in our fair value analysis: (a) discount rates; (b) long-term sales growth rates; (c) forecasted operating margins; and (d) market multiples. If the fair value exceeds the carrying value, no further work is required and no impairment loss is recognized. If the carrying value exceeds the fair value, the goodwill of the reporting unit is potentially impaired and we would then complete step 2 in order to measure the impairment loss. In step 2, we would calculate the implied fair value of goodwill by deducting the fair value of all tangible and intangible net assets (including unrecognized intangible assets) of the reporting unit from the fair value of the reporting unit. If the implied fair value of goodwill is less than the carrying value of goodwill, we would recognize an impairment loss, in the period identified, equal to the difference. We review indefinite-lived intangible assets at least annually for impairment by calculating the fair value of the assets and comparing those fair values to the carrying value, as we have chosen not to perform a qualitative assessment for impairment. In assessing fair value, we generally utilize a relief from royalty method. If the carrying value of the indefinite-lived intangible assets exceeds the fair value of the asset, the carrying value is written down to fair value in the period identified. During the fourth quarters of 2015, 2014 and 2013, we completed our annual goodwill and indefinite-lived intangible asset impairment reviews with no impairments to the carrying values identified. There was no change to our reporting units in 2015, 2014 or 2013. Considerable management judgment is necessary to evaluate the impact of operating and macroeconomic changes and to estimate future cash flows. Assumptions used in our impairment evaluations, such as long-term sales growth rates, forecasted operating margins, market multiples and our discount rate, are based on the best available market information at the time of our analysis and are consistent with our internal forecasts and operating plans. Additionally, in assessing goodwill impairment, we considered the implied control premium and concluded it was reasonable based on other recent market transactions. Changes in these estimates or a continued decline in general economic conditions could change our conclusion regarding an impairment of goodwill and potentially result in a non-cash impairment loss in a future period. The discount rate, long-term sales growth rate, forecasted operating margins and market multiple assumptions are the four material assumptions utilized in our calculations of the present value cash flows and the business enterprise fair value used to estimate the fair value of the reporting units when performing the annual goodwill impairment test and in testing indefinite-lived intangible assets for impairment. We utilize a cash flow approach (Level 3 valuation technique) in estimating the fair value of the reporting units for the income approach, where the discount rate reflects a weighted average cost of capital rate. The cash flow model used to derive fair value is most sensitive to the discount rate, long-term sales growth rate and forecasted operating margin assumptions used. For the market approach, average revenue and earnings before interest, tax, depreciation and amortization multiples derived from our peer group are weighted and adjusted for size, risk and growth of the individual reporting unit to determine the reporting unit’s business enterprise fair value. The resulting values from the two approaches are weighted to derive the final fair value of the reporting units that will be compared with the reporting units carrying value when assessing impairment in step 1. For reporting units that pass step 1, we perform a sensitivity analysis on the discount rate, long-term sales growth rate and forecasted operating margin assumptions. The discount rate could increase by more than 10% of the discount rate utilized, the long-term sales growth rate assumption could decline to zero or costs could remain at the current spending level with no cost savings realized in future periods and our reporting units and indefinite-lived intangible assets would continue to have fair value in excess of carrying value. In fiscal 2015, we have no reporting units that are at risk of failing step 1 of our goodwill or indefinite-lived intangible asset impairment tests as the fair values of the reporting units substantially exceed their respective carrying values. There have been no significant events since the timing of our impairment tests that would have triggered additional impairment testing. The assumptions used in our impairment testing could be adversely affected by certain risks discussed in “Risk Factors” in Item 1A of this report. For additional information about goodwill and intangible assets, see Notes 1 and 4 in Notes to Consolidated Financial Statements. Pension and Post-Retirement Medical Obligations We sponsor several defined benefit plans for certain hourly and salaried employees. We sponsor post-retirement medical benefits for certain U.S. employees. The amounts recognized in our financial statements are determined on an actuarial basis. To accomplish this, extensive use is made of assumptions about inflation, investment returns, mortality, turnover, medical trend rates and discount rates. A change in these assumptions could cause actual results to differ from those reported. A reduction of 50 basis points in the long-term rate of return and a reduction of 50 basis points in the discount rate would have increased our pension expense $2,210 in fiscal 2015. A 1% increase in the medical trend rates would not have a material effect on post-retirement medical expense or the post-retirement benefit obligation. See Note 11 in Notes to Consolidated Financial Statements, for further details regarding accounting for pensions and post-retirement medical benefits. Income Taxes At each period end, it is necessary for us to make certain estimates and assumptions to compute the provision for income taxes including, but not limited to, the projections of the proportion of income (or loss) earned and taxed in the foreign jurisdictions and the extent to which this income (or loss) may also be taxed in the United States, permanent and temporary differences, the likelihood of deferred tax assets being recovered and the outcome of uncertain tax positions. Our income tax returns, like those of most companies, are periodically audited by domestic and foreign tax authorities. These audits include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income among various tax jurisdictions. At any one time, multiple tax years are subject to audit by the various tax authorities. We record an accrual for more likely than not exposures after evaluating the positions associated with our various income tax filings. A number of years may elapse before a particular matter for which we have established an accrual is audited and fully resolved or clarified. We adjust our tax contingencies accrual and income tax provision in the period in which matters are effectively settled with tax authorities at amounts different from our established accrual, the statute of limitations expires for the relevant taxing authority to examine the tax position or when more information becomes available. The Internal Revenue Service (IRS) has nearly completed the audit of our fiscal year 2010 U.S. federal amended tax return, along with our fiscal year 2013 U.S. federal tax return. We do not anticipate any material adjustments to our income tax expense or balance of unrecognized tax benefits as a result. We are currently under audit in several state and foreign jurisdictions. We also expect various statutes of limitation to expire during the next 12 months. While we do not expect any material adjustments in the next 12 months due to the pending audit activity or expiring statutes, we are unable to estimate a range of outcomes at this time. Stock-based Compensation The valuation of stock options requires us to use judgments and assumptions. Annually, we make predictive assumptions regarding future stock price volatility, employee exercise behavior, dividend yield and the forfeiture rate. We estimate our future stock price volatility using historical volatility over the expected life of the option. If all other assumptions are held constant, a one percentage point increase in our fiscal 2015 volatility assumption would increase the grant-date fair value of our fiscal 2015 option awards by 4 percent. Our expected life represents the period of time that options granted are expected to be outstanding based on historical data to estimate option exercises and employee terminations within the valuation model. An increase in the expected life by 1 year, leaving all other assumptions constant, would increase the grant date fair value of our 2015 stock option grants by 5 percent. The risk-free interest rate for periods during the expected term of the options is based on yields available on the grant date for US Treasury STRIPS with maturity consistent with the expected life assumption. We recognize compensation expense for these options ratably over the requisite period, which considers retirement eligibility. Certain restricted stock units have performance-based features that are subject to three-year cliff vesting and a cumulative three-year EPS target. The valuation of these performance awards requires judgment to assess the probability of reaching the targets and the achievement level within the target. If the estimate of the probability or achievement level changes during the performance period, a cumulative adjustment will be recorded in the period the probability or achievement level changes. We currently believe the achievement of the performance targets is probable, and, therefore, we have recognized compensation expense over the requisite service period using the average results of the performance period. The average results include the actual performance for the completed periods associated with these awards and our estimate of the target performance for the remaining performance periods associated with the awards. Inventories We record inventories at the lower of cost or net realizable value, with expense estimates made for obsolescence or unsaleable inventory equal to the difference between the recorded cost of inventories and their estimated market value based upon assumptions about future demand and market conditions. On an ongoing basis, we monitor these estimates and record adjustments for differences between estimates and actual experience. Historically, actual results have not significantly deviated from those determined using these estimates. Our domestic inventories, except for Quest, are recorded using the last-in, first-out (LIFO) method, while all other inventories are recorded using the first-in, first-out (FIFO) method. If inventories accounted for using the LIFO method are reduced on a year-over-year basis, liquidation of certain quantities carried at costs prevailing in prior years occurs. If inventories accounted for using the LIFO method are increased on a year-over-year basis, certain quantities are carried at costs prevailing in the current year. An actual valuation of inventory under the LIFO method can be made only at the end of the year based on inventory levels and costs at that time. Interim LIFO calculations are based on management reviews of price changes, as well as estimates of expected year-end inventory levels and costs, and are subject to the final year-end LIFO inventory valuation. OFF-BALANCE SHEET ARRANGEMENTS We do not have off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. FORWARD-LOOKING STATEMENTS Certain statements contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Forward-looking statements are based on management’s current expectations, estimates, assumptions and beliefs about future events, conditions and financial performance. Forward-looking statements are subject to risks, uncertainties and other factors, many of which are outside our control and could cause actual results to differ materially from such statements. Any statement that is not historical in nature is a forward-looking statement. We may identify forward-looking statements with words and phrases such as “expects,” “projects,” “estimates,” “anticipates,” “believes,” “could,” “may,” “will,” “plans to,” “intends,” “should” and similar expressions. These risks, uncertainties and other factors include, but are not limited to, deterioration in general economic conditions, both domestic and international, that may adversely affect our business; fluctuations in availability and prices of raw materials, including raw material shortages and other supply chain disruptions, and the inability to pass along or delays in passing along raw material cost increases to our customers; dependence of internal sales and earnings growth on business cycles affecting our customers and growth in the domestic and international coatings industry; market share loss to, and pricing or margin pressure from, larger competitors with greater financial resources; significant indebtedness that restricts the use of cash flow from operations for acquisitions and other investments; our access to capital is subject to global economic and capital market conditions; dependence on acquisitions for growth, and risks related to future acquisitions, including adverse changes in the results of acquired businesses, the assumption of unforeseen liabilities and disruptions resulting from the integration of acquisitions; risks and uncertainties associated with operating in foreign markets, including achievement of profitable growth in developing markets; impact of fluctuations in foreign currency exchange rates on our financial results; loss of business with key customers; our ability to innovate in order to meet customers' product demands, which may change based on customers' preferences and competitive factors; damage to our reputation and business resulting from product claims or recalls, litigation, customer perception and other matters; our ability to respond to technology changes and to protect our technology; possible interruption, failure or compromise of the information systems we use to operate our business; our reliance on the efforts of vendors, government agencies, utilities and other third parties to achieve adequate compliance and avoid disruption of our business; changes in governmental regulation, including more stringent environmental, health and safety regulations; changes in accounting policies and standards and taxation requirements such as new tax laws or revised tax law interpretations; the nature, cost and outcome of pending and future litigation and other legal proceedings; unusual weather conditions adversely affecting sales; and civil unrest and the outbreak of war and other significant national and international events. We undertake no obligation to subsequently revise any forward-looking statement to reflect new information, events or circumstances after the date of such statement, except as required by law.

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Unless otherwise noted, transactions, trends and other factors significantly impacting our financial condition, results of operations and liquidity are discussed in order of magnitude. In addition, unless expressly stated otherwise, the comparisons presented in this MD&A refer to the same period in the prior year. Our MD&A is presented in seven sections: Overview Results of Operations Financial Condition NonGAAP Financial Measures Critical Accounting Estimates OffBalance Sheet Arrangements ForwardLooking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Form 10K. OVERVIEW The Valspar Corporation is a global leader in the paints and coatings industry. We develop, manufacture and distribute a broad range of coatings, paints and related products and we operate our business in two reportable segments: Coatings and Paints. Our Coatings segment aggregates our industrial and packaging product lines. Our Paints segment aggregates our consumer paints and automotive refinish product lines. See Note 15 in Notes to Consolidated Financial Statements for further information on our reportable segments. We operate in over 25 countries, and approximately 46% of our total net sales in 2015 was generated outside of the U.S. In the discussions of our operating results, we sometimes refer to the impact of changes in foreign currency exchange rates or the impact of foreign currency exchange rate fluctuations, which are references to the differences between the foreign currency exchange rates we use to translate international operating results from local currencies into U.S. dollars for reporting purposes. The impact of foreign currency exchange rate fluctuations is calculated as the difference between current period activity translated using the current period’s currency exchange rates and the comparable prioryear period’s currency exchange rates. We use this method to calculate the impact of changes in foreign currency exchange rates for all countries where the functional currency is not the U.S. dollar. We have a 445 week accounting cycle with the fiscal year ending on the Friday on or immediately preceding October 31. Fiscal years 2015 and 2013 included 52 weeks while fiscal year 2014 included 53 weeks. Our fundamental business objective is to create longterm value for our stockholders. We intend to accomplish this by: Focusing on Customer Success by delivering coatings products and solutions that add value for our customers; Building Strong Brands and Distribution Partners by investing in brands that are well recognized in the markets in which we operate and building differentiated distribution networks in key markets; Developing Differentiated Technologies by investing in technologies that enhance our competitive position and add value for our customers; Driving IndustryLeading Innovation by developing unique products and services that differentiate us in the marketplace with our customers; and Attracting and Developing the Best People by creating a world class team with deep expertise and stockholder value orientation. In addition to creating value for our stockholders, we are committed to: Adhering to our values, engaging in ethical business conduct and doing business with integrity; Improving the safety and reducing the environmental footprint of our business and the products we manufacture while also delivering solutions that enable our customers to meet their safety and environmental objectives; and Demonstrating our corporate citizenship by supporting the communities in which we work and live through volunteer efforts and philanthropy. The following discussion of results of operations and financial condition should be read in the context of this overview. RESULTS OF OPERATIONS Overview Net sales in 2015 were $4,392,622 compared to $4,625,624 in 2014. The decline was primarily due to the impact of foreign currency exchange and lower sales in our Consumer Paints product line due to a change in product line offering at a key North America customer that took effect in the first quarter of 2015. Additionally [/INST] Negative. </s>

VALSPAR CORP

2016-12-20

2016-10-28

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (Dollars in thousands, except per share amounts) Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Unless otherwise noted, transactions, trends and other factors significantly impacting our financial condition, results of operations and liquidity are discussed in order of magnitude. In addition, unless expressly stated otherwise, the comparisons presented in this MD&A refer to the same period in the prior year. Our MD&A is presented in six sections: • Overview • Results of Operations • Financial Condition • Critical Accounting Estimates • Off-Balance Sheet Arrangements • Forward-Looking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. OVERVIEW Valspar is a global leader in the paints and coatings industry. We develop, manufacture and distribute a broad range of coatings, paints and related products and we operate our business in two reportable segments: Coatings and Paints. Our Coatings segment aggregates our industrial and packaging product lines. Our Paints segment aggregates our consumer paints and automotive refinish product lines. See Note 15 in Notes to Consolidated Financial Statements for further information on our reportable segments. We operate in over 25 countries, and approximately 45% of our total net sales in 2016 were generated outside of the U.S. In the discussions of our operating results, we sometimes refer to the impact of changes in foreign currency exchange rates or the impact of foreign currency exchange rate fluctuations, which are references to the differences between the foreign currency exchange rates we use to translate international operating results from local currencies into U.S. dollars for reporting purposes. The impact of foreign currency exchange rate fluctuations is calculated as the difference between current period activity translated using the current period’s currency exchange rates and the comparable prior-year period’s currency exchange rates. We use this method to calculate the impact of changes in foreign currency exchange rates for all countries where the functional currency is not the U.S. dollar. We have a 4-4-5 week accounting cycle with the fiscal year ending on the Friday on or immediately preceding October 31. Fiscal years 2016 and 2015 included 52 weeks while fiscal year 2014 included 53 weeks. Our fundamental business objective is to create long-term value for our stockholders. We intend to accomplish this by: • Focusing on Customer Success by delivering coatings products and solutions that add value for our customers; • Building Strong Brands and Distribution Partners by investing in brands that are well recognized in the markets in which we operate and building differentiated distribution networks in key markets; • Developing Differentiated Technologies by investing in technologies that enhance our competitive position and add value for our customers; • Driving Industry-Leading Innovation by developing unique products and services that differentiate us in the marketplace with our customers; and • Attracting and Developing the Best People by creating a world class team with deep expertise and stockholder value orientation. In addition to creating value for our stockholders, we are committed to: • Adhering to our values, engaging in ethical business conduct and doing business with integrity; • Improving the safety and reducing the environmental footprint of our business and the products we manufacture while also delivering solutions that enable our customers to meet their safety and environmental objectives; and • Demonstrating our corporate citizenship by supporting the communities in which we work and live through volunteer efforts and philanthropy. Proposed Merger with The Sherwin-Williams Company On March 19, 2016, Valspar entered into an Agreement and Plan of Merger (the Merger Agreement) with The Sherwin-Williams Company (Sherwin-Williams) and Viking Merger Sub, Inc., a wholly-owned subsidiary of Sherwin-Williams (Merger Sub). The Merger Agreement provides that, among other things and subject to the terms and conditions of the Merger Agreement, (1) Merger Sub will be merged with and into Valspar (the Merger), with Valspar surviving the Merger as a wholly-owned subsidiary of Sherwin-Williams, and (2) at the effective time of the Merger, each outstanding share of common stock of Valspar, par value $0.50 per share (Valspar common stock) (other than Valspar common stock held in treasury by Valspar, owned by a subsidiary of Valspar or owned by Sherwin-Williams or any of its wholly-owned subsidiaries, or shares with respect to which appraisal rights have been validly exercised and not lost in accordance with Delaware law) will be converted into the right to receive the Merger Consideration. The Merger Consideration means $113.00 per share in cash, except that if Sherwin-Williams is required, in order to obtain the necessary antitrust approvals, to commit to any divestiture, license, hold separate, sale or other disposition of or with respect to assets, businesses or product lines of Valspar, Sherwin-Williams or their subsidiaries representing, in the aggregate, in excess of $650 million of Net Sales (as defined in the Merger Agreement), then the Merger Consideration will be $105.00 per share in cash. The Merger Agreement contains certain termination rights, and we may be required to pay Sherwin-Williams a termination fee of $300 million. For further information on the Merger Agreement, refer to the Merger Agreement, a copy of which was filed as Exhibit 2.1 to our Current Report on Form 8-K filed with the Securities and Exchange Commission on March 21, 2016, and which is incorporated by reference herein. On June 29, 2016, Valspar stockholders voted to adopt the Merger Agreement at a special meeting of stockholders held for that purpose. Completion of the Merger remains subject to certain closing conditions, including the expiration or termination of the applicable waiting period under the U.S. Hart-Scott-Rodino Antitrust Improvements Act and the receipt of regulatory approvals in certain other jurisdictions. The following discussion of results of operations and financial condition should be read in the context of this overview. RESULTS OF OPERATIONS Overview Net sales in 2016 were $4,190,552 compared to $4,392,622 in 2015. The decline was primarily due to lower sales in our consumer paints product line, the impact of foreign currency exchange and lower sales in our general industrial product line. This decline was partially offset by the acquisition of the performance coating businesses of Quest Specialty Chemicals (Quest), which took place in the third quarter of 2015, and higher sales in our coil product line. Foreign currency translation had a $128,600 negative impact on our net sales in 2016. The impact on earnings was partially mitigated by our management of operating activities at the local level, with underlying costs generally denominated in the same currency as sales. This foreign currency exchange impact reflects the strengthening of the U.S. dollar against many international currencies versus the prior year. Our raw material costs were approximately 80% of our cost of goods sold in 2016 and 2015. Gross profit as a percent of sales increased to 36.6% from 35.3% in the prior year driven by improved productivity and favorable cost/price comparison. Operating expenses as a percentage of net sales increased to 24.0% from 21.7% primarily due to higher employee-related costs and costs related to the proposed merger, partially offset by lower marketing expenses. Net income as a percent of sales of 8.4% declined from 9.1%. This decline was the result of higher operating expenses and a 2015 gain on sale of certain assets of a non-strategic specialty product offering, partially offset by a lower tax rate and improved gross margin. Restructuring Fiscal year 2016 restructuring expenses primarily relate to initiatives to improve our global cost structure by consolidating our manufacturing operations in the Paints segment and reducing non-manufacturing headcount in our Paints and Coatings segments. These initiatives included moving manufacturing of selected products in our consumer paints product line to a third party (continuation of an initiative started in 2015), consolidating three sites in our automotive product line as a result of the Quest acquisition and reducing headcount in our Australia and Europe regions. These restructuring activities resulted in pre-tax charges of $18,505 or $0.15 per diluted share after taxes in fiscal year 2016. Included in fiscal 2016 restructuring charges are pre-tax non-cash asset-related charges of $7,358. Asset-related charges include asset impairment charges as well as accelerated depreciation for assets with useful lives that have been shortened, accounted for in accordance with Accounting Standards Codification (ASC)Topic 360, Property, Plant and Equipment. We currently expect additional expenses of approximately $1,200 in fiscal year 2017 for these restructuring plans, primarily related to site clean-up costs, employment-related costs and accelerated depreciation. We currently estimate that upon their completion in fiscal year 2017, these actions will reduce annual costs by approximately $10,000, which is primarily due to lower employee-related costs and lower depreciation expense. We expect a portion of these savings, net of execution costs, will be achieved over the next year and the full annual benefit of these actions is expected in fiscal year 2018. Restructuring charges in fiscal year 2015 included the following: (i) actions to close a manufacturing facility and other facilities in the Coatings segment to rationalize operations in the Australia region, (ii) actions to streamline and consolidate administrative operations in the Europe region and (iii) initiatives in the Paints segment to improve our North American cost structure through staffing reductions and actions to rationalize our manufacturing operations by moving certain manufacturing to a third party. These restructuring activities resulted in pre-tax charges of $21,569 or $0.18 per diluted share for fiscal year 2015, including pre-tax non-cash asset-related charges of $2,842. See Note 18 in Notes to Consolidated Financial Statements for further information on restructuring. Financial Results 2016 vs. 2015 The following tables present selected financial data for the years ended October 28, 2016 and October 30, 2015. • Consolidated Net Sales - Consolidated net sales for the year decreased 4.6%, including a negative impact of 2.9% from foreign currency. Excluding foreign currency exchange, the decrease was driven by lower sales in our consumer paints product line, primarily in North America, and lower sales in our general industrial product line, partially offset by the acquisition of Quest and higher sales in our coil product line. • Coatings Segment Net Sales - Our Coatings segment net sales for the year decreased 4.3%, including a negative impact of 3.6% from foreign currency. Excluding foreign currency exchange, the decrease was driven by lower sales in our general industrial product line offset by improved sales in our coil and wood product lines. • Paints Segment Net Sales - Our Paints segment net sales for the year decreased 5.8%, including a negative impact of 2.1% from foreign currency. Excluding foreign currency exchange, the decrease was driven by lower sales in North America (primarily at Lowe's) and our Australia and Asia regions. This was partially offset by higher sales in our automotive refinish product line primarily due to the acquisition of Quest. Approximately $39,000 of the fiscal year 2016 decrease in sales was due to an adjustment in our product line offering at Lowe's, which impacted the first half of fiscal year 2016. • Other and Administrative Net Sales - The Other and Administrative category includes the following product lines: resins, furniture protection plans and colorants. Other and Administrative net sales increased 1.3%, including a negative impact of 1.0% from foreign currency. Excluding foreign currency exchange, the increased sales were primarily due to resins and furniture protection plans. • Gross Profit - The gross profit rate for 2016 increased 1.3 percentage points compared to 2015. The increase in gross profit rate was primarily driven by improved productivity and favorable cost/price comparison, partially offset by the impact of lower volume on manufacturing cost. Productivity includes procurement and manufacturing efficiencies, product reformulations and benefits from previously completed restructuring actions. Cost/price comparison reflects the impact of market changes in raw material costs, offset by changes in product pricing and promotions. Restructuring charges of $9,906 or 0.2% of net sales and $14,007 or 0.3% of net sales were included in the 2016 and 2015 periods, respectively. Includes research and development and selling, general and administrative costs. For breakout see Consolidated Statements of Operations. • Consolidated Operating Expenses (dollars) - Consolidated operating expenses increased $55,142 or 5.8% including a favorable impact of 2.7% from foreign currency. Excluding foreign currency exchange, the increase was primarily due to higher employee-related costs, costs related to the proposed merger and the addition of Quest, partially offset by lower marketing expenses. 2016 included costs of $28,021 related to the proposed merger with The Sherwin-Williams Company. There were no costs related to the proposed merger in the prior year. Restructuring charges of $8,599 or 0.2% of net sales and $7,562 or 0.2% of net sales were included in the 2016 and 2015 periods, respectively. EBIT is defined as earnings before interest and taxes. • Consolidated EBIT - EBIT for 2016 declined $120,070 or 18.6% or 2.2 percentage points as a percent of net sales from the prior year. 2015 EBIT included a pre-tax gain of $48,001 from the sale of certain assets of a non-strategic specialty product offering, recorded in the Coatings segment in the first quarter. 2016 EBIT declined due to higher employee-related costs, lower volumes and costs related to the proposed merger, partially offset by improved productivity. Restructuring charges were $18,505 or 0.4% of net sales, compared to $21,569 or 0.5% of net sales in fiscal year 2015. Foreign currency exchange had a negative impact on consolidated EBIT of $11,000 in 2016. • Coatings Segment EBIT - EBIT as a percent of net sales declined 0.8 percentage points from the prior year. The decrease was primarily due to the gain on sale of certain assets in the prior period and higher employee-related costs, partially offset by improved productivity, favorable cost/price comparison and lower restructuring charges. Restructuring charges for the 2016 and 2015 periods were $581 or 0.0% of net sales and $9,574 or 0.4% of net sales, respectively. • Paints Segment EBIT - EBIT as a percent of net sales decreased 0.8 percentage points from the prior year. The decrease was driven by the effect of lower volumes, impairment of a certain asset group in our consumer paints product line and higher restructuring charges, partially offset by improved productivity and favorable cost/price comparison. Restructuring charges for 2016 and 2015 periods were $16,239 or 1.0% of net sales and $11,913 or 0.7% of net sales, respectively. Acquisition-related charges of $5,320 or 0.3% were included in fiscal year 2015. • Other and Administrative EBIT - Other and Administrative EBIT includes corporate expenses. EBIT as a percent of net sales decreased 23.8 percentage points from the prior year primarily due to costs related to the proposed merger and increased employee-related costs. • Interest Expense - Interest expense increased in fiscal year 2016 primarily due to higher average debt levels, primarily from the Quest acquisition. • Effective Tax Rate - The lower 2016 effective tax rate was primarily due to the recognition of U.S. foreign tax credits, additional U.S. research and development credits, and the reversal of certain foreign valuation allowances. Financial Results 2015 vs. 2014 The following tables present selected financial data for the years ended October 30, 2015 and October 31, 2014. • Consolidated Net Sales - Consolidated net sales for the year decreased 5.0%, including a negative impact of 5.0% from foreign currency. Lower sales in our consumer paints product line due to a change in product line offering at Lowe's that took effect in the first quarter of 2015 and the 53rd week in 2014 were primarily offset by net new business in our Coatings segment and the acquisition of Quest in our Paints segment. • Coatings Segment Net Sales - Our Coatings segment net sales for the year decreased 3.4%, including a negative impact of 6.0% from foreign currency. Excluding foreign currency exchange, the increase was due to new business, partially offset by the impact of the 53rd week in 2014. • Paints Segment Net Sales - Our Paints segment net sales for the year decreased 8.0%, including a negative impact of 4.0% from foreign currency. Excluding foreign currency exchange, the decrease in net sales was driven primarily by a change in our product line offering at Lowe's that took effect in the first quarter of 2015, a change in price/mix and the 53rd week in 2014, partially offset by the acquisition of Quest in the third quarter of 2015 and volume growth outside the U.S due to new business. Paints segment sales in North America in fiscal year 2015 have declined versus the previous year primarily due to an adjustment in our product line offering at Lowe's. This customer informed us that in fiscal year 2015 they were discontinuing one of the several products that we supply. The total net impact of this adjustment on fiscal year 2015 net sales was approximately $150,000. We took actions to mitigate a portion of the effect on our business of this expected sales decline, including reductions in operating expenses as well as restructuring activities in the Paints segment (see Note 18 in the Consolidated Financial Statements for more information on restructuring activities). • Other and Administrative Net Sales - The Other and Administrative category includes the following product lines: resins, furniture protection plans and colorants. Other and Administrative net sales increased 0.3%, including a negative impact of 2.5% from foreign currency. Excluding foreign currency exchange, the increased sales were primarily due to furniture protection plans and resins. • Gross Profit - The gross profit rate increased 2.0 percentage points. The increase in gross profit rate was primarily driven by improved productivity, favorable cost/price comparison and lower restructuring charges, partially offset by acquisition-related charges from Quest. Productivity includes procurement efficiencies, product reformulations and benefits from previously completed restructuring actions. Cost/price comparison reflects the impact of market changes in raw material costs, offset by changes in product pricing and promotions. Restructuring charges of $14,007 or 0.3% of net sales and $28,471 or 0.6% of net sales were included in the 2015 and 2014 periods, respectively. Acquisition-related charges of $4,428 or 0.1% of net sales were included in fiscal year 2015. Includes research and development and selling, general and administrative costs. For breakout see Consolidated Statements of Operations. Consolidated Operating Expenses (dollars) - Consolidated operating expenses decreased $27,734 or 2.8% including a favorable impact of 5.0% from foreign currency. Excluding foreign currency exchange, dollars in fiscal year 2015 increased primarily due to investments to support our growth initiatives, Quest operating expenses and higher bad debt expense, partially offset by lower incentive compensation accruals and lower restructuring charges. Restructuring charges of $7,562 or 0.2% of net sales and 12,668 or 0.3% of net sales were included in the 2015 and 2014 periods, respectively. Acquisition-related charges of $892 were included in fiscal year 2015. EBIT is defined as earnings before interest and taxes. • Consolidated EBIT - EBIT for 2015 increased $87,937 or 15.8% or 2.7 percentage points as a percent of net sales from the prior year. Fiscal year 2015 results included a pre-tax gain on sale of certain assets of a non-strategic specialty product line of $48,001. Restructuring charges were $21,569 or 0.5% of net sales, compared to $41,139 or 0.9% of net sales in fiscal year 2014. Acquisition-related charges of $5,320 or 0.1% of net sales were included in fiscal year 2015. Foreign currency exchange had a negative impact of $23,001 on EBIT. • Coatings Segment EBIT - EBIT as a percent of net sales increased 4.3 percentage points from the prior year. The increase was primarily due to the gain on sale of certain assets of a non-strategic specialty product offering of $48,001, improved productivity, favorable cost/price comparison and lower restructuring charges, partially offset by higher operating expense. Restructuring charges for the 2015 and 2014 periods were $9,574 or 0.4% of net sales and $28,902 or 1.1% of net sales, respectively. • Paints Segment EBIT - EBIT as a percent of net sales decreased 0.2 percentage points from the prior year. The decrease was driven by the effect of lower volumes in our consumer product line in North America and acquisition-related charges from the Quest acquisition, partially offset by improved productivity. Restructuring charges for 2015 and 2014 periods were $11,913 or 0.7% of net sales and $11,934 or 0.7% of net sales, respectively. Acquisition-related charges of $5,320 or 0.3% of net sales were included in fiscal year 2015. • Other and Administrative EBIT - Other and Administrative EBIT includes corporate expenses. EBIT as a percent of net sales increased 5.3 percentage points from the prior year primarily due to lower operating expenses and improved operating performance. Restructuring charges of $82 or 0.0% of net sales and $303 or 0.1% of net sales were included in the 2015 and 2014 periods, respectively. • Interest Expense - Interest expense increased in fiscal year 2015 primarily due to higher average debt levels and higher average interest rates. • Effective Tax Rate - The lower 2015 effective tax rate was primarily due to the U.S. foreign tax credit and the sale of a specialty product offering in a foreign location, which is taxed at a lower rate than the U.S. federal statutory rate, partially offset by a reversal of valuation allowances in 2014, which did not recur in 2015. FINANCIAL CONDITION Cash Flow Cash flow provided by operations was $482,712 in 2016, compared to $383,200 in 2015 and $347,104 in 2014. Cash flow provided by operations in 2016 increased due to overall working capital becoming a source of cash as accounts receivable declined in line with lower sales. In 2016, we used cash flow from operations to reduce debt by $264,521 and to fund $120,420 in capital expenditures, $104,553 of dividend payments and $24,408 for acquisitions of businesses, net of cash acquired. Debt and Capital Resources Our debt classified as current was $221,446 at October 28, 2016 compared to $334,153 at October 30, 2015. Total debt was $1,778,398 at October 28, 2016 and $2,041,086 at October 30, 2015. The decrease in total debt from October 30, 2015 was driven by the use of cash flow from operations to repay debt. The ratio of total debt to capital was 61.5% at October 28, 2016, compared to 70.5% at October 30, 2015. Average debt outstanding during 2016 was $2,019,317 at a weighted average interest rate of 4.48% versus $1,908,101 at 4.26% in 2015. Interest expense for 2016 was $90,560 compared to $81,348 in 2015. During 2016, $150,000 of unsecured Senior Notes that mature on May 1, 2017 were reclassified as current portion of long-term debt. On August 3, 2015, we retired $150,000 of unsecured Senior Notes in accordance with their scheduled maturity using commercial paper. On July 27, 2015, we issued $350,000 of unsecured Senior Notes that mature on January 15, 2026 with a coupon rate of 3.95%. The net proceeds of the issuance were approximately $345,000. The public offering was made pursuant to a registration statement filed with the U.S. Securities and Exchange Commission (SEC). We used the net proceeds from this offering for the repayment of borrowings under the term loan credit facility that was entered into on May 29, 2015. On May 29, 2015, we entered into a $350,000 term loan credit agreement with a syndicate of banks with a maturity date of November 29, 2016. This facility was used to provide funding for the acquisition of Quest. See Note 2 in the Consolidated Financial Statements for further information on the acquisition. This facility was repaid and terminated on July 29, 2015 primarily using the net proceeds from the unsecured Senior Notes issued in July 2015. On January 21, 2015, we issued $250,000 of unsecured Senior Notes that mature on February 1, 2025 with a coupon rate of 3.30%, and $250,000 of unsecured Senior Notes that mature on February 1, 2045 with a coupon rate of 4.40%. The net proceeds of both issuances were approximately $492,000 in the aggregate. The public offering was made pursuant to a registration statement filed with the SEC. We used the net proceeds to repay short-term borrowings under our commercial paper program and credit facility in the first quarter of 2015. We maintain a $750,000 unsecured revolving credit facility with a syndicate of banks with a maturity date of December 14, 2018. Under certain circumstances we have the option to increase this credit facility to $1,000,000. Our short-term debt consists primarily of commercial paper. The weighted-average annual interest rates on outstanding short-term borrowings were 1.27% and 0.64% on October 28, 2016 and October 30, 2015, respectively. To ensure availability of funds, we maintain uncommitted bank lines of credit sufficient to cover outstanding short-term borrowings. These arrangements are reviewed periodically for renewal and modification. In July 2013, we entered into a U.S. dollar equivalent unsecured committed revolving bilateral credit facility, expiring July 2014. In July 2014, this facility was extended for one year to July 2015. We paid off and terminated the bilateral credit facility in December 2014. As of October 28, 2016 and October 30, 2015, our bank credit facilities consisted of the following: We have a $450,000 commercial paper program backed by our $750,000 bank syndicate committed credit revolving facility, as amended and restated. We pay a 0.15% per year commitment fee on the full amount of the facility. The facility includes $62,389 and $327,869 of commercial paper as of October 28, 2016 and October 30, 2015, respectively. Our unsecured committed credit revolving facility has covenants that require us to maintain certain financial ratios. We were in compliance with these covenants as of October 28, 2016. Our debt covenants do not limit, nor are they reasonably likely to limit, our ability to obtain additional debt or equity financing. We maintain uncommitted bank lines of credit to meet short-term funding needs in certain of our international locations. These arrangements are reviewed periodically for renewal and modification. As of October 28, 2016, we had total committed liquidity of $862,331, comprised of $174,720 in cash and cash equivalents and $687,611 in unused committed bank credit facilities, compared to $608,092 of total committed liquidity as of October 30, 2015. At October 28, 2016 we had unused lines of committed and uncommitted credit available from banks of $788,486. Our cash and cash equivalent balances consist of high quality, short-term money market instruments and cash held by our international subsidiaries that are used to fund those subsidiaries’ day-to-day operating needs. Those balances have also been used to finance international acquisitions. Our investment policy on excess cash is to preserve principal. As of October 28, 2016, $165,616 of the $174,720 of cash (on the Consolidated Balance Sheets) was held by foreign subsidiaries. If these funds were repatriated to the U.S. we would be required to accrue and pay income taxes. No provision has been made for U.S. federal income taxes on certain undistributed earnings of foreign subsidiaries that we intend to permanently invest or that may be remitted substantially tax-free. We believe cash flow from operations, existing lines of credit, access to credit facilities and access to debt and capital markets will be sufficient to meet our domestic and international liquidity needs. In the current market conditions, we have demonstrated continued access to capital markets. We have committed liquidity and cash reserves in excess of our anticipated funding requirements. We use derivative instruments with a number of counterparties principally to manage interest rate and foreign currency exchange risks. We evaluate the financial stability of each counterparty and spread the risk among several financial institutions to limit our exposure. We will continue to monitor counterparty risk on an ongoing basis. We do not have any credit-risk related contingent features in our derivative contracts as of October 28, 2016. We paid common stock dividends of $104,553 or $1.32 per share in 2016, an increase of 10.0% per share over 2015 common stock dividends of $96,890 or $1.20 per share. We have continuing authorization to purchase shares of our common stock for general corporate purposes. We repurchased 221,060 shares totaling $18,134 in 2016 compared to 3,891,545 shares totaling $322,420 in 2015 and 4,705,081 shares totaling $349,181 in 2014. On November 21, 2014, the Board approved a new share repurchase program, with no expiration date, authorizing us to purchase up to $1,500,000 of outstanding shares of common stock. This new program was effective immediately and replaced the previous repurchase authorization. As of October 28, 2016, $1,175,630 remained available for purchase under our repurchase authorization. We are involved in various claims relating to environmental matters at a number of current and former plant sites and waste management sites. We engage or participate in remedial and other environmental compliance activities at certain of these sites. At other sites, we have been named as a potentially responsible party (PRP) under federal and state environmental laws for site remediation. We analyze each individual site, considering the number of parties involved, the level of our potential liability or contribution relative to the other parties, the nature and magnitude of the hazardous wastes involved, the method and extent of remediation, the potential insurance coverage, the estimated legal and consulting expense with respect to each site and the time period over which any costs would likely be incurred. Based on the above analysis, we estimate the clean-up costs and related claims for each site. The estimates are based in part on discussion with other PRPs, governmental agencies and engineering firms. We accrue appropriate reserves for potential environmental liabilities when the amount of the costs that will be incurred can be reasonably determined. Accruals are reviewed and adjusted as additional information becomes available. While uncertainties exist with respect to the amounts and timing of our ultimate environmental liabilities, we believe it is neither probable nor reasonably possible that such liabilities, individually or in the aggregate, will have a material adverse effect on our financial condition, results of operations or cash flows. We are involved in a variety of legal claims and proceedings relating to personal injury, product liability, warranties, customer contracts, employment, trade practices, environmental and other legal matters that arise in the normal course of business. These claims and proceedings include cases where we are one of a number of defendants in proceedings alleging that the plaintiffs suffered injuries or contracted diseases from exposure to chemicals or other ingredients used in the production of some of our products or waste disposal. We are also subject to claims related to the performance of our products. We believe these claims and proceedings are in the ordinary course for a business of the type and size in which we are engaged. While we are unable to predict the ultimate outcome of these claims and proceedings, we believe it is neither probable nor reasonably possible that the costs and liabilities of such matters, individually or in the aggregate, will have a material adverse effect on our financial condition, results of operations or cash flows. Under various agreements, we are obligated to make future cash payments in fixed amounts. These include payments under our multi-currency credit facilities, senior notes, capital leases, employee benefit plans, non-cancelable operating leases with initial or remaining terms in excess of one year, capital expenditures, commodity purchase commitments, telecommunication commitments, IT commitments, and marketing commitments. Some of our interest charges are variable and are assumed at current rates. Contractual Obligations The following table summarizes our contractual obligations as of October 28, 2016 for the fiscal years ending in October: We expect to make cash outlays in the future related to uncertain tax positions. However, due to the uncertainty of the timing of future cash flows, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, unrecognized tax benefits of $19,067 as of October 28, 2016, have been excluded from the contractual obligations table above. For further information related to unrecognized tax benefits, see Note 12 in Notes to Consolidated Financial Statements. CRITICAL ACCOUNTING ESTIMATES The discussion and analysis of our financial condition and results of operations are based upon our Consolidated Financial Statements, which have been prepared in accordance with generally accepted accounting principles in the United States (GAAP). The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of any contingent assets and liabilities at the date of the financial statements. We regularly review our estimates and assumptions, which are based on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following areas are affected by significant judgments and estimates used in the preparation of our Consolidated Financial Statements and that the judgments and estimates are reasonable: Revenue Recognition We recognize revenue from product sales at the time the product is delivered or title has passed, a sales agreement is in place, pricing is fixed or determinable and collection is reasonably assured. Discounts provided to customers at the point of sale are recognized as reductions in revenue as the products are sold. We offer promotional and rebate programs to our customers. These programs require estimates of customer participation and performance and are recorded at the time of sale as deductions from revenue. We also offer consumer programs to promote the sale of our products and record them as a reduction in revenue at the time the consumer offer is made using estimated redemption and participation. Revenues exclude sales taxes collected from our customers. Additionally, in the U.S., we sell extended furniture protection plans for which revenue is deferred and recognized over the life of the contract. An actuarial study utilizing historical claims data is used to forecast claim payments over the contract period and revenue is recognized based on the forecasted claims payments. Actual claims costs are reflected in earnings in the period incurred. Anticipated losses on programs in progress are charged to earnings when identified. Differences between estimated and actual results, which have been insignificant historically, are recognized as a change in management estimate in a subsequent period. Goodwill and Indefinite-Lived Intangible Assets Goodwill represents the excess of cost over the fair value of identifiable net assets of businesses acquired. Indefinite-lived intangible assets primarily consist of purchased technology, trademarks and trade names. Goodwill for each of our reporting units and indefinite-lived assets is tested for impairment at least annually during the fourth quarter, and between annual tests if an event occurs, or circumstances change. A reporting unit is an operating segment or a component of an operating segment for which discrete financial information is available and reviewed by management on a regular basis. We have determined that we have four separate reporting units with goodwill. There was no change to our reporting units in 2016, 2015, or 2014. The goodwill test involves a two-step process. The first step is a comparison of the reporting unit’s fair value to its carrying value, including goodwill. If the reporting unit’s fair value exceeds its carrying value, no further procedures are required. However, if the reporting unit’s fair value is less than the carrying value, an impairment of goodwill may exist, requiring a second step to measure the amount of impairment loss. In step 2, we would calculate the implied fair value of goodwill by deducting the fair value of all tangible and intangible net assets (including unrecognized intangible assets) of the reporting unit from the fair value of the reporting unit. If the implied fair value of goodwill is less than the recorded goodwill, an impairment charge is recorded for the difference. In applying the goodwill and indefinite-lived intangible assets impairment tests, we may assess qualitative factors to determine whether it is more likely than not that the fair value of the reporting units is less than its carrying value (step 0). Qualitative factors may include, but are not limited to, economic, market and industry conditions, cost factors, and overall financial performance of the reporting unit. If, after assessing these qualitative factors, the Company determines it is more likely than not that the carrying value is less than the fair value, then performing the two-step impairment test is unnecessary. For the two-step impairment test, in step 1, we calculate the fair value of the reporting units weighting the income approach and the market approach which is then compared with the reporting units carrying value. For the income approach, we utilize a discounted cash flow where the discount rate reflects the weighted average costs of capital. The income approach is most sensitive to the discount rate, long-term sales growth rates and forecasted operating margins. For the market approach, average revenue and earnings before interest, tax, depreciation and amortization multiples derived from our peer group are weighted and adjusted for size, risk and growth of the individual reporting unit to determine the reporting unit’s business enterprise fair value. Additionally, in assessing goodwill impairment, we consider the implied control premium and if it is reasonable based on other recent market transactions. For reporting units that pass step 1, we perform a sensitivity analysis on the discount rate, long-term sales growth rate and forecasted operating margin assumptions. Changes in these estimates or a continued decline in general economic conditions could change our conclusion regarding an impairment of goodwill and potentially result in a non-cash impairment loss in a future period. If the fair value exceeds the carrying value, no further work is required and no impairment loss is recognized. For indefinite-lived intangible assets, we utilize a relief from royalty method when applying the quantitative assessment. The relief from royalty method is most sensitive to the discount rate, royalty rate and long-term sales growth rates. If the carrying value of the indefinite-lived intangible assets exceeds the fair value of the asset, the carrying value is written down to fair value in the period identified. The following is a description of the goodwill and indefinite-lived assets impairment tests performed for each of the fiscal years: Fiscal Year 2016 During the annual goodwill and indefinite-lived intangible assets impairment tests, we assessed qualitative factors to determine whether it was more likely than not that the fair value of each reporting unit is less than its carrying value (step 0). We concluded that it was more likely than not that the carrying value was less than the fair value. Accordingly, we did not perform a two-step quantitative analysis. Fiscal Years 2015 and 2014 During the annual impairment tests, we performed step 1 of the quantitative goodwill impairment test. In both years, we determined that the fair value exceeded the carrying value and did not perform step 2. During the annual impairment tests, we performed step 1 of the indefinite-lived intangible assets impairment test. In both years, we determined that the fair value exceeded the carrying value and did not perform further analysis. The assumptions used in our impairment testing could be adversely affected by certain risks discussed in “Risk Factors” in Item 1A of this report. Pension and Post-Retirement Medical Obligations We sponsor several defined benefit plans for certain hourly and salaried employees. We sponsor post-retirement medical benefits for certain U.S. employees. The amounts recognized in our financial statements are determined on an actuarial basis. To accomplish this, extensive use is made of assumptions about inflation, investment returns, mortality, turnover, medical trend rates and discount rates. A change in these assumptions could cause actual results to differ from those reported. A reduction of 50 basis points in the long-term rate of return and a reduction of 50 basis points in the discount rate would have increased our pension expense $2,236 in fiscal 2016. A 1% increase in the medical trend rates would not have a material effect on post-retirement medical expense or the post-retirement benefit obligation. Income Taxes At each period end, it is necessary for us to make certain estimates and assumptions to compute the provision for income taxes including, but not limited to, the projections of the proportion of income (or loss) earned and taxed in the foreign jurisdictions and the extent to which this income (or loss) may also be taxed in the United States, permanent and temporary differences, the likelihood of deferred tax assets being recovered and the outcome of uncertain tax positions. Our income tax returns, like those of most companies, are periodically audited by domestic and foreign tax authorities. These audits include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income among various tax jurisdictions. At any one time, multiple tax years are subject to audit by the various tax authorities. We record an accrual for more likely than not exposures after evaluating the positions associated with our various income tax filings. A number of years may elapse before a particular matter for which we have established an accrual is audited and fully resolved or clarified. We adjust our tax contingencies accrual and income tax provision in the period in which matters are effectively settled with tax authorities at amounts different from our established accrual, the statute of limitations expires for the relevant taxing authority to examine the tax position or when more information becomes available. The Internal Revenue Service (IRS) has completed the audit of our U.S. federal tax returns for fiscal years 2010, 2011 and 2013. There were no material adjustments to our income tax expense or balance of unrecognized tax benefits as a result of those audits. The IRS is currently auditing our U.S. federal income tax return for fiscal year 2012. We are also currently under audit in several state and foreign jurisdictions. We do not anticipate any material adjustments to our income tax expense or balance of unrecognized tax benefits as a result of those audits. We also expect various statutes of limitation to expire during the next 12 months. Due to the uncertain response of taxing authorities, a range of outcomes cannot be reasonably estimated at this time. Stock-based Compensation The valuation of stock options requires us to use judgments and assumptions. There were no stock options issued in 2016. Certain restricted stock units have performance-based features that are subject to three-year cliff vesting and a cumulative three-year EPS target. The valuation of these performance awards requires judgment to assess the probability of reaching the targets and the achievement level within the target. If the estimate of the probability or achievement level changes during the performance period, a cumulative adjustment will be recorded in the period the probability or achievement level changes. We currently believe the achievement of the performance targets is probable, and, therefore, we have recognized compensation expense over the requisite service period using the average results of the performance period. The average results include the actual performance for the completed periods associated with these awards and our estimate of the target performance for the remaining performance periods associated with the awards. Inventories We record inventories at the lower of cost or net realizable value, with expense estimates made for obsolescence or unsaleable inventory equal to the difference between the recorded cost of inventories and their estimated market value based upon assumptions about future demand and market conditions. On an ongoing basis, we monitor these estimates and record adjustments for differences between estimates and actual experience. Historically, actual results have not significantly deviated from those determined using these estimates. Our domestic inventories, except for Quest, are recorded using the last-in, first-out (LIFO) method, while all other inventories are recorded using the first-in, first-out (FIFO) method. If inventories accounted for using the LIFO method are reduced on a year-over-year basis, liquidation of certain quantities carried at costs prevailing in prior years occurs. If inventories accounted for using the LIFO method are increased on a year-over-year basis, certain quantities are carried at costs prevailing in the current year. An actual valuation of inventory under the LIFO method can be made only at the end of the year based on inventory levels and costs at that time. Interim LIFO calculations are based on management reviews of price changes, as well as estimates of expected year-end inventory levels and costs, and are subject to the final year-end LIFO inventory valuation. OFF-BALANCE SHEET ARRANGEMENTS We do not have off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. FORWARD-LOOKING STATEMENTS Certain statements contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Forward-looking statements are based on management’s current expectations, estimates, assumptions and beliefs about future events, conditions and financial performance. Forward-looking statements are subject to risks, uncertainties and other factors, many of which are outside our control and could cause actual results to differ materially from such statements. Any statement that is not historical in nature is a forward-looking statement. We may identify forward-looking statements with words and phrases such as “expect,” “project,” “forecast,” “outlook,” “estimate,” “anticipate,” “believe,” “could,” “may,” “will,” “plan to,” “intend,” “should” and similar words or expressions. These risks, uncertainties and other factors include, but are not limited to, deterioration in general economic conditions, both domestic and international, that may adversely affect our business; fluctuations in availability and prices of raw materials, including raw material shortages and other supply chain disruptions, and the inability to pass along or delays in passing along raw material cost increases to our customers; dependence of internal sales and earnings growth on business cycles affecting our customers and growth in the domestic and international coatings industry; market share loss to, and pricing or margin pressure from, larger competitors with greater financial resources; significant indebtedness that restricts the use of cash flow from operations for acquisitions and other investments; our access to capital is subject to global economic and capital market conditions; dependence on acquisitions for growth, and risks related to future acquisitions, including adverse changes in the results of acquired businesses, the assumption of unforeseen liabilities and disruptions resulting from the integration of acquisitions; risks and uncertainties associated with operating in foreign markets, including achievement of profitable growth in developing markets; impact of fluctuations in foreign currency exchange rates on our financial results; loss of business with key customers; our ability to innovate in order to meet customers' product demands, which may change based on customers' preferences and competitive factors; damage to our reputation and business resulting from product claims or recalls, litigation, customer perception and other matters; our ability to respond to technology changes and to protect our technology; possible interruption, failure or compromise of the information systems we use to operate our business; our reliance on the efforts of vendors, government agencies, utilities and other third parties to achieve adequate compliance and avoid disruption of our business; changes in governmental regulation, including more stringent environmental, health and safety regulations; changes in accounting policies and standards and taxation requirements such as new tax laws or revised tax law interpretations; the nature, cost and outcome of pending and future litigation and other legal proceedings; unusual weather conditions adversely affecting sales; civil unrest and the outbreak of war and other significant national and international events; risks relating to our Merger with Sherwin-Williams including, the possibility that the closing conditions to the contemplated transaction may not be satisfied or waived, including that a governmental entity may prohibit, delay or refuse to grant a necessary regulatory approval; delay in closing the transaction or the possibility of non-consummation of the transaction; the potential for regulatory authorities to require divestitures in connection with the proposed transaction and the possibility that Valspar stockholders consequently receive $105 per share instead of $113 per share; the occurrence of any event that could give rise to termination of the Merger Agreement; the risk that stockholder litigation in connection with the contemplated transaction may affect the timing or occurrence of the contemplated transaction or result in significant costs of defense, indemnification and liability; risks inherent in the achievement of cost synergies and the timing thereof; risks related to the disruption of the transaction to Valspar and its management; and the effect of announcement of the transaction on Valspar’s ability to retain and hire key personnel and maintain relationships with customers, suppliers and other third parties. We caution investors not to place undue reliance on any such forward-looking statements, which speak only as of the date on which such statements were made. We undertake no obligation to subsequently revise any forward-looking statement to reflect new information, events or circumstances after the date of such statement, except as required by law.

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Unless otherwise noted, transactions, trends and other factors significantly impacting our financial condition, results of operations and liquidity are discussed in order of magnitude. In addition, unless expressly stated otherwise, the comparisons presented in this MD&A refer to the same period in the prior year. Our MD&A is presented in six sections: Overview Results of Operations Financial Condition Critical Accounting Estimates OffBalance Sheet Arrangements ForwardLooking Statements Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Item 8, Financial Statements and Supplementary Data, of this Form 10K. OVERVIEW Valspar is a global leader in the paints and coatings industry. We develop, manufacture and distribute a broad range of coatings, paints and related products and we operate our business in two reportable segments: Coatings and Paints. Our Coatings segment aggregates our industrial and packaging product lines. Our Paints segment aggregates our consumer paints and automotive refinish product lines. See Note 15 in Notes to Consolidated Financial Statements for further information on our reportable segments. We operate in over 25 countries, and approximately 45% of our total net sales in 2016 were generated outside of the U.S. In the discussions of our operating results, we sometimes refer to the impact of changes in foreign currency exchange rates or the impact of foreign currency exchange rate fluctuations, which are references to the differences between the foreign currency exchange rates we use to translate international operating results from local currencies into U.S. dollars for reporting purposes. The impact of foreign currency exchange rate fluctuations is calculated as the difference between current period activity translated using the current period’s currency exchange rates and the comparable prioryear period’s currency exchange rates. We use this method to calculate the impact of changes in foreign currency exchange rates for all countries where the functional currency is not the U.S. dollar. We have a 445 week accounting cycle with the fiscal year ending on the Friday on or immediately preceding October 31. Fiscal years 2016 and 2015 included 52 weeks while fiscal year 2014 included 53 weeks. Our fundamental business objective is to create longterm value for our stockholders. We intend to accomplish this by: Focusing on Customer Success by delivering coatings products and solutions that add value for our customers; Building Strong Brands and Distribution Partners by investing in brands that are well recognized in the markets in which we operate and building differentiated distribution networks in key markets; Developing Differentiated Technologies by investing in technologies that enhance our competitive position and add value for our customers; Driving IndustryLeading Innovation by developing unique products and services that differentiate us in the marketplace with our customers; and Attracting and Developing the Best People by creating a world class team with deep expertise and stockholder value orientation. In addition to creating value for our stockholders, we are committed to: Adhering to our values, engaging in ethical business conduct and doing business with integrity; Improving the safety and reducing the environmental footprint of our business and the products we manufacture while also delivering solutions that enable our customers to meet their safety and environmental objectives; and Demonstrating our corporate citizenship by supporting the communities in which we work and live through volunteer efforts and philanthropy. Proposed Merger with The SherwinWilliams Company On March 19, 2016, Valspar entered into an Agreement and Plan of Merger (the Merger Agreement) with The SherwinWilliams Company (SherwinWilliams) and Viking Merger Sub, Inc., a whollyowned subsidiary of SherwinWilliams (Merger Sub). The Merger Agreement provides that, among other things and subject to the terms and conditions of the Merger Agreement, (1) Merger Sub will be merged with and into Valspar (the Merger), with Vals [/INST] Negative. </s>

SOUTHWESTERN ENERGY CO

2015-02-26

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Annual Report contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in forward-looking statements for many reasons, including the risks described in the “Cautionary Statement About Forward-Looking Statements” below, in Item 1A - “Risk Factors” in Part I and elsewhere in this Annual Report. You should read the following discussion with Item 6 - Selected Financial Data and our consolidated financial statements and related notes included in this Annual Report. OVERVIEW Background Southwestern Energy Company is an independent energy company engaged in natural gas and oil exploration, development and production, or E&P. We also focused on creating and capturing additional value through our natural gas gathering and marketing businesses, which we refer to as Midstream Services. We operate principally in two segments: E&P and Midstream Services. Our primary business is the exploration for and production of natural gas and oil, with our current operations principally focused within the United States on development of two unconventional natural gas reservoirs located in Arkansas and Pennsylvania. Our operations in Arkansas are primarily focused on an unconventional natural gas reservoir known as the Fayetteville Shale, and our operations in northeast Pennsylvania are focused on an unconventional natural gas reservoir known as the Marcellus Shale (herein referred to as “Northeast Appalachia”). Recently, we acquired a significant stake in properties located in West Virginia and southwest Pennsylvania which we also intend to develop. These operations in West Virginia are also focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs (herein referred to as “Southwest Appalachia”). Collectively, our properties located in West Virginia and Pennsylvania are herein referred to as the “Appalachian Basin.” To a lesser extent, we have exploration and production activities ongoing in Colorado, Louisiana, Texas and in the Arkoma Basin in Arkansas and Oklahoma. We also actively seek to find and develop new natural gas and oil plays with significant exploration and exploitation potential, which we refer to as “New Ventures,” and through acquisitions. We also operate drilling rigs in Arkansas and Pennsylvania, as well as in other operating areas, and provide oilfield products and services, principally serving our exploration and production operations. We are focused on providing long-term growth in the net asset value per share of our business. We derive the vast majority of our operating income and cash flow from the production associated with our E&P business and expect this to continue in the future. We expect that growth in our operating income and revenues will depend primarily on natural gas and oil prices and our ability to increase our production. We expect our production volumes will continue to increase due to ongoing development in our Fayetteville Shale, Northeast Appalachia and Southwest Appalachia divisions. The price we expect to receive for our production is a critical factor in the capital investments we make in order to develop our properties. In recent years, there has been significant volatility in natural gas prices as evidenced by New York Mercantile Exchange, or NYMEX, natural gas prices ranging from a high of $13.58 per MMBtu in 2008 to a low of $1.91 per MMBtu in 2012. Natural gas prices fluctuate due to a variety of factors we cannot control or predict. These factors, which include increased supplies of natural gas due to greater exploration and development activities, weather conditions, political and economic events, and competition from other energy sources, impact supply and demand for natural gas, which in turn determines the sale prices for our production. Going forward, we will be impacted by crude oil prices which have ranged from approximately $145 per barrel in July 2008 to approximately $45 per barrel in January 2015. In addition to the factors identified above, the prices we realize for our production are affected by our hedging activities as well as locational differences in market prices. Recent Financial and Operating Results In 2014, our net income was $924 million, or $2.62 per diluted share, up from net income of $704 million, or $2.00 per diluted share in 2013. Our net loss was $707 million, or $2.03 per diluted share in 2012. In 2012, we incurred a $1,940 million, or $1,192 million net of taxes, non-cash ceiling test impairment of our United States natural gas and oil properties that resulted from a significant decline in natural gas prices during 2012. In 2014, our natural gas and oil production increased 17% to 768 Bcfe, up from 657 Bcfe in 2013. The 111 Bcfe increase in our 2014 production resulted from a 103 Bcf increase in net production from our Northeast Appalachia properties and an 8 Bcf increase in net production from our Fayetteville Shale properties. In 2013, our natural gas and oil production increased to 657 Bcfe, up from 565 Bcfe in 2012. We are targeting 2015 natural gas and oil production of 940 to 955 Bcfe, an increase of approximately 23% over our 2014 production, using midpoints. Our year-end reserves increased 54% in 2014 to 10,747 Bcfe, up from 6,976 Bcfe at the end of 2013 and 4,018 Bcfe at the end of 2012. The overall increase in total estimated proved reserves in 2014 was primarily due to the acquisition of approximately 413,000 net acres in Southwest Appalachia which increased reserves by 33%, our successful drilling programs in the Fayetteville Shale and Northeast Appalachia and upward performance revisions in Northeast Appalachia where reserves grew 63% from 2013. The overall increase in total estimated proved reserves in 2013 was primarily due to significant additions in our Fayetteville Shale reserves including substantial additions of proved undeveloped reserves primarily driven by an increase in average natural gas prices in 2013 and a 141% growth rate in our reserves in Northeast Appalachia. Our E&P segment operating income was $1,013 million in 2014, up from an operating income of $879 million in 2013. Operating income in 2014 increased $134 million over 2013 as the revenue impact of our 17%, or 111 Bcfe, increase in production and 2%, or $0.07, increase in our average realized natural gas price more than offset the $324 million increase in operating costs and expenses that resulted from our production growth. Operating income was $879 million in 2013, up from an operating loss of $1,396 million in 2012. The operating loss in 2012 included a $1,940 million non-cash ceiling test impairment of our United States natural gas and oil properties. Excluding the non-cash ceiling test impairment, operating income in 2013 increased $335 million over 2012 as the revenue impact of our 16%, or 92 Bcfe, increase in production and 6%, or $0.21, increase in our average realized natural gas price more than offset the $105 million increase in operating costs that resulted from our production growth. Operating income for our Midstream Services segment was $361 million in 2014, up from $325 million in 2013 and $294 million in 2012. Operating income for our Midstream Services segment increased in 2014 due to an increase of $46 million in gathering revenues and a $12 million increase in the margin generated from our natural gas marketing activities, which was partially offset by a $22 million increase in operating costs and expenses, exclusive of natural gas purchase costs, that resulted from our continued growth in volumes gathered. Volumes gathered grew to 963 Bcf in 2014 compared to 900 Bcf in 2013. Operating income for our Midstream Services segment increased in 2013 due to an increase of $42 million in gathering revenues and a $17 million increase in the margin generated from our natural gas marketing activities which was partially offset by an increase of $28 million in operating costs and expenses, exclusive of natural gas purchase costs, that resulted from our growth in volumes gathered. Volumes gathered grew to 900 Bcf in 2013 compared to 846 Bcf in 2012. We had total capital investments of $7.4 billion in 2014, compared to $2.2 billion in 2013 and $2.1 billion in 2012. Of our total capital investments, $7.3 billion was invested in our E&P segment in 2014 which included $5.2 billion primarily related to the Chesapeake Property Acquisition compared to $2.1 billion in 2013 which included $96 million primarily related to the acquisition of properties in Northeast Appalachia and $1.9 billion in 2012. Outlook We believe the outlook for our business is favorable despite the continued uncertainty of natural gas and crude oil prices in the United States and the legislative and regulatory challenges facing our industry. Our resource base, financial strength and disciplined investment of capital provide us with an opportunity to exploit and develop our position through our Fayetteville Shale, Northeast Appalachia and Southwest Appalachia divisions to maximize efficiency through economies of scale in our key operating areas, enhance our overall returns through our Midstream Services operations and grow through our E&P development activities. Our capital investment plan for 2015 is flexible and may be adjusted based on actual and expected natural gas and oil prices. RESULTS OF OPERATIONS The following discussion of our results of operations for our segments is presented before intersegment eliminations. We evaluate our segments as if they were stand-alone operations and accordingly discuss their results prior to any intersegment eliminations. Interest expense and income tax expense are discussed on a consolidated basis. Exploration and Production (1)Represents the gain (loss) on derivatives, settled, associated with derivatives not designated for hedge accounting. (2)Including the gain (loss) on derivatives excluding derivatives, settled effects of commodity hedging contracts not designated for hedge accounting, results in an average price of $3.90, $3.68 and $3.43 for the year ended December 31, 2014, 2013 and 2012, respectively. Revenues Revenues for our E&P segment were up $458 million, or 19%, in 2014 compared to 2013. Higher natural gas production volumes in 2014 increased revenues by $403 million, and higher realized prices for our natural gas production increased revenue by $55 million compared to 2013. E&P revenues were up $440 million, or 22%, in 2013 compared to 2012. Higher natural gas production volumes in 2013 increased revenues by $316 million, higher realized prices for our natural gas production increased revenue by $118 million, and higher oil production volumes in 2013 increased revenues by $6 million compared to 2012. We expect our natural gas production volumes to continue to increase due to the development of our Northeast and Southwest Appalachia properties. Natural gas and oil prices are difficult to predict and are subject to wide price fluctuations. As of February 24, 2015, we had hedged 240 Bcf of our remaining 2015 natural gas production to help limit our exposure to price fluctuations. For more information about our derivatives and risk management activities, we refer you to Note 5 to the consolidated financial statements included in this Annual Report and to “Commodity Prices” below for additional information. Production In 2014, our natural gas and oil production increased 17% to 768 Bcfe, up from 657 Bcfe in 2013. The 111 Bcfe increase in our 2014 production resulted from a 103 Bcf increase in net production from our Northeast Appalachia properties, and an 8 Bcf increase in net production from our Fayetteville Shale properties. In 2013, our natural gas and oil production increased to 657 Bcfe, up from 565 Bcfe in 2012. The 92 Bcfe increase in our 2013 production resulted from a 97 Bcf increase in net production from our Northeast Appalachia properties and a 2 Bcfe increase in net production in our New Ventures and Fayetteville Shale properties, which more than offset a combined 7 Bcfe decrease in net production from our East Texas and Arkoma Basin properties. Our net production from the Fayetteville Shale was 494 Bcf in 2014, up from 486 Bcf in 2013 and 2012. Our net production from Northeast Appalachia was 254 Bcf in 2014, up from 151 Bcf in 2013 and 54 Bcf in 2012. We are targeting 2015 natural gas and oil production of 940 to 955 Bcfe, an increase of approximately 23% over our 2014 production, using midpoints. Approximately 448 to 453 Bcf of our 2015 targeted natural gas production is projected to come from our activities in the Fayetteville Shale, 356 to 361 Bcf is projected to come from our activities in Northeast Appalachia and 136 to 141 Bcfe is projected to come from our activities in Southwest Appalachia. Although we expect production volumes in 2015 to increase, we cannot guarantee our success in discovering, developing and producing our total reserves. Our ability to discover, develop and produce reserves is dependent upon a number of factors, many of which are beyond our control, including the availability of capital, availability of transportation, weather, the timing and extent of changes in natural gas and oil prices and competition. There are also many risks inherent in the discovery, development and production of natural gas and oil. We refer you to “Risk Factors” in Item 1A of Part I of this Annual Report for a discussion of these risks and the impact they could have on our financial condition and results of operations. Commodity Prices The average price realized for our natural gas production, including the effects of hedges, increased 2% to $3.72 per Mcf in 2014 and increased 6% to $3.65 per Mcf in 2013. The increase in the average price realized in 2014 compared to 2013 and the increase in 2013 compared to 2012 primarily reflects the increase in average market prices and to a lesser extent the decreased effect of our natural gas price hedging activities. We periodically enter into various hedging and other financial arrangements with respect to a portion of our projected natural gas production in order to ensure certain desired levels of cash flow and to minimize the impact of price fluctuations, including fluctuations in locational market differentials. We refer you to

<s>[INST] OVERVIEW Background Southwestern Energy Company is an independent energy company engaged in natural gas and oil exploration, development and production, or E&P. We also focused on creating and capturing additional value through our natural gas gathering and marketing businesses, which we refer to as Midstream Services. We operate principally in two segments: E&P and Midstream Services. Our primary business is the exploration for and production of natural gas and oil, with our current operations principally focused within the United States on development of two unconventional natural gas reservoirs located in Arkansas and Pennsylvania. Our operations in Arkansas are primarily focused on an unconventional natural gas reservoir known as the Fayetteville Shale, and our operations in northeast Pennsylvania are focused on an unconventional natural gas reservoir known as the Marcellus Shale (herein referred to as “Northeast Appalachia”). Recently, we acquired a significant stake in properties located in West Virginia and southwest Pennsylvania which we also intend to develop. These operations in West Virginia are also focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs (herein referred to as “Southwest Appalachia”). Collectively, our properties located in West Virginia and Pennsylvania are herein referred to as the “Appalachian Basin.” To a lesser extent, we have exploration and production activities ongoing in Colorado, Louisiana, Texas and in the Arkoma Basin in Arkansas and Oklahoma. We also actively seek to find and develop new natural gas and oil plays with significant exploration and exploitation potential, which we refer to as “New Ventures,” and through acquisitions. We also operate drilling rigs in Arkansas and Pennsylvania, as well as in other operating areas, and provide oilfield products and services, principally serving our exploration and production operations. We are focused on providing longterm growth in the net asset value per share of our business. We derive the vast majority of our operating income and cash flow from the production associated with our E&P business and expect this to continue in the future. We expect that growth in our operating income and revenues will depend primarily on natural gas and oil prices and our ability to increase our production. We expect our production volumes will continue to increase due to ongoing development in our Fayetteville Shale, Northeast Appalachia and Southwest Appalachia divisions. The price we expect to receive for our production is a critical factor in the capital investments we make in order to develop our properties. In recent years, there has been significant volatility in natural gas prices as evidenced by New York Mercantile Exchange, or NYMEX, natural gas prices ranging from a high of $13.58 per MMBtu in 2008 to a low of $1.91 per MMBtu in 2012. Natural gas prices fluctuate due to a variety of factors we cannot control or predict. These factors, which include increased supplies of natural gas due to greater exploration and development activities, weather conditions, political and economic events, and competition from other energy sources, impact supply and demand for natural gas, which in turn determines the sale prices for our production. Going forward, we will be impacted by crude oil prices which have ranged from approximately $145 per barrel in July 2008 to approximately $45 per barrel in January 2015. In addition to the factors identified above, the prices we realize for our production are affected by our hedging activities as well as locational differences in market prices. Recent Financial and Operating Results In 2014, our net income was $924 million, or $2.62 per diluted share, up from net income of $704 million, or $2.00 per diluted share in 2013. Our net loss was $707 million, or $2.03 per diluted share in 2012. In 2012, we incurred a $1,940 million, or $1,192 million net of taxes, noncash ceiling test impairment of our United States natural gas and oil properties that resulted from a significant decline in natural gas prices during 2012. In 2014, our natural gas and oil production increased 17% to 768 Bcfe, up from 657 Bcfe in 2013. The [/INST] Negative. </s>

SOUTHWESTERN ENERGY CO

2016-02-25

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis is the Company’s analysis of its financial performance and of significant trends that may affect future performance. It should be read in conjunction with the financial statements and notes, and supplemental oil and gas disclosures included elsewhere in this report. It contains forward-looking statements including, without limitation, statements relating to the Company’s plans, strategies, objectives, expectations and intentions that are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The words “anticipate,” “intend,” “plan,” “project,” “estimate,” “continue,” “potential,” “should,” “could,” “may,” “will,” “objective,” “guidance,” “outlook,” “effort,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “forecast,” “target” or similar words identify forward-looking statements. The Company does not undertake to update, revise or correct any of the forward-looking information unless required to do so under the federal securities laws. Readers are cautioned that such forward-looking statements should be read in conjunction with the Company’s disclosures under the heading: “Cautionary Statement about Forward-Looking Statements.” OVERVIEW Background Southwestern Energy Company (including its subsidiaries, collectively, “we”, “our”, “us” or “Southwestern”) is an independent energy company engaged in natural gas and oil exploration, development and production, which we refer to as E&P. We are also focused on creating and capturing additional value through our natural gas gathering and marketing businesses, which we refer to as Midstream Services. We operate principally in two segments: E&P and Midstream Services. Our primary business is the exploration, development and production of natural gas and oil. Our current operations are principally focused on the development of unconventional natural gas reservoirs located in Pennsylvania, West Virginia and Arkansas. Our operations in northeast Pennsylvania, which we refer to as “Northeast Appalachia,” are primarily focused on the unconventional natural gas reservoir known as the Marcellus Shale. Our operations in West Virginia, which we refer to as “Southwest Appalachia,” are focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs. Collectively, we refer to our properties located in Pennsylvania and West Virginia as the “Appalachian Basin.” Our operations in Arkansas are primarily focused on an unconventional natural gas reservoir known as the Fayetteville Shale. We also actively seek to find and develop new natural gas and oil plays with significant exploration and exploitation potential, which we refer to as “New Ventures.” Under our New Ventures operations, we have exploration and production activities ongoing in Colorado and Louisiana, along with other areas in which we are currently exploring for new development opportunities. We operate drilling rigs and provide oilfield products and services, principally serving our exploration and production operations, though the level of these services in 2016 will depend upon our capital investing for the year. Our natural gas gathering and marketing activities primarily support our E&P activities in Arkansas, Pennsylvania, Louisiana and West Virginia. We are focused on providing long-term growth in the net asset value per share of our business. Historically, the vast majority of our operating income and cash flow has been derived from the production associated with our E&P business. However, in 2015, depressed commodity prices significantly decreased our E&P results of operations. The price we expect to receive for our production is a critical factor in the capital investments we make in order to develop our properties. In 2016, we expect to have decreased activity in the Appalachian Basin and the Fayetteville Shale as a result of the lower commodity price environment. We anticipate adjusting our activity levels throughout our portfolio and are targeting a capital investment program aligned with the cash flow expected to be generated during the year. Natural gas prices fluctuate due to a variety of factors we cannot control or predict. These factors, which include increased supplies of natural gas due to greater exploration and development activities, weather conditions, political and economic events, and competition from other energy sources, impact supply and demand for natural gas, which in turn determines the sales prices for our production. Going forward, we will be impacted by crude oil and natural gas liquids (“NGLs”) prices which have been volatile and have recently declined significantly. In addition to the factors identified above, the prices we realize for our production are affected by our hedging activities as well as locational differences in market prices, including basis differentials. Current 2016 forward pricing will likely result in additional impairments to our natural gas and oil properties in the first quarter of 2016 ranging from approximately $300 million to $500 million, net of tax, when excluding future changes in costs excluded from amortization, with likely material impairments continuing beyond the first quarter. Recent Financial and Operating Results In 2015, our net loss attributable to common stock was $4,662 million, or ($12.25) per diluted share, down from net income of $924 million, or $2.62 per diluted share, in 2014. Our net income was $704 million, or $2.00 per diluted share, in 2013. In 2015, we incurred non-cash impairments of our natural gas and oil properties totaling $6,950 million, or $4,287 million net of taxes, that resulted from a significant decline in natural gas prices during 2015. In 2015, our natural gas and liquids production increased 27% to 976 Bcfe, up from 768 Bcfe in 2014. The 208 Bcfe increase in our 2015 production resulted from a 140 Bcfe increase in net production from our Southwest Appalachia properties, a 106 Bcf increase in net production from our Northeast Appalachia properties and was offset by a 38 Bcfe decrease in net production from our Fayetteville Shale and other properties. In 2014, our natural gas and liquids production increased to 768 Bcfe, up from 657 Bcfe in 2013. The 111 Bcfe increase in our 2014 production resulted from a 103 Bcf increase in net production from our Northeast Appalachia properties and an 8 Bcf increase in net production from our Fayetteville Shale properties. Our year-end reserves decreased 42% in 2015 to 6,215 Bcfe, down from 10,747 Bcfe at the end of 2014 and 6,976 Bcfe at the end of 2013. The overall decrease in total estimated proved reserves in 2015 was primarily due to downward price revisions associated with decreased commodity prices, partially offset by upward performance revisions in Northeast and Southwest Appalachia. The overall increase in total estimated proved reserves in 2014 was primarily due to the acquisition of approximately 413,000 net acres in Southwest Appalachia which increased reserves by 33%, our successful drilling programs in the Fayetteville Shale and Northeast Appalachia and upward performance revisions in Northeast Appalachia where reserves grew 63% from 2013. Our E&P segment operating loss was $7,104 million in 2015, down from operating income of $1,013 million in 2014. The operating loss in 2015 included non-cash impairments of natural gas and oil properties totaling $6,950 million. Excluding the non-cash impairments, operating income in 2015 decreased $1,167 million from 2014 as the revenue impact of our 27%, or 208 Bcfe, increase in production was more than offset by a 36%, or $1.35, decrease in our average realized natural gas price and a $379 million increase in operating costs and expenses that resulted from our production growth. Operating income was $1,013 million in 2014, up from operating income of $879 million in 2013. Operating income in 2014 increased $134 million over 2013 as the revenue impact of our 17%, or 111 Bcfe, increase in production and 2%, or $0.07, increase in our average realized natural gas price more than offset the $324 million increase in operating costs that resulted from our production growth. In May 2015, we sold our conventional oil and gas assets located in East Texas and the Arkoma Basin that accounted for $27 and $21 million in operating income for the years ended December 31, 2014 and 2013, respectively. Operating income for our Midstream Services segment was $583 million in 2015, up from $361 million in 2014 and $325 million in 2013. Operating income for our Midstream Services segment increased in 2015 due to a $277 million net gain on sale of assets and a $13 million decrease in operating costs and expenses, exclusive of marketing purchase costs, partially offset by a decrease of $71 million in gathering revenues, which resulted from decreased volumes gathered. Volumes gathered decreased to 799 Bcf in 2015, compared to 963 Bcf in 2014. In the second quarter of 2015, we sold our northeast Pennsylvania and East Texas gathering assets that accounted for $13, $35 and $23 million in operating income for the years ended December 31, 2015, 2014 and 2013, respectively. A net gain of $277 million was recognized and is included in gain on sale of assets, net in the consolidated statement of operations. Operating income for our Midstream Services segment increased in 2014 due to an increase of $46 million in gathering revenues and a $12 million increase in the margin generated from our natural gas marketing activities, which was partially offset by a $22 million increase in operating costs and expenses, exclusive of natural gas purchase costs, that resulted from our growth in volumes gathered. Volumes gathered grew to 963 Bcf in 2014 compared to 900 Bcf in 2013. We had total capital investments of $2.4 billion in 2015, compared to $7.4 billion in 2014 and $2.2 billion in 2013. Of our total capital investments, $2.3 billion was invested in our E&P segment in 2015, which included $533 million related to acquisitions, compared to $7.3 billion in 2014, which included $5.2 billion primarily related to the December 2014 acquisition of certain oil and natural gas assets in Southwest Appalachia from Chesapeake Energy Corporation (the “Chesapeake Property Acquisition”), and $2.1 billion in 2013, which included $96 million primarily related to the acquisition of properties in Northeast Appalachia. Our Midstream Services capital investments for 2015 included $109 million related to the acquisition from WPX. Outlook We are exercising capital discipline by aligning our 2016 capital investing program within our expected cash flow. We will also look for opportunities to strengthen our balance sheet, maximize margins in each core area of our business and continue to seek alternative means to further our knowledge of our asset base. We believe that 2016 will be a challenging year for our business due to the depressed commodity price environment and continued uncertainty of natural gas and oil prices in the United States. However, we expect that our resource base, financial flexibility and disciplined investment of capital will position us for success when commodity prices ultimately recover. RESULTS OF OPERATIONS The following discussion of our results of operations for our segments is presented before intersegment eliminations. We evaluate our segments as if they were stand-alone operations and accordingly discuss their results prior to any intersegment eliminations. Interest expense and income tax expense are discussed on a consolidated basis. Exploration and Production (1) Represents the gain (loss) on derivatives, settled, associated with derivatives not designated for hedge accounting. (2) Including the gain (loss) on derivatives excluding derivatives, settled effects of commodity hedging contracts not designated for hedge accounting, results in an average price of $2.20, $3.90 and $3.68 for the years ended December 31, 2015, 2014 and 2013, respectively. Revenues Revenues for our E&P segment were down $788 million, or 28%, in 2015 compared to 2014. A decrease in the price realized from the sale of our natural gas production decreased revenue by $1,647 million in 2015, partially offset by an increase of $497 million due to higher natural gas production volumes and an increase of $235 million in hedge settlement proceeds. Additionally, there was a $328 million increase due to increased liquids production related to our Southwest Appalachia property acquisition partially offset by a $201 million decrease due to decreased liquids pricing. E&P revenues were up $458 million, or 19%, in 2014 compared to 2013. Higher natural gas production volumes in 2014 increased revenue by $403 million and higher realized prices for our natural gas production increased revenue by $55 million. In May 2015, we sold our conventional oil and gas assets located in East Texas and the Arkoma Basin that accounted for $15, $70 and $68 million of our gas and oil revenues for the years ended December 31, 2015, 2014 and 2013, respectively. In 2016, we expect to have decreased activity in our Appalachian Basin and Fayetteville Shale assets as a result of the lower commodity price environment. Production In 2015, our natural gas and liquids production increased 27% to 976 Bcfe, up from 768 Bcfe in 2014, and was produced entirely by our properties in the United States. The 208 Bcfe increase in our 2015 production resulted from a 140 Bcfe increase in net production from our Southwest Appalachia properties, a 106 Bcf increase in net production from our Northeast Appalachia properties, partially offset by 29 Bcf and 9 Bcfe decreases in net production in our Fayetteville Shale and other properties, respectively. In 2014, our natural gas and liquids production increased to 768 Bcfe, up from 657 Bcfe in 2013. The 111 Bcfe increase in our 2014 production resulted from a 103 Bcf increase in net production from our Northeast Appalachia properties and an 8 Bcfe increase in net production in our Fayetteville Shale and other properties. Our net production from Northeast Appalachia was 360 Bcf in 2015, up from 254 Bcf in 2014 and 151 Bcf in 2013. Our net production from Southwest Appalachia was 143 Bcfe in 2015, up from 3 Bcfe in 2014; we owned no properties in this area before late December 2014. Our net production from the Fayetteville Shale was 465 Bcf in 2015, down from 494 Bcf in 2014 and 486 Bcf in 2013. Natural gas accounted for approximately 92%, 100% and 100% of our total production for the years ended December 31, 2015, 2014 and 2013, respectively. Oil and NGLs accounted for 1% and 7%, respectively, of our total production for the year ended December 31, 2015. Our ability to discover, develop and produce reserves is dependent upon a number of factors, many of which are beyond our control, including the availability of capital, availability of transportation, weather, the timing and extent of changes in natural gas and oil prices and competition. There are also many risks inherent in the discovery, development and production of natural gas and oil. We refer you to “Risk Factors” in Item 1A of Part I of this Annual Report for a discussion of these risks and the impact they could have on our financial condition and results of operations. Commodity Prices The average price realized for our natural gas production, including the effects of hedges, decreased 36% to $2.37 per Mcf in 2015, compared to an increase of 2% in 2014 to $3.72 per Mcf from 2013 levels. The decrease in 2015 was the result of a $1.83 decrease in the average natural gas price, excluding hedges, partially offset by higher proceeds from our hedging activities in 2015 as compared to 2014. The increase in 2014 compared to 2013 was primarily the result of increased natural gas prices as our hedging activities marginally decreased our average realized price. In 2015, our hedging activities increased the average natural gas sales price we realized by $0.46 per Mcf, compared to a decrease of $0.02 per Mcf in 2014 and an increase of $0.48 per Mcf in 2013. Disregarding the impact of hedges, the average realized sales price we received for our natural gas production in 2015 was $1.83 per Mcf lower than 2014 and $0.75 lower than the average monthly NYMEX settlement price for 2015. Our E&P segment receives a sales price for our natural gas at a discount to average monthly NYMEX settlement prices due to heating content of the gas, locational basis differentials, transportation charges and fuel charges. Additionally, we receive a sales price for our oil and NGLs at a difference to average monthly West Texas Intermediate settlement and Mont Belvieu NGL composite prices, respectively, due to a number of factors including product quality, composition, and types of NGLs sold, locational basis differentials, transportation and fuel charges. We periodically enter into various hedging and other financial arrangements with respect to a portion of our projected natural gas production in order to ensure certain desired levels of cash flow and to minimize the impact of price fluctuations, including fluctuations in locational market differentials. We refer you to

<s>[INST] OVERVIEW Background Southwestern Energy Company (including its subsidiaries, collectively, “we”, “our”, “us” or “Southwestern”) is an independent energy company engaged in natural gas and oil exploration, development and production, which we refer to as E&P. We are also focused on creating and capturing additional value through our natural gas gathering and marketing businesses, which we refer to as Midstream Services. We operate principally in two segments: E&P and Midstream Services. Our primary business is the exploration, development and production of natural gas and oil. Our current operations are principally focused on the development of unconventional natural gas reservoirs located in Pennsylvania, West Virginia and Arkansas. Our operations in northeast Pennsylvania, which we refer to as “Northeast Appalachia,” are primarily focused on the unconventional natural gas reservoir known as the Marcellus Shale. Our operations in West Virginia, which we refer to as “Southwest Appalachia,” are focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs. Collectively, we refer to our properties located in Pennsylvania and West Virginia as the “Appalachian Basin.” Our operations in Arkansas are primarily focused on an unconventional natural gas reservoir known as the Fayetteville Shale. We also actively seek to find and develop new natural gas and oil plays with significant exploration and exploitation potential, which we refer to as “New Ventures.” Under our New Ventures operations, we have exploration and production activities ongoing in Colorado and Louisiana, along with other areas in which we are currently exploring for new development opportunities. We operate drilling rigs and provide oilfield products and services, principally serving our exploration and production operations, though the level of these services in 2016 will depend upon our capital investing for the year. Our natural gas gathering and marketing activities primarily support our E&P activities in Arkansas, Pennsylvania, Louisiana and West Virginia. We are focused on providing longterm growth in the net asset value per share of our business. Historically, the vast majority of our operating income and cash flow has been derived from the production associated with our E&P business. However, in 2015, depressed commodity prices significantly decreased our E&P results of operations. The price we expect to receive for our production is a critical factor in the capital investments we make in order to develop our properties. In 2016, we expect to have decreased activity in the Appalachian Basin and the Fayetteville Shale as a result of the lower commodity price environment. We anticipate adjusting our activity levels throughout our portfolio and are targeting a capital investment program aligned with the cash flow expected to be generated during the year. Natural gas prices fluctuate due to a variety of factors we cannot control or predict. These factors, which include increased supplies of natural gas due to greater exploration and development activities, weather conditions, political and economic events, and competition from other energy sources, impact supply and demand for natural gas, which in turn determines the sales prices for our production. Going forward, we will be impacted by crude oil and natural gas liquids (“NGLs”) prices which have been volatile and have recently declined significantly. In addition to the factors identified above, the prices we realize for our production are affected by our hedging activities as well as locational differences in market prices, including basis differentials. Current 2016 forward pricing will likely result in additional impairments to our natural gas and oil properties in the first quarter of 2016 ranging from approximately $300 million to $500 million, net of tax, when excluding future changes in costs excluded from amortization, with likely material impairments continuing beyond the first quarter. Recent Financial and Operating Results In 2015, our net loss attributable to common stock was $4,662 million, or ($12.25) per diluted share, down from net income of $924 million, or $2.62 per diluted share, in 2014. Our net income was $704 million, or $2.00 per diluted share, in 2013. In 2015, we incurred noncash impairments of our natural gas and oil properties [/INST] Negative. </s>

SOUTHWESTERN ENERGY CO

2017-02-23

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  Management’s Discussion and Analysis is the Company’s analysis of its financial performance and of significant trends that may affect future performance. It should be read in conjunction with the financial statements and notes, and supplemental oil and gas disclosures included elsewhere in this report. It contains forward-looking statements including, without limitation, statements relating to the Company’s plans, strategies, objectives, expectations and intentions that are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The words “anticipate,” “intend,” “plan,” “project,” “estimate,” “continue,” “potential,” “should,” “could,” “may,” “will,” “objective,” “guidance,” “outlook,” “effort,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “forecast,” “target” or similar words identify forward-looking statements. The Company does not undertake to update, revise or correct any of the forward-looking information unless required to do so under the federal securities laws. Readers are cautioned that such forward-looking statements should be read in conjunction with the Company’s disclosures under the heading: “Cautionary Statement about Forward-Looking Statements.”  OVERVIEW  Background  Southwestern Energy Company (including its subsidiaries, collectively, “we”, “our”, “us” or “Southwestern”) is an independent energy company engaged in natural gas, oil and NGL exploration, development and production, which we refer to as “E&P.” We are also focused on creating and capturing additional value through our natural gas gathering and marketing businesses, which we refer to as “Midstream Services.” We conduct most of our businesses through subsidiaries and we operate principally in two segments: E&P and Midstream Services. Currently we operate only in the United States.  Exploration and Production. Our primary business is the exploration for and production of natural gas, oil and NGLs, with our current operations principally focused on the development of unconventional natural gas reservoirs located in Pennsylvania, West Virginia and Arkansas. Our operations in northeast Pennsylvania, which we refer to as “Northeast Appalachia,” are primarily focused on the unconventional natural gas reservoir known as the Marcellus Shale. Our operations in West Virginia and southwest Pennsylvania, which we refer to as “Southwest Appalachia,” are focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs. Collectively, we refer to our properties located in Pennsylvania and West Virginia as the “Appalachian Basin.” Our operations in Arkansas are primarily focused on an unconventional natural gas reservoir known as the Fayetteville Shale. We have smaller holdings in Colorado and Louisiana, along with other areas in which we are testing potential new resources. We also have drilling rigs located in Pennsylvania, West Virginia and Arkansas and provide oilfield products and services, principally serving our E&P operations.  Midstream Services. Through our affiliated midstream subsidiaries, we engage in natural gas gathering activities in Arkansas and Louisiana. These activities primarily support our E&P operations and generate revenue from fees associated with the gathering of natural gas. Our marketing activities capture opportunities that arise through the marketing and transportation of natural gas, oil, and NGLs produced in our E&P operations.  We are focused on providing long-term growth in the net asset value per share of our business. Historically, the vast majority of our operating income and cash flow has been derived from the production associated with our E&P business. However, beginning in 2015 and continuing through 2016, depressed commodity prices significantly decreased our E&P results of operations. The price we expect to receive for our production is a critical factor in the capital investments we make to develop our properties. The current commodity price environment has resulted in the impairment of a significant portion of our natural gas and oil properties over recent reporting periods. Commodity prices fluctuate due to a variety of factors we cannot control or predict. These factors, which include increased supplies of natural gas, oil or NGLs due to greater exploration and development activities, weather conditions, political and economic events, and competition from other energy sources, impact supply and demand, which in turn determines the sales prices for our production. In addition to the factors identified above, the prices we realize for our production are affected by our hedging activities as well as locational differences in market prices, including basis differentials. Our 2016 results also reflect reduced costs of third-party services we were able to negotiate during the downturn in the industry. As industry activity increases, demand for these services also increases, and these service providers are likely to seek higher prices than we were able to obtain in 2016.  Beginning in the fourth quarter of 2015, we decreased activity in the Appalachian Basin and the Fayetteville Shale as a result of the lower commodity price environment. During the first half of 2016, we took steps to refocus the Company through a 40% reduction in our workforce, executive management restructuring and a commitment to strengthen our balance sheet by addressing potential near-term liquidity challenges, as we waited for commodity prices to recover. With the successful implementation of our debt reduction strategy, along with improving forward pricing, we began increasing our activity in the third quarter of 2016, and expect to continue these operations in 2017. During the second half of 2016, we increased our hedging activity designed to assure certain desired levels of cash flow.  Recent Financial and Operating Results  In 2016, our net loss attributable to common stock was $2,751 million, or ($6.32) per diluted share, a decrease from a net loss of $4,662 million, or ($12.25) per diluted share, in 2015. Our net income was $924 million, or $2.62 per diluted share, in 2014. We incurred non-cash impairments of our natural gas and oil properties totaling $2,321 million, or $1,444 million net of taxes, in 2016 and $6,950 million, or $4,287 million net of taxes, in 2015, which resulted primarily from the significant decline in natural gas prices.  In 2016, our natural gas and liquids production totaled 875 Bcfe, a decrease of 10% from 976 Bcfe in 2015. The 101 Bcfe decrease in our 2016 production resulted from a 96 Bcfe decrease in net production from our Fayetteville Shale and other properties and a 10 Bcf decrease in net production from our Northeast Appalachia properties, partially offset by a 5 Bcfe increase in net production from our Southwest Appalachia properties. The reductions resulted primarily from the suspension of drilling activities in the first half of 2016. Our 2015 total natural gas and liquids production of 976 Bcfe increased 27% from 768 Bcfe in 2014. The 208 Bcfe increase in our 2015 production resulted from a 140 Bcfe increase in net production from our Southwest Appalachia properties, a 106 Bcf increase in net production from our Northeast Appalachia properties and was partially offset by a 38 Bcfe decrease in net production from our Fayetteville Shale and other properties.  Our year-end reserves decreased 15% in 2016 to 5,253 Bcfe from 6,215 Bcfe at the end of 2015 and 10,747 Bcfe at the end of 2014. The overall decrease in total estimated proved reserves in 2016 was primarily due to production and downward price revisions associated with decreased commodity prices, partially offset by upward performance revisions in Northeast and Southwest Appalachia and the Fayetteville Shale. The overall decrease in total estimated proved reserves in 2015 was primarily due to downward revisions associated with decreased commodity prices, partially offset by upward performance revisions in Northeast and Southwest Appalachia.  Our E&P segment operating loss was $2,404 million in 2016, a decrease from an operating loss of $7,104 million in 2015. The operating loss in 2016 included non-cash impairments of natural gas and oil properties totaling $2,321 million. Excluding the non-cash impairments, our E&P segment operating loss decreased to $83 million in 2016 from $154 million in 2015 as the $732 million decrease in operating costs and expenses and $19 million increase in NGL revenues was only partially offset by a 31%, or $0.73 per Mcf, decrease in our average realized natural gas price, a 12%, or 111 Bcf, decrease in natural gas production and a $7 million decrease in oil revenues. Our E&P segment operating loss was $7,104 million in 2015, a decrease from operating income of $1,013 million in 2014. Excluding the non-cash impairments, operating income in 2015 decreased $1,167 million over 2014 as the revenue impact of our 27%, or 208 Bcfe, increase in production was more than offset by a 36%, or $1.35, decrease in our average realized natural gas price and a $379 million increase in operating costs and expenses that resulted from our production growth. In May 2015, we sold our conventional oil and gas assets located in East Texas and the Arkoma Basin that accounted for $27 million in operating income for the year ended December 31, 2014.  Operating income for our Midstream Services segment was $209 million in 2016, a decrease from $583 million in 2015 and $361 million in 2014. Operating income in 2015 includes a $277 million net gain related to the sale of our northeast Pennsylvania and East Texas gathering assets. Excluding the gain on sales, our Midstream Services segment operating income decreased $97 million primarily due to decreased volumes gathered and decreased marketing margin, partially offset by a $32 million decrease in operating costs and expenses, exclusive of marketing purchase costs. Volumes gathered decreased to 601 Bcf in 2016, compared to 799 Bcf in 2015. Excluding the gain on sales, operating income for our Midstream Services segment decreased in 2015 primarily due to a $71 million decrease in gathering revenues, which resulted from decreased volumes gathered, partially offset by a $13 million decrease in operating costs and expenses, exclusive of marketing purchase costs. Volumes gathered decreased to 799 Bcf in 2015, compared to 963 Bcf in 2014. In the second quarter of 2015, we sold our northeastern Pennsylvania and East Texas gathering assets that accounted for $13 million and $35 million in operating income for the years ended December 31, 2015 and 2014, respectively. A net gain of $277 million was recognized and is included in gain on sale of assets, net in the consolidated statement of operations.  We had total capital investments of $648 million in 2016, compared to $2.4 billion in 2015 and $7.4 billion in 2014. Of our total capital investments for 2016, $623 million was invested in our E&P segment, which included $152 million related to capitalized interest and $87 million in capitalized expenses. Of our total capital investments in 2015, $2.3 billion was invested in our E&P segment, which included $533 million related to acquisitions from WPX Energy, Inc. (“WPX” with acquisition called the “WPX Property Acquisition”) and Statoil ASA (“Statoil” with the acquisition called “Statoil Property Acquisition”), compared to $7.3 billion in 2014, which included $5.2 billion primarily related to the December 2014 acquisition of certain oil and natural gas assets in Southwest Appalachia from Chesapeake Energy Corporation (the “Chesapeake Property Acquisition”). Our Midstream Services capital investments for 2015 included $109 million related to the WPX Property Acquisition.  Outlook  We expect to continue to exercise capital discipline by aligning our 2017 capital investing program with our expected cash flow from operations and the remaining funds from our equity offering and sale of West Virginia assets. We will also look for opportunities to further strengthen our balance sheet, maximize margins in each core area of our business and further develop our knowledge of our asset base. We believe that 2017 will continue to be a challenging year for our business due to the commodity price environment and continued uncertainty of natural gas, oil and NGL prices in the United States. However, we expect that our resource base, financial flexibility and disciplined investment of capital will position us for success in the current environment and any improvements thereto.  RESULTS OF OPERATIONS  The following discussion of our results of operations for our segments is presented before intersegment eliminations. We evaluate our segments as if they were stand-alone operations and accordingly discuss their results prior to any intersegment eliminations. Interest expense and income tax expense are discussed on a consolidated basis.  Exploration and Production   (1) Includes $86 million of restructuring and other one-time charges for the year ended December 31, 2016. (2) Represents the gain (loss) on settled commodity derivatives. (3) Includes the gain (loss) on settled commodity derivatives. (4) Excludes $83 million of restructuring and other one-time charges for the year ended December 31, 2016. (5) Excludes $3 million of restructuring charges for the year ended December 31, 2016.  Revenues  Revenues for our E&P segment were $1,413 million in 2016, a decrease of 32% compared to 2015. Revenues decreased by $248 million as a result of decreased realized natural gas pricing, excluding the effects of derivatives, $212 million as a result of decreased natural gas production, $209 million as a result of decreased derivative settlement proceeds, $7 million as a result of decreased oil production and realized price and $4 million as a result of decreased other operating revenue. These decreases were partially offset by an increase of $19 million in NGL sales resulting from increased production and realized price. Revenues for our E&P segment were $2,074 million in 2015, a decrease of 28% compared to 2014. A decrease in the price realized from the sale of our natural gas production decreased revenue by $1,647 million in 2015, partially offset by an increase of $497 million due to higher natural gas production volumes and an increase of $235 million in hedge settlement proceeds. Additionally, there was a $328 million increase due to increased net NGL and oil production related to our Southwest Appalachia property acquisition partially offset by a $201 million decrease due to decreased net NGL and oil pricing. Natural gas, oil and NGL prices are difficult to predict and are subject to wide price fluctuations. We refer you to Note 4 to the consolidated financial statements included in this Annual Report and to the discussion of “Commodity Prices” provided below for additional information. In May 2015, we sold our conventional oil and gas assets located in East Texas and the Arkoma Basin that accounted for $15 million and $70 million of our gas and oil revenues for the years ended December 31, 2015 and 2014, respectively.  Production  In 2016, our natural gas and liquids production totaled 875 Bcfe, a 10% decrease from 976 Bcfe in 2015, and was produced entirely by our properties in the United States. The 101 Bcfe decrease was primarily due to a 96 Bcfe decrease in net production from our Fayetteville Shale and other properties and a 10 Bcf decrease in net production from our Northeast Appalachia properties, partially offset by a 5 Bcfe increase in net production from our Southwest Appalachia properties. Net production from our Northeast Appalachia, Southwest Appalachia and Fayetteville Shale properties was 350 Bcf, 148 Bcfe and 375 Bcf, respectively, for the year ended 2016, compared to 360 Bcf, 143 Bcfe, and 465 Bcf, respectively, for 2015. The reductions resulted primarily from the suspension of drilling activities in the first half of 2016. Our 2015 total natural gas and liquids production of 976 Bcfe increased 27% from 768 Bcfe in 2014, and was also produced entirely by our properties in the United States. The 208 Bcfe increase in our 2015 production resulted from a 140 Bcfe increase in net production from our Southwest Appalachia properties and a 106 Bcf increase in net production from our Northeast Appalachia properties, partially offset by a 38 Bcfe decrease in net production in our Fayetteville Shale and other properties. Net production for 2014 from our Northeast Appalachia, Southwest Appalachia and Fayetteville Shale properties was 254 Bcf, 3 Bcfe and 494 Bcf, respectively.  Natural gas accounted for approximately 90%, 92% and 100% of our total production for the years ended December 31, 2016, 2015 and 2014, respectively. Oil accounted for 2% and 1% of our total production for the years ended December 31, 2016 and 2015, respectively. NGLs accounted for 8% and 7% of our total production for the years ended December 31, 2016 and 2015, respectively.  Our ability to identify, develop and produce reserves is dependent upon a number of factors, many of which are beyond our control, including the availability of capital, availability of transportation, weather, the timing and extent of changes in natural gas, oil and NGL prices and competition. There are also many risks inherent in the discovery, development and production of natural gas, oil and NGLs. We refer you to “Risk Factors” in Item 1A of Part I of this Annual Report for a discussion of these risks and the impact they could have on our financial condition and results of operations.  Commodity Prices  The average price realized for our natural gas production, after the effects of derivatives, decreased 31% to $1.64 per Mcf in 2016, compared to a decrease of 36% to $2.37 per Mcf in 2015 from 2014 levels. The decrease in 2016 was the result of a $0.32 per Mcf decrease in the average natural gas price, excluding derivatives, and lower proceeds from our hedging program in 2016 as compared to 2015. The decrease in 2015 was the result of a $1.83 per Mcf decrease in the average natural gas price, excluding derivatives, partially offset by higher proceeds from our hedging program in 2015 as compared to 2014. In 2016, our derivatives increased the average natural gas price we realized by $0.05 per Mcf, compared to an increase of $0.46 per Mcf in 2015 and a decrease of $0.02 per Mcf in 2014.  Our E&P segment receives a sales price for our natural gas at a discount to average monthly NYMEX settlement prices due to heating content of the gas, locational basis differentials, transportation charges and fuel charges. Additionally, we receive a sales price for our oil and NGLs at a difference to average monthly West Texas Intermediate settlement and Mont Belvieu NGL composite prices, respectively, due to a number of factors including product quality, composition, and types of NGLs sold, locational basis differentials, transportation and fuel charges. We regularly enter into various hedging and other financial arrangements with respect to a portion of our projected natural gas production in order to ensure certain desired levels of cash flow and to minimize the impact of price fluctuations, including fluctuations in locational market differentials. We refer you to

<s>[INST] Management’s Discussion and Analysis is the Company’s analysis of its financial performance and of significant trends that may affect future performance. It should be read in conjunction with the financial statements and notes, and supplemental oil and gas disclosures included elsewhere in this report. It contains forwardlooking statements including, without limitation, statements relating to the Company’s plans, strategies, objectives, expectations and intentions that are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The words “anticipate,” “intend,” “plan,” “project,” “estimate,” “continue,” “potential,” “should,” “could,” “may,” “will,” “objective,” “guidance,” “outlook,” “effort,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “forecast,” “target” or similar words identify forwardlooking statements. The Company does not undertake to update, revise or correct any of the forwardlooking information unless required to do so under the federal securities laws. Readers are cautioned that such forwardlooking statements should be read in conjunction with the Company’s disclosures under the heading: “Cautionary Statement about ForwardLooking Statements.”  OVERVIEW  Background  Southwestern Energy Company (including its subsidiaries, collectively, “we”, “our”, “us” or “Southwestern”) is an independent energy company engaged in natural gas, oil and NGL exploration, development and production, which we refer to as “E&P.” We are also focused on creating and capturing additional value through our natural gas gathering and marketing businesses, which we refer to as “Midstream Services.” We conduct most of our businesses through subsidiaries and we operate principally in two segments: E&P and Midstream Services. Currently we operate only in the United States.  Exploration and Production. Our primary business is the exploration for and production of natural gas, oil and NGLs, with our current operations principally focused on the development of unconventional natural gas reservoirs located in Pennsylvania, West Virginia and Arkansas. Our operations in northeast Pennsylvania, which we refer to as “Northeast Appalachia,” are primarily focused on the unconventional natural gas reservoir known as the Marcellus Shale. Our operations in West Virginia and southwest Pennsylvania, which we refer to as “Southwest Appalachia,” are focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs. Collectively, we refer to our properties located in Pennsylvania and West Virginia as the “Appalachian Basin.” Our operations in Arkansas are primarily focused on an unconventional natural gas reservoir known as the Fayetteville Shale. We have smaller holdings in Colorado and Louisiana, along with other areas in which we are testing potential new resources. We also have drilling rigs located in Pennsylvania, West Virginia and Arkansas and provide oilfield products and services, principally serving our E&P operations.  Midstream Services. Through our affiliated midstream subsidiaries, we engage in natural gas gathering activities in Arkansas and Louisiana. These activities primarily support our E&P operations and generate revenue from fees associated with the gathering of natural gas. Our marketing activities capture opportunities that arise through the marketing and transportation of natural gas, oil, and NGLs produced in our E&P operations.  We are focused on providing longterm growth in the net asset value per share of our business. Historically, the vast majority of our operating income and cash flow has been derived from the production associated with our E&P business. However, beginning in 2015 and continuing through 2016, depressed commodity prices significantly decreased our E&P results of operations. The price we expect to receive for our production is a critical factor in the capital investments we make to develop our properties. The current commodity price environment has resulted in the impairment of a significant portion of our natural gas and oil properties over recent reporting periods. Commodity prices fluctuate due to a variety of factors we cannot control or predict. These factors, which include increased supplies of natural gas, oil or NGLs due to greater exploration and development activities, weather conditions, political and economic events, and competition from other energy sources, impact supply and demand, which in turn determines the [/INST] Negative. </s>

SOUTHWESTERN ENERGY CO

2018-03-01

2018-03-01

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  Management’s Discussion and Analysis is the Company’s analysis of its financial performance and of significant trends that may affect future performance. It should be read in conjunction with the financial statements and notes, and supplemental oil and gas disclosures included elsewhere in this report. It contains forward-looking statements including, without limitation, statements relating to the Company’s plans, strategies, objectives, expectations and intentions that are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. In many cases you can identify forward-looking statements by words such as “anticipate,” “intend,” “plan,” “project,” “estimate,” “continue,” “potential,” “should,” “could,” “may,” “will,” “objective,” “guidance,” “outlook,” “effort,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “forecast,” “target” or similar words. Unless required to do so under the federal securities laws, the Company does not undertake to update, revise or correct any forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned that such forward-looking statements should be read in conjunction with the Company’s disclosures under the heading: “Cautionary Statement about Forward-Looking Statements.”  OVERVIEW  Background  Southwestern Energy Company (including its subsidiaries, collectively, “we”, “our”, “us”, “the Company” or “Southwestern”) is an independent energy company engaged in natural gas, oil and NGL exploration, development and production, which we refer to as “E&P.” We are also focused on creating and capturing additional value through our natural gas gathering and marketing businesses, which we refer to as “Midstream.” We conduct most of our businesses through subsidiaries, and we currently operate exclusively in the United States.  Exploration and Production. Our primary business is the exploration for and production of natural gas, oil and NGLs, with our current operations focused on the development of unconventional natural gas reservoirs located in Pennsylvania, West Virginia and Arkansas. Our operations in northeast Pennsylvania, which we refer to as “Northeast Appalachia,” are primarily focused on the unconventional natural gas reservoir known as the Marcellus Shale. Our operations in West Virginia and southwest Pennsylvania, which we refer to as “Southwest Appalachia,” are focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs. Our operations in Arkansas are primarily focused on an unconventional natural gas reservoir known as the Fayetteville Shale. We have smaller holdings in Colorado and Louisiana, along with other areas in which we are testing potential new resources. We also have drilling rigs located in Pennsylvania, West Virginia and Arkansas, and we provide certain oilfield products and services, principally serving our E&P operations.  Midstream. Through our affiliated midstream subsidiaries, we engage in natural gas gathering activities in Arkansas and Louisiana. These activities primarily support our E&P operations and generate revenue from fees associated with the gathering of natural gas. Our marketing activities capture opportunities that arise through the marketing and transportation of natural gas, oil, and NGLs produced in our E&P operations.  In 2017, we focused on our core strategies of capital discipline, operational and technical excellence, margin expansion, strengthening the balance sheet and risk management. Our 2017 capital investment program was fully funded from our operating cash flows, supplemented by the remaining proceeds from our July 2016 equity issuance. We made technological advances in drilling precision and completion optimization that enhanced well productivity and economics, resulting in improved returns. We improved our debt maturity profile, leaving approximately $92 million in bond debt due prior to 2022 with no significant other debt maturities expected before December 2020, and added to our derivative portfolio, protecting approximately 489 Bcf and 201 Bcf of our forecasted 2018 and 2019 natural gas production, respectively, from price volatility through the use of commodity derivatives. Recent Financial and Operating Results  Significant operating and financial highlights for 2017 include:  Total Company  · Net income attributable to common stock of $816 million, or $1.63 per diluted share, improved substantially from a net loss attributable to common stock of $2,751 million, or ($6.32) per diluted share, in 2016.  · Net cash provided by operating activities of $1,097 million was up 120% from $498 million in 2016.  · Total capital investing of $1,293 million was up 100% from $648 million in 2016.  · We retired the remaining outstanding balance of $316 million of our near-term senior notes due 2017 and 2018.  · We extended the maturities on our debt profile by issuing approximately $1.15 billion in senior notes due 2026 and 2027 and using the net proceeds to repurchase $758 million of our senior notes due 2020 and to repay the outstanding balance of $327 million on our 2015 Term Loan.  Exploration and Production  · E&P segment operating income of $549 million improved substantially from an operating loss of $2,404 million in 2016.  · Year-end reserves of 14,775 Bcfe increased 181% from 5,253 Bcfe at the end of 2016.  · Total net production from our Appalachian Basin of 578 Bcfe was up 16% from 498 Bcfe in 2016.  · Realized NGL prices increased 94% from 2016.  Outlook  In February 2018, we announced several strategic steps to reposition our portfolio, sharpen our focus on our highest return assets, strengthen our balance sheet and enhance financial performance. These initiatives include:  · Actively pursuing strategic alternatives for the Fayetteville Shale E&P and related Midstream gathering assets;  · Identifying and implementing structural, process and organizational changes to further reduce costs; and  · Utilizing funds realized from the foregoing to reduce debt, supplement Appalachian Basin development capital, potentially return capital to shareholders, and for general corporate purposes.  We expect to continue to exercise capital discipline by aligning our 2018 capital investing program with our expected cash flow from operations net of changes in working capital. We will also look for opportunities to maximize margins in each core area of our business and further develop our knowledge of our asset base. We believe that 2018 will continue to be a challenging year for our business due to the commodity price environment and continued uncertainty of natural gas, oil and NGL prices in the United States.  RESULTS OF OPERATIONS  The following discussion of our results of operations for our segments is presented before intersegment eliminations. We evaluate our segments as if they were stand-alone operations and accordingly discuss their results prior to any intersegment eliminations. Interest expense and income tax expense are discussed on a consolidated basis.  Exploration and Production    (1) Includes $86 million of restructuring and other one-time charges for the year ended December 31, 2016. (2) Represents the gain (loss) on settled commodity derivatives, and includes $5 million amortization of premiums paid related to certain call options for the year ended December 31, 2017.  Operating Income  · E&P segment operating income for years ended December 31, 2016 and 2015 includes impairments of natural gas and oil properties of $2.3 billion and $7.0 billion, respectively. Excluding the 2016 impairment, our E&P segment operating income increased $632 million for year ended December 31, 2017, compared to the same period in 2016, primarily due to a $673 million increase in revenues, partially offset by a $41 million increase in operating costs.  · Excluding the 2016 and 2015 impairments, our E&P segment operating income increased $71 million for the year ended December 31, 2016, compared to the same period in 2015, as a $661 million decrease in revenues was more than offset by a $732 million decrease in operating costs.  Revenues  The following illustrate the effects on sales revenues associated with changes in commodity prices and production volumes:   (1) Includes $209 million of gains associated with settled derivatives designated for hedge accounting, which were presented on the 2015 consolidated statements of operations as gas sales. There were no derivatives designated for hedge accounting in 2017 or 2016.  In addition to the sales revenues detailed above, our E&P segment had $4 million of other operating revenues, primarily related to water sales to third-party operators for the year ended December 31, 2017, and $2 million of gathering revenues for the year ended December 31, 2015. Production Volumes   · Production volumes for our E&P segment increased by 22 Bcfe for the year ended December 31, 2017, compared to the same period in 2016, as increased production volumes from Northeast and Southwest Appalachia more than offset decreased natural gas production volumes in the Fayetteville Shale.  · E&P segment production volumes decreased 101 Bcfe for the year ended December 31, 2016, compared to the same period in 2015, as decreased natural gas production volumes in the Fayetteville Shale and Northeast Appalachia more than offset increased production volumes from Southwest Appalachia.  Commodity Prices  The price we expect to receive for our production is a critical factor in determining the capital investments we make to develop our properties. Commodity prices fluctuate due to a variety of factors we cannot control or predict, including increased supplies of natural gas, oil or NGLs due to greater exploration and development activities, weather conditions, political and economic events, and competition from other energy sources. These factors impact supply and demand, which in turn determine the sales prices for our production. In addition to these factors, the prices we realize for our production are affected by our hedging activities as well as locational differences in market prices, including basis differentials. We will continue to evaluate the commodity price environments and adjust the pace of our activity to invest within cash flows in order to maintain appropriate liquidity and financial flexibility.    · Our average price realized for natural gas production, including the effect of derivatives, increased for the year ended December 31, 2017, compared to the same period in 2016, due to a $0.64 per Mcf increase in the average realized price, excluding derivatives, partially offset by a $0.09 per Mcf decrease associated with our settled derivatives.  · The average price realized for our crude oil production increased by $11.92 per Bbl for the year ended December 31, 2017, compared to the same period in 2016. We did not use derivatives to financially protect our 2017, 2016 or 2015 oil production.  · Our average price realized for NGL production, including the effect of derivatives, increased for the year ended December 31, 2017, compared to the same period in 2016, due to a $7.00 per Bbl increase in the average realized price, excluding derivatives, and a $0.02 per Mcf increase associated with our settled derivatives. We did not use derivatives to financially protect our 2016 or 2015 NGL production.  Our E&P segment receives a sales price for our natural gas at a discount to average monthly NYMEX settlement prices based on heating content of the gas, locational basis differentials, transportation and fuel charges. Additionally, we receive a sales price for our oil and NGLs at a difference to average monthly West Texas Intermediate settlement and Mont Belvieu NGL composite prices, respectively, due to a number of factors including product quality, composition and types of NGLs sold, locational basis differentials, transportation and fuel charges.  · Excluding the impact of derivatives, the average price received for our natural gas production for the year ended December 31, 2017 of $2.23 per Mcf was approximately $0.88 per Mcf lower than the average monthly NYMEX settlement price, primarily due to locational basis differentials and transportation charges. In comparison, the average price received for our natural gas production for the same period in 2016 of $1.59 per Mcf was approximately $0.87 per Mcf lower than the average monthly NYMEX settlement price.  We regularly enter into various hedging and other financial arrangements with respect to a portion of our projected natural gas production in order to ensure certain desired levels of cash flow and to minimize the impact of price fluctuations, including fluctuations in locational market differentials. We refer you to

<s>[INST] Management’s Discussion and Analysis is the Company’s analysis of its financial performance and of significant trends that may affect future performance. It should be read in conjunction with the financial statements and notes, and supplemental oil and gas disclosures included elsewhere in this report. It contains forwardlooking statements including, without limitation, statements relating to the Company’s plans, strategies, objectives, expectations and intentions that are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. In many cases you can identify forwardlooking statements by words such as “anticipate,” “intend,” “plan,” “project,” “estimate,” “continue,” “potential,” “should,” “could,” “may,” “will,” “objective,” “guidance,” “outlook,” “effort,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “forecast,” “target” or similar words. Unless required to do so under the federal securities laws, the Company does not undertake to update, revise or correct any forwardlooking statements, whether as a result of new information, future events or otherwise. Readers are cautioned that such forwardlooking statements should be read in conjunction with the Company’s disclosures under the heading: “Cautionary Statement about ForwardLooking Statements.”  OVERVIEW  Background  Southwestern Energy Company (including its subsidiaries, collectively, “we”, “our”, “us”, “the Company” or “Southwestern”) is an independent energy company engaged in natural gas, oil and NGL exploration, development and production, which we refer to as “E&P.” We are also focused on creating and capturing additional value through our natural gas gathering and marketing businesses, which we refer to as “Midstream.” We conduct most of our businesses through subsidiaries, and we currently operate exclusively in the United States.  Exploration and Production. Our primary business is the exploration for and production of natural gas, oil and NGLs, with our current operations focused on the development of unconventional natural gas reservoirs located in Pennsylvania, West Virginia and Arkansas. Our operations in northeast Pennsylvania, which we refer to as “Northeast Appalachia,” are primarily focused on the unconventional natural gas reservoir known as the Marcellus Shale. Our operations in West Virginia and southwest Pennsylvania, which we refer to as “Southwest Appalachia,” are focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs. Our operations in Arkansas are primarily focused on an unconventional natural gas reservoir known as the Fayetteville Shale. We have smaller holdings in Colorado and Louisiana, along with other areas in which we are testing potential new resources. We also have drilling rigs located in Pennsylvania, West Virginia and Arkansas, and we provide certain oilfield products and services, principally serving our E&P operations.  Midstream. Through our affiliated midstream subsidiaries, we engage in natural gas gathering activities in Arkansas and Louisiana. These activities primarily support our E&P operations and generate revenue from fees associated with the gathering of natural gas. Our marketing activities capture opportunities that arise through the marketing and transportation of natural gas, oil, and NGLs produced in our E&P operations.  In 2017, we focused on our core strategies of capital discipline, operational and technical excellence, margin expansion, strengthening the balance sheet and risk management. Our 2017 capital investment program was fully funded from our operating cash flows, supplemented by the remaining proceeds from our July 2016 equity issuance. We made technological advances in drilling precision and completion optimization that enhanced well productivity and economics, resulting in improved returns. We improved our debt maturity profile, leaving approximately $92 million in bond debt due prior to 2022 with no significant other debt maturities expected before December 2020, and added to our derivative portfolio, protecting approximately 489 Bcf and 201 Bcf of our forecasted 2018 and 2019 natural gas production, respectively, from price volatility through the use of commodity derivatives. [/INST] Positive. </s>

SOUTHWESTERN ENERGY CO

2019-02-28

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  Management’s Discussion and Analysis is the Company’s analysis of its financial performance and of significant trends that may affect future performance. It should be read in conjunction with the financial statements and notes, and supplemental oil and gas disclosures included elsewhere in this report. It contains forward-looking statements including, without limitation, statements relating to the Company’s plans, strategies, objectives, expectations and intentions that are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. In many cases you can identify forward-looking statements by words such as “anticipate,” “intend,” “plan,” “project,” “estimate,” “continue,” “potential,” “should,” “could,” “may,” “will,” “objective,” “guidance,” “outlook,” “effort,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “forecast,” “target” or similar words. Unless required to do so under the federal securities laws, the Company does not undertake to update, revise or correct any forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned that such forward-looking statements should be read in conjunction with the Company’s disclosures under the heading: “Cautionary Statement about Forward-Looking Statements.”  OVERVIEW  Background  Southwestern Energy Company (including its subsidiaries, collectively, “we,” “our,” “us,” “the Company” or “Southwestern”) is an independent energy company engaged in natural gas, oil and NGL exploration, development and production, which we refer to as “E&P.” We are also focused on creating and capturing additional value through our marketing business, which we refer to as “Midstream.” We conduct most of our businesses through subsidiaries, and we currently operate exclusively in the United States.  E&P. Our primary business is the exploration for and production of natural gas, oil and NGLs, with our ongoing operations focused on the development of unconventional natural gas reservoirs located in Pennsylvania and West Virginia. Our operations in northeast Pennsylvania, which we refer to as “Northeast Appalachia,” are primarily focused on the unconventional natural gas reservoir known as the Marcellus Shale. Our operations in West Virginia and southwest Pennsylvania, which we refer to as “Southwest Appalachia,” are focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs. Collectively, our properties in Pennsylvania and West Virginia are herein referred to as the “Appalachian Basin.” We also have drilling rigs located in Pennsylvania and West Virginia, and we provide certain oilfield products and services, principally serving our E&P operations though vertical integration.  On August 30, 2018, we entered into an agreement to sell 100% of the equity in certain of our subsidiaries that conducted our operations in Arkansas, which were primarily focused on an unconventional natural gas reservoir known as the Fayetteville Shale, for $1,865 million, subject to customary adjustments. In early December 2018, we completed the Fayetteville Shale sale, resulting in net proceeds of $1,650 million, following adjustments due primarily to the net cash flows from the economic effective date of July 1, 2018, to the closing date. Midstream. Our marketing activities capture opportunities that arise through the marketing and transportation of natural gas, oil, and NGLs produced in our E&P operations. In December 2018, we divested almost all of our gathering assets as part of the Fayetteville Shale sale.  Changes in 2018. At the beginning of 2018, we announced our strategy to reposition the Company through portfolio optimization, balance sheet management and leveraging our technical, commercial and operational expertise to improve margins. We sharpened our focus on developing our high-value, liquids-rich Appalachian basin assets. We strengthened our balance sheet through asset monetization and debt reduction by entering into a new reserve-based credit facility and paying down outstanding debt, which improved our debt maturity profile while preserving financial and operational flexibility. We sold our Fayetteville Shale assets, further reducing our debt, repurchasing shares and earmarking proceeds for our 2019 and 2020 capital investment programs and other general corporate purposes. We made further technological advances in drilling precision and completion optimization that enhanced well productivity and economics, resulting in improved returns, and we focused on identifying and implementing opportunities to lower our overall cost structure. We added to our derivative portfolio, protecting approximately 479 Bcfe and 117 Bcfe of our forecasted 2019 and 2020 production, respectively, from price volatility through the use of commodity derivatives. Recent Financial and Operating Results  Significant operating and financial highlights for 2018 include:  Total Company · Net income attributable to common stock of $535 million, or $0.93 per diluted share, down from a net income attributable to common stock of $816 million, or $1.63 per diluted share, in 2017. The decrease was primarily due to a loss on unsettled derivatives of $24 million in 2018 as compared to a gain of $451 million in 2017. Excluding the impact of unsettled derivatives, net income attributable to common stock was up $194 million, or 53%, compared to 2017. · Net cash provided by operating activities of $1,223 million was up 11% from $1,097 million in 2017. · Total capital invested of $1,248 million was down 3% from $1,293 million in 2017. · Total debt of approximately $2.3 billion decreased by $2.1 billion, or 47%, compared to 2017. · We repurchased approximately 39 million shares of our common stock for $180 million.  E&P · E&P segment operating income of $794 million was up 45%, compared to $549 million in 2017. · Year-end reserves of 11,921 Bcfe decreased 19% from 14,775 Bcfe at the end of 2017. Excluding the 3,443 Bcfe of reserves sold during the year, year-end reserves were up 589 Bcfe, resulting from 946 Bcfe of production offset by 1,009 Bcfe of additions and 526 Bcfe of revisions. · Total net production of 946 Bcfe, including 702 Bcfe from our Appalachian Basin and 243 Bcf from the Fayetteville Shale, increased 5% from 2017, and was comprised of 85% natural gas and 15% oil and NGLs. · Excluding the effect of derivatives, our realized natural gas price of $2.45 per Mcf, realized oil price of $56.79 per barrel and realized NGL price of $17.91 per barrel increased 10%, 32% and 24%, respectively, from 2017. · The E&P segment invested $1,231 million in capital drilling 106 wells, completing 119 wells and placing 138 wells to sales.  Outlook  We expect to continue to exercise capital discipline through a fully-funded 2019 capital investment program. We remain committed to our focus on optimizing our portfolio by concentrating our efforts on our highest return assets, looking for opportunities to maximize margins in each core area of our business and further developing our knowledge of our asset base. We believe our industry will continue to face challenges due to the uncertainty of natural gas, oil and NGL prices in the United States, changes in laws, regulations and investor sentiment, and other key factors described above under “Risk Factors.”   RESULTS OF OPERATIONS  The following discussion of our results of operations for our segments is presented before intersegment eliminations. We evaluate our segments as if they were stand-alone operations and accordingly discuss their results prior to any intersegment eliminations. Restructuring charges, interest expense, gain (loss) on derivatives, loss on early extinguishment of debt and income tax expense are discussed on a consolidated basis.  E&P  The table below includes the effects of the sale of the E&P assets included in the Fayetteville Shale sale which closed on December 3, 2018.   (1) Includes $37 million of restructuring charges, an $18 million loss on the sale of assets and $15 million of non-full cost pool asset impairments.  (2) Includes $81 million of restructuring and other one-time charges for the year ended December 31, 2016.  (3) Represents the gain (loss) on settled commodity derivatives and includes $1 million and $5 million amortization of premiums paid related to certain natural gas call options for the year ended December 31, 2018 and 2017, respectively.  Operating Income · Operating income for the E&P segment increased $245 million for the year ended December 31, 2018, compared to 2017 due to a $439 million increase in revenues, partially offset by a $194 million increase in operating costs. In 2018, operating costs included $37 million in restructuring charges, an $18 million loss on sale of assets and a $15 million impairment of non-full cost pool assets. · E&P segment operating income for the year ended December 31, 2016 includes an impairment of natural gas and oil properties of $2.3 billion. Excluding the 2016 impairment, our E&P segment operating income increased $627 million for the year ended December 31, 2017, compared to the same period in 2016, due to a $673 million increase in revenues, partially offset by a $46 million increase in operating costs.  Revenues  The following illustrate the effects on sales revenues associated with changes in commodity prices and production volumes:   In addition to the sales revenues detailed above, our E&P segment had $5 million and $4 million of other operating revenues, primarily related to water sales to third-party operators for the years ended December 31, 2018 and 2017, respectively.  Production Volumes  (1) The Fayetteville Shale assets and associated reserves were sold on December 3, 2018.  (2) Approximately 240 Bcfe, 179 Bcfe and 148 Bcfe for the years ended December 31, 2018, 2017 and 2016, respectively, were produced from the Marcellus Shale formation.  · Production volumes for our E&P segment increased by 49 Bcfe for the year ended December 31, 2018, compared to the same period in 2017, as increased production volumes from Northeast and Southwest Appalachia more than offset decreased natural gas production volumes in the Fayetteville Shale, which reflects only eleven months of production in 2018 as a result of its sale in December 2018. · E&P segment production volumes increased 22 Bcfe for the year ended December 31, 2017, compared to the same period in 2016, as increased natural gas production volumes in Northeast and Southwest Appalachia more than offset decreased production volumes in the Fayetteville Shale.  Commodity Prices  The price we expect to receive for our production is a critical factor in determining the capital investments we make to develop our properties. Commodity prices fluctuate due to a variety of factors we cannot control or predict, including increased supplies of natural gas, oil or NGLs due to greater exploration and development activities, weather conditions, political and economic events, and competition from other energy sources. These factors impact supply and demand, which in turn determine the sales prices for our production. In addition to these factors, the prices we realize for our production are affected by our hedging activities as well as locational differences in market prices, including basis differentials. We will continue to evaluate the commodity price environments and adjust the pace of our activities in order to not exceed our fully-funded 2019 capital investment program.  (1) Based on last day settlement prices from monthly futures contracts. (2) This discount includes a basis differential, a heating content adjustment, physical basis sales, third-party transportation charges and fuel charges, and excludes financial basis hedges.  We receive a sales price for our natural gas at a discount to average monthly NYMEX settlement prices based on heating content of the gas, locational basis differentials and transportation and fuel charges. Additionally, we receive a sales price for our oil and NGLs at a difference to average monthly West Texas Intermediate settlement and Mont Belvieu NGL composite prices, respectively, due to a number of factors including product quality, composition and types of NGLs sold, locational basis differentials and transportation and fuel charges.  We regularly enter into various hedging and other financial arrangements with respect to a portion of our projected natural gas, oil and NGL production in order to ensure certain desired levels of cash flow and to minimize the impact of price fluctuations, including fluctuations in locational market differentials. We refer you to Item 7A, Quantitative and Qualitative Disclosures about Market Risk, of this Annual Report, Note 5 to the consolidated financial statements included in this Annual Report, and our derivative risk factor for additional discussion about our derivatives and risk management activities.  The table below presents the amount of our future production in which the basis is protected as of December 31, 2018:   In addition to protecting basis, the table below presents the amount of our future production in which price is financially protected as of December 31, 2018:    We refer you to Note 5 to the consolidated financial statements included in this Annual Report for additional details about our derivative instruments.  Operating Costs and Expenses   (1) Includes $9 million of legal settlement charges for the year ended December 31, 2018.  (2) Includes $5 million of legal settlement charges for the year ended December 31, 2017.  (3) Excludes $36 million of restructuring charges and $9 million of legal settlement charges for the year ended December 31, 2018.  (4) Excludes $5 million of legal settlements for the year ended December 31, 2017.  (5) Excludes $67 million of restructuring charges and $11 million of legal settlements for the year ended December 31, 2016.  (6) Excludes $1 million of restructuring charges for the year ended December 31, 2018.  (7) Excludes $3 million of restructuring charges for the year ended December 31, 2016.  Lease Operating Expenses · On a per Mcfe basis, lease operating expenses increased $0.03 for the year ended December 31, 2018, compared to 2017, primarily due to additional NGL processing fees associated with our increased production in Southwest Appalachia. · Lease operating expenses per Mcfe increased $0.03 for the year ended December 31, 2017, compared to 2016, primarily due to increased transportation and processing costs, as our production growth shifted toward the Appalachian Basin.  General and Administrative Expenses · General and administrative expenses decreased in 2018, compared to 2017, as a $20 million decrease in costs resulting from the mid-year implementation of cost reductions and decreased personnel costs was partially offset by a $4 million increase in legal settlement charges. · On a per Mcfe basis, excluding restructuring and legal settlement charges, general and administrative expenses per Mcfe decreased for the year ended December 31, 2018, compared to 2017, due to a 10% decrease in expenses and a 5% increase in production volumes. · On a per Mcfe basis, excluding restructuring and legal settlement charges, general and administrative expenses per Mcfe remained flat for the year ended December 31, 2017, compared to 2016, as a slight increase in expenses was offset by a 3% increase in production volumes.  Taxes, Other than Income Taxes · Taxes other than income taxes per Mcfe may vary from period to period due to changes in ad valorem and severance taxes that result from the mix of our production volumes and fluctuations in commodity prices. Excluding $1 million of restructuring charges in 2018, taxes, other than income taxes, per Mcfe decreased $0.01 per Mcfe for the year ended December 31, 2018, compared to the same period in 2017, primarily due to an $8 million severance tax refund related to a favorable assessment on deductible expenses in Southwest Appalachia, a $1 million severance tax refund related to a favorable assessment on deductible expenses in the Fayetteville Shale, favorable property tax assessments, and property and sales tax refunds recorded in the first quarter of 2018. · On a per Mcfe basis, taxes, other than income taxes, remained flat for the year ended December 31, 2017 compared to 2016 as a slight increase in expense was more than offset by an increase in production volumes.  Full Cost Pool Amortization · Our full cost pool amortization rate increased $0.06 per Mcfe for the year ended December 31, 2018, as compared to 2017. The increase in the average amortization rate resulted primarily from the addition of future development costs associated with proved undeveloped reserves recognized as a result of improved commodity prices. · The amortization rate is impacted by the timing and amount of reserve additions and the costs associated with those additions, revisions of previous reserve estimates due to both price and well performance, write-downs that result from full cost ceiling impairments, proceeds from the sale of properties that reduce the full cost pool, and the levels of costs subject to amortization. We cannot predict our future full cost pool amortization rate with accuracy due to the variability of each of the factors discussed above, as well as other factors, including but not limited to the uncertainty of the amount of future reserve changes. · Unevaluated costs excluded from amortization were $1.8 billion at December 31, 2018, and 2017, compared to $2.1 billion at December 31, 2016. The unevaluated costs excluded from amortization slightly decreased, as compared to 2017, as the evaluation of previously unevaluated properties totaling $361 million in 2018 was only partially offset by the impact of $299 million of unevaluated capital invested during the same period.  See “Supplemental Oil and Gas Disclosures” in Item 8 of Part II of this Annual Report for additional information regarding our unevaluated costs excluded from amortization.  Impairments  In accordance with accounting guidance for Property, Plant and Equipment, assets held for sale are measured at the lower of carrying value or fair value less costs to sell. Because the assets outside the full cost pool met the criteria for held for sale accounting in the third quarter of 2018, we determined the carrying value of certain non-full cost pool E&P assets exceeded the fair value less costs to sell. As a result, an impairment charge of $15 million was recorded during the year ended December 31, 2018.  Midstream  The table below reflects the sale of gas gathering assets included in the Fayetteville Shale sale which closed on December 3, 2018, resulting in a net gain and approximately eleven months of gathering activity for the year ended December 31, 2018.   (1) Includes $2 million of restructuring charges for the year ended December 31, 2018.  (2) Includes $3 million of restructuring charges for the year ended December 31, 2016.  Operating Income · Operating income for the year ended December 31, 2018 included $155 million of impairments and $2 million of restructuring charges. The impairments were comprised of $145 million related to our gathering assets included in the Fayetteville Shale sale, and $10 million related to other non-core gathering assets. Excluding the impairment and restructuring charges, operating income from our Midstream segment decreased $22 million for the year ended December 31, 2018, compared to 2017, primarily due to an $83 million decrease in gas gathering revenues and a $1 million decrease in marketing margin, partially offset by a $33 million decrease in operating costs and expenses and a $29 million increase in gain on sale of assets, net. · Operating income decreased $26 million for the year ended December 31, 2017, compared to 2016, primarily due to a $47 million decrease in gas gathering revenues and a $3 million decrease in marketing margin, partially offset by an $18 million decrease in operating costs and expenses and a $6 million gain on the sale of certain compressor equipment. · The margin generated from marketing activities was $42 million, $43 million and $46 million for the years ended December 31, 2018, 2017 and 2016, respectively.  Margins are driven primarily by volumes marketed and may fluctuate depending on the prices paid for commodities and the ultimate disposition of those commodities. Increases and decreases in marketing revenues due to changes in commodity prices and volumes marketed are largely offset by corresponding changes in marketing purchase expenses. We enter into derivative contracts from time to time with respect to our marketing activities to provide margin protection. For more information about our derivatives and risk management activities, we refer you to

<s>[INST] Management’s Discussion and Analysis is the Company’s analysis of its financial performance and of significant trends that may affect future performance. It should be read in conjunction with the financial statements and notes, and supplemental oil and gas disclosures included elsewhere in this report. It contains forwardlooking statements including, without limitation, statements relating to the Company’s plans, strategies, objectives, expectations and intentions that are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. In many cases you can identify forwardlooking statements by words such as “anticipate,” “intend,” “plan,” “project,” “estimate,” “continue,” “potential,” “should,” “could,” “may,” “will,” “objective,” “guidance,” “outlook,” “effort,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “forecast,” “target” or similar words. Unless required to do so under the federal securities laws, the Company does not undertake to update, revise or correct any forwardlooking statements, whether as a result of new information, future events or otherwise. Readers are cautioned that such forwardlooking statements should be read in conjunction with the Company’s disclosures under the heading: “Cautionary Statement about ForwardLooking Statements.”  OVERVIEW  Background  Southwestern Energy Company (including its subsidiaries, collectively, “we,” “our,” “us,” “the Company” or “Southwestern”) is an independent energy company engaged in natural gas, oil and NGL exploration, development and production, which we refer to as “E&P.” We are also focused on creating and capturing additional value through our marketing business, which we refer to as “Midstream.” We conduct most of our businesses through subsidiaries, and we currently operate exclusively in the United States.  E&P. Our primary business is the exploration for and production of natural gas, oil and NGLs, with our ongoing operations focused on the development of unconventional natural gas reservoirs located in Pennsylvania and West Virginia. Our operations in northeast Pennsylvania, which we refer to as “Northeast Appalachia,” are primarily focused on the unconventional natural gas reservoir known as the Marcellus Shale. Our operations in West Virginia and southwest Pennsylvania, which we refer to as “Southwest Appalachia,” are focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs. Collectively, our properties in Pennsylvania and West Virginia are herein referred to as the “Appalachian Basin.” We also have drilling rigs located in Pennsylvania and West Virginia, and we provide certain oilfield products and services, principally serving our E&P operations though vertical integration.  On August 30, 2018, we entered into an agreement to sell 100% of the equity in certain of our subsidiaries that conducted our operations in Arkansas, which were primarily focused on an unconventional natural gas reservoir known as the Fayetteville Shale, for $1,865 million, subject to customary adjustments. In early December 2018, we completed the Fayetteville Shale sale, resulting in net proceeds of $1,650 million, following adjustments due primarily to the net cash flows from the economic effective date of July 1, 2018, to the closing date. Midstream. Our marketing activities capture opportunities that arise through the marketing and transportation of natural gas, oil, and NGLs produced in our E&P operations. In December 2018, we divested almost all of our gathering assets as part of the Fayetteville Shale sale.  Changes in 2018. At the beginning of 2018, we announced our strategy to reposition the Company through portfolio optimization, balance sheet management and leveraging our technical, commercial and operational expertise to improve margins. We sharpened our focus on developing our highvalue, liquidsrich Appalachian basin assets. We strengthened our balance sheet through asset monetization and debt reduction by entering into a new reservebased credit facility and paying down outstanding debt, which improved our debt maturity profile while preserving financial and operational flexibility. We sold [/INST] Positive. </s>

SOUTHWESTERN ENERGY CO

2020-02-27

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis is the Company’s analysis of its financial performance and of significant trends that may affect future performance. It should be read in conjunction with the financial statements and notes, and supplemental oil and gas disclosures included elsewhere in this report. It contains forward-looking statements including, without limitation, statements relating to the Company’s plans, strategies, objectives, expectations and intentions that are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. In many cases you can identify forward-looking statements by words such as “anticipate,” “intend,” “plan,” “project,” “estimate,” “continue,” “potential,” “should,” “could,” “may,” “will,” “objective,” “guidance,” “outlook,” “effort,” “expect,” “believe,” “predict,” “budget,” “projection,” “goal,” “forecast,” “target” or similar words. Unless required to do so under the federal securities laws, the Company does not undertake to update, revise or correct any forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned that such forward-looking statements should be read in conjunction with the Company’s disclosures under the heading: “Cautionary Statement about Forward-Looking Statements.” OVERVIEW Background Southwestern Energy Company (including its subsidiaries, collectively, “we,” “our,” “us,” “the Company” or “Southwestern”) is an independent energy company engaged in natural gas, oil and NGLs exploration, development and production, which we refer to as “E&P.” We are also focused on creating and capturing additional value through our marketing business, which we call “Marketing” but previously referred to as “Midstream” when it included the operations of gathering systems. We conduct most of our businesses through subsidiaries, and we currently operate exclusively in the lower 48 United States. Our historical financial and operating results include the Fayetteville Shale E&P and related midstream gathering businesses which were sold in early December 2018. E&P. Our primary business is the exploration for and production of natural gas, oil and NGLs, with our ongoing operations focused on the development of unconventional natural gas reservoirs located in Pennsylvania and West Virginia. Our operations in northeast Pennsylvania, which we refer to as “Northeast Appalachia,” are primarily focused on the unconventional natural gas reservoir known as the Marcellus Shale. Our operations in West Virginia and southwest Pennsylvania, which we refer to as “Southwest Appalachia,” are focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs. Collectively, our properties in Pennsylvania and West Virginia are herein referred to as “Appalachia.” We also have drilling rigs located in Pennsylvania and West Virginia, and we provide certain oilfield products and services, principally serving our E&P operations though vertical integration. Marketing. Our marketing activities capture opportunities that arise through the marketing and transportation of natural gas, oil, and NGLs primarily produced in our E&P operations. In December 2018, we divested almost all of our midstream gathering assets as part of the Fayetteville Shale sale. Focus in 2019. In 2019, we continued our strategy to reposition the Company through portfolio optimization, balance sheet management and leveraging our technical, commercial and operational expertise to improve margins. We continued our strategic shift towards prioritizing the development of our high-value, liquids-rich Southwest Appalachia assets over our pure natural gas assets. We strengthened our balance sheet through an additional debt reduction of $80 million (net) and by amending our revolving credit facility to extend the maturity into 2024, which improved our debt maturity profile while preserving financial and operational flexibility. We made further technological advances in drilling longer laterals with increased precision and completion optimization that enhanced well productivity and significantly reduced our well costs on a per lateral foot basis, resulting in improved returns. In addition, we focused on identifying and implementing opportunities to lower our overall cost structure. We added to our derivative portfolio, limiting the impact of price volatility on approximately 604 Bcfe and 307 Bcfe of our forecasted 2020 and 2021 production, respectively, through the use of commodity derivatives. Recent Financial and Operating Results Significant operating and financial highlights for 2019 include: Total Company •Net income attributable to common stock of $891 million, or $1.65 per diluted share, up from a net income attributable to common stock of $535 million, or $0.93 per diluted share, in 2018. Net income increased in 2019 as a $409 million increase in deferred tax benefit, a $392 million increase in net derivative gains and a $59 million decrease in interest expense more than offset a $527 million decrease in operating income. •Operating income of $270 million for the year ended December 31, 2019 decreased 66% from $797 million in 2018. The decrease was primarily due to lower margins associated with reduced commodity prices and the divestiture of the Fayetteville Shale E&P and related midstream gathering assets in December 2018. •Net cash provided by operating activities of $964 million was down 21% from $1,223 million in 2018 primarily due to the decrease in operating income net of depreciation, depletion and amortization and non-cash impairments, partially offset by the improvement in settled derivatives and positive change in assets and liabilities. •Total capital invested of $1,140 million was down 9% from $1,248 million in 2018. •We repurchased $62 million of our outstanding long-term senior notes at a discount and recognized a gain on the extinguishment of debt of $8 million. In addition, we retired the remaining $52 million principal of our outstanding senior notes that were due in January 2020. E&P •E&P segment operating income of $283 million was down 64%, compared to $794 million in 2018. This excludes the impact of derivatives. •Year-end reserves of 12,721 Bcfe increased 800 Bcfe, or 7%, from 11,921 Bcfe at the end of 2018, resulting from 1,195 Bcfe of additions and 385 Bcfe of revisions, partially offset by 778 Bcfe of production and 2 Bcfe of sales. •Total net production of 778 Bcfe was comprised of 78% natural gas, 18% NGLs and 4% oil. In 2018, E&P segment production volumes of 946 Bcfe included 243 Bcf of production from our operations in the Fayetteville Shale, which was sold in December 2018. Excluding the impact of production from the sold Fayetteville Shale assets, our production increased 11% from 703 Bcfe in 2018, and our liquids production increased 23% over the same period. •Excluding the effect of derivatives, our realized natural gas price of $1.98 per Mcf, realized oil price of $46.90 per barrel and realized NGL price of $11.59 per barrel decreased 19%, 17% and 35%, respectively, from 2018. Our weighted average realized price excluding the effect of derivatives of $2.18 per Mcfe decreased 18% from the same period in 2018. •The E&P segment invested capital totaling $1,138 million, drilling 105 wells, completing 116 wells and placing 113 wells to sales. Outlook We expect to continue to exercise capital discipline in our 2020 capital investment program by investing within cash flow from operations, net of changes in working capital, supplemented by earmarked proceeds of the Fayetteville Shale sale that in the meantime have been used to reduce debt. We remain committed to our focus on optimizing our portfolio by concentrating our efforts on our highest return investment opportunities, looking for ways to optimize our cost structure and to maximize margins in each core area of our business and further developing our knowledge of our asset base. We believe that we and our industry will continue to face challenges due to the uncertainty of natural gas, oil and NGL prices in the United States, changes in laws, regulations and investor sentiment, and other key factors described above under “Risk Factors.” RESULTS OF OPERATIONS The following discussion of our results of operations for our segments is presented before intersegment eliminations. We report on our segments as if they were stand-alone operations and accordingly discuss their results prior to any intersegment eliminations. Restructuring charges, interest expense, gain (loss) on derivatives, gain (loss) on early extinguishment of debt and income taxes are discussed on a consolidated basis. We have applied the Securities and Exchange Commission’s recently adopted FAST Act Modernization and Simplification of Regulation S-K, which limits the discussion to the two most recent fiscal years. This discussion and analysis deals with comparisons of material changes in the consolidated financial statements for fiscal 2019 and fiscal 2018. For the comparison of fiscal 2018 and fiscal 2017, see “Management's Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of our 2018 Annual Report on Form 10-K, filed with the Securities and Exchange Commission on February 28, 2019. E&P The 2018 information in the table below includes the financial results from E&P assets in the Fayetteville Shale that were sold in December 2018. (1)Includes $2 million and $5 million in third-party water sales for the years ended December 31, 2019 and 2018, respectively. (2)Includes $11 million of restructuring charges and $13 million of non-cash, non-full cost pool impairments for the year ended December 31, 2019. (3)Includes $37 million of restructuring charges, an $18 million loss on the sale of assets and $15 million of non-cash, non-full cost pool asset impairments for the year ended December 31, 2018. (4)Includes $1 million amortization of premiums paid related to certain natural gas call options for each of the years ended December 31, 2019 and 2018. Operating Income •E&P segment operating income for the year ended December 31, 2018 included $105 million related to our operations in the Fayetteville Shale, which were sold in December 2018. Excluding the amounts related to Fayetteville, our E&P segment operating income decreased $406 million for the year ended December 31, 2019, compared to the same period in 2018, as lower margins associated with decreased commodity pricing were only partially offset by increased efficiencies and production. Revenues The following illustrate the effects on sales revenues associated with changes in commodity prices and production volumes: (1)Excludes $5 million in other operating revenues for the year ended December 31, 2018 related to third-party water sales. (2)This amount represents the revenues associated with the Fayetteville Shale assets, which were sold in December 2018. There were no Fayetteville Shale revenues in 2019. (3)Excludes $2 million in other operating revenues for the year ended December 31, 2019 related to third-party water sales. Production Volumes (1)The Fayetteville Shale assets were sold in December 2018. (2)Approximately 317 Bcfe and 240 Bcfe for the years ended December 31, 2019 and 2018, respectively, were produced from the Marcellus Shale formation. •E&P segment production volumes for the year ended December 31, 2018 included 243 Bcf of production from our operations in the Fayetteville Shale which were sold in December 2018. Excluding this amount, production volumes for our E&P segment increased 75 Bcfe for the year ended December 31, 2019, compared to the same period in 2018, primarily due to a 31% increase in production volumes in Southwest Appalachia. •Oil and NGL production increased 38% and 20%, respectively, for the year ended December 31, 2019, compared to 2018, reflecting our investment in our liquids-rich acreage in Southwest Appalachia. Commodity Prices The price we expect to receive for our production is a critical factor in determining the capital investments we make to develop our properties. Commodity prices fluctuate due to a variety of factors we cannot control or predict, including increased supplies of natural gas, oil or NGLs due to greater exploration and development activities, weather conditions, political and economic events, and competition from other energy sources. These factors impact supply and demand, which in turn determine the sales prices for our production. In addition to these factors, the prices we realize for our production are affected by our hedging activities as well as locational differences in market prices, including basis differentials. We will continue to evaluate the commodity price environments and adjust the pace of our activities in order to maintain appropriate liquidity and financial flexibility. (1)Based on last day settlement prices from monthly futures contracts. (2)This discount includes a basis differential, a heating content adjustment, physical basis sales, third-party transportation charges and fuel charges, and excludes financial basis hedges. We receive a sales price for our natural gas at a discount to average monthly NYMEX settlement prices based on heating content of the gas, locational basis differentials and transportation and fuel charges. Additionally, we receive a sales price for our oil and NGLs at a difference to average monthly West Texas Intermediate settlement and Mont Belvieu NGL composite prices, respectively, due to a number of factors including product quality, composition and types of NGLs sold, locational basis differentials and transportation and fuel charges. We regularly enter into various hedging and other financial arrangements with respect to a portion of our projected natural gas, oil and NGL production in order to ensure certain desired levels of cash flow and to minimize the impact of price fluctuations, including fluctuations in locational market differentials. We refer you to Item 7A, Quantitative and Qualitative Disclosures about Market Risk, of this Annual Report, Note 6 to the consolidated financial statements included in this Annual Report, and our derivative risk factor for additional discussion about our derivatives and risk management activities. The table below presents the amount of our future production in which the impact of basis volatility has been limited as of December 31, 2019: In addition to limiting the impact of basis volatility, the table below presents the amount of our future production in which the impact of price volatility has been limited through the use of derivatives as of December 31, 2019: We refer you to Note 6 to the consolidated financial statements included in this Annual Report for additional details about our derivative instruments. Operating Costs and Expenses (1)Includes eleven months of expenses from our Fayetteville Shale operations, which were sold in December 2018. (2)Includes a $6 million residual value guarantee short-fall payment to the previous lessor of our headquarters building and $6 million of legal settlement charges for the year ended December 31, 2019. (3)Includes $9 million of legal settlement charges for the year ended December 31, 2018. (1)Includes post-production costs such as gathering, processing, fractionation and compression. (2)Excludes $11 million in restructuring charges, a $6 million residual value guarantee short-fall payment to the previous lessor of our headquarters building and $6 million of legal settlement charges for the year ended December 31, 2019. (3)Excludes $36 million in restructuring charges, $9 million of legal settlement charges for the year ended December 31, 2018. (4)Excludes $1 million of restructuring charges for the year ended December 31, 2018. Lease Operating Expenses •Lease operating expenses per Mcfe decreased $0.01 for the year ended December 31, 2019, compared to 2018, as a $0.02 per Mcfe decrease associated with the Fayetteville Shale sale was partially offset by a $0.01 per Mcfe increase primarily related to increased liquids production, which includes higher costs from processing and NGL fees. General and Administrative Expenses •General and administrative expenses in 2019 included a $6 million residual value guarantee short-fall payment to the previous lessor of our headquarters building and $6 million in legal settlement charges. 2018 included $9 million in legal settlement charges. Excluding these amounts, general and administrative expenses decreased $39 million for the year ended December 31, 2019, compared to 2018, primarily due to decreased personnel costs and the implementation of cost reduction initiatives. •On a per Mcfe basis, excluding restructuring, legal settlement charges and the residual value guarantee short-fall payment, general and administrative expenses per Mcfe decreased by $0.01 for the year ended December 31, 2019, compared to 2018, as a decrease in expenses more than offset an 18% decrease in production volumes primarily associated with the Fayetteville Shale sale. Taxes, Other than Income Taxes •Taxes other than income taxes per Mcfe may vary from period to period due to changes in ad valorem and severance taxes that result from the mix of our production volumes and fluctuations in commodity prices. Taxes, other than income taxes, per Mcfe decreased $0.01 per Mcfe for the year ended December 31, 2019, compared to the same period in 2018, primarily due to a $7 million severance tax refund/credit received in the fourth quarter of 2019 related to additional favorable assessments on deductible expenses in Southwest Appalachia and lower realized commodity pricing in 2019. In 2018, we received an $8 million severance tax refund related to a favorable assessment on deductible expenses in Southwest Appalachia which reduced our average severance tax rate applied in 2019. Full Cost Pool Amortization •Our full cost pool amortization rate increased $0.05 per Mcfe for the year ended December 31, 2019, as compared to 2018. The increase in the average amortization rate resulted primarily as a result of the impact of capital investments and the further evaluation of our unproved properties during the year and the impact of the Fayetteville Shale sale, which reduced our total natural gas reserves along with the carrying value of our full cost pool assets. •The amortization rate is impacted by the timing and amount of reserve additions and the future development costs associated with those additions, revisions of previous reserve estimates due to both price and well performance, write-downs that result from non-cash full cost ceiling impairments, proceeds from the sale of properties that reduce the full cost pool, and the levels of costs subject to amortization. We cannot predict our future full cost pool amortization rate with accuracy due to the variability of each of the factors discussed above, as well as other factors, including but not limited to the uncertainty of the amount of future reserve changes. •Unevaluated costs excluded from amortization were $1.5 billion at December 31, 2019 compared to $1.8 billion at December 31, 2018. The unevaluated costs excluded from amortization decreased, as compared to 2018, as the evaluation of previously unevaluated properties totaling $507 million in 2019 was only partially offset by the impact of $258 million of unevaluated capital invested during the same period. See “Supplemental Oil and Gas Disclosures” in Item 8 of Part II of this Annual Report for additional information regarding our unevaluated costs excluded from amortization. Impairments •During the year ended December 31, 2019, we recognized non-cash impairments of $13 million associated with non-core E&P assets. •In accordance with accounting guidance for Property, Plant and Equipment, assets held for sale are measured at the lower of carrying value or fair value less costs to sell. Because the assets outside the full cost pool associated with the Fayetteville Shale sale met the criteria for held for sale accounting in the third quarter of 2018, we determined the carrying value of certain non-full cost pool E&P assets exceeded the fair value less costs to sell. As a result, a non-cash impairment charge of $15 million was recorded during the year ended December 31, 2018. Marketing The 2018 information in the table below includes the results from the gas gathering assets included in the Fayetteville Shale sale which closed in December 2018. (1)Amounts for 2018 include our Fayetteville Shale-related midstream gathering business, which was sold in December 2018. (2)Includes $2 million of restructuring charges for the year ended December 31, 2018. (3)Includes a $145 million non-cash impairment related to the midstream gathering assets associated with the Fayetteville Shale sale in December 2018 and a $10 million non-cash impairment related to certain non-core gathering assets for the year ended December 31, 2018. Operating Income •Marketing operating income for the year ended December 31, 2018 included a $7 million loss related to our midstream gathering operations in the Fayetteville Shale, which we sold in December 2018. Excluding this amount, operating income decreased $24 million for the year ended December 31, 2019, compared to 2018, primarily due to a $26 million decrease in marketing margin. •The margin generated from marketing activities was $16 million and $42 million for the years ended December 31, 2019 and 2018, respectively. Marketing margins are driven primarily by volumes marketed and may fluctuate depending on the prices paid for commodities, related cost of transportation and the ultimate disposition of those commodities. Increases and decreases in marketing revenues due to changes in commodity prices and volumes marketed are largely offset by corresponding changes in marketing purchase expenses. Efforts to mitigate the costs of excess transportation capacity can result in greater expenses and therefore lower Marketing margins. Revenues •Revenues from our marketing activities decreased $648 million for the year ended December 31, 2019, compared to 2018, primarily due to a 14% decrease in the price received for volumes marketed and a 62 Bcfe decrease in the volumes marketed. Operating Costs and Expenses •Marketing operating costs and expenses for the year ended December 31, 2018 included $140 million related to our midstream gathering operations in the Fayetteville Shale, which were sold in December 2018. Excluding this amount, operating costs and expenses decreased $1 million for the year ended December 31, 2019, compared to the year ended December 31, 2018, primarily due to decreased personnel costs and the implementation of cost reduction initiatives. Impairments •In the third quarter of 2019, we recorded non-cash impairments of $3 million to non-core gathering assets. •During 2018, we determined the carrying value of our midstream gathering assets held for sale exceeded the fair value less the costs to sell. As a result, we recorded a non-cash impairment charge of $145 million in 2018. Additionally, in 2018, we recognized a $10 million non-cash impairment on unrelated non-core gathering assets. Consolidated Restructuring Charges For the year ended December 31, 2019, we recognized total restructuring charges of $11 million, of which $6 million primarily related to office consolidation and $5 million in cash severance, including payroll taxes withheld. As of December 31, 2019, we had recorded a liability of $2 million related to severance to be paid out in 2020. In June 2018, we announced a workforce reduction plan, which resulted primarily from our previously announced study of structural, process and organizational changes to enhance shareholder value and continues with respect to other aspects of our business and activities. Affected employees were offered a severance package, which included a one-time cash payment depending on length of service and, if applicable, the current value of a portion of equity awards that were canceled. We recognized $23 million in restructuring charges related to the workforce reduction plan for the year ended December 31, 2018. In December 2018, we closed the sale of the equity in certain of our subsidiaries that owned and operated our Fayetteville Shale E&P and related midstream gathering assets in Arkansas. As part of this transaction, most employees associated with those assets became employees of the buyer, although the employment of some was terminated. All affected employees were offered a severance package, which included a one-time cash payment depending on length of service and, if applicable, the current value of a portion of equity awards that were forfeited. We incurred $12 million in severance costs related to the Fayetteville Shale sale for the year ended December 31, 2018 and have recognized these costs as restructuring charges. As a result of the Fayetteville Shale sale during 2018, we incurred $4 million in charges primarily related to office consolidation and recognized these costs as restructuring charges for the year ended December 31, 2018. Interest Expense •Interest expense related to our senior notes decreased for the year ended December 31, 2019, as compared to the same period in 2018, as we repurchased $114 million and $900 million of our outstanding senior notes in the second half of 2019 and December 2018, respectively. Additionally, S&P and Moody's upgraded our public bond ratings in April and May 2018, respectively, which lowered the interest relates associated with our senior notes due 2020 and 2025 by 50 basis points, starting in July 2018. •For the year ended December 31, 2019, interest expense related to our credit arrangements decreased, as compared to the same period in 2018, primarily due to the extinguishment of our 2016 term loan and entering into our revolving credit facility in April 2018, which decreased our outstanding borrowing amount, along with the repayment of our revolving credit facility borrowings with a portion of the net proceeds from the Fayetteville Shale sale in December 2018. •Capitalized interest decreased $6 million for the year ended December 31, 2019, compared to the same period in 2018, due to the evaluation of natural gas and oil properties over the past twelve months. Capitalized interest increased over the same periods as a percentage of gross interest expense primarily due to a smaller percentage decrease in our unevaluated natural gas and oil properties balance, as compared to the larger percentage decrease in our gross interest expense over the same period, in addition to an increase in our average cost of debt over the past twelve months. Gain (Loss) on Derivatives (1)Includes $1 million of premiums paid related to certain natural gas purchased call options for each of the years ended December 31, 2019 and 2018, which is included in gain (loss) on derivatives on the consolidated statement of operations. We refer you to Note 6 to the consolidated financial statements included in this Annual Report for additional details about our gain (loss) on derivatives. Gain (Loss) on Early Extinguishment of Debt •In 2019, we recorded a gain of $8 million on early extinguishment of debt as a result of our repurchase at a discount of $62 million in aggregate principal amount of our outstanding senior notes. See Note 9 to the consolidated financial statements of this Annual Report for more information on our long-term debt. •In December 2018, we used a portion of the net proceeds from our Fayetteville Shale sale to repurchase $40 million of our senior notes due January 2020, $787 million of our senior notes due March 2022 and $73 million of our senior notes due January 2025. We recognized a loss of $9 million for the redemption of these senior notes, which included $2 million of premiums paid. •Concurrent with the closing of our revolving credit facility in April 2018, we repaid our $1,191 million 2016 secured term loan balance and recognized a loss of $8 million on early debt extinguishment on the consolidated statements of operations related to the unamortized debt issuance expense. Income Taxes •As of the first quarter of 2019, we had sustained a three-year cumulative level of profitability. Based on this factor and other positive evidence including forecasted income, we concluded that it was more likely than not that the deferred tax assets would be realized and determined that $522 million of the valuation allowance will be released. As a result, a net tax benefit was recorded during 2019 of $411 million, which was primarily comprised of a deferred tax benefit of $522 million related to the valuation allowance release offset by the recognition of deferred tax expense of $112 million related to taxes on pre-tax income. We expect to retain a valuation allowance of $87 million related to net operating losses in jurisdictions in which we no longer operate. •Our low effective income tax rate in 2018 was the result of our recognition of a valuation allowance that reduced the deferred tax asset primarily related to our current net operating loss carryforward, as well as changes to the deferred tax rate enacted under the Tax Reform Act. A valuation allowance for deferred tax assets, including net operating losses, is recognized when it is more likely than not that some or all of the benefit from the deferred tax asset will not be realized. We refer you to Note 11 to the consolidated financial statements included in this Annual Report for additional discussion about our income taxes. LIQUIDITY AND CAPITAL RESOURCES We depend primarily on funds generated from our operations, our secured revolving credit facility, our cash and cash equivalents balance and capital markets as our primary sources of liquidity. We refer you to Note 9 to the consolidated financial statements included in this Annual Report and the section below under “Credit Arrangements and Financing Activities” for additional discussion of our revolving credit facility. Looking forward to 2020, although we have financial flexibility with our ability to draw on the $1.8 billion in available liquidity under our revolving credit facility as of December 31, 2019, we remain committed to our capital discipline strategy of investing within our cash flow from operations net of changes in working capital, supplemented by a portion of the remaining net proceeds from the Fayetteville Shale sale realized in December 2018 that in the meantime was used to reduce outstanding debt. See Note 3 to the consolidated financial statements included in this Annual Report for additional discussion of the Fayetteville Shale sale. In December 2018, we closed on the Fayetteville Shale sale and received net proceeds of approximately $1,650 million after customary purchase price adjustments. From the net proceeds received, $914 million was immediately used to repurchase $900 million of our outstanding senior notes along with related accrued interest and retirement premiums paid, $201 million was used in late 2018 and early 2019 to repurchase over 44 million shares of our outstanding common stock and the remainder was earmarked to supplement our 2019 and 2020 capital investing programs. Rather than hold these proceeds as cash and cash equivalents during this time, we chose to repurchase or pay down outstanding debt until such time that the sale proceeds would be used to supplement our capital investing program. Accordingly, as our 2020 capital investing program is expected to exceed our cash flow from operations, net of changes in working capital, supplemented by Fayetteville Shale sale proceeds, we plan on drawing no more than $300 million of the remaining earmarked sale proceeds from our revolving credit facility. Our cash flow from operating activities is highly dependent upon the sales prices that we receive for our natural gas and liquids production. Natural gas, oil and NGL prices are subject to wide fluctuations and are driven by market supply and demand, which is impacted by many factors. The sales price we realize for our production is also influenced by our commodity hedging activities. Our derivative contracts allow us to ensure a certain level of cash flow to fund our operations. In 2019, gains on derivatives have offset a large portion of the impact of the recent decline in prices, and we currently have derivative positions in place for portions of our expected 2020, 2021 and 2022 production at prices above current market levels. There can be no assurance that we will be able to add derivative positions to cover the remainder of our expected production at favorable prices. See “Risk Factors” in Item 1A, “Quantitative and Qualitative Disclosures about Market Risk” in

<s>[INST] OVERVIEW Background Southwestern Energy Company (including its subsidiaries, collectively, “we,” “our,” “us,” “the Company” or “Southwestern”) is an independent energy company engaged in natural gas, oil and NGLs exploration, development and production, which we refer to as “E&P.” We are also focused on creating and capturing additional value through our marketing business, which we call “Marketing” but previously referred to as “Midstream” when it included the operations of gathering systems. We conduct most of our businesses through subsidiaries, and we currently operate exclusively in the lower 48 United States. Our historical financial and operating results include the Fayetteville Shale E&P and related midstream gathering businesses which were sold in early December 2018. E&P. Our primary business is the exploration for and production of natural gas, oil and NGLs, with our ongoing operations focused on the development of unconventional natural gas reservoirs located in Pennsylvania and West Virginia. Our operations in northeast Pennsylvania, which we refer to as “Northeast Appalachia,” are primarily focused on the unconventional natural gas reservoir known as the Marcellus Shale. Our operations in West Virginia and southwest Pennsylvania, which we refer to as “Southwest Appalachia,” are focused on the Marcellus Shale, the Utica and the Upper Devonian unconventional natural gas and oil reservoirs. Collectively, our properties in Pennsylvania and West Virginia are herein referred to as “Appalachia.” We also have drilling rigs located in Pennsylvania and West Virginia, and we provide certain oilfield products and services, principally serving our E&P operations though vertical integration. Marketing. Our marketing activities capture opportunities that arise through the marketing and transportation of natural gas, oil, and NGLs primarily produced in our E&P operations. In December 2018, we divested almost all of our midstream gathering assets as part of the Fayetteville Shale sale. Focus in 2019. In 2019, we continued our strategy to reposition the Company through portfolio optimization, balance sheet management and leveraging our technical, commercial and operational expertise to improve margins. We continued our strategic shift towards prioritizing the development of our highvalue, liquidsrich Southwest Appalachia assets over our pure natural gas assets. We strengthened our balance sheet through an additional debt reduction of $80 million (net) and by amending our revolving credit facility to extend the maturity into 2024, which improved our debt maturity profile while preserving financial and operational flexibility. We made further technological advances in drilling longer laterals with increased precision and completion optimization that enhanced well productivity and significantly reduced our well costs on a per lateral foot basis, resulting in improved returns. In addition, we focused on identifying and implementing opportunities to lower our overall cost structure. We added to our derivative portfolio, limiting the impact of price volatility on approximately 604 Bcfe and 307 Bcfe of our forecasted 2020 and 2021 production, respectively, through the use of commodity derivatives. Recent Financial and Operating Results Significant operating and financial highlights for 2019 include: Total Company Net income attributable to common stock of $891 million, or $1.65 per diluted share, up from a net income attributable to common stock of $535 million, or $0.93 per diluted share, in 2018. Net income increased in 2019 as a $409 million increase in deferred tax benefit, a $392 million increase in net derivative gains and a $59 million decrease in interest expense more than offset a $527 million decrease in operating income. Operating income of $270 million for the year ended December 31, 2019 decreased 66% from $797 million in 2018. The decrease was primarily due to lower margins associated with reduced commodity prices and the divestiture of the Fayetteville Shale E&P and related midstream gathering assets in December 2018. Net cash provided by operating activities of $964 million was down 21% from $1,223 million in 2018 [/INST] Positive. </s>

IDEX CORP /DE/

2015-02-23

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Cautionary Statement Under the Private Securities Litigation Reform Act This management’s discussion and analysis, including, but not limited to, the section entitled “2014 Overview and Outlook”, and other portions of this report, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act of 1934, as amended. These statements may relate to, among other things, capital expenditures, cost reductions, cash flow, and operating improvements and are indicated by words or phrases such as “anticipate,” “estimate,” “plans,” “expects,” “projects,” “should,” “will,” “management believes,” “the Company believes,” “we believe,” “the Company intends” and similar words or phrases. These statements are subject to inherent uncertainties and risks that could cause actual results to differ materially from the results described in those statements. These risks and uncertainties include, but are not limited to, the risks described in Item 1A, "Risk Factors" of this report, economic and political consequences resulting from terrorist attacks and wars; levels of industrial activity and economic conditions in the U.S. and other countries around the world; pricing pressures and other competitive factors, and levels of capital spending in certain industries - all of which could have a material impact on our order rates and results, particularly in light of the low levels of order backlogs we typically maintain; our ability to make acquisitions and to integrate and operate acquired businesses on a profitable basis; the relationship of the U.S. dollar to other currencies and its impact on pricing and cost competitiveness; political and economic conditions in foreign countries in which we operate; interest rates; capacity utilization and its effect on costs; labor markets; market conditions and material costs; and developments with respect to contingencies, such as litigation and environmental matters. The forward-looking statements included in this report are only made as of the date of this report, and we undertake no obligation to update them to reflect subsequent events or circumstances. Investors are cautioned not to rely unduly on forward-looking statements when evaluating the information presented here. 2014 Overview and Outlook IDEX is an applied solutions company specializing in fluid and metering technologies, health and science technologies, and fire, safety and other diversified products built to customer specifications. IDEX’s products are sold in niche markets to a wide range of industries throughout the world. Accordingly, our businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where we do business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in the industries that use our products and overall industrial activity are important factors that influence the demand for our products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains six platforms, where we will invest in organic growth and acquisitions with a strategic view towards a platform with the potential for at least $500 million in revenue, and seven groups, where we will focus on organic growth and strategic acquisitions. The Fluid & Metering Technologies segment contains the Energy, Water (comprised of Water Services & Technology and Diaphragm & Dosing Pump Technology), and Chemical, Food & Process platforms as well as the Agricultural group (comprised of Banjo.) The Health & Science Technologies segment contains the IDEX Optics & Photonics, Scientific Fluidics and Material Processing Technologies platforms, as well as the Sealing Solutions and the Industrial (comprised of Micropump and Gast) groups. The Fire & Safety/Diversified Products segment is comprised of the Dispensing, Rescue, Band-It, and Fire Suppression groups. Each platform or group is comprised of one or more of our 15 reporting units: five reporting units within Fluid & Metering Technologies (Energy; Chemical, Food, & Process; Water Services & Technology; Banjo; Diaphragm & Dosing Pump Technology); six reporting units within Health & Science Technologies (IDEX Optics and Photonics; Scientific Fluidics; Material Processing Technologies; Sealing Solutions; Micropump; and Gast); and four reporting units within Fire & Safety/Diversified Products (Dispensing, Rescue, Band-It, and Fire Suppression). The Fluid & Metering Technologies segment designs, produces and distributes positive displacement pumps, flow meters, valves, injectors, and other fluid-handling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water and wastewater, agricultural and energy industries. The Health & Science Technologies segment designs, produces and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical and cosmetics, pneumatic components and sealing solutions, including very high precision, low-flow rate pumping solutions required in analytical instrumentation, clinical diagnostics and drug discovery, high performance molded and extruded, biocompatible medical devices and implantables, air compressors used in medical, dental and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, life sciences, aerospace, telecommunications and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life sciences, research and defense markets, and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Fire & Safety/Diversified Products segment produces firefighting pumps and controls, rescue tools, lifting bags and other components and systems for the fire and rescue industry, and engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications, precision equipment for dispensing, metering and mixing colorants and paints used in a variety of retail and commercial businesses around the world. Our 2014 financial results are as follows: • Sales of $2.1 billion increased 6%; organic sales - excluding acquisitions and foreign currency translation - were up 5%. • Operating income of $431.2 million increased 9% and operating margin of 20.1% was up 60 basis points from the prior year. • Net income increased 9% to $279.4 million. • Diluted EPS of $3.45 increased $0.36 or 12% compared to 2013. Our 2014 financial results, adjusted for $13.7 million of restructuring costs, are as follows (These non-GAAP measures have been reconciled to U.S. GAAP measures in Item 6, "Selected Financial Data"): • Adjusted operating income of $444.9 million increased 12% and adjusted operating margin of 20.7% was up 120 basis points from the prior year. • Adjusted net income of $288.8 million is 13% higher than the prior year of $255.2 million. • Adjusted EPS of $3.57 was 16% higher than the prior year EPS of $3.09. Overall, we believe we are operating in a challenging market environment, which will continue throughout 2015. On a regional basis, we anticipate North American demand will be solid, the European market will remain soft throughout 2015, and Asia will be volatile. For 2015, based on the Company’s current outlook, we anticipate 1 to 2 percent organic revenue growth and EPS of $3.65 to $3.75. Results of Operations The following is a discussion and analysis of our results of operations for each of the three years in the period ended December 31, 2014. For purposes of this Item, reference is made to the Consolidated Statements of Operations in Part II, Item 8, “Financial Statements and Supplementary Data.” Segment operating income excludes unallocated corporate operating expenses. Management's primary measurements of segment performance are sales, operating income, and operating margin. In the following discussion, and throughout this report, references to organic sales, a non-GAAP measure, refers to sales from continuing operations calculated according to generally accepted accounting principles in the United States but excludes (1) the impact of foreign currency translation and (2) sales from acquired businesses during the first twelve months of ownership. The portion of sales attributable to foreign currency translation is calculated as the difference between (a) the period-to-period change in organic sales and (b) the period-to-period change in organic sales after applying prior period foreign exchange rates to the current year period. Management believes that reporting organic sales provides useful information to investors by helping identify underlying growth trends in our business and facilitating easier comparisons of our revenue performance with prior and future periods and to our peers. The Company excludes the effect of foreign currency translation from organic sales because foreign currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends. The Company excludes the effect of acquisitions because the nature, size, and number of acquisitions can vary dramatically from period to period and between the Company and its peers and can also obscure underlying business trends and make comparisons of long-term performance difficult. Performance in 2014 Compared with 2013 Sales in 2014 were $2.1 billion, a 6% increase from the comparable period last year. This increase reflects a 5% increase in organic sales and 1% from acquisitions (Aegis - April 2014 and FTL - March 2013). Organic sales to customers outside the U.S. represented approximately 50% of total sales in 2014 compared with 51% in 2013. In 2014, Fluid & Metering Technologies contributed 42% of sales and 43% of operating income; Health & Science Technologies contributed 35% of sales and 31% of operating income; and Fire & Safety/Diversified Products contributed 23% of sales and 26% of operating income. Gross profit of $949.3 million in 2014 increased $76.0 million, or 9%, from 2013, while gross margins were 44.2% in 2014 and 43.1% in 2013. The increases are mainly attributable to increased sales volume, favorable net material costs as well as benefits from productivity initiatives. SG&A expenses increased to $504.4 million in 2014 from $477.9 million in 2013. The $26.6 million increase reflects approximately $4.0 million of incremental costs from new acquisitions and $22.6 million of volume-related expenses. As a percentage of sales, SG&A expenses were 23.5% for 2014 and 23.6% for 2013. During 2014, the Company recorded pre-tax restructuring expenses totaling $13.7 million. No restructuring expenses were recorded in 2013. The 2014 restructuring expenses were mainly attributable to employee severance related to head count reductions across all three segments and corporate. Operating income of $431.2 million in 2014 increased from the $395.5 million recorded in 2013, primarily reflecting an increase in volume, improved productivity partially offset by the $13.7 million of restructuring-related charges recorded in 2014. Operating margin of 20.1% in 2014 was up from 19.5% in 2013 primarily due to volume leverage and productivity partially offset by the restructuring-related charges in 2014. Other (income) expense increased $3.3 million from other expense of $0.2 million in 2013 to $3.1 million of income in 2014 mainly due to a favorable impact from foreign currency transactions and an increase in interest income. Interest expense decreased slightly to $41.9 million in 2014 from $42.2 million in 2013. The decrease was principally due to lower interest rates. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes increased to $113.1 million in 2014 compared to $97.9 million in 2013. The effective tax rate increased to 28.8% in 2014 compared to 27.7% in 2013, due to a mix of global pre-tax income among jurisdictions and the 2012 U.S. R&D credit in 2013, which was retroactively reinstated to January 1, 2012 as a result of the the enactment of the American Taxpayer Relief Act of 2012 on January 2, 2013. Net income for the year of $279.4 million increased from the $255.2 million earned in 2013. Diluted earnings per share in 2014 of $3.45 increased $0.36 from $3.09 in 2013 due to higher net income and lower share count resulting from share repurchases. Fluid & Metering Technologies Segment Sales of $899.6 million increased $27.8 million, or 3%, in 2014 compared with 2013. This increase reflected 2% organic growth and 1% acquisition. The increase in organic sales was attributable to growth across all our platforms and groups within the segment. In 2014, organic sales increased approximately 4% domestically and 1% internationally. Organic sales to customers outside the U.S. were approximately 45% of total segment sales in 2014, compared with 46% in 2013. Sales within our Energy platform increased modestly compared to 2013, due to the strength of the LPG and refined fuel markets. Sales have grown in the North American and Asian markets, while Europe and the Middle East sales have declined, due to the fall in oil prices and large project delays. Sales within our CFP platform increased compared to 2013 on continued strength of the North American industrial distribution and chemical markets. This increase was partially offset by a decline in CFP chemical sales in Europe due to a lack of project activity. Sales within our Agriculture group increased slightly driven by strong aftermarket demand in North America, which was offset by weak OEM demand due to falling farm income. The sales increase in WST was driven by share gains from new products and increased global project activity. DDPT saw modest sales growth due to softness in the Asian and European markets, offset by a pickup in the Middle East and the semiconductor markets. Operating income of $216.9 million was higher than the $211.3 million recorded in 2013, while operating margin of 24.1% was lower than the 24.2% recorded in 2013, primarily due to $6.4 million of restructuring charges recorded in 2014, partially offset by volume leverage and productivity initiatives. Health & Science Technologies Segment Sales of $752.0 million increased $37.4 million, or 5%, in 2014 compared with 2013. This increase reflected 4% growth in organic sales and 1% favorable foreign currency translation. In 2014, organic sales increased 7% domestically and 1% internationally. Organic sales to customers outside the U.S. were approximately 54% of total segment sales in 2014 compared with 53% in 2013. Sales within our MPT platform increased compared to 2013 due to large projects in the Asian food and pharmaceutical markets. Sales within our Scientific Fluidics platform increased after pausing in the middle part of 2014 as customers right-sized their inventory. In the latter part of 2014 we saw increased demand from the core biotech, in-vitro diagnostic and analytical instrumentation markets. Sales within our Sealing Solutions group increased compared to 2013 due to strong growth in the semiconductor and marine diesel markets, partially offset by softness in oil & gas towards year end due to declining oil prices. Sales within our IOP platform were flat when compared to 2013, primarily from continued slow demand in the industrial and life sciences markets. Sales in our Industrial group increased compared to 2013 due strong growth in the North American distribution markets, and the success of new product introductions. Operating income and operating margin of $153.0 million and 20.3%, respectively, in 2014 were up from $136.7 million and 19.1%, respectively, recorded in 2013, primarily due to volume leverage and productivity initiatives, partially offset by $4.9 million of restructuring charges recorded in 2014. Fire & Safety/Diversified Products Segment Sales of $502.7 million increased $57.7 million, or 13%, in 2014 compared with 2013. This increase was driven entirely by organic growth. In 2014, organic sales increased 17% domestically and 9% internationally. Organic sales to customers outside the U.S. were approximately 54% of total segment sales in 2014, compared with 56% in 2013. Sales within our Dispensing group increased due to the fulfillment of a large order in the first quarter of 2014 and the strength of Asian and Western European markets. The sales increase within our Band-It group was driven by continued strength in the transportation, cable management and industrial industries, offset by declines in oil and gas application markets to close out the year. Sales within our Fire Suppression group increased as a result of orders for fire suppression trailers at power production facilities and stable project orders in China and North America. Sales within our Rescue group decreased slightly, due to delayed decision making for municipal projects in Europe and Asia. Operating income and operating margin of $130.5 million and 26.0%, respectively, were higher than the $102.7 million and 23.1% recorded in 2013, primarily due to volume leverage, partially offset by $1.0 million of restructuring charges recorded in 2014. Performance in 2013 Compared with 2012 Sales in 2013 were $2.0 billion, a 4% increase from 2012. This increase reflects a 2% increase in organic sales and 2% from acquisitions (ERC - April 2012, Matcon - July 2012 and FTL -March 2013). Organic sales to customers outside the U.S. represented approximately 51% of total sales in the period compared with 50% in 2012. In 2013, Fluid & Metering Technologies contributed 43% of sales and 47% of operating income; Health & Science Technologies contributed 35% of sales and 30% of operating income; and Fire & Safety/Diversified Products contributed 22% of sales and 23% of operating income. Gross profit of $873.4 million in 2013 increased $69.7 million, or 8.7%, from 2012. Gross margins were 43.1% in 2013 and 41.1% in 2012. SG&A expenses increased to $477.9 million in 2013 from $444.5 million in 2012. The $33.4 million increase reflects approximately $10.4 million of incremental costs from new acquisitions, $5.6 million of cost-out actions, a $1.7 million pension settlement, $1.2 million related to environmental reserve costs, and $18.6 million of volume-related expenses, partially offset by a $4.0 million gain on the settlement of the contingent consideration related to the Matcon business acquired in July 2012. As a percentage of sales, SG&A expenses were 23.6% for 2013 and 22.7% for 2012. During 2012, the Company recorded pre-tax restructuring expenses totaling $32.5 million. These restructuring expenses were mainly attributable to employee severance related to employee reductions across various functional areas, the termination of a defined benefit pension plan and facility rationalization resulting from the Company’s cost savings initiatives. These initiatives included exit costs related to five facility closures and severance benefits for 491 employees in 2012. Operating income of $395.5 million in 2013 increased from the $128.2 million recorded in 2012, primarily reflecting an increase in volume, improved productivity and the impact of the $198.5 million asset impairment charges and the $32.5 million of restructuring-related charges recorded in 2012. Operating margin of 19.5% in 2013 was up from 6.6% in 2012 primarily due to volume leverage, productivity and the impact of asset impairment charges and restructuring-related charges in 2012. Interest expense decreased slightly to $42.2 million in 2013 from $42.3 million in 2012. The decrease was principally due to lower debt levels. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes increased to $97.9 million in 2013 compared to $48.6 million in 2012. The effective tax rate decreased to 27.7% in 2013 compared to 56.3% in 2012, mainly due to the 2012 asset impairment charge recorded in the fourth quarter of 2012. The impairment charge increased our 2012 effective tax rate by 26.9%. Our effective tax rate was also impacted by recognition of the 2012 U.S. R&D credit in 2013 due to the enactment of the American Taxpayer Relief Act of 2012 on January 2, 2013 which reinstated the U.S. R&D Credit retroactively to January 1, 2012, recognition of additional UK R&D tax benefits, revaluation of the UK deferred tax liability due to the reduction in the UK statutory tax rate, the settlement of the contingent consideration agreement related to the Matcon business acquired in July 2012, and the mix of global pre-tax income among jurisdictions. Net income for the year of $255.2 million increased from the $37.6 million earned in 2012. Diluted earnings per share in 2013 of $3.09 increased $2.64 from $0.45 in 2012. Fluid & Metering Technologies Segment Sales of $871.8 million increased $38.5 million, or 5%, in 2013 compared with 2012. This increase reflected 4% organic growth and 1% favorable foreign currency translation. The increase in organic sales was attributable to growth across all our platforms and groups within the segment. In 2013, organic sales increased approximately 3% domestically and 6% internationally. Organic sales to customers outside the U.S. were approximately 46% of total segment sales in 2013, compared with 47% in 2012. Sales within our Energy platform increased compared to 2012, due to the strength of OEM truck builds and electronic retrofits in North America. Additional growth has been driven by growth across the LPG market, including North America, China, India and Russia. Sales within our CFP platform increased compared to 2012 on continued strength in the chemical markets, particularly with project opportunities in the Middle East and Asia, coupled with solid aftermarket performance. The CFP North American industrial distribution market started the year soft, but gradually recovered in the second half of 2013. Sales increases within our Agriculture group were driven by strong OEM demand in North America, new product introductions and an increase in market share. The sales increase in WST was driven by share gains and strong global project activity, specifically for projects in the US and Japan. DDPT saw only modest sales growth due to softness in several core markets, but this was offset by a pickup in the Middle East and the semiconductor markets. Operating income and operating margin of $211.3 million and 24.2%, respectively, were higher than the $146.7 million and 17.6% recorded in 2012, primarily due to volume leverage and productivity initiatives as well as the impact of the $27.7 million of impairment charges and $6.3 million of restructuring charges recorded in 2012. Health & Science Technologies Segment Sales of $714.7 million increased $19.4 million, or 3%, in 2013 compared with 2012. This increase reflected 6% growth from acquisitions (ERC, Matcon and FTL), offset by a 1% unfavorable foreign currency translation and a 2% decrease in organic sales. In 2013, organic sales decreased 1% domestically and 3% internationally. Organic sales to customers outside the U.S. were approximately 53% of total segment sales in 2013 compared with 51% in 2012. Sales within our MPT platform increased compared to 2012 due to large projects in the pharmaceutical and chemical markets, driven by released capital spending, particularly in North America and Europe. Sales within our Scientific Fluidics platform increased on the success of new products introduced throughout 2013 and share gains. In the latter part of 2013, Scientific Fluidics benefited from the the easing of National Institute of Health funding constraints, which opened up further spending in our core Analytical Instruments and In Vitro Diagnostic markets. Sales within our Specialty Seals group increased compared to 2012 due to a full nine months of sales from FTL, acquired in March 2013, continued strong growth in oil & gas, and stability in the scientific and commercial aircraft end markets. Sales within our IOP platform decreased compared to 2012, primarily from continued weak demand in the defense, biotechnology and electronics end markets as well as the decision to exit certain product lines. Sales in our Industrial group decreased compared to 2012 due to several original equipment manufacturer orders that did not repeat in 2013. Operating income and operating margin of $136.7 million and 19.1%, respectively, in 2013 were up from the operating loss and negative operating margin of $62.8 million and 9.0%, respectively, recorded in 2012, primarily due to volume leverage and productivity initiatives as well as the impact of the $170.8 million of impairment charges and the $14.7 million of restructuring charges recorded in 2012. Fire & Safety/Diversified Products Segment Sales of $445.0 million increased $8.0 million, or 2%, in 2013 compared with 2012. This increase reflected 1% organic growth and 1% favorable foreign currency translation. In 2013, organic sales increased 1% domestically and 2% internationally. Organic sales to customers outside the U.S. were approximately 56% of total segment sales in 2013, compared with 57% in 2012. Sales within our Dispensing group decreased due to the fulfillment of a large replenishment order in the first half of 2012. However, excluding this order, sales increased on strength in our core North American markets, driven by low volatile organic compound programs, and expanded sales from our low-end automatic dispenser, X-Smart, in EMEA and Asia. The sales increase within our Band-It group was driven by general strength in the oil and gas applications market and large automotive blanket orders for new vehicle platforms in North America. Sales within our Fire Suppression group increased as a result of orders for fire suppression trailers at power production facilities, project orders in China, and a stable core business in North America and Western Europe. Sales within our Rescue group increased as a result of robust demand for our rescue tools within the North American and European markets. Operating income and operating margin of $102.7 million and 23.1%, respectively, were higher than the $96.1 million and 22.0% recorded in 2012, primarily due to the impact of the $8.3 million of restructuring charges recorded in 2012, as well as volume leverage, partially offset by mix across businesses. Liquidity and Capital Resources Operating Activities Cash flows from operating activities decreased $33.6 million, or 8.4%, to $368.0 million in 2014, primarily due to higher investments in working capital, partially offset by an increase in net income and accrued expenses. At December 31, 2014, working capital was $663.8 million and the Company’s current ratio was 2.61 to 1. At December 31, 2014, the Company’s cash and cash equivalents totaled $509.1 million, of which $403.5 million was held outside of the United States. Investing Activities Cash flow used in investing activities increased $4.1 million, or 6.0% to $72.3 million in 2014, primarily as a result of higher capital expenditures, partially offset by lower cash paid for acquisitions. Cash flows from operations were more than adequate to fund capital expenditures of $48.0 million and $31.5 million in 2014 and 2013, respectively. Capital expenditures were generally for machinery and equipment that improved productivity, although a portion was for business system technology, replacement of equipment, and construction of new facilities. Management believes that the Company has ample capacity in its plants and equipment to meet demand increases for future growth in the intermediate term. The Company acquired Aegis Flow Technologies ("Aegis") in April 2014 for cash consideration of $25.4 million, and FTL Seals Technology, Ltd ("FTL") in March 2013 for cash consideration of $34.5 million (£23.1 million). The entire purchase price for both acquisitions was funded with borrowings under the Company's bank credit facility. Financing Activities Cash flow used in financing activities decreased $35.0 million, or 16.0% to $184.1 million in 2014, primarily as a result of increased borrowings, net of payments, of $119.4 million under our credit facility, partially offset by an increase of $12.8 million of dividends paid, $18.1 million of lower proceeds from the exercise of stock options, and an increase of $52.4 million in purchases of common stock. The Company maintains a revolving credit facility (the “Revolving Facility”), which is a $700.0 million unsecured, multi-currency bank credit facility expiring on June 27, 2016. At December 31, 2014, $115.0 million was outstanding under the Revolving Facility, with $7.4 million of outstanding letters of credit. The net available borrowing capacity under the Revolving Facility at December 31, 2014, was approximately $577.6 million. Borrowings under the Revolving Facility bear interest, at either an alternate base rate or an adjusted LIBOR rate plus, in each case, an applicable margin. This applicable margin is based on the Company’s senior, unsecured, long-term debt rating and can range from .875% to 1.70%. Based on the Company’s credit rating at December 31, 2014, the applicable margin was 1.05%. Interest is payable (a) in the case of base rate loans, quarterly, and (b) in the case of LIBOR rate loans, on the maturity date of the borrowing, or quarterly from the effective date for borrowings exceeding three months. An annual Revolving Facility fee, also based on the Company’s credit rating, is currently 20 basis points and is payable quarterly. On June 9, 2010, the Company completed a private placement of €81.0 million aggregate principal amount of 2.58% Series 2010 Senior Euro Notes due June 9, 2015 (“2.58% Senior Euro Notes”) pursuant to a Master Note Purchase Agreement, dated June 9, 2010 (the “Purchase Agreement”). The Purchase Agreement provides for the issuance of additional series of notes in the future, provided that the aggregate principal amount outstanding under the agreement at any time does not exceed $750.0 million. The 2.58% Senior Euro Notes bear interest at a rate of 2.58% per annum, which is payable semi-annually in arrears on each June 9th and December 9th and will mature on June 9, 2015. The 2.58% Senior Euro Notes are unsecured obligations of the Company and rank pari passu in right of payment with all of the Company’s other senior debt. The Company may at any time prepay all or any portion of the 2.58% Senior Euro Notes; provided that any such portion is greater than 5% of the aggregate principal amount of notes then outstanding under the Purchase Agreement. In the event of a prepayment, the Company would be required to pay an amount equal to par plus accrued interest plus a make-whole premium. The Purchase Agreement contains certain covenants that restrict the Company’s ability to, among other things, transfer or sell assets, create liens and engage in certain mergers or consolidations. In addition, the Company must comply with a leverage ratio and interest coverage ratio as set forth in the Purchase Agreement. The Purchase Agreement provides for customary events of default. In the case of an event of default arising from specified events of bankruptcy or insolvency, all outstanding 2.58% Senior Euro Notes will become due and payable immediately without further action or notice. In the case of payment events of defaults, any holder of the 2.58% Senior Euro Notes affected thereby may declare all the 2.58% Senior Euro Notes held by it due and payable immediately. In the case of any other event of default, a majority of the holders of the 2.58% Senior Euro Notes may declare all the 2.58% Senior Euro Notes to be due and payable immediately. As of December 31, 2014, the Company included the outstanding balance of the 2.58% Senior Euro Notes, $98.5 million, within Current liabilities on the Consolidated Balance Sheet as the maturity date is within twelve months and the Company expects to repay the principal balance using cash on the balance sheet. On December 6, 2010, the Company completed a public offering of $300.0 million 4.5% senior notes due December 15, 2020 (“4.5% Senior Notes”). The net proceeds from the offering of approximately $295.7 million, after deducting a $1.6 million issuance discount, a $1.9 million underwriting commission and $0.8 million offering expenses, were used to repay $250.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.5% Senior Notes bear interest at a rate of 4.5% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or a portion of the 4.5% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.5% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.5% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all the Company’s assets. The terms of the 4.5% Senior Notes also require the Company to make an offer to repurchase the 4.5% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. On December 9, 2011, the Company completed a public offering of $350.0 million 4.2% senior notes due December 15, 2021 (“4.2% Senior Notes”). The net proceeds from the offering of approximately $346.2 million, after deducting a $0.9 million issuance discount, a $2.3 million underwriting commission and $0.6 million offering expenses, were used to repay $306.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.2% Senior Notes bear interest at a rate of 4.2% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or part of the 4.2% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.2% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.2% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all the Company’s assets. The terms of the 4.2% Senior Notes also require the Company to make an offer to repurchase the 4.2% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. There are two key financial covenants that the Company is required to maintain in connection with the Revolving Facility and the 2.58% Senior Euro Notes. The most restrictive financial covenants under these debt instruments require a minimum interest coverage ratio of 3.0 to 1 and a maximum leverage ratio of 3.25 to 1. At December 31, 2014, the Company was in compliance with both of these financial covenants, as the Company’s interest coverage ratio was 12.72 to 1 and the leverage ratio was 1.69 to 1. There are no financial covenants relating to the 4.5% Senior Notes or 4.2% Senior Notes; however, both are subject to cross-default provisions. On November 6, 2014 the Company’s Board of Directors approved an increase of $400.0 million in the authorized level for repurchases of common stock. Repurchases under the program will be funded with future cash flow generation. During 2014, the Company purchased a total of 3.0 million shares at a cost of $222.5 million, of which $2.6 million was settled in January 2015, compared to 2.9 million shares purchased at a cost of $167.5 million in 2013. As of December 31, 2014, there was $545 million of repurchase authorization remaining. The Company believes current cash, cash from operations and cash available under the Revolving Facility will be sufficient to meet its operating cash requirements, planned capital expenditures, interest and principal payments on all borrowings, pension and postretirement funding requirements, authorized share repurchases and annual dividend payments to holders of the Company’s common stock for the next twelve months. Additionally, in the event that suitable businesses are available for acquisition on acceptable terms, the Company may obtain all or a portion of the financing for these acquisitions through the incurrence of additional borrowings. As of December 31, 2014, $115.0 million was outstanding under the Revolving Facility, with $7.4 million of outstanding letters of credit, resulting in net available borrowing capacity under the Revolving Facility at December 31, 2014 of approximately $577.6 million. Contractual Obligations Our contractual obligations include pension and postretirement medical benefit plans, rental payments under operating leases, payments under capital leases, and other long-term obligations arising in the ordinary course of business. There are no identifiable events or uncertainties, including the lowering of our credit rating, which would accelerate payment or maturity of any of these commitments or obligations. The following table summarizes our significant contractual obligations and commercial commitments at December 31, 2014, and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal and interest payments on outstanding borrowings. Additional detail regarding these obligations is provided in the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” (1) Includes interest payments based on contractual terms and current interest rates for variable debt. (2) Consists primarily of tangible personal property leases. (3) Consists primarily of inventory commitments. (4) Comprises liabilities recorded on the balance sheet of $956.3 million, and obligations not recorded on the balance sheet of $346.1 million. Critical Accounting Policies We believe that the application of the following accounting policies, which are important to our financial position and results of operations, requires significant judgments and estimates on the part of management. For a summary of all of our accounting policies, including the accounting policies discussed below, see Note 1 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Revenue recognition - The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectibility of the sales price is reasonably assured. For product sales, delivery does not occur until the products have been shipped and risk of loss has been transferred to the customer. Revenue from services is recognized when the services are provided or ratably over the contract term. Some arrangements with customers may include multiple deliverables, including the combination of products and services. In such cases, the Company has identified these as separate elements in accordance with ASC 605-25 “Revenue Recognition-Multiple-Element Arrangements-Recognition” and recognizes revenue consistent with the policy for each separate element based on the relative selling price method. Revenues from some long-term contracts are recognized on the percentage-of-completion method. Percentage-of-completion is measured principally by the percentage of costs incurred to date for each contract to the estimated total costs for such contract at completion. Provisions for estimated losses on uncompleted long-term contracts are made in the period in which such losses are determined. Due to uncertainties inherent in the estimation process, it is reasonably possible that completion costs, including those arising from contract penalty provisions and final contract settlements, will be revised in the near-term. Such revisions to costs and income are recognized in the period in which the revisions are determined. The Company records allowances for discounts, product returns and customer incentives at the time of sale as a reduction of revenue as such allowances can be reliably estimated based on historical experience and known trends. The Company also offers product warranties and accrues its estimated exposure for warranty claims at the time of sale based upon the length of the warranty period, warranty costs incurred and any other related information known to the Company. Goodwill, long-lived and intangible assets - The Company evaluates the recoverability of certain noncurrent assets utilizing various estimation processes. An impairment of a long-lived asset exists when the asset’s carrying amount exceeds its fair value, and is recorded when the carrying amount is not recoverable through future operations. An indefinite lived intangible asset or goodwill impairment exists when the carrying amount of intangible assets and goodwill exceeds its fair value. Assessments of possible impairments of goodwill, long-lived or intangible assets are made when events or changes in circumstances indicate that the carrying value of the asset may not be recoverable through future operations. Additionally, testing for possible impairment of recorded goodwill and indefinite-lived intangible asset balances is performed annually. The amount and timing of impairment charges for these assets require the estimation of future cash flows and the fair value of the related assets. The Company’s business acquisitions result in recording goodwill and other intangible assets, which affect the amount of amortization expense and possible impairment expense that the Company will incur in future periods. The Company follows the guidance prescribed in ASC 350, “Goodwill and Other Intangible Assets” to test goodwill and intangible assets for impairment. Annually, on October 31, or more frequently if triggering events occur, the Company compares the fair value of their reporting units to the carrying value of each reporting unit to determine if a goodwill impairment exists. The Company determines the fair value of each reporting unit utilizing an income approach (discounted cash flows) weighted 50% and a market approach consisting of a comparable public company multiples methodology weighted 50%. To determine the reasonableness of the calculated fair values, the Company reviews the assumptions to ensure that neither the income approach nor the market approach yielded significantly different valuations. The key assumptions are updated every year for each reporting unit for the income and market methodology used to determine fair value. Various assumptions are utilized including forecasted operating results, annual operating plans, strategic plans, economic projections, anticipated future cash flows, the weighted average cost of capital, market data and market multiples. The assumptions that have the most significant effect on the fair value calculation are the weighted average cost of capital, the market multiples and terminal growth rates. The 2014 and 2013 ranges for these three assumptions utilized by the Company are as follows: In assessing the fair value of the reporting units, the Company considered both the market approach and income approach. Under the market approach, the fair value of the reporting unit is based on comparing the reporting unit to comparable publicly traded companies. Under the income approach, the fair value of the reporting unit is based on the present value of estimated future cash flows. The income approach is dependent on a number of significant management assumptions including estimates of operating results, capital expenditures, net working capital requirements, long term growth rate and discount rates. Weighting was equally attributed to both the market and income approaches (50% each) in arriving at the fair value of the reporting units. In 2014 and 2013, there were no triggering events or changes in circumstances that would have required a review other than as of our annual test date. Based on the results of our measurement as of October 31, 2014, all reporting units had a fair value that was greater than 100% in excess of carrying value, except for our IOP reporting unit, which had a fair value that was greater than 15% in excess of carrying value. The unamortized Banjo trade name was determined to be an indefinite lived intangible asset which is tested for impairment on an annual basis in accordance with ASC 350 or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company uses the relief-from-royalty method, a form of the income approach. The relief-from-royalty method is dependent on a number of significant management assumptions, including estimates of revenues, royalty rates and discount rates. In 2014 and 2013, there were no triggering events or changes in circumstances that would have required a review other than as of our annual test date. Based on the results of our measurement as of October 31, 2014, the fair value of the Banjo trade name was greater than 40% in excess of carrying value. A long-lived asset impairment exists when the carrying amount of the asset exceeds its fair value. Assessments of possible impairments of long-lived assets are made when events or changes in circumstances indicate that the carrying value of the asset may not be recoverable through future operations. The amount and timing of impairment charges for these assets require the estimation of future cash flows and the fair value of the related assets. In 2014 and 2013, the Company concluded that certain long lived assets had a fair value that was less than the carrying value of the assets, resulting in $2.5 million and $2.7 million, respectively, of impairment charges. Defined benefit retirement plans - The plan obligations and related assets of the defined benefit retirement plans are presented in Note 15 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Level 1 assets are valued using unadjusted quoted prices for identical assets in active markets. Level 2 assets are valued using quoted prices or other observable inputs for similar assets. Level 3 assets are valued using unobservable inputs, but reflect the assumptions market participants would use in pricing the assets. Plan obligations and the annual pension expense are determined by consulting with actuaries using a number of assumptions provided by the Company. Key assumptions in the determination of the annual pension expense include the discount rate, the rate of salary increases, and the estimated future return on plan assets. To the extent actual amounts differ from these assumptions and estimated amounts, results could be adversely affected. The Society of Actuaries recently released revised mortality tables, which update life expectancy assumptions. In consideration of these tables, we modified the mortality assumptions used in determining our pension and post-retirement benefit obligations as of December 31, 2014, which will have a related impact on our annual benefit expense in future years. The new mortality tables may result in additional funding requirements dependent upon the funded status of our plans. These expectations presume all other assumptions remain constant and there are no changes to applicable funding regulations. Changes in the discount rate assumptions will impact the (gain) loss amortization and interest cost components of the projected benefit obligation (PBO), which in turn, may impact the Company’s funding decisions if the PBO exceeds plan assets. Each 100 basis point increase in the discount rate will cause a corresponding decrease in the PBO of approximately $27 million based upon the December 31, 2014 data. Each 100 basis point decrease in the discount rate will cause a corresponding increase in the PBO of approximately $33 million based upon the December 31, 2014 data. New Accounting Pronouncements In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") 2014-09 which introduces a new five-step revenue recognition model. Under ASU 2014-09, an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This ASU also requires disclosures sufficient to enable users to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers, including qualitative and quantitative disclosures about contracts with customers, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. This standard is effective for fiscal years beginning after December 15, 2016, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption. The Company is currently evaluating the impact of the new guidance on our consolidated financial statements and have not yet determined the method by which we will adopt the standard in 2017.

<s>[INST] This management’s discussion and analysis, including, but not limited to, the section entitled “2014 Overview and Outlook”, and other portions of this report, contains forwardlooking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act of 1934, as amended. These statements may relate to, among other things, capital expenditures, cost reductions, cash flow, and operating improvements and are indicated by words or phrases such as “anticipate,” “estimate,” “plans,” “expects,” “projects,” “should,” “will,” “management believes,” “the Company believes,” “we believe,” “the Company intends” and similar words or phrases. These statements are subject to inherent uncertainties and risks that could cause actual results to differ materially from the results described in those statements. These risks and uncertainties include, but are not limited to, the risks described in Item 1A, "Risk Factors" of this report, economic and political consequences resulting from terrorist attacks and wars; levels of industrial activity and economic conditions in the U.S. and other countries around the world; pricing pressures and other competitive factors, and levels of capital spending in certain industries all of which could have a material impact on our order rates and results, particularly in light of the low levels of order backlogs we typically maintain; our ability to make acquisitions and to integrate and operate acquired businesses on a profitable basis; the relationship of the U.S. dollar to other currencies and its impact on pricing and cost competitiveness; political and economic conditions in foreign countries in which we operate; interest rates; capacity utilization and its effect on costs; labor markets; market conditions and material costs; and developments with respect to contingencies, such as litigation and environmental matters. The forwardlooking statements included in this report are only made as of the date of this report, and we undertake no obligation to update them to reflect subsequent events or circumstances. Investors are cautioned not to rely unduly on forwardlooking statements when evaluating the information presented here. 2014 Overview and Outlook IDEX is an applied solutions company specializing in fluid and metering technologies, health and science technologies, and fire, safety and other diversified products built to customer specifications. IDEX’s products are sold in niche markets to a wide range of industries throughout the world. Accordingly, our businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where we do business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in the industries that use our products and overall industrial activity are important factors that influence the demand for our products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains six platforms, where we will invest in organic growth and acquisitions with a strategic view towards a platform with the potential for at least $500 million in revenue, and seven groups, where we will focus on organic growth and strategic acquisitions. The Fluid & Metering Technologies segment contains the Energy, Water (comprised of Water Services & Technology and Diaphragm & Dosing Pump Technology), and Chemical, Food & Process platforms as well as the Agricultural group (comprised of Banjo.) The Health & Science Technologies segment contains the IDEX Optics & Photonics, Scientific Fluidics and Material Processing Technologies platforms, as well as the Sealing Solutions and the Industrial (comprised of Micropump and Gast) groups. The Fire & Safety/Diversified Products segment is comprised of the Dispensing, Rescue, BandIt, and Fire Suppression groups. Each platform or group is comprised of one or more of our 15 reporting units: five reporting units within Fluid & Metering Technologies (Energy; Chemical, Food, & Process; Water Services & Technology; Banjo; Diaphragm & Dosing Pump Technology); six reporting units within Health & Science Technologies (IDEX Optics and Photonics; Scientific Fluidics; Material Processing Technologies; Sealing Solutions; Micropump; and Gast); and four reporting units within Fire & Safety/Divers [/INST] Negative. </s>

IDEX CORP /DE/

2016-02-19

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. 2015 Overview and Outlook IDEX is an applied solutions company specializing in fluid and metering technologies, health and science technologies, and fire, safety and other diversified products built to customer specifications. IDEX’s products are sold in niche markets to a wide range of industries throughout the world. Accordingly, our businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where we do business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in the industries that use our products and overall industrial activity are important factors that influence the demand for our products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains fifteen platforms, where we focus on organic growth and strategic acquisitions. Each of our fifteen platforms is also a reporting unit, where we annually test for goodwill impairment. The Fluid & Metering Technologies segment contains the Energy (comprised of Corken, Faure Herman, Liquid Controls, SAMPI and Toptech), Valves (comprised of Alfa Valvole), Water (comprised of Pulsafeeder, Knight, ADS, IETG, and iPEK), Industrial (comprised of Richter, Viking, Aegis, Warren Rupp, and Trebor), and Agriculture (comprised of Banjo) platforms. The Health & Science Technologies segment contains the Scientific Fluidics (comprised of Eastern Plastics, Rheodyne, Sapphire Engineering, Upchurch Scientific, ERC, and CiDRA Precision Services), IDEX Optics & Photonics (comprised of CVI Melles Griot, Semrock, and AT Films), Sealing Solutions (comprised of PPE, FTL, and Novotema), Gast, Micropump, and Material Processing Technologies (comprised of Quadro, Fitzpatrick, Microfluidics, and Matcon) platforms. The Fire & Safety/Diversified Products segment is comprised of the Fire Suppression (comprised of Class 1, Hale, and Godiva), Rescue (comprised of Dinglee, Hurst Jaws of Life, Lukas, and Vetter), Band-It, and Dispensing platforms. The Fluid & Metering Technologies segment designs, produces and distributes positive displacement pumps, flow meters, valves, injectors, and other fluid-handling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water & wastewater, agriculture and energy industries. The Health & Science Technologies segment designs, produces and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical and cosmetics, pneumatic components and sealing solutions, including very high precision, low-flow rate pumping solutions required in analytical instrumentation, clinical diagnostics and drug discovery, high performance molded and extruded, biocompatible medical devices and implantables, air compressors used in medical, dental and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, life sciences, aerospace, telecommunications and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life sciences, research and defense markets, and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Fire & Safety/Diversified Products segment produces firefighting pumps and controls, rescue tools, lifting bags and other components and systems for the fire and rescue industry, and engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications, precision equipment for dispensing, metering and mixing colorants and paints used in a variety of retail and commercial businesses around the world. Our 2015 financial results are as follows: • Sales of $2.0 billion decreased (6)%; reflecting a 4% decrease in organic sales (excluding acquisitions and foreign currency translation), a 4% decrease due to foreign currency, and a 2% increase due to acquisitions. • Operating income of $431.7 million remained flat and operating margin of 21.4% was up 130 basis points from the prior year. • Net income increased 1% to $282.8 million. • Diluted EPS of $3.62 increased $0.17 or 5% compared to 2014. Our 2015 financial results, adjusted for $11.2 million of restructuring costs and an $18.1 million gain on the sale of a business, are as follows (these non-GAAP measures have been reconciled to U.S. GAAP measures in Item 6, “Selected Financial Data”): • Adjusted operating income of $424.9 million decreased 4% and adjusted operating margin of 21.0% was up 30 basis points from the prior year adjusted operating income of $444.9 million and adjusted operating margin of 20.7%. • Adjusted net income of $277.2 million is 4% lower than the prior year of $288.8 million. • Adjusted EPS of $3.55 was 1% lower than the prior year adjusted EPS of $3.57. Overall, we believe the current contraction of global economies will continue to pressure our end markets, creating an unstable growth environment for 2016. Based on the Company’s current outlook, we anticipate organic growth to be flat in 2016 with full year EPS of $3.60 to $3.70. Results of Operations The following is a discussion and analysis of our results of operations for each of the three years in the period ended December 31, 2015. For purposes of this Item, reference is made to the Consolidated Statements of Operations in Part II, Item 8, “Financial Statements and Supplementary Data.” Segment operating income excludes unallocated corporate operating expenses. Management’s primary measurements of segment performance are sales, operating income, and operating margin. In the following discussion, and throughout this report, references to organic sales, a non-GAAP measure, refers to sales from continuing operations calculated according to generally accepted accounting principles in the United States but excludes (1) the impact of foreign currency translation and (2) sales from acquired businesses during the first twelve months of ownership. The portion of sales attributable to foreign currency translation is calculated as the difference between (a) the period-to-period change in organic sales and (b) the period-to-period change in organic sales after applying prior period foreign exchange rates to the current year period. Management believes that reporting organic sales provides useful information to investors by helping identify underlying growth trends in our business and facilitating easier comparisons of our revenue performance with prior and future periods and to our peers. The Company excludes the effect of foreign currency translation from organic sales because foreign currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends. The Company excludes the effect of acquisitions because the nature, size, and number of acquisitions can vary dramatically from period to period and between the Company and its peers and can also obscure underlying business trends and make comparisons of long-term performance difficult. Performance in 2015 Compared with 2014 Sales in 2015 were $2.0 billion, a (6)% decrease from the comparable period last year. This decrease reflects a 4% decrease in organic sales, a 4% decrease from foreign currency translation and a 2% increase from acquisitions (CiDRA Precision Services - July 2015; Alfa Valvole - June 2015; Novotema - May 2015 and Aegis - April 2014). Sales to customers outside the U.S. represented approximately 50% of total sales in both 2015 and 2014. In 2015, Fluid & Metering Technologies contributed 43% of sales and 43% of operating income; Health & Science Technologies contributed 36% of sales and 33% of operating income; and Fire & Safety/Diversified Products contributed 21% of sales and 24% of operating income. Gross profit of $904.3 million in 2015 decreased $45.0 million, or 5%, from 2014, while gross margins increased 60 basis points to 44.8% in 2015 from 44.2% in 2014. The margin increase is mainly attributable to benefits from productivity initiatives, partially offset by decreased sales volume. SG&A expenses decreased to $479.4 million in 2015 from $504.4 million in 2014. The $25.0 million decrease is mainly attributable to a reduction in volume-related expenses of $35.1 million, partially offset by approximately $10.1 million of incremental costs from new acquisitions. As a percentage of sales, SG&A expenses were 23.7% for 2015 and 23.5% for 2014. During 2015, the Company recorded pre-tax restructuring expenses totaling $11.2 million compared to $13.7 million recorded in 2014. The restructuring expenses for both years were mainly attributable to employee severance related to head count reductions across all three segments and corporate. Operating income of $431.7 million in 2015 increased slightly from the $431.2 million recorded in 2014, primarily reflecting improved productivity offset by decreased volumes. Operating margin of 21.4% in 2015 was up 130 basis points from 20.1% in 2014 primarily due to the gain on the sale of the Ismatec product line and productivity improvements. Other (income) expense decreased $0.9 million from other income of $3.1 million in 2014 to $2.2 million of income in 2015 mainly due to mark-to-market gains in available for sale securities in 2014 compared to losses in 2015. Interest expense decreased slightly to $41.6 million in 2015 from $41.9 million in 2014. The decrease was primarily due to the maturation of the 2.58% Senior Euro Notes, partially offset by a higher balance on the Revolving Facility. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes decreased to $109.5 million in 2015 compared to $113.1 million in 2014. The effective tax rate decreased to 27.9% in 2015 compared to 28.8% in 2014, due to the revaluation of the Italian deferred tax liability related to the reduction in the Italian statutory tax rate, the disposition of the Ismatec product line and the mix of global pre-tax income among jurisdictions. Net income for the year of $282.8 million increased from the $279.4 million earned in 2014. Diluted earnings per share in 2015 of $3.62 increased $0.17 from $3.45 in 2014 as a result of the gain on the sale of the Ismatec product line and lower share count resulting from share repurchases, partially offset by lower sales volume. Fluid & Metering Technologies Segment Sales of $860.8 million decreased $38.8 million, or 4%, in 2015 compared with 2014. This decrease reflected a 2% decline in organic growth, a 2% increase from acquisitions (Alfa Valvole - June 2015 and Aegis - April 2014) and 4% of unfavorable foreign currency translation. In 2015, sales decreased approximately 3% domestically and 5% internationally. Sales to customers outside the U.S. were approximately 44% of total segment sales in 2015, compared with 45% in 2014. Sales within our Energy platform decreased compared to 2014 primarily due to the fall in oil prices and the related delay in large capital projects in Europe and the Middle East. Sales within our Industrial platform similarly decreased compared to 2014 due to the fall in oil & gas prices, but also due to the weakening of the North American industrial distribution market. This decrease was partially offset by an increase in European chemical project activity. Sales within our Agriculture platform decreased as OEM and after-market distribution sales fell significantly due to depressed commodity prices and lower farm incomes. The slight sales decrease in the Water platform was driven by weakness in North American industrial markets, offset by growth in the global municipal markets and share gains from new products. Sales in the Valves platform, which was created in the third quarter of 2015, increased as a result of the Alfa acquisition. Operating income and operating margin of $204.5 million and 23.8%; respectively, were lower than the $216.9 million and 24.1%; respectively, recorded in 2014, primarily due to the lower sales volume. Health & Science Technologies Segment Sales of $739.0 million decreased $13.0 million, or 2%, in 2015 compared with 2014. This decrease reflected a 1% decline in organic sales, a 2% increase from acquisitions (CiDRA Precision Services - July 2015 and Novotema - May 2015) and 3% unfavorable foreign currency translation. In 2015, sales decreased 3% domestically and 1% internationally. Sales to customers outside the U.S. were approximately 55% of total segment sales in 2015 compared with 54% in 2014. Sales within our Scientific Fluidics platform increased as demand from the core biotech, in-vitro diagnostic and analytical instrumentation markets grew and remained consistently strong through the year. Sales within our Material Processing Technologies platform decreased compared to 2014 due to softer orders in the first half of the year, as general spending on large capital projects declined. Sales within our Sealing Solutions platform increased compared to 2014 due to the acquisition of Novotema and strong growth in the semiconductor markets, partially offset by declines in the oil & gas market. Sales within the IDEX Optics and Photonics platform decreased compared to 2014, primarily from slow demand in the industrial and laser optical end markets. Sales in our Gast platform decreased compared to 2014 due to softness in North American industrial distribution markets. Sales in our Micropump platform decreased compared to 2014 due to softness in Asian printing markets, and declines in the North American industrial distribution market. Operating income and operating margin of $157.9 million and 21.4%, respectively, in 2015 were up from $153.0 million and 20.3%, respectively, recorded in 2014, primarily due to productivity initiatives, partially offset by lower volume. Fire & Safety/Diversified Products Segment Sales of $423.9 million decreased $78.8 million, or 16%, in 2015 compared with 2014. This decrease reflected a 10% decline in organic growth and 6% unfavorable foreign currency translation. In 2015, sales decreased 12% domestically and 19% internationally. Sales to customers outside the U.S. were approximately 52% of total segment sales in 2015, compared with 54% in 2014. Sales within our Dispensing platform decreased due to the benefit of large projects in the first half of the prior year and softness in Asian markets. The sales decrease in our Band-It platform was driven by the decline of upstream oil & gas sales, due to depressed prices, slightly offset by continued strength in the North American transportation markets. Sales within our Fire Suppression platform decreased due to prior year trailer sales for North American power production facilities, and lack of project orders in China and North America. Sales within our Rescue platform decreased, due to continued decision delays on municipal projects in Europe and Asia. Operating income of $115.7 million was lower than the $130.5 million recorded in 2014, while operating margin of 27.3% was higher than the 26.0% recorded in 2014, primarily due to favorable mix within the Dispensing platform along with productivity improvements across the entire segment, partially offset by lower volume. Performance in 2014 Compared with 2013 Sales in 2014 were $2.1 billion, a 6% increase from the comparable period the previous year. This increase reflects a 5% increase in organic sales and 1% from acquisitions (Aegis - April 2014 and FTL - March 2013). Organic sales to customers outside the U.S. represented approximately 50% of total sales in 2014 compared with 51% in 2013. In 2014, Fluid & Metering Technologies contributed 42% of sales and 43% of operating income; Health & Science Technologies contributed 35% of sales and 31% of operating income; and Fire & Safety/Diversified Products contributed 23% of sales and 26% of operating income. Gross profit of $949.3 million in 2014 increased $76.0 million, or 9%, from 2013, while gross margins were 44.2% in 2014 and 43.1% in 2013. The increases are mainly attributable to increased sales volume, favorable net material costs as well as benefits from productivity initiatives. SG&A expenses increased to $504.4 million in 2014 from $477.9 million in 2013. The $26.6 million increase reflects approximately $4.0 million of incremental costs from new acquisitions and $22.6 million of volume-related expenses. As a percentage of sales, SG&A expenses were 23.5% for 2014 and 23.6% for 2013. During 2014, the Company recorded pre-tax restructuring expenses totaling $13.7 million. No restructuring expenses were recorded in 2013. The 2014 restructuring expenses were mainly attributable to employee severance related to head count reductions across all three segments and corporate. Operating income of $431.2 million in 2014 increased from the $395.5 million recorded in 2013, primarily reflecting an increase in volume, improved productivity partially offset by the $13.7 million of restructuring-related charges recorded in 2014. Operating margin of 20.1% in 2014 was up from 19.5% in 2013 primarily due to volume leverage and productivity partially offset by the restructuring-related charges in 2014. Other (income) expense increased $3.3 million from other expense of $0.2 million in 2013 to $3.1 million of income in 2014 mainly due to a favorable impact from foreign currency transactions and an increase in interest income. Interest expense decreased slightly to $41.9 million in 2014 from $42.2 million in 2013. The decrease was principally due to lower interest rates. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes increased to $113.1 million in 2014 compared to $97.9 million in 2013. The effective tax rate increased to 28.8% in 2014 compared to 27.7% in 2013, due to a mix of global pre-tax income among jurisdictions and the 2012 U.S. R&D credit in 2013, which was retroactively reinstated to January 1, 2012 as a result of the the enactment of the American Taxpayer Relief Act of 2012 on January 2, 2013. Net income for the year of $279.4 million increased from the $255.2 million earned in 2013. Diluted earnings per share in 2014 of $3.45 increased $0.36 from $3.09 in 2013 due to higher net income and lower share count resulting from share repurchases. Fluid & Metering Technologies Segment Sales of $899.6 million increased $27.8 million, or 3%, in 2014 compared with 2013. This increase reflected 2% organic growth and 1% acquisition. The increase in organic sales was attributable to growth across all our platforms and groups within the segment. In 2014, organic sales increased approximately 4% domestically and 1% internationally. Organic sales to customers outside the U.S. were approximately 45% of total segment sales in 2014, compared with 46% in 2013. Sales within our Energy platform increased modestly compared to 2013, due to the strength of the LPG and refined fuel markets. Sales have grown in the North American and Asian markets, while Europe and the Middle East sales have declined, due to the fall in oil prices and large project delays. Sales within our Industrial platform increased compared to 2013 on continued strength of the North American industrial distribution and chemical markets. This increase was partially offset by a decline in Industrial chemical sales in Europe due to a lack of project activity. Sales within our Agriculture platform increased slightly driven by strong aftermarket demand in North America, which was offset by weak OEM demand due to falling farm income. The sales increase in our Water platform was driven by share gains from new products and increased global project activity. Operating income of $216.9 million was higher than the $211.3 million recorded in 2013, while operating margin of 24.1% was lower than the 24.2% recorded in 2013, primarily due to $6.4 million of restructuring charges recorded in 2014, partially offset by volume leverage and productivity initiatives. Health & Science Technologies Segment Sales of $752.0 million increased $37.4 million, or 5%, in 2014 compared with 2013. This increase reflected 4% growth in organic sales and 1% favorable foreign currency translation. In 2014, organic sales increased 7% domestically and 1% internationally. Organic sales to customers outside the U.S. were approximately 54% of total segment sales in 2014 compared with 53% in 2013. Sales within our MPT platform increased compared to 2013 due to large projects in the Asian food and pharmaceutical markets. Sales within our Scientific Fluidics platform increased after pausing in the middle part of 2014 as customers right-sized their inventory. In the latter part of 2014 we saw increased demand from the core biotech, in-vitro diagnostic and analytical instrumentation markets. Sales within our Sealing Solutions platform increased compared to 2013 due to strong growth in the semiconductor and marine diesel markets, partially offset by softness in oil & gas towards year end due to declining oil prices. Sales within our IOP platform were flat when compared to 2013, primarily from continued slow demand in the industrial and life sciences markets. Sales in our Gast platform increased compared to 2013 due to strong growth in the North American distribution markets. Sales in our Micropump platform increased compared to 2013 due to the success of new product introductions. Operating income and operating margin of $153.0 million and 20.3%, respectively, in 2014 were up from $136.7 million and 19.1%, respectively, recorded in 2013, primarily due to volume leverage and productivity initiatives, partially offset by $4.9 million of restructuring charges recorded in 2014. Fire & Safety/Diversified Products Segment Sales of $502.7 million increased $57.7 million, or 13%, in 2014 compared with 2013. This increase was driven entirely by organic growth. In 2014, organic sales increased 17% domestically and 9% internationally. Organic sales to customers outside the U.S. were approximately 54% of total segment sales in 2014, compared with 56% in 2013. Sales within our Dispensing platform increased due to the fulfillment of a large order in the first quarter of 2014 and the strength of Asian and Western European markets. The sales increase within our Band-It platform was driven by continued strength in the transportation, cable management and industrial industries, offset by declines in oil & gas application markets to close out the year. Sales within our Fire Suppression platform increased as a result of orders for fire suppression trailers at power production facilities and stable project orders in China and North America. Sales within our Rescue platform decreased slightly, due to delayed decision making for municipal projects in Europe and Asia. Operating income and operating margin of $130.5 million and 26.0%, respectively, were higher than the $102.7 million and 23.1% recorded in 2013, primarily due to volume leverage, partially offset by $1.0 million of restructuring charges recorded in 2014. Liquidity and Capital Resources Operating Activities Cash flows from operating activities decreased $7.6 million, or 2.1%, to $360.3 million in 2015, primarily due to lower earnings (excluding the gain on sale of business), partially offset by improved working capital performance. At December 31, 2015, working capital was $553.1 million and the Company’s current ratio was 2.79 to 1. At December 31, 2015, the Company’s cash and cash equivalents totaled $328.0 million, of which $298.8 million was held outside of the United States. Investing Activities Cash flow used in investing activities increased $138.2 million to $210.5 million in 2015, primarily as a result of cash paid for acquisitions, partially offset by proceeds from the sale of a business. Cash flows from operations were more than adequate to fund capital expenditures of $43.8 million and $48.0 million in 2015 and 2014, respectively. Capital expenditures were generally for machinery and equipment that improved productivity, although a portion was for business system technology, replacement of equipment, and construction of new facilities. Management believes that the Company has ample capacity in its plants and equipment to meet demand increases for future growth in the intermediate term. The Company acquired Novotema in May 2015 for cash consideration of $61.1 million (€56 million); Alfa in June 2015 for cash consideration of $112.6 million (€99.8 million); and CPS in July 2015 for cash consideration of $19.5 million and non-cash contingent consideration valued at $4.7 million. The entire purchase price for all of the 2015 acquisitions were funded with cash on hand. The Company acquired Aegis in April 2014 for cash consideration of $25.4 million and the entire purchase price was funded with borrowings under the Company’s bank credit facility. Financing Activities Cash flow used in financing activities increased $111.5 million, or 60.6% to $295.5 million in 2015, primarily as a result of the Company paying off the $88.4 million balance on the 2.58% Senior Euro Notes and increased payments, net of borrowings, of $23 million on the Company’s revolving credit facility. The Company maintains a revolving credit facility (the “Revolving Facility”), which is a $700.0 million unsecured, multi-currency bank credit facility expiring on June 23, 2020. At December 31, 2015, $195.0 million was outstanding under the Revolving Facility, with $7.2 million of outstanding letters of credit resulting in net available borrowing capacity under the Revolving Facility at December 31, 2015, was approximately $497.8 million. Borrowings under the Revolving Facility bear interest, at either an alternate base rate or an adjusted LIBOR rate plus, in each case, an applicable margin. This applicable margin is based on the Company’s senior, unsecured, long-term debt rating and can range from .005% to 1.50%. Based on the Company’s credit rating at December 31, 2015, the applicable margin was 1.10% resulting in an interest rate of 1.51% at December 31, 2015. Interest is payable (a) in the case of base rate loans, quarterly, and (b) in the case of LIBOR rate loans, on the maturity date of the borrowing, or quarterly from the effective date for borrowings exceeding three months. The Company may request increases in the lending commitments under the Credit Agreement, but the aggregate lending commitments pursuant to such increases may not exceed $350.0 million. An annual Revolving Facility fee, also based on the Company’s credit rating, is currently 15 basis points and is payable quarterly. As of December 31, 2014 the Company included the outstanding balance of the 2.58% Senior Euro Notes, $98.5 million, within Current liabilities on the Consolidated Balance Sheet as the maturity date was within twelve months. On June 9, 2015, the Company paid the balance of the 2.58% Senior Euro Notes, upon its maturity, using cash on hand. On December 6, 2010, the Company completed a public offering of $300.0 million 4.5% senior notes due December 15, 2020 (“4.5% Senior Notes”). The net proceeds from the offering of approximately $295.7 million, after deducting a $1.6 million issuance discount, a $1.9 million underwriting commission and $0.8 million offering expenses, were used to repay $250.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.5% Senior Notes bear interest at a rate of 4.5% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or a portion of the 4.5% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.5% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.5% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all the Company’s assets. The terms of the 4.5% Senior Notes also require the Company to make an offer to repurchase the 4.5% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. On December 9, 2011, the Company completed a public offering of $350.0 million 4.2% senior notes due December 15, 2021 (“4.2% Senior Notes”). The net proceeds from the offering of approximately $346.2 million, after deducting a $0.9 million issuance discount, a $2.3 million underwriting commission and $0.6 million offering expenses, were used to repay $306.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.2% Senior Notes bear interest at a rate of 4.2% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or part of the 4.2% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.2% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.2% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all the Company’s assets. The terms of the 4.2% Senior Notes also require the Company to make an offer to repurchase the 4.2% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. There are two key financial covenants that the Company is required to maintain in connection with the Revolving Facility, which requires a minimum interest coverage ratio of 3.0 to 1 and a maximum leverage ratio of 3.50 to 1. At December 31, 2015, the Company was in compliance with both of these financial covenants, as the Company’s interest coverage ratio was 12.73 to 1 and the leverage ratio was 1.63 to 1. There are no financial covenants relating to the 4.5% Senior Notes or 4.2% Senior Notes; however, both are subject to cross-default provisions. On December 1, 2015 the Company’s Board of Directors approved an increase of $300.0 million in the authorized level for repurchases of common stock. Repurchases under the program will be funded with future cash flow generation or borrowings available under the Revolving Facility. During 2015, the Company purchased a total of 2.8 million shares at a cost of $210.5 million, of which $2.3 million was settled in January 2016, compared to 3.0 million shares purchased at a cost of $222.5 million in 2014. As of December 31, 2015, there was $635 million of repurchase authorization remaining. The Company believes current cash, cash from operations and cash available under the Revolving Facility will be sufficient to meet its operating cash requirements, planned capital expenditures, interest and principal payments on all borrowings, pension and postretirement funding requirements, authorized share repurchases and annual dividend payments to holders of the Company’s common stock for the next twelve months. Additionally, in the event that suitable businesses are available for acquisition on acceptable terms, the Company may obtain all or a portion of the financing for these acquisitions through the incurrence of additional borrowings. As of December 31, 2015, $195.0 million was outstanding under the Revolving Facility, with $7.2 million of outstanding letters of credit, resulting in net available borrowing capacity under the Revolving Facility at December 31, 2015 of approximately $497.8 million. Contractual Obligations Our contractual obligations include pension and postretirement medical benefit plans, rental payments under operating leases, payments under capital leases, and other long-term obligations arising in the ordinary course of business. There are no identifiable events or uncertainties, including the lowering of our credit rating, which would accelerate payment or maturity of any of these commitments or obligations. The following table summarizes our significant contractual obligations and commercial commitments at December 31, 2015, and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal and interest payments on outstanding borrowings. Additional detail regarding these obligations is provided in the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” (1) Includes interest payments based on contractual terms and current interest rates for variable debt. (2) Consists primarily of tangible personal property leases. (3) Consists primarily of inventory commitments. (4) Comprises liabilities recorded on the balance sheet of $918.2 million, and obligations not recorded on the balance sheet of $364.0 million. Critical Accounting Policies We believe that the application of the following accounting policies, which are important to our financial position and results of operations, requires significant judgments and estimates on the part of management. For a summary of all of our accounting policies, including the accounting policies discussed below, see Note 1 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Revenue recognition - The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectibility of the sales price is reasonably assured. For product sales, delivery does not occur until the products have been shipped and risk of loss has been transferred to the customer. Revenue from services is recognized when the services are provided or ratably over the contract term. Some arrangements with customers may include multiple deliverables, including the combination of products and services. In such cases, the Company has identified these as separate elements in accordance with Accounting Standards Codification (“ASC”) 605-25, Revenue Recognition-Multiple-Element Arrangements-Recognition, and recognizes revenue consistent with the policy for each separate element based on the relative selling price method. Revenues from some long-term contracts are recognized on the percentage-of-completion method. Percentage-of-completion is measured principally by the percentage of costs incurred to date for each contract to the estimated total costs for such contract at completion. Provisions for estimated losses on uncompleted long-term contracts are made in the period in which such losses are determined. Due to uncertainties inherent in the estimation process, it is reasonably possible that completion costs, including those arising from contract penalty provisions and final contract settlements, will be revised in the near-term. Such revisions to costs and income are recognized in the period in which the revisions are determined. The Company records allowances for discounts, product returns and customer incentives at the time of sale as a reduction of revenue as such allowances can be reliably estimated based on historical experience and known trends. The Company also offers product warranties and accrues its estimated exposure for warranty claims at the time of sale based upon the length of the warranty period, warranty costs incurred and any other related information known to the Company. Goodwill, long-lived and intangible assets - The Company evaluates the recoverability of certain noncurrent assets utilizing various estimation processes. An impairment of a long-lived asset exists when the asset’s carrying amount exceeds its fair value, and is recorded when the carrying amount is not recoverable through future operations. An indefinite lived intangible asset or goodwill impairment exists when the carrying amount of intangible assets and goodwill exceeds its fair value. Assessments of possible impairments of goodwill, long-lived or intangible assets are made when events or changes in circumstances indicate that the carrying value of the asset may not be recoverable through future operations. Additionally, testing for possible impairment of recorded goodwill and indefinite-lived intangible asset balances is performed annually. The amount and timing of impairment charges for these assets require the estimation of future cash flows and the fair value of the related assets. The Company’s business acquisitions result in recording goodwill and other intangible assets, which affect the amount of amortization expense and possible impairment expense that the Company will incur in future periods. The Company follows the guidance prescribed in ASC 350, Goodwill and Other Intangible Assets, to test goodwill and intangible assets for impairment. Annually, on October 31, or more frequently if triggering events occur, the Company compares the fair value of their reporting units to the carrying value of each reporting unit to determine if a goodwill impairment exists. The Company determines the fair value of each reporting unit utilizing an income approach (discounted cash flows) weighted 50% and a market approach consisting of a comparable public company multiples methodology weighted 50%. To determine the reasonableness of the calculated fair values, the Company reviews the assumptions to ensure that neither the income approach nor the market approach yielded significantly different valuations. The key assumptions are updated every year for each reporting unit for the income and market methodology used to determine fair value. Various assumptions are utilized including forecasted operating results, annual operating plans, strategic plans, economic projections, anticipated future cash flows, the weighted average cost of capital, market data and market multiples. The assumptions that have the most significant effect on the fair value calculation are the weighted average cost of capital, the market multiples, forecasted EBITDA, and terminal growth rates. The 2015 and 2014 ranges for these three assumptions utilized by the Company are as follows: In assessing the fair value of the reporting units, the Company considered both the market approach and income approach. Under the market approach, the fair value of the reporting unit is determined by the respective trailing twelve month EBITDA and forward looking 2016 EBITDA (50% each), based on multiples of comparable public companies. The market approach is dependent on a number of significant management assumptions including forecasted EBITDA and selected market multiples. Under the income approach, the fair value of the reporting unit is determined based on the present value of estimated future cash flows. The income approach is dependent on a number of significant management assumptions including estimates of operating results, capital expenditures, net working capital requirements, long term growth rate and discount rates. Weighting was equally attributed to both the market and income approaches (50% each) in arriving at the fair value of the reporting units. In 2015 and 2014, there were no triggering events or changes in circumstances that would have required a review other than as of our annual test date. Based on the results of our measurement as of October 31, 2015, all reporting units had a fair value that was greater than 70% in excess of carrying value, except for our IOP and Valves reporting unit. Our IOP reporting unit had a fair value that was approximately 20% in excess of carrying value and our Valves reporting unit had a fair value near its carrying value as a result of the formation of this reporting unit in conjunction with our Alfa acquisition in June 2015. The unamortized Banjo trade name was determined to be an indefinite lived intangible asset which is tested for impairment on an annual basis in accordance with ASC 350 or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company uses the relief-from-royalty method, a form of the income approach. The relief-from-royalty method is dependent on a number of significant management assumptions, including estimates of revenues, royalty rates and discount rates. In 2015 and 2014, there were no triggering events or changes in circumstances that would have required a review other than as of our annual test date. Based on the results of our measurement as of October 31, 2015, the fair value of the Banjo trade name was greater than 20% in excess of carrying value. A long-lived asset impairment exists when the carrying amount of the asset exceeds its fair value. Assessments of possible impairments of long-lived assets are made when events or changes in circumstances indicate that the carrying value of the asset may not be recoverable through future operations. The amount and timing of impairment charges for these assets require the estimation of future cash flows and the fair value of the related assets. In 2015 and 2014, the Company concluded that certain long lived assets had a fair value that was less than the carrying value of the assets, resulting in $0.8 million and $2.5 million, respectively, of impairment charges. Defined benefit retirement plans - The plan obligations and related assets of the defined benefit retirement plans are presented in Note 15 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Level 1 assets are valued using unadjusted quoted prices for identical assets in active markets. Level 2 assets are valued using quoted prices or other observable inputs for similar assets. Level 3 assets are valued using unobservable inputs, but reflect the assumptions market participants would use in pricing the assets. Plan obligations and the annual pension expense are determined by consulting with actuaries using a number of assumptions provided by the Company. Key assumptions in the determination of the annual pension expense include the discount rate, the rate of salary increases, and the estimated future return on plan assets. To the extent actual amounts differ from these assumptions and estimated amounts, results could be adversely affected. The Society of Actuaries recently released revised mortality tables, which update life expectancy assumptions. In consideration of these tables, we modified the mortality assumptions used in determining our pension and post-retirement benefit obligations as of December 31, 2015, which will have a related impact on our annual benefit expense in future years. The new mortality tables may result in additional funding requirements dependent upon the funded status of our plans. These expectations presume all other assumptions remain constant and there are no changes to applicable funding regulations. Changes in the discount rate assumptions will impact the (gain) loss amortization and interest cost components of the projected benefit obligation (“PBO”), which in turn, may impact the Company’s funding decisions if the PBO exceeds plan assets. Each 100 basis point increase in the discount rate will cause a corresponding decrease in the PBO of approximately $22 million based upon the December 31, 2015 data. Each 100 basis point decrease in the discount rate will cause a corresponding increase in the PBO of approximately $26 million based upon the December 31, 2015 data. New Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09 which introduces a new five-step revenue recognition model. Under ASU 2014-09, an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This ASU also requires disclosures sufficient to enable users to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers, including qualitative and quantitative disclosures about contracts with customers, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. This standard is effective for fiscal years beginning after December 15, 2017, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption. The Company is currently evaluating the impact of the new guidance on our consolidated financial statements and have not yet determined the method by which we will adopt the standard in 2018.

<s>[INST] IDEX is an applied solutions company specializing in fluid and metering technologies, health and science technologies, and fire, safety and other diversified products built to customer specifications. IDEX’s products are sold in niche markets to a wide range of industries throughout the world. Accordingly, our businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where we do business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in the industries that use our products and overall industrial activity are important factors that influence the demand for our products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains fifteen platforms, where we focus on organic growth and strategic acquisitions. Each of our fifteen platforms is also a reporting unit, where we annually test for goodwill impairment. The Fluid & Metering Technologies segment contains the Energy (comprised of Corken, Faure Herman, Liquid Controls, SAMPI and Toptech), Valves (comprised of Alfa Valvole), Water (comprised of Pulsafeeder, Knight, ADS, IETG, and iPEK), Industrial (comprised of Richter, Viking, Aegis, Warren Rupp, and Trebor), and Agriculture (comprised of Banjo) platforms. The Health & Science Technologies segment contains the Scientific Fluidics (comprised of Eastern Plastics, Rheodyne, Sapphire Engineering, Upchurch Scientific, ERC, and CiDRA Precision Services), IDEX Optics & Photonics (comprised of CVI Melles Griot, Semrock, and AT Films), Sealing Solutions (comprised of PPE, FTL, and Novotema), Gast, Micropump, and Material Processing Technologies (comprised of Quadro, Fitzpatrick, Microfluidics, and Matcon) platforms. The Fire & Safety/Diversified Products segment is comprised of the Fire Suppression (comprised of Class 1, Hale, and Godiva), Rescue (comprised of Dinglee, Hurst Jaws of Life, Lukas, and Vetter), BandIt, and Dispensing platforms. The Fluid & Metering Technologies segment designs, produces and distributes positive displacement pumps, flow meters, valves, injectors, and other fluidhandling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water & wastewater, agriculture and energy industries. The Health & Science Technologies segment designs, produces and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical and cosmetics, pneumatic components and sealing solutions, including very high precision, lowflow rate pumping solutions required in analytical instrumentation, clinical diagnostics and drug discovery, high performance molded and extruded, biocompatible medical devices and implantables, air compressors used in medical, dental and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, life sciences, aerospace, telecommunications and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life sciences, research and defense markets, and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Fire & Safety/Diversified Products segment produces firefighting pumps and controls, rescue tools, lifting bags and other components and systems for the fire and rescue industry, and engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications, precision equipment for dispensing, metering and mixing colorants and paints used in a variety of retail and commercial businesses around the world. Our 2015 financial results are as follows: Sales of $2.0 billion decreased (6)%; reflecting a 4% decrease in organic sales (excluding acquisitions and foreign currency translation), a 4% decrease due to foreign currency, and a 2% increase due to ac [/INST] Positive. </s>

IDEX CORP /DE/

2017-02-23

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. 2016 Overview and Outlook IDEX is an applied solutions company specializing in fluid and metering technologies, health and science technologies, and fire, safety and other diversified products built to customers’ specifications. IDEX’s products are sold in niche markets to a wide range of industries throughout the world. Accordingly, IDEX’s businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where it does business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in certain industries and overall industrial activity are important factors that influence the demand for IDEX’s products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains thirteen platforms, where we focus on organic growth and strategic acquisitions. Each of our thirteen platforms is also a reporting unit, where we annually test for goodwill impairment. The Fluid & Metering Technologies segment contains the Energy (comprised of Corken, Faure Herman, Liquid Controls, SAMPI, and Toptech), Valves (comprised of Alfa Valvole, Richter, and Aegis), Water (comprised of Pulsafeeder, Knight, ADS, Trebor, and iPEK), Pumps (comprised of Viking and Warren Rupp), and Agriculture (comprised of Banjo) platforms. The Health & Science Technologies segment contains the Scientific Fluidics & Optics (comprised of Eastern Plastics, Rheodyne, Sapphire Engineering, Upchurch Scientific, ERC, CiDRA Precision Services, CVI Melles Griot, Semrock, and AT Films), Sealing Solutions (comprised of Precision Polymer Engineering, FTL Seals Technology, Novotema, and SFC Koenig), Gast, Micropump, and Material Processing Technologies (comprised of Quadro, Fitzpatrick, Microfluidics, and Matcon) platforms. The Fire & Safety/Diversified Products segment is comprised of the Fire & Safety (comprised of Class 1, Hale, Akron Brass, AWG Fittings, Godiva, Dinglee, Hurst Jaws of Life, Lukas, and Vetter), Band-It, and Dispensing platforms. The Fluid & Metering Technologies segment designs, produces and distributes positive displacement pumps, flow meters, valves, injectors, and other fluid-handling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water & wastewater, agriculture and energy industries. The Health & Science Technologies segment designs, produces and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical and cosmetics, pneumatic components and sealing solutions, including very high precision, low-flow rate pumping solutions required in analytical instrumentation, clinical diagnostics and drug discovery, high performance molded and extruded, biocompatible medical devices and implantables, air compressors used in medical, dental and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, life sciences, aerospace, telecommunications and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life sciences, research and defense markets, and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Fire & Safety/Diversified Products segment produces firefighting pumps and controls, valves, monitors, nozzles, rescue tools, lifting bags and other components and systems for the fire and rescue industry, engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications, and precision equipment for dispensing, metering and mixing colorants and paints used in a variety of retail and commercial businesses around the world. Our 2016 financial results were as follows: • Sales of $2.1 billion increased 5%, reflecting a 1% decrease in organic sales (excluding acquisitions, divestitures and foreign currency translation), a 1% decrease due to foreign currency translation, and a 7% increase due to acquisitions/divestitures. • Operating income of $405.8 million and operating margin of 19.2% were down 6% and 220 basis points, respectively, from the prior year. • Net income decreased 4% to $271.1 million. • Diluted EPS of $3.53 decreased $0.09 or 2% compared to 2015. Our 2016 financial results, adjusted for $3.7 million of restructuring costs, a $3.6 million pension settlement charge and a $22.3 million loss on sale of businesses, compared to our 2015 financial results adjusted for $11.2 million of restructuring costs and an $18.1 million gain on sale of a business are as follows (these non-GAAP measures have been reconciled to U.S. GAAP measures in Item 6, “Selected Financial Data”): • Adjusted operating income of $435.3 million and adjusted operating margin of 20.6% were up 2% and down 40 basis points, respectively, from the prior year. • Adjusted net income increased 4% to $288.4 million. • Adjusted EPS of $3.75 was 6% higher than prior year adjusted EPS of $3.55. Overall, we remain cautious due to the uncertainty within the global economy and the global political environment and project 1 to 2 percent organic growth in 2017. We expect to deliver full year 2017 EPS of $3.87 to $3.95. Results of Operations The following is a discussion and analysis of our results of operations for each of the three years in the period ended December 31, 2016. For purposes of this Item, reference is made to the Consolidated Statements of Operations in Part II, Item 8, “Financial Statements and Supplementary Data.” Segment operating income excludes unallocated corporate operating expenses. Management’s primary measurements of segment performance are sales, operating income, and operating margin. In the following discussion, and throughout this report, references to organic sales, a non-GAAP measure, refers to sales from continuing operations calculated according to generally accepted accounting principles in the United States but excludes (1) the impact of foreign currency translation and (2) sales from acquired or divested businesses during the first twelve months of ownership or divestiture. The portion of sales attributable to foreign currency translation is calculated as the difference between (a) the period-to-period change in organic sales and (b) the period-to-period change in organic sales after applying prior period foreign exchange rates to the current year period. Management believes that reporting organic sales provides useful information to investors by helping identify underlying growth trends in our business and facilitating easier comparisons of our revenue performance with prior and future periods and to our peers. The Company excludes the effect of foreign currency translation from organic sales because foreign currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends. The Company excludes the effect of acquisitions and divestitures because the nature, size, and number of acquisitions and divestitures can vary dramatically from period to period and between the Company and its peers and can also obscure underlying business trends and make comparisons of long-term performance difficult. Performance in 2016 Compared with 2015 Sales in 2016 were $2.1 billion, a 5% increase from last year. This increase reflects a 1% decrease in organic sales, a 1% decrease from foreign currency translation and a 7% increase from acquisitions/divestitures (Acquisitions: SFC Koenig - September 2016; AWG Fittings - July 2016; Akron Brass - March 2016; CiDRA Precision Services - July 2015; Alfa Valvole - June 2015 and Novotema - June 2015. Divestitures: CVI Korea - December 2016; IETG - October 2016; CVI Japan - September 2016; Hydra-Stop - July 2016 and Ismatec - July 2015). Sales to customers outside the U.S. represented approximately 50% of total sales in both 2016 and 2015. In 2016, Fluid & Metering Technologies contributed 40% of sales and 44% of operating income; Health & Science Technologies contributed 35% of sales and 31% of operating income; and Fire & Safety/Diversified Products contributed 25% of sales and 25% of operating income. Gross profit of $930.8 million in 2016 increased $26.5 million, or 3%, from 2015, while gross margin decreased 80 basis points to 44.0% in 2016 from 44.8% in 2015. The increase in gross profit is primarily a result of increased sales volume as a result of acquisitions, while the margin decrease is mainly attributable to $14.7 million of fair value inventory step up charges from 2016 acquisitions compared to $3.4 million from 2015 acquisitions. SG&A expenses increased to $499.0 million in 2016 from $479.4 million in 2015. The $19.6 million increase is mainly attributable to $41.4 million of incremental costs from new acquisitions and $3.6 million of pension settlement charges in 2016, partially offset by current year divestitures and cost savings from prior year restructuring actions. As a percentage of sales, SG&A expenses were 23.6% for 2016 and 23.7% for 2015. During 2016, the Company recorded a $22.3 million pre-tax loss on the sale of businesses related to the four divestitures during the year (Hydra-Stop - July 2016; CVI Japan - September 2016; IETG - October 2016; and CVI Korea - December 2016), compared to the $18.1 million pre-tax gain on the sale of a business in 2015 (Ismatec - July 2015). During 2016, the Company recorded pre-tax restructuring expenses totaling $3.7 million as part of initiatives that support the implementation of key strategic efforts designed to facilitate long-term, sustainable growth through cost reduction actions primarily consisting of employee reductions and facility rationalization. In 2015, the Company recorded $11.2 million of restructuring expenses mainly attributable to employee severance from headcount reductions across all three segments and corporate. Operating income of $405.8 million in 2016 decreased from $431.7 million in 2015, primarily resulted from the impact of the four divestitures in 2016 and the associated loss compared to the one divestiture in 2015 and the associated gain as well as the $3.6 million pension settlement charge in 2016 and the incremental fair value inventory step-up charges related to the 2016 acquisitions, partially offset by the reversal of $4.7 million of contingent consideration related to a 2015 acquisition and lower restructuring costs recorded in 2016 compared to 2015. Operating margin of 19.2% in 2016 was down 220 basis points from 21.4% in 2015 primarily due to the loss on the sale of businesses in 2016 compared to a gain on the sale of a business in 2015, and the 2016 pension settlement, partially offset by productivity improvements and lower restructuring costs year over year. Other (income) expense increased $6.1 million from income of $2.2 million in 2015 to income of $8.3 million in 2016 mainly due to $4.7 million of foreign currency transaction gains on intercompany loans that were established in conjunction with the SFC Koenig acquisition. Interest expense increased to $45.6 million in 2016 from $41.6 million in 2015. The increase was primarily due to the $200 million series of Senior Notes issued in 2016 and higher borrowings outstanding on the Revolving Facility. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes decreased to $97.4 million in 2016 compared to $109.5 million in 2015. The effective tax rate decreased to 26.4% in 2016 compared to 27.9% in 2015, due to tax benefits on the divestitures of CVI Korea and CVI Japan, certain return-to-provision adjustments and the early adoption of ASU 2016-09 and the related tax effects of share based payments now recognized as a reduction to income tax expense. These adjustments were offset by the incurrence of additional foreign withholding taxes, the prior year revaluation of the Italian deferred tax liability related to the reduction in the Italian statutory tax rate and tax expense on the divestiture of the Hydra-Stop product line and the prior year divestiture of the Ismatec product line as well as the mix of global pre-tax income among jurisdictions. Net income for the year of $271.1 million decreased from the $282.8 million in 2015. Diluted earnings per share in 2016 of $3.53 decreased $0.09 from $3.62 in 2015. Fluid & Metering Technologies Segment Sales of $849.1 million decreased $11.7 million, or 1%, in 2016 compared with 2015. This decrease reflected a 1% decline in organic sales, a 1% increase from acquisitions (Alfa Valvole - June 2015) and 1% of unfavorable foreign currency translation. In 2016, sales were flat domestically and decreased approximately 3% internationally. Sales to customers outside the U.S. were approximately 44% of total segment sales in both 2016 and 2015. Sales within our Energy platform increased compared to 2015 primarily due to strength within the aviation market, partially offset by continued weakness in the propane and oil and gas markets as well as challenges in the mobile end market. Sales within our Pumps platform (formerly Industrial) decreased compared to 2015 due to weakness in the North American industrial distribution market. Sales within the Water platform decreased due to the divestitures of Hydra-Stop and IETG and slowing demand in the chemical end market, partially offset by increased municipal spending. Sales within our Agriculture platform increased year over year due to increased demand in the second half of 2016 from both OEMs and distributors in anticipation of the 2017 planting season. Sales within the Valves platform, which was created in the third quarter of 2015, increased as a result of the full year impact of the Alfa Valvole acquisition, offset by a challenging oil & gas market and overall weakness in the European market. Operating income and operating margin of $214.2 million and 25.2%, respectively, were higher than the $204.5 million and 23.8%, respectively, recorded in 2015, primarily due to the full year impact of the Alfa Valvole acquisition as well as productivity initiatives, partially offset by lower volume. Health & Science Technologies Segment Sales of $744.8 million increased $5.8 million, or 1%, in 2016 compared with 2015. This increase reflected a 1% decrease in organic sales, a 3% increase from acquisitions / divestitures (Acquisitions: SFC Koenig - September 2016; CiDRA Precision Services - July 2015 and Novotema - May 2015. Divestitures: CVI Korea - December 2016 and CVI Japan - September 2016) and 1% of unfavorable foreign currency translation. In 2016, sales decreased 1% domestically and increased 3% internationally. Sales to customers outside the U.S. were approximately 55% of total segment sales in both 2016 and 2015. Sales within our Scientific Fluidics & Optics platform were down year over year due to a slowed demand in the industrial and laser optics end markets as well as the impact of the CVI Japan and CVI Korea divestitures in 2016 and the Ismatec divestiture in 2015 partially offset by strong demand in the core biotech and in-vitro diagnostic markets coupled with the full year impact of the CiDRA Precision Services acquisition and a strong semiconductor market. Sales within our Material Processing Technologies platform decreased compared to 2015 due to challenges in the North American markets which offset strength in the European and Indian pharma markets. Sales within our Sealing Solutions platform increased compared to 2015 due to the full year impact of the Novotema acquisition in 2015, the 2016 acquisition of SFC Koenig and continued strength in the semiconductor markets, partially offset by pressure in the oil & gas market. Sales in our Gast and Micropump platforms decreased year over year due to continued softness in the North American industrial distribution markets. Operating income and operating margin of $153.7 million and 20.6%, respectively, in 2016 were down from $157.9 million and 21.4%, respectively, in 2015, primarily due to the inventory step-up charges related to the SFC Koenig acquisition, the incremental impact of divestitures, partially offset by volume increases. Fire & Safety/Diversified Products Segment Sales of $520.0 million increased $96.1 million, or 23%, in 2016 compared with 2015. This increase reflected a 3% decline in organic sales, a 27% increase due to acquisitions (AWG Fittings - July 2016 and Akron Brass - March 2016) and 1% of unfavorable foreign currency translation. In 2016, sales increased 28% domestically and 18% internationally. Sales to customers outside the U.S. were approximately 51% of total segment sales in 2016 compared with 52% in 2015. Sales within our Dispensing platform increased year over year due to a strong Asian market and the overall strength of the X-Smart product sales, partially offset by the foreign currency impact caused by the strength of the U.S. dollar and challenges within the European markets. Sales decreased in our Band-It platform compared to 2015 as a result of declines in the oil & gas market, offset by strength in the transportation industry and the rebound of the European and Asian markets. Sales within our Fire & Safety platform increased compared to 2015 primarily due to the Akron Brass and AWG Fittings acquisitions as well as increased sales due to new product development, partially offset by project delays in Asia and large projects in Europe in 2015 which did not reoccur. Operating income of $121.9 million was higher than the $115.7 million in 2015, while operating margin of 23.4% was lower than the 27.3% in 2015, primarily due to the dilutive impact of acquisitions on margins and the inventory step-up charges related to the Akron Brass and AWG Fittings acquisitions. The higher operating income is primarily related to the impact of 2016 acquisitions. Performance in 2015 Compared with 2014 Sales in 2015 were $2.0 billion, a 6% decrease from 2014. This decrease reflects a 4% decrease in organic sales, a 4% decrease from foreign currency translation and a 2% increase from acquisitions (CiDRA Precision Services - July 2015; Alfa Valvole - June 2015; Novotema - May 2015 and Aegis - April 2014). Sales to customers outside the U.S. represented approximately 50% of total sales in both 2015 and 2014. In 2015, Fluid & Metering Technologies contributed 43% of sales and 43% of operating income; Health & Science Technologies contributed 36% of sales and 33% of operating income; and Fire & Safety/Diversified Products contributed 21% of sales and 24% of operating income. Gross profit of $904.3 million in 2015 decreased $45.0 million, or 5%, from 2014, while gross margins increased 60 basis points to 44.8% in 2015 from 44.2% in 2014. The margin increase is mainly attributable to benefits from productivity initiatives, partially offset by decreased sales volume. SG&A expenses decreased to $479.4 million in 2015 from $504.4 million in 2014. The $25.0 million decrease is mainly attributable to a reduction in volume-related expenses of $35.1 million, partially offset by approximately $10.1 million of incremental costs from new acquisitions. As a percentage of sales, SG&A expenses were 23.7% for 2015 and 23.5% for 2014. During 2015, the Company recorded pre-tax restructuring expenses totaling $11.2 million compared to $13.7 million recorded in 2014. The restructuring expenses for both years were mainly attributable to employee severance related to head count reductions across all three segments and corporate. Operating income of $431.7 million in 2015 increased slightly from the $431.2 million recorded in 2014, primarily reflecting improved productivity offset by decreased volumes. Operating margin of 21.4% in 2015 was up 130 basis points from 20.1% in 2014 primarily due to the gain on the sale of the Ismatec product line and productivity improvements. Other (income) expense decreased $0.9 million from other income of $3.1 million in 2014 to $2.2 million of income in 2015 mainly due to mark-to-market gains in available for sale securities in 2014 compared to losses in 2015. Interest expense decreased slightly to $41.6 million in 2015 from $41.9 million in 2014. The decrease was primarily due to the maturation of the 2.58% Senior Euro Notes, partially offset by a higher balance on the Revolving Facility. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes decreased to $109.5 million in 2015 compared to $113.1 million in 2014. The effective tax rate decreased to 27.9% in 2015 compared to 28.8% in 2014, due to the revaluation of the Italian deferred tax liability related to the reduction in the Italian statutory tax rate, the disposition of the Ismatec product line and the mix of global pre-tax income among jurisdictions. Net income for the year of $282.8 million increased from the $279.4 million earned in 2014. Diluted earnings per share in 2015 of $3.62 increased $0.17 from $3.45 in 2014. Fluid & Metering Technologies Segment Sales of $860.8 million decreased $38.8 million, or 4%, in 2015 compared with 2014. This decrease reflected a 2% decline in organic sales, a 2% increase from acquisitions (Alfa Valvole - June 2015 and Aegis - April 2014) and 4% of unfavorable foreign currency translation. In 2015, sales decreased approximately 3% domestically and 5% internationally. Sales to customers outside the U.S. were approximately 44% of total segment sales in 2015, compared with 45% in 2014. Sales within our Energy platform decreased compared to 2014 primarily due to the fall in oil prices and the related delay in large capital projects in Europe and the Middle East. Sales within our Pumps platform (formerly Industrial) similarly decreased compared to 2014 due to the fall in oil & gas prices, but also due to the weakening of the North American industrial distribution market. This decrease was partially offset by an increase in European chemical project activity. Sales within our Agriculture platform decreased as OEM and after-market distribution sales fell significantly due to depressed commodity prices and lower farm incomes. The slight sales decrease in the Water platform was driven by weakness in North American industrial markets, offset by growth in the global municipal markets and share gains from new products. Sales in the Valves platform, which was created in the third quarter of 2015, increased as a result of the Alfa acquisition. Operating income and operating margin of $204.5 million and 23.8%; respectively, were lower than the $216.9 million and 24.1%; respectively, recorded in 2014, primarily due to the lower sales volume. Health & Science Technologies Segment Sales of $739.0 million decreased $13.0 million, or 2%, in 2015 compared with 2014. This decrease reflected a 1% decline in organic sales, a 2% increase from acquisitions (CiDRA Precision Services - July 2015 and Novotema - May 2015) and 3% unfavorable foreign currency translation. In 2015, sales decreased 3% domestically and 1% internationally. Sales to customers outside the U.S. were approximately 55% of total segment sales in 2015 compared with 54% in 2014. Sales within our Scientific Fluidics & Optics platform increased as demand from the core biotech, in-vitro diagnostic and analytical instrumentation markets grew and remained consistently strong through the year, partially offset by from slow demand in the industrial and laser optical end markets. Sales within our Material Processing Technologies platform decreased compared to 2014 due to softer orders in the first half of the year, as general spending on large capital projects declined. Sales within our Sealing Solutions platform increased compared to 2014 due to the acquisition of Novotema and strong growth in the semiconductor markets, partially offset by declines in the oil & gas market. Sales in our Gast platform decreased compared to 2014 due to softness in North American industrial distribution markets. Sales in our Micropump platform decreased compared to 2014 due to softness in Asian printing markets, and declines in the North American industrial distribution market. Operating income and operating margin of $157.9 million and 21.4%, respectively, in 2015 were up from $153.0 million and 20.3%, respectively, recorded in 2014, primarily due to productivity initiatives, partially offset by lower volume. Fire & Safety/Diversified Products Segment Sales of $423.9 million decreased $78.8 million, or 16%, in 2015 compared with 2014. This decrease reflected a 10% decline in organic sales and 6% unfavorable foreign currency translation. In 2015, sales decreased 12% domestically and 19% internationally. Sales to customers outside the U.S. were approximately 52% of total segment sales in 2015, compared with 54% in 2014. Sales within our Dispensing platform decreased due to the benefit of large projects in the first half of the prior year and softness in Asian markets. The sales decrease in our Band-It platform was driven by the decline of upstream oil & gas sales, due to depressed prices, slightly offset by continued strength in the North American transportation markets. Sales within our Fire & Safety platform decreased due to prior year trailer sales for North American power production facilities, a lack of project orders in China and North America, and continued decision delays on municipal projects in Europe and Asia. Operating income of $115.7 million was lower than the $130.5 million recorded in 2014, while operating margin of 27.3% was higher than the 26.0% recorded in 2014, primarily due to favorable mix within the Dispensing platform along with productivity improvements across the entire segment, partially offset by lower volume. Liquidity and Capital Resources Operating Activities Cash flows from operating activities increased $39.6 million, or 11.0%, to $399.9 million in 2016, primarily due to the impact of current year acquisitions, lower bonus payments, early adoption of ASU 2016-09, and improved operating working capital performance, partially offset by higher prepaid income taxes in 2016. At December 31, 2016, working capital was $513.6 million and the Company’s current ratio was 2.66 to 1. At December 31, 2016, the Company’s cash and cash equivalents totaled $236.0 million, of which $190.3 million was held outside of the United States. Investing Activities Cash flows used in investing activities increased $298.7 million to $509.2 million in 2016, primarily as a result of an additional $315.0 million of cash paid for acquisitions, partially offset by $11.4 million of higher proceeds from the sale of businesses and $5.5 million of lower capital expenditures. Cash flows from operations were more than adequate to fund capital expenditures of $38.2 million and $43.8 million in 2016 and 2015, respectively. Capital expenditures were generally for machinery and equipment that improved productivity, although a portion was for business system technology, replacement of equipment, and construction of new facilities. Management believes that the Company has ample capacity in its plants and equipment to meet demand increases for future growth in the intermediate term. The Company acquired Akron Brass in March 2016 for cash consideration of $221.4 million; AWG Fittings in July 2016 for cash consideration of $47.5 million (€42.8 million); and SFC Koenig in September 2016 for cash consideration of $241.1 million (€215.9 million). The purchase prices for the 2016 acquisitions were funded with both cash on hand and borrowings under the Company’s revolving facilities. The Company acquired Novotema in May 2015 for cash consideration of $61.1 million (€56 million); Alfa Valvole in June 2015 for cash consideration of $112.6 million (€99.8 million); and CPS in July 2015 for cash consideration of $19.5 million and non-cash contingent consideration valued at $4.7 million. The entire purchase price for all of the 2015 acquisitions was funded with cash on hand. Financing Activities Cash flows from financing activities increased from $295.5 million of cash used in financing activities in 2015 to $46.5 million of cash provided by financing activities in 2016, primarily as a result of the Company paying off the $88.4 million balance on the 2.58% Senior Euro Notes in 2015, a reduction of $153.6 million of purchases of common stock in 2016, and the issuance of $200 million of Senior Notes in 2016. On June 13, 2016, the Company completed a private placement of $100 million aggregate principal amount of 3.20% Senior Notes due June 13, 2023 and $100 million aggregate principal amount of 3.37% Senior Notes due June 13, 2025 (collectively, the “Notes”) pursuant to a Note Purchase Agreement, dated June 13, 2016 (the “Purchase Agreement”). Each series of Notes bears interest at the stated amount per annum, which is payable semi-annually in arrears on each June 13th and December 13th. The Notes are unsecured obligations of the Company and rank pari passu in right of payment with all of the Company’s other unsecured, unsubordinated debt. The Company may at any time prepay all, or any portion of the Notes; provided that such portion is greater than 5% of the aggregate principal amount of Notes then outstanding. In the event of a prepayment, the Company will pay an amount equal to par plus accrued interest plus a make-whole amount. In addition, the Company may repurchase the Notes by making an offer to all holders of the Notes, subject to certain conditions. The Company maintains a revolving credit facility (the “Revolving Facility”), which is a $700.0 million unsecured, multi-currency bank credit facility expiring on June 23, 2020. At December 31, 2016, there was $169.6 million outstanding under the Revolving Facility and $9.2 million of outstanding letters of credit, resulting in a net available borrowing capacity under the Revolving Facility at December 31, 2016 of $521.2 million. Borrowings under the Revolving Facility bear interest, at either an alternate base rate or an adjusted LIBOR rate plus, in each case, an applicable margin. This applicable margin is based on the Company’s senior, unsecured, long-term debt rating and can range from .005% to 1.50%. Based on the Company’s credit rating at December 31, 2016, the applicable margin was 1.10%, resulting in a weighted average interest rate of 1.50% at December 31, 2016. Interest is payable (a) in the case of base rate loans, quarterly, and (b) in the case of LIBOR rate loans, on the maturity date of the borrowing, or quarterly from the effective date for borrowings exceeding three months. The Company may request increases in the lending commitments under the Credit Agreement, but the aggregate lending commitments pursuant to such increases may not exceed $350.0 million. An annual Revolving Facility fee, also based on the Company’s credit rating, is currently 15 basis points and is payable quarterly. On June 9, 2015, the Company paid the balance of the 2.58% Senior Euro Notes, upon its maturity, using cash on hand. On December 9, 2011, the Company completed a public offering of $350.0 million 4.2% senior notes due December 15, 2021 (“4.2% Senior Notes”). The net proceeds from the offering of $346.2 million, after deducting a $0.9 million issuance discount, a $2.3 million underwriting commission and $0.6 million offering expenses, were used to repay $306.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.2% Senior Notes bear interest at a rate of 4.2% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or part of the 4.2% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.2% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.2% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all the Company’s assets. The terms of the 4.2% Senior Notes also require the Company to make an offer to repurchase the 4.2% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. On December 6, 2010, the Company completed a public offering of $300.0 million 4.5% senior notes due December 15, 2020 (“4.5% Senior Notes”). The net proceeds from the offering of $295.7 million, after deducting a $1.6 million issuance discount, a $1.9 million underwriting commission and $0.8 million offering expenses, were used to repay $250.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.5% Senior Notes bear interest at a rate of 4.5% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or a portion of the 4.5% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.5% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.5% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all the Company’s assets. The terms of the 4.5% Senior Notes also require the Company to make an offer to repurchase the 4.5% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. There are two key financial covenants that the Company is required to maintain in connection with the Revolving Facility and the Notes, a minimum interest coverage ratio of 3.0 to 1 and a maximum leverage ratio of 3.50 to 1. At December 31, 2016, the Company was in compliance with both of these financial covenants, as the Company’s interest coverage ratio was 11.51 to 1 and the leverage ratio was 1.91 to 1. There are no financial covenants relating to the 4.5% Senior Notes or 4.2% Senior Notes; however, both are subject to cross-default provisions. On December 1, 2015 the Company’s Board of Directors approved an increase of $300.0 million in the authorized level for repurchases of common stock. Repurchases under the program will be funded with future cash flow generation or borrowings available under the Revolving Facility. During 2016, the Company purchased a total of 0.7 million shares at a cost of $55.0 million compared to 2.8 million shares purchased in 2015 at a cost of $210.5 million, of which $2.3 million was settled in January 2016. As of December 31, 2016, there was $580 million of repurchase authorization remaining. The Company believes current cash, cash from operations and cash available under the Revolving Facility will be sufficient to meet its operating cash requirements, planned capital expenditures, interest and principal payments on all borrowings, pension and postretirement funding requirements, authorized share repurchases and annual dividend payments to holders of the Company’s common stock for the next twelve months. Additionally, in the event that suitable businesses are available for acquisition upon acceptable terms, the Company may obtain all or a portion of the financing for these acquisitions through the incurrence of additional borrowings. As of December 31, 2016, $169.6 million was outstanding under the Revolving Facility, with $9.2 million of outstanding letters of credit, resulting in net available borrowing capacity under the Revolving Facility at December 31, 2016 of approximately $521.2 million. Contractual Obligations Our contractual obligations include pension and postretirement medical benefit plans, rental payments under operating leases, payments under capital leases, and other long-term obligations arising in the ordinary course of business. There are no identifiable events or uncertainties, including the lowering of our credit rating, which would accelerate payment or maturity of any of these commitments or obligations. The following table summarizes our significant contractual obligations and commercial commitments at December 31, 2016, and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal and interest payments on outstanding borrowings. Additional detail regarding these obligations is provided in the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” (1) Includes interest payments based on contractual terms and current interest rates for variable debt. (2) Consists primarily of tangible personal property leases. (3) Consists primarily of inventory commitments. (4) Comprises liabilities recorded on the balance sheet of $1,110.5 million, and obligations not recorded on the balance sheet of $396.0 million. Critical Accounting Policies We believe that the application of the following accounting policies, which are important to our financial position and results of operations, require significant judgments and estimates on the part of management. For a summary of all of our accounting policies, including the accounting policies discussed below, see Note 1 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Revenue recognition - The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectability of the sales price is reasonably assured. For product sales, delivery does not occur until the products have been shipped and risk of loss has been transferred to the customer. Revenue from services is recognized when the services are provided or ratably over the contract term. Some arrangements with customers may include multiple deliverables, including the combination of products and services. In such cases, the Company has identified these as separate elements in accordance with ASC 605-25, Revenue Recognition-Multiple-Element Arrangements, and recognizes revenue consistent with the policy for each separate element based on the relative selling price method. Revenues from certain long-term contracts are recognized on the percentage-of-completion method. Percentage-of-completion is measured principally by the percentage of costs incurred to date for each contract to the estimated total costs for such contract at completion. Provisions for estimated losses on uncompleted long-term contracts are made in the period in which such losses are determined. Due to uncertainties inherent in the estimation process, it is reasonably possible that completion costs, including those arising from contract penalty provisions and final contract settlements, will be revised in the near-term. Such revisions to costs and income are recognized in the period in which the revisions are determined. The Company records allowances for discounts, product returns and customer incentives at the time of sale as a reduction of revenue as such allowances can be reliably estimated based on historical experience and known trends. The Company also offers product warranties and accrues its estimated exposure for warranty claims at the time of sale based upon the length of the warranty period, warranty costs incurred and any other related information known to the Company. Goodwill, long-lived and intangible assets - The Company evaluates the recoverability of certain noncurrent assets utilizing various estimation processes. An impairment of a long-lived asset exists when the asset’s carrying amount exceeds its fair value, and is recorded when the carrying amount is not recoverable through future operations. An impairment of an indefinite-lived intangible asset or goodwill exists when the carrying amount of the intangible asset or goodwill exceeds its fair value. Assessments of possible impairments of long-lived or indefinite-lived intangible assets or goodwill are made if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Additionally, testing for possible impairments of recorded indefinite-lived intangible asset balances and goodwill is performed annually. On October 31, or more frequently if triggering events occur, the Company compares the fair value of its reporting units to the carrying value of each reporting unit to determine if a goodwill impairment exists. The amount and timing of impairment charges for these assets require the estimation of future cash flows to determine the fair value of the related assets. In 2016 and 2015, the Company concluded that certain long-lived assets had a fair value that was less than the carrying value of the assets, resulting in $0.2 million and $0.8 million, respectively, of long-lived asset impairment charges. The Company’s business acquisitions result in recording goodwill and other intangible assets, which affect the amount of amortization expense and possible impairment expense that the Company will incur in future periods. The Company follows the guidance prescribed in ASC 350, Goodwill and Other Intangible Assets, to test goodwill and intangible assets for impairment. The Company determines the fair value of each reporting unit utilizing an income approach (discounted cash flows) weighted 50% and a market approach (consisting of a comparable public company multiples methodology) weighted 50%. To determine the reasonableness of the calculated fair values, the Company reviews the assumptions to ensure that neither the income approach nor the market approach yielded significantly different valuations. The key assumptions are updated every year for each reporting unit for the income and market approaches used to determine fair value. Various assumptions are utilized including forecasted operating results, annual operating plans, strategic plans, economic projections, anticipated future cash flows, the weighted average cost of capital, market data and market multiples. The assumptions that have the most significant effect on the fair value calculations are the weighted average cost of capital, market multiples, forecasted EBITDA, and terminal growth rates. The 2016 and 2015 ranges for these three assumptions utilized by the Company are as follows: In assessing the fair value of the reporting units, the Company considers both the market approach and the income approach. Under the market approach, the fair value of the reporting unit is determined by the respective trailing twelve month EBITDA and the forward looking 2017 EBITDA (generally 50% each), based on multiples of comparable public companies. The market approach is dependent on a number of significant management assumptions including forecasted EBITDA and selected market multiples. Under the income approach, the fair value of the reporting unit is determined based on the present value of estimated future cash flows. The income approach is dependent on a number of significant management assumptions including estimates of operating results, capital expenditures, net working capital requirements, long-term growth rates and discount rates. Weighting was equally attributed to both the market and income approaches (50% each) in arriving at the fair value of the reporting units. In addition to performing our annual impairment test, we also performed interim impairment tests due to the divestitures in the third and fourth quarters of 2016 as well as the reorganization of certain reporting units. As a result of these impairment tests, the Company concluded that the reporting units had fair values in excess of their carrying values. The Banjo trade name is an indefinite-lived intangible asset which is tested for impairment on an annual basis in accordance with ASC 350 or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company uses the relief-from-royalty method, a form of the income approach. The relief-from-royalty method is dependent on a number of significant management assumptions, including estimates of revenues, royalty rates and discount rates. The Akron Brass trade name is an indefinite-lived intangible asset that was acquired as a result of the Akron Brass acquisition in March 2016 and is tested for impairment on an annual basis in accordance with ASC 350 or more frequently if events or changes in circumstances indicate that the asset might be impaired. The Company uses the relief-from-royalty method, a form of the income approach. The relief-from-royalty method is dependent on a number of significant management assumptions, including estimates of revenues, royalty rates and discount rates. In 2016 and 2015, there were no triggering events or changes in circumstances that would have required a review other than as of our annual test date. Based on the results of our measurement as of October 31, 2016, the fair value of the Banjo trade name was more than 25% in excess of the carrying value and the fair value of the Akron Brass trade name was near its carrying value as a result of the acquisition of this business in March 2016. Defined benefit retirement plans - The plan obligations and related assets of the defined benefit retirement plans are presented in Note 15 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Level 1 assets are valued using unadjusted quoted prices for identical assets in active markets. Level 2 assets are valued using quoted prices or other observable inputs for similar assets. Level 3 assets are valued using unobservable inputs, but reflect the assumptions market participants would use in pricing the assets. Plan obligations and the annual pension expense are determined by consulting with actuaries using a number of assumptions provided by the Company. Key assumptions in the determination of the annual pension expense include the discount rate, the rate of salary increases, and the estimated future return on plan assets. To the extent actual amounts differ from these assumptions and estimated amounts, results could be adversely affected. The Society of Actuaries releases annual updates to mortality tables, which update life expectancy assumptions. IDEX adopts these annual updates and, in consideration of these tables, we modified the mortality assumptions used in determining our pension and post-retirement benefit obligations as of December 31, 2016, which will have a related impact on our annual benefit expense in future years. New mortality tables may result in additional funding requirements dependent upon the funded status of our plans. These expectations presume all other assumptions remain constant and there are no changes to applicable funding regulations. Changes in the discount rate assumptions will impact the (gain) loss amortization and interest cost components of the projected benefit obligation (“PBO”), which in turn, may impact the Company’s funding decisions if the PBO exceeds plan assets. Each 100 basis point increase in the discount rate will cause a corresponding decrease in the PBO of approximately $27 million based upon the December 31, 2016 data. Each 100 basis point decrease in the discount rate will cause a corresponding increase in the PBO of approximately $33 million based upon the December 31, 2016 data.

<s>[INST] IDEX is an applied solutions company specializing in fluid and metering technologies, health and science technologies, and fire, safety and other diversified products built to customers’ specifications. IDEX’s products are sold in niche markets to a wide range of industries throughout the world. Accordingly, IDEX’s businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where it does business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in certain industries and overall industrial activity are important factors that influence the demand for IDEX’s products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains thirteen platforms, where we focus on organic growth and strategic acquisitions. Each of our thirteen platforms is also a reporting unit, where we annually test for goodwill impairment. The Fluid & Metering Technologies segment contains the Energy (comprised of Corken, Faure Herman, Liquid Controls, SAMPI, and Toptech), Valves (comprised of Alfa Valvole, Richter, and Aegis), Water (comprised of Pulsafeeder, Knight, ADS, Trebor, and iPEK), Pumps (comprised of Viking and Warren Rupp), and Agriculture (comprised of Banjo) platforms. The Health & Science Technologies segment contains the Scientific Fluidics & Optics (comprised of Eastern Plastics, Rheodyne, Sapphire Engineering, Upchurch Scientific, ERC, CiDRA Precision Services, CVI Melles Griot, Semrock, and AT Films), Sealing Solutions (comprised of Precision Polymer Engineering, FTL Seals Technology, Novotema, and SFC Koenig), Gast, Micropump, and Material Processing Technologies (comprised of Quadro, Fitzpatrick, Microfluidics, and Matcon) platforms. The Fire & Safety/Diversified Products segment is comprised of the Fire & Safety (comprised of Class 1, Hale, Akron Brass, AWG Fittings, Godiva, Dinglee, Hurst Jaws of Life, Lukas, and Vetter), BandIt, and Dispensing platforms. The Fluid & Metering Technologies segment designs, produces and distributes positive displacement pumps, flow meters, valves, injectors, and other fluidhandling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water & wastewater, agriculture and energy industries. The Health & Science Technologies segment designs, produces and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical and cosmetics, pneumatic components and sealing solutions, including very high precision, lowflow rate pumping solutions required in analytical instrumentation, clinical diagnostics and drug discovery, high performance molded and extruded, biocompatible medical devices and implantables, air compressors used in medical, dental and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, life sciences, aerospace, telecommunications and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life sciences, research and defense markets, and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Fire & Safety/Diversified Products segment produces firefighting pumps and controls, valves, monitors, nozzles, rescue tools, lifting bags and other components and systems for the fire and rescue industry, engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications, and precision equipment for dispensing, metering and mixing colorants and paints used in a variety of retail and commercial businesses around the world. Our 2016 financial results were as follows: Sales of $2.1 billion increased 5%, reflecting a 1% decrease in organic sales (excluding acquisitions, divestitures [/INST] Negative. </s>

IDEX CORP /DE/

2018-02-22

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. 2017 Overview and Outlook IDEX is an applied solutions company specializing in fluid and metering technologies, health and science technologies, and fire, safety and other diversified products built to customers’ specifications. IDEX’s products are sold in niche markets to a wide range of industries throughout the world. Accordingly, IDEX’s businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where it does business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in certain industries and overall industrial activity are important factors that influence the demand for IDEX’s products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains thirteen platforms, where we focus on organic growth and strategic acquisitions. Each of our thirteen platforms is also a reporting unit, where we annually test for goodwill impairment. The Fluid & Metering Technologies segment designs, produces, and distributes positive displacement pumps, flow meters, valves, injectors, and other fluid-handling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water & wastewater, agriculture, and energy industries. The Fluid & Metering Technologies segment contains the Energy platform (comprised of Corken, Liquid Controls, SAMPI, and Toptech), the Valves platform (comprised of Alfa Valvole, Richter, and Aegis), the Water platform (comprised of Pulsafeeder, OBL, Knight, ADS, Trebor, and iPEK), the Pumps platform (comprised of Viking and Warren Rupp), and the Agriculture platform (comprised of Banjo). The Health & Science Technologies segment designs, produces, and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical, and cosmetics, pneumatic components and sealing solutions, including very high precision, low-flow rate pumping solutions required in analytical instrumentation, clinical diagnostics, and drug discovery, high performance molded and extruded sealing components, biocompatible medical devices and implantables, air compressors used in medical, dental, and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, life sciences, aerospace, telecommunications, and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life science, research, and defense markets, and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Health & Science Technologies segment contains the Scientific Fluidics & Optics platform (comprised of Eastern Plastics, Rheodyne, Sapphire Engineering, Upchurch Scientific, ERC, CiDRA Precision Services, thinXXS, CVI Melles Griot, Semrock, and AT Films), the Sealing Solutions platform (comprised of Precision Polymer Engineering, FTL Seals Technology, Novotema, and SFC Koenig) the Gast platform, the Micropump platform, and the Material Processing Technologies platform (comprised of Quadro, Fitzpatrick, Microfluidics, and Matcon). The Fire & Safety/Diversified Products segment produces firefighting pumps and controls, valves, monitors, nozzles, rescue tools, lifting bags and other components and systems for the fire and rescue industry, engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications, and precision equipment for dispensing, metering, and mixing colorants and paints used in a variety of retail and commercial businesses around the world. The Fire & Safety/Diversified Products segment is comprised of the Fire & Safety platform (comprised of Class 1, Hale, Akron Brass, AWG Fittings, Godiva, Dinglee, Hurst Jaws of Life, Lukas, and Vetter), the Band-It platform, and the Dispensing platform. Our 2017 financial results were as follows: • Sales of $2.3 billion increased 8%, reflecting a 6% increase in organic sales (excluding acquisitions and divestitures) and a 2% increase due to acquisitions/divestitures. • Operating income of $502.6 million was up 22% and operating margin of 22.0% was up 250 basis points, respectively, from the prior year. • Net income increased 24% to $337.3 million. • Diluted EPS of $4.36 increased $0.83, or 24%, compared to 2016. Our 2017 financial results, adjusted for $8.5 million of restructuring expense and a $9.3 million gain on sale of a business, compared to our 2016 financial results, adjusted for $3.7 million of restructuring expense, a $3.6 million pension settlement charge and a $22.3 million loss on the sale of businesses - net, were as follows (these non-GAAP measures have been reconciled to U.S. GAAP measures in Item 6, “Selected Financial Data”): • Adjusted operating income of $501.7 million was up 14% and adjusted operating margin of 21.9% was up 120 basis points, respectively, from the prior year. • Adjusted net income increased 16% to $333.7 million. • Adjusted EPS of $4.31 was 15% higher than prior year adjusted EPS of $3.75. Based on continued order strength in the fourth quarter, as well as benefits from our growth initiatives and segmentation efforts, we project approximately 5% organic revenue growth in 2018. Full year 2018 EPS is expected to be in the range of $4.90 to $5.10. Results of Operations The following is a discussion and analysis of our results of operations for each of the three years in the period ended December 31, 2017. For purposes of this Item, reference is made to the Consolidated Statements of Operations in Part II, Item 8, “Financial Statements and Supplementary Data.” Segment operating income excludes unallocated corporate operating expenses. Management’s primary measurements of segment performance are sales, operating income, and operating margin. In the following discussion, and throughout this report, references to organic sales, a non-GAAP measure, refers to sales from continuing operations calculated according to generally accepted accounting principles in the United States but excludes (1) the impact of foreign currency translation and (2) sales from acquired or divested businesses during the first twelve months of ownership or divestiture. The portion of sales attributable to foreign currency translation is calculated as the difference between (a) the period-to-period change in organic sales and (b) the period-to-period change in organic sales after applying prior period foreign exchange rates to the current year period. Management believes that reporting organic sales provides useful information to investors by helping identify underlying growth trends in our business and facilitating easier comparisons of our revenue performance with prior and future periods and to our peers. The Company excludes the effect of foreign currency translation from organic sales because foreign currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends. The Company excludes the effect of acquisitions and divestitures because the nature, size, and number of acquisitions and divestitures can vary dramatically from period to period and between the Company and its peers and can also obscure underlying business trends and make comparisons of long-term performance difficult. Performance in 2017 Compared with 2016 Sales in 2017 were $2.3 billion, an 8% increase from last year. This increase reflects a 6% increase in organic sales and a 2% increase from acquisitions/divestitures (Acquisitions: thinXXS - December 2017; SFC Koenig - September 2016; AWG Fittings - July 2016 and Akron Brass - March 2016 / Divestitures: Faure Herman - October 2017; CVI Korea - December 2016; IETG - October 2016; CVI Japan - September 2016 and Hydra-Stop - July 2016). Sales to customers outside the U.S. represented approximately 49% of total sales in 2017 compared with 50% in 2016. In 2017, Fluid & Metering Technologies contributed 38% of sales and 42% of operating income; Health & Science Technologies contributed 36% of sales and 32% of operating income; and Fire & Safety/Diversified Products contributed 26% of sales and 26% of operating income. Gross profit of $1.0 billion in 2017 increased $95.9 million, or 10%, from 2016, while gross margin increased 90 basis points to 44.9% in 2017 from 44.0% in 2016. The increase in gross profit and margin is primarily a result of increased sales volume and the dilutive impact in the prior year attributable to $14.7 million of fair value inventory step-up charges from 2016 acquisitions. SG&A expenses increased to $524.9 million in 2017 from $492.4 million in 2016. The $32.5 million increase is mainly attributable to $15.2 million of net incremental impact from acquisitions and divestitures as well as higher variable compensation and stock compensation expense. As a percentage of sales, SG&A expenses were 23.0% for 2017 and 23.3% for 2016. In 2017, the Company divested its Faure Herman business for a pre-tax gain of $9.3 million. In 2016, the Company divested four businesses during the year (Hydra-Stop - July 2016; CVI Japan - September 2016; IETG - October 2016; and CVI Korea - December 2016) for a pre-tax loss-net of $22.3 million. In 2017 and 2016, the Company incurred pre-tax restructuring expenses totaling $8.5 million and $3.7 million, respectively, as part of initiatives that support the implementation of key strategic efforts designed to facilitate long-term, sustainable growth through cost reduction actions primarily consisting of employee reductions and facility rationalization. Operating income of $502.6 million in 2017 increased from $412.4 million in 2016, primarily due to a gain on a divestiture in 2017 compared to a net loss on four divestitures in 2016, higher sales volume and the $14.7 million of fair value inventory step- up charges from 2016 acquisitions, partially offset by higher restructuring costs in 2017 and overall higher SG&A costs in 2017 due to higher variable and share-based compensation as well as outside consulting costs. Operating margin of 22.0% in 2017 was up 250 basis points from 19.5% in 2016 primarily due to the gain on the sale of a business in 2017 compared to a net loss on the sale of businesses in 2016, the dilutive impact in the prior year due to $14.7 million of fair value inventory step-up charges from 2016 acquisitions, as well as higher volume and productivity initiatives. Other (income) expense - net changed by $4.1 million, from income of $1.7 million in 2016 to expense of $2.4 million in 2017 mainly due to a $4.7 million foreign exchange gain on intercompany loans in the prior year that did not repeat in 2017 due to the fact that the Company entered into foreign currency exchange contracts to minimize the earnings impact associated with these intercompany loans. Interest expense decreased to $44.9 million in 2017 from $45.6 million in 2016. The decrease was primarily due to slightly lower borrowings in 2017 compared with 2016. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes increased to $118.0 million in 2017 compared to $97.4 million in 2016. The effective tax rate decreased to 25.9% in 2017 compared to 26.4% in 2016 due to the enactment of the Tax Cuts and Jobs Act (the “Tax Act”), a change in the permanent reinvestment assertion related to certain foreign subsidiaries as well as the incurrence of certain foreign income withholding taxes in the prior year. These amounts were offset by the prior year tax benefits on the divestitures of CVI Korea and CVI Japan, certain return-to-provision adjustments, a partial change in the assertion of permanent reinvestment of certain foreign earnings, as well as the mix of global pre-tax income among jurisdictions. On December 22, 2017, the President of the United States signed into law the Tax Act. The Tax Act included significant changes to the existing tax law, including, but not limited to, a permanent reduction to the U.S. federal corporate income tax rate from 35% to 21%, effective January 1, 2018, and the creation of a territorial tax system with a one-time repatriation tax on deferred foreign income (“Transition Tax”). We have estimated our provision for income taxes in accordance with the Tax Act and guidance available as of the date of this filing and as a result have recorded a net $0.1 million tax benefit in the fourth quarter of 2017, the period in which the legislation was enacted. Although the net effect from the Tax Act was a $0.1 million tax benefit, there were several offsetting adjustments, including: a $40.6 million provisional tax benefit related to the remeasurement of certain deferred tax assets and liabilities, based on the rates at which they are expected to reverse in the future; $30.3 million of provisional tax expense related to the one-time Transition Tax on the mandatory deemed repatriation of foreign earnings based on cumulative foreign earnings of $779.0 million; and an additional $10.2 million of tax expense primarily related to the removal of the permanent reinvestment representation with respect to certain of its subsidiaries in Canada, Italy, and Germany. The Tax Act also establishes new provisions that will affect the Company’s 2018 results, including but not limited to, a reduction in the U.S. corporate tax rate on domestic operations from 35 percent to 21 percent; a tax on certain income from foreign operations (Global Intangible Low-Tax Income, or “GILTI”); a general elimination of U.S. federal income taxes on dividends from foreign subsidiaries; the repeal of the domestic manufacturing deduction; and limitations on the deductibility of certain employee compensation. On December 22, 2017, the SEC issued Staff Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“SAB 118”), which provides guidance on accounting for tax effects of the Tax Act. SAB 118 provides a measurement period that should not extend beyond one year from the Tax Act enactment date for companies to complete the accounting under ASC 740. In accordance with SAB 118, a company must reflect the income tax effects of those aspects of the Tax Act for which the accounting under ASC 740 is complete. To the extent that a company’s accounting for certain income tax effects of the Tax Act is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate to be included in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provision of the tax laws that were in effect immediately before the enactment of the Tax Act. While the Company is able to make reasonable estimates of the impact of the reduction in corporate rate and the deemed repatriation transition tax, the final impact of the Tax Act may differ from these estimates, due to, among other things, changes in the Company’s interpretations and assumptions, additional guidance that may be issued by either the Internal Revenue Service or the U.S. Department of Treasury, and actions the Company may take. SAB 118 provides up to a one-year window for companies to finalize the accounting for the impacts of this new legislation and the Company anticipates finalizing its accounting during 2018. The Company has determined the following items are provisional amounts and reasonable estimates as of December 31, 2017: $40.6 million of deferred tax benefit recorded in connection with the remeasurement of certain deferred tax assets and liabilities, $30.3 million of current tax expense recorded in connection with the Transition Tax on the mandatory deemed repatriation of foreign earnings and $9.2 million of deferred tax expense recorded in connection with the removal of the permanent reinvestment representation with respect to certain of its subsidiaries in Canada, Italy and Germany. Net income for the year of $337.3 million increased from $271.1 million in 2016. Diluted earnings per share in 2017 of $4.36 increased $0.83 from $3.53 in 2016. Fluid & Metering Technologies Segment Sales of $881.0 million increased $31.9 million, or 4%, in 2017 compared with 2016. This increase reflected a 6% increase in organic sales and a 2% decline from divestitures (Faure Herman - October 2017; IETG - October 2016; and Hydra-Stop - July 2016). In 2017, sales were up 7% domestically and down 1% internationally. Sales to customers outside the U.S. were approximately 42% of total segment sales in 2017 compared with 44% in 2016. Sales within our Energy platform decreased compared to 2016 primarily due to the impact of the 2017 divestiture as well as a large, non-recurring project in 2016 and weakness in the midstream oil and gas markets, partially offset by continued strength within the aviation market, increased market share in LPG mobile and increasing truck builds. Sales within our Pumps platform increased compared to 2016 due to strength in the upstream oil market and the improving economy as well as a strong U.S. distribution channel. Sales within the Water platform decreased slightly compared to 2016 primarily due to the Hydra-Stop and IETG divestitures, partially offset by increased municipal spending and share gain from new product development. Sales within our Agriculture platform increased year over year due to increased demand across both OEM and distribution channels as well as pre-season order strength in the fourth quarter of 2017. Sales within the Valves platform increased over 2016 as a result of strong global industrial markets as well as an uptick in chemical markets. Operating income and operating margin of $241.0 million and 27.4%, respectively, were higher than the $217.5 million and 25.6%, respectively, recorded in 2016, primarily due to productivity initiatives and higher volume. Health & Science Technologies Segment Sales of $820.1 million increased $75.3 million, or 10%, in 2017 compared with 2016. This increase reflected an 8% increase in organic sales, a 3% increase from acquisitions / divestitures (Acquisitions: thinXXS - December 2017 and SFC Koenig - September 2016 / Divestitures: CVI Korea - December 2016 and CVI Japan - September 2016) and 1% of unfavorable foreign currency translation. In 2017, sales increased 10% both domestically and internationally. Sales to customers outside the U.S. were approximately 55% of total segment sales in both 2017 and 2016. Sales within our Scientific Fluidics & Optics platform increased compared to 2016 due to strong demand in all primary end markets, including analytical instrumentation, in-vitro diagnostics and biotechnology, DNA sequencing and semiconductor, partially offset by the impact of the CVI Japan and CVI Korea divestitures in 2016. Sales within our Material Processing Technologies platform were relatively flat compared to the prior year primarily due to the impact of strategic changes in product focus which resulted in discontinued products, offset by global strength in the food and pharma end markets and a strong project funnel. Sales within our Sealing Solutions platform increased significantly compared to 2016 due to the full year impact of the SFC Koenig acquisition in 2016 as well as strength in the semiconductor market and an uptick in the oil and gas, mining and automotive markets. Sales in our Gast platform remained relatively flat year over year primarily due to the impact of OEM headwinds during the first half of 2017 offset by increasing demand in industrial and dental markets. Sales within our Micropump platform increased year over year due to solid demand in the North American industrial markets. Operating income and operating margin of $179.6 million and 21.9%, respectively, in 2017 were up from $153.7 million and 20.6%, respectively, in 2016, primarily due to higher volume and the dilutive impact of the inventory step-up charge related to the SFC Koenig acquisition in the prior year, partially offset by higher restructuring expenses in 2017, costs associated with site consolidations within the Material Processing Technologies and the Scientific Fluidics & Optics platforms as well as additional engineering investments and operational challenges as a result of the strong growth within the segment. Fire & Safety/Diversified Products Segment Sales of $587.5 million increased $67.5 million, or 13%, in 2017 compared with 2016. This increase reflected a 4% increase in organic sales and a 9% increase due to acquisitions (AWG Fittings - July 2016 and Akron Brass - March 2016). In 2017, sales increased 9% domestically and 17% internationally. Sales to customers outside the U.S. were approximately 52% of total segment sales in 2017 compared with 51% in 2016. Sales within our Dispensing platform decreased slightly compared to 2016 due to declining markets in Latin America and U.S. retail, partially offset by growing strength in Europe and Asia. Sales increased in our Band-It platform compared to the prior year as a result of rebounding energy markets as well as strength across the transportation and industrial markets and increasing demand in Asia and Latin America. Sales within our Fire & Safety platform increased significantly compared to 2016 primarily due to the full year impact of the prior year acquisitions as well as strength in municipal and North American OEM markets. Operating income of $147.0 million and operating margin of 25.0% were higher than the $123.6 million and 23.8%, respectively, in 2016, primarily due to higher volume and productivity, as well as the full year impact of the Akron Brass and AWG Fittings acquisitions on 2017 financial results and the inclusion of $7.5 million of fair value inventory step-up charges related to the acquisitions in the prior year period. Performance in 2016 Compared with 2015 Sales in 2016 were $2.1 billion, a 5% increase from 2015. This increase reflects a 1% decrease in organic sales, a 1% decrease from foreign currency translation and a 7% increase from acquisitions/divestitures (Acquisitions: SFC Koenig - September 2016; AWG Fittings - July 2016; Akron Brass - March 2016; CiDRA Precision Services - July 2015; Alfa Valvole - June 2015 and Novotema - June 2015. Divestitures: CVI Korea - December 2016; IETG - October 2016; CVI Japan - September 2016; Hydra-Stop - July 2016 and Ismatec - July 2015). Sales to customers outside the U.S. represented approximately 50% of total sales in both 2016 and 2015. In 2016, Fluid & Metering Technologies contributed 40% of sales and 44% of operating income; Health & Science Technologies contributed 35% of sales and 31% of operating income; and Fire & Safety/Diversified Products contributed 25% of sales and 25% of operating income. Gross profit of $930.8 million in 2016 increased $26.5 million, or 3%, from 2015, while gross margin decreased 80 basis points to 44.0% in 2016 from 44.8% in 2015. The increase in gross profit is primarily a result of increased sales volume as a result of acquisitions, while the margin decrease is mainly attributable to $14.7 million of fair value inventory step-up charges from 2016 acquisitions compared to $3.4 million from 2015 acquisitions. SG&A expenses increased to $492.4 million in 2016 from $474.2 million in 2015. The $18.2 million increase is mainly attributable to $41.4 million of incremental costs from new acquisitions, partially offset by current year divestitures and cost savings from prior year restructuring actions. As a percentage of sales, SG&A expenses were 23.3% for 2016 and 23.5% for 2015. During 2016, the Company recorded a $22.3 million pre-tax loss on the sale of businesses related to the four divestitures during the year (Hydra-Stop - July 2016; CVI Japan - September 2016; IETG - October 2016; and CVI Korea - December 2016), compared to the $18.1 million pre-tax gain on the sale of a business in 2015 (Ismatec - July 2015). During 2016, the Company recorded pre-tax restructuring expenses totaling $3.7 million as part of initiatives that support the implementation of key strategic efforts designed to facilitate long-term, sustainable growth through cost reduction actions primarily consisting of employee reductions and facility rationalization. In 2015, the Company recorded $11.2 million of restructuring expenses mainly attributable to employee severance from headcount reductions across all three segments and corporate. Operating income of $412.4 million in 2016 decreased from $437.0 million in 2015, primarily as a result of the impact of the four divestitures in 2016 and the associated loss compared to the one divestiture in 2015 and the associated gain as well as the incremental fair value inventory step-up charges related to the 2016 acquisitions, partially offset by the reversal of $4.7 million of contingent consideration related to a 2015 acquisition and lower restructuring costs recorded in 2016 compared to 2015. Operating margin of 19.5% in 2016 was down 210 basis points from 21.6% in 2015 primarily due to the loss on the sale of businesses in 2016 compared to a gain on the sale of a business in 2015, partially offset by productivity improvements and lower restructuring costs year over year. Other (income) expense - net changed by $4.7 million from expense of $3.0 million in 2015 to income of $1.7 million in 2016 mainly due to $4.7 million of foreign currency transaction gains on intercompany loans that were established in conjunction with the SFC Koenig acquisition. Interest expense increased to $45.6 million in 2016 from $41.6 million in 2015. The increase was primarily due to the $200 million series of Senior Notes issued in 2016 and higher borrowings outstanding on the Revolving Facility. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes decreased to $97.4 million in 2016 compared to $109.5 million in 2015. The effective tax rate decreased to 26.4% in 2016 compared to 27.9% in 2015, due to tax benefits on the divestitures of CVI Korea and CVI Japan, certain return-to-provision adjustments and the early adoption of ASU 2016-09 and the related tax effects of share based payments now recognized as a reduction to income tax expense. These adjustments were offset by the incurrence of additional foreign withholding taxes, the prior year revaluation of the Italian deferred tax liability related to the reduction in the Italian statutory tax rate and tax expense on the divestiture of the Hydra-Stop product line and the prior year divestiture of the Ismatec product line as well as the mix of global pre-tax income among jurisdictions. Net income for the year of $271.1 million decreased from the $282.8 million in 2015. Diluted earnings per share in 2016 of $3.53 decreased $0.09 from $3.62 in 2015. Fluid & Metering Technologies Segment Sales of $849.1 million decreased $11.7 million, or 1%, in 2016 compared with 2015. This decrease reflected a 1% decline in organic sales, a 1% increase from acquisitions (Alfa Valvole - June 2015) and 1% of unfavorable foreign currency translation. In 2016, sales were flat domestically and decreased approximately 3% internationally. Sales to customers outside the U.S. were approximately 44% of total segment sales in both 2016 and 2015. Sales within our Energy platform increased compared to 2015 primarily due to strength within the aviation market, partially offset by continued weakness in the propane and oil and gas markets as well as challenges in the mobile end market. Sales within our Pumps platform (formerly Industrial) decreased compared to 2015 due to weakness in the North American industrial distribution market. Sales within the Water platform decreased due to the divestitures of Hydra-Stop and IETG and slowing demand in the chemical end market, partially offset by increased municipal spending. Sales within our Agriculture platform increased year over year due to increased demand in the second half of 2016 from both OEMs and distributors in anticipation of the 2017 planting season. Sales within the Valves platform, which was created in the third quarter of 2015, increased as a result of the full year impact of the Alfa Valvole acquisition, offset by a challenging oil & gas market and overall weakness in the European market. Operating income and operating margin of $217.5 million and 25.6%, respectively, were higher than the $206.4 million and 24.0%, respectively, recorded in 2015, primarily due to the full year impact of the Alfa Valvole acquisition as well as productivity initiatives, partially offset by lower volume. Health & Science Technologies Segment Sales of $744.8 million increased $5.8 million, or 1%, in 2016 compared with 2015. This increase reflected a 1% decrease in organic sales, a 3% increase from acquisitions / divestitures (Acquisitions: SFC Koenig - September 2016; CiDRA Precision Services - July 2015 and Novotema - May 2015. Divestitures: CVI Korea - December 2016 and CVI Japan - September 2016) and 1% of unfavorable foreign currency translation. In 2016, sales decreased 1% domestically and increased 3% internationally. Sales to customers outside the U.S. were approximately 55% of total segment sales in both 2016 and 2015. Sales within our Scientific Fluidics & Optics platform were down year over year due to slowed demand in the industrial and laser optics end markets as well as the impact of the CVI Japan and CVI Korea divestitures in 2016 and the Ismatec divestiture in 2015 partially offset by strong demand in the core biotech and in-vitro diagnostic markets coupled with the full year impact of the CiDRA Precision Services acquisition and a strong semiconductor market. Sales within our Material Processing Technologies platform decreased compared to 2015 due to challenges in the North American markets which offset strength in the European and Indian pharma markets. Sales within our Sealing Solutions platform increased compared to 2015 due to the full year impact of the Novotema acquisition in 2015, the 2016 acquisition of SFC Koenig and continued strength in the semiconductor markets, partially offset by pressure in the oil & gas market. Sales in our Gast and Micropump platforms decreased year over year due to continued softness in the North American industrial distribution markets. Operating income and operating margin of $153.7 million and 20.6%, respectively, in 2016 were down from $158.4 million and 21.4%, respectively, in 2015, primarily due to the inventory step-up charges related to the SFC Koenig acquisition, the incremental impact of divestitures, partially offset by volume increases. Fire & Safety/Diversified Products Segment Sales of $520.0 million increased $96.1 million, or 23%, in 2016 compared with 2015. This increase reflected a 3% decline in organic sales, a 27% increase due to acquisitions (AWG Fittings - July 2016 and Akron Brass - March 2016) and 1% of unfavorable foreign currency translation. In 2016, sales increased 28% domestically and 18% internationally. Sales to customers outside the U.S. were approximately 51% of total segment sales in 2016 compared with 52% in 2015. Sales within our Dispensing platform increased year over year due to a strong Asian market and the overall strength of the X-Smart product sales, partially offset by the foreign currency impact caused by the strength of the U.S. dollar and challenges within the European markets. Sales decreased in our Band-It platform compared to 2015 as a result of declines in the oil & gas market, offset by strength in the transportation industry and the rebound of the European and Asian markets. Sales within our Fire & Safety platform increased compared to 2015 primarily due to the Akron Brass and AWG Fittings acquisitions as well as increased sales due to new product development, partially offset by project delays in Asia and large projects in Europe in 2015 which did not reoccur. Operating income of $123.6 million was higher than the $117.3 million in 2015, while operating margin of 23.8% was lower than the 27.7% in 2015, primarily due to the dilutive impact of acquisitions on margins and the inventory step-up charges related to the Akron Brass and AWG Fittings acquisitions. The higher operating income is primarily related to the impact of 2016 acquisitions. Liquidity and Capital Resources Operating Activities Cash flows from operating activities increased $32.8 million, or 8.2%, to $432.8 million in 2017, primarily due to higher earnings in 2017. At December 31, 2017, working capital was $643.1 million and the Company’s current ratio was 2.78 to 1. At December 31, 2017, the Company’s cash and cash equivalents totaled $376.0 million, of which $219.6 million was held outside of the United States. Investing Activities Cash flows used in investing activities decreased $454.5 million to $54.7 million in 2017, primarily as a result of $471.8 million less cash paid for acquisitions, $17.3 million of lower proceeds from the sale of businesses, and $6.0 million of higher proceeds from fixed asset disposals, partially offset by $5.6 million of higher capital expenditures. Cash flows from operations were more than adequate to fund capital expenditures of $43.9 million and $38.2 million in 2017 and 2016, respectively. Capital expenditures were generally for machinery and equipment that improved productivity, although a portion was for business system technology, replacement of equipment, and construction of new facilities. Management believes that the Company has ample capacity in its plants and equipment to meet demand increases for future growth in the intermediate term. The Company acquired thinXXS in December 2017 for cash consideration of $38.2 million and the assumption of $1.2 million in debt. The purchase price for this acquisition was funded with cash on hand. The Company acquired Akron Brass in March 2016 for cash consideration of $221.4 million; AWG Fittings in July 2016 for cash consideration of $47.5 million (€42.8 million); and SFC Koenig in September 2016 for cash consideration of $241.1 million (€215.9 million). The purchase prices for the 2016 acquisitions were funded with both cash on hand and borrowings under the Company’s revolving facilities. Financing Activities Cash flows from financing activities changed from $46.5 million of cash provided by financing activities in 2016 to $277.4 million of cash used in financing activities in 2017, primarily as a result of higher payments under revolving facilities (net of borrowings) and proceeds from the issuance of $200.0 million senior notes, partially offset by a reduction of $28.2 million of purchases of common stock in 2017 and $7.3 million of lower proceeds from the exercise of stock options. On June 13, 2016, the Company completed a private placement of $100 million aggregate principal amount of 3.20% Senior Notes due June 13, 2023 and $100 million aggregate principal amount of 3.37% Senior Notes due June 13, 2025 (collectively, the “Notes”) pursuant to a Note Purchase Agreement, dated June 13, 2016 (the “Purchase Agreement”). Each series of Notes bears interest at the stated amount per annum, which is payable semi-annually in arrears on each June 13th and December 13th. The Notes are unsecured obligations of the Company and rank pari passu in right of payment with all of the Company’s other unsecured, unsubordinated debt. The Company may at any time prepay all, or any portion of the Notes; provided that such portion is greater than 5% of the aggregate principal amount of Notes then outstanding. In the event of a prepayment, the Company will pay an amount equal to par plus accrued interest plus a make-whole amount. In addition, the Company may repurchase the Notes by making an offer to all holders of the Notes, subject to certain conditions. The Company maintains a revolving credit facility (the “Revolving Facility”), which is a $700.0 million unsecured, multi-currency bank credit facility expiring on June 23, 2020. At December 31, 2017, there was $10.7 million outstanding under the Revolving Facility and $7.2 million of outstanding letters of credit, resulting in a net available borrowing capacity under the Revolving Facility at December 31, 2017 of $682.1 million. Borrowings under the Revolving Facility bear interest, at either an alternate base rate or an adjusted LIBOR rate plus, in each case, an applicable margin. This applicable margin is based on the Company’s senior, unsecured, long-term debt rating and can range from .005% to 1.50%. Based on the Company’s credit rating at December 31, 2017, the applicable margin was 1.10%. Given the fact that LIBOR was negative at December 31, 2017, the default interest rate is equal to the applicable margin, resulting in a weighted average interest rate of 1.10% at December 31, 2017. Interest is payable (a) in the case of base rate loans, quarterly, and (b) in the case of LIBOR rate loans, on the maturity date of the borrowing, or quarterly from the effective date for borrowings exceeding three months. The Company may request increases in the lending commitments under the Credit Agreement, but the aggregate lending commitments pursuant to such increases may not exceed $350.0 million. An annual Revolving Facility fee, also based on the Company’s credit rating, is currently 15 basis points and is payable quarterly. On June 9, 2015, the Company paid the balance of the 2.58% Senior Euro Notes, upon its maturity, using cash on hand. On December 9, 2011, the Company completed a public offering of $350.0 million 4.2% senior notes due December 15, 2021 (“4.2% Senior Notes”). The net proceeds from the offering of $346.2 million, after deducting a $0.9 million issuance discount, a $2.3 million underwriting commission and $0.6 million of offering expenses, were used to repay $306.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.2% Senior Notes bear interest at a rate of 4.2% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or part of the 4.2% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.2% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.2% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all the Company’s assets. The terms of the 4.2% Senior Notes also require the Company to make an offer to repurchase the 4.2% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. On December 6, 2010, the Company completed a public offering of $300.0 million 4.5% senior notes due December 15, 2020 (“4.5% Senior Notes”). The net proceeds from the offering of $295.7 million, after deducting a $1.6 million issuance discount, a $1.9 million underwriting commission and $0.8 million of offering expenses, were used to repay $250.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.5% Senior Notes bear interest at a rate of 4.5% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or a portion of the 4.5% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.5% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.5% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all the Company’s assets. The terms of the 4.5% Senior Notes also require the Company to make an offer to repurchase the 4.5% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. There are two key financial covenants that the Company is required to maintain in connection with the Revolving Facility and the Notes, a minimum interest coverage ratio of 3.0 to 1 and a maximum leverage ratio of 3.50 to 1. At December 31, 2017, the Company was in compliance with both of these financial covenants, as the Company’s interest coverage ratio was 13.64 to 1 and the leverage ratio was 1.45 to 1. There are no financial covenants relating to the 4.5% Senior Notes or 4.2% Senior Notes; however, both are subject to cross-default provisions. On December 1, 2015 the Company’s Board of Directors approved an increase of $300.0 million in the authorized level for repurchases of common stock. Repurchases under the program will be funded with future cash flow generation or borrowings available under the Revolving Facility. During 2017, the Company purchased a total of 0.3 million shares at a cost of $29.1 million compared to 0.7 million shares purchased in 2016 at a cost of $55.0 million. As of December 31, 2017, there was $551 million of repurchase authorization remaining. The Company believes current cash, cash from operations and cash available under the Revolving Facility will be sufficient to meet its operating cash requirements, planned capital expenditures, interest and principal payments on all borrowings, pension and postretirement funding requirements, authorized share repurchases and annual dividend payments to holders of the Company’s common stock for the next twelve months. Additionally, in the event that suitable businesses are available for acquisition upon acceptable terms, the Company may obtain all or a portion of the financing for these acquisitions through the incurrence of additional borrowings. As of December 31, 2017, $10.7 million was outstanding under the Revolving Facility, with $7.2 million of outstanding letters of credit, resulting in net available borrowing capacity under the Revolving Facility at December 31, 2017 of approximately $682.1 million. Contractual Obligations Our contractual obligations include pension and postretirement medical benefit plans, rental payments under operating leases, payments under capital leases, and other long-term obligations arising in the ordinary course of business. There are no identifiable events or uncertainties, including the lowering of our credit rating, which would accelerate payment or maturity of any of these commitments or obligations. The following table summarizes our significant contractual obligations and commercial commitments at December 31, 2017, and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal and interest payments on outstanding borrowings. Additional detail regarding these obligations is provided in the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” (1) Includes interest payments based on contractual terms and current interest rates for variable debt. (2) Consists primarily of tangible personal property leases. (3) Consists primarily of inventory commitments. (4) Comprises liabilities recorded on the balance sheet of $993.9 million, and obligations not recorded on the balance sheet of $358.7 million. Critical Accounting Policies We believe that the application of the following accounting policies, which are important to our financial position and results of operations, require significant judgments and estimates on the part of management. For a summary of all of our accounting policies, including the accounting policies discussed below, see Note 1 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Revenue recognition - The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectability of the sales price is reasonably assured. For product sales, delivery does not occur until the products have been shipped and risk of loss has been transferred to the customer. Revenue from services is recognized when the services are provided or ratably over the contract term. Some arrangements with customers may include multiple deliverables, including the combination of products and services. In such cases, the Company has identified these as separate elements in accordance with ASC 605-25, Revenue Recognition-Multiple-Element Arrangements, and recognizes revenue consistent with the policy for each separate element based on the relative selling price method. Revenues from certain long-term contracts are recognized on the percentage-of-completion method. Percentage-of-completion is measured principally by the percentage of costs incurred to date for each contract to the estimated total costs for such contract at completion. Provisions for estimated losses on uncompleted long-term contracts are made in the period in which such losses are determined. Due to uncertainties inherent in the estimation process, it is reasonably possible that completion costs, including those arising from contract penalty provisions and final contract settlements, will be revised in the near-term. Such revisions to costs and income are recognized in the period in which the revisions are determined. The Company records allowances for discounts, product returns and customer incentives at the time of sale as a reduction of revenue as such allowances can be reliably estimated based on historical experience and known trends. The Company also offers product warranties and accrues its estimated exposure for warranty claims at the time of sale based upon the length of the warranty period, warranty costs incurred and any other related information known to the Company. Goodwill, long-lived and intangible assets - The Company evaluates the recoverability of certain noncurrent assets utilizing various estimation processes. An impairment of a long-lived asset exists when the asset’s carrying amount exceeds its fair value, and is recorded when the carrying amount is not recoverable through future operations. An impairment of an indefinite-lived intangible asset or goodwill exists when the carrying amount of the intangible asset or goodwill exceeds its fair value. Assessments of possible impairments of long-lived or indefinite-lived intangible assets or goodwill are made if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Additionally, testing for possible impairments of recorded indefinite-lived intangible asset balances and goodwill is performed annually. On October 31, or more frequently if triggering events occur, the Company compares the fair value of each reporting unit to the carrying amount of each reporting unit to determine if a goodwill impairment exists. The amount and timing of impairment charges for these assets require the estimation of future cash flows to determine the fair value of the related assets. In 2017 and 2016, the Company concluded that certain long-lived assets had a fair value that was less than the carrying value of the assets, resulting in zero and $0.2 million of long-lived asset impairment charges, respectively. The Company’s business acquisitions result in recording goodwill and other intangible assets, which affect the amount of amortization expense and possible impairment expense that the Company will incur in future periods. The Company follows the guidance prescribed in ASC 350, Goodwill and Other Intangible Assets, to test goodwill and intangible assets for impairment. The Company determines the fair value of each reporting unit utilizing an income approach (discounted cash flows) weighted 50% and a market approach (consisting of a comparable public company multiples methodology) weighted 50%. To determine the reasonableness of the calculated fair values, the Company reviews the assumptions to ensure that neither the income approach nor the market approach yielded significantly different valuations. The key assumptions are updated every year for each reporting unit for the income and market approaches used to determine fair value. Various assumptions are utilized including forecasted operating results, annual operating plans, strategic plans, economic projections, anticipated future cash flows, the weighted average cost of capital, market data and market multiples. The assumptions that have the most significant effect on the fair value calculations are the weighted average cost of capital, market multiples, forecasted EBITDA, and terminal growth rates. The 2017 and 2016 ranges for these three assumptions utilized by the Company are as follows: In assessing the fair value of the reporting units, the Company considers both the market approach and the income approach. Under the market approach, the fair value of the reporting unit is determined by the respective trailing twelve month EBITDA and the forward looking 2018 EBITDA (50% each), based on multiples of comparable public companies. The market approach is dependent on a number of significant management assumptions including forecasted EBITDA and selected market multiples. Under the income approach, the fair value of the reporting unit is determined based on the present value of estimated future cash flows. The income approach is dependent on a number of significant management assumptions including estimates of operating results, capital expenditures, net working capital requirements, long-term growth rates and discount rates. Weighting was equally attributed to both the market and income approaches (50% each) in arriving at the fair value of the reporting units. The Banjo trade name and the Akron Brass trade name are indefinite-lived intangible assets which are tested for impairment on an annual basis in accordance with ASC 350 or more frequently if events or changes in circumstances indicate that the assets might be impaired. The Company uses the relief-from-royalty method, a form of the income approach, to determine the fair value of these trade names. The relief-from-royalty method is dependent on a number of significant management assumptions, including estimates of revenues, royalty rates and discount rates. In 2017 and 2016, there were no events that occurred or circumstances that changed that would have required a review other than as of our annual test date. Defined benefit retirement plans - The plan obligations and related assets of the defined benefit retirement plans are presented in Note 15 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Level 1 assets are valued using unadjusted quoted prices for identical assets in active markets. Level 2 assets are valued using quoted prices or other observable inputs for similar assets. Level 3 assets are valued using unobservable inputs, but reflect the assumptions market participants would use in pricing the assets. Plan obligations and the annual pension expense are determined by consulting with actuaries using a number of assumptions provided by the Company. Key assumptions in the determination of the annual pension expense include the discount rate, the rate of salary increases, and the estimated future return on plan assets. To the extent actual amounts differ from these assumptions and estimated amounts, results could be adversely affected. The Society of Actuaries releases annual updates to mortality tables, which update life expectancy assumptions. IDEX adopts these annual updates and, in consideration of these tables, we modified the mortality assumptions used in determining our pension and post-retirement benefit obligations as of December 31, 2017, which will have a related impact on our annual benefit expense in future years. New mortality tables may result in additional funding requirements dependent upon the funded status of our plans. These expectations presume all other assumptions remain constant and there are no changes to applicable funding regulations. Changes in the discount rate assumptions will impact the (gain) loss amortization and interest cost components of the projected benefit obligation (“PBO”), which in turn, may impact the Company’s funding decisions if the PBO exceeds plan assets. Each 100 basis point increase in the discount rate will cause a corresponding decrease in the PBO of approximately $29 million based upon the December 31, 2017 data. Each 100 basis point decrease in the discount rate will cause a corresponding increase in the PBO of approximately $35 million based upon the December 31, 2017 data.

<s>[INST] IDEX is an applied solutions company specializing in fluid and metering technologies, health and science technologies, and fire, safety and other diversified products built to customers’ specifications. IDEX’s products are sold in niche markets to a wide range of industries throughout the world. Accordingly, IDEX’s businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where it does business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in certain industries and overall industrial activity are important factors that influence the demand for IDEX’s products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains thirteen platforms, where we focus on organic growth and strategic acquisitions. Each of our thirteen platforms is also a reporting unit, where we annually test for goodwill impairment. The Fluid & Metering Technologies segment designs, produces, and distributes positive displacement pumps, flow meters, valves, injectors, and other fluidhandling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water & wastewater, agriculture, and energy industries. The Fluid & Metering Technologies segment contains the Energy platform (comprised of Corken, Liquid Controls, SAMPI, and Toptech), the Valves platform (comprised of Alfa Valvole, Richter, and Aegis), the Water platform (comprised of Pulsafeeder, OBL, Knight, ADS, Trebor, and iPEK), the Pumps platform (comprised of Viking and Warren Rupp), and the Agriculture platform (comprised of Banjo). The Health & Science Technologies segment designs, produces, and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical, and cosmetics, pneumatic components and sealing solutions, including very high precision, lowflow rate pumping solutions required in analytical instrumentation, clinical diagnostics, and drug discovery, high performance molded and extruded sealing components, biocompatible medical devices and implantables, air compressors used in medical, dental, and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, life sciences, aerospace, telecommunications, and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life science, research, and defense markets, and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Health & Science Technologies segment contains the Scientific Fluidics & Optics platform (comprised of Eastern Plastics, Rheodyne, Sapphire Engineering, Upchurch Scientific, ERC, CiDRA Precision Services, thinXXS, CVI Melles Griot, Semrock, and AT Films), the Sealing Solutions platform (comprised of Precision Polymer Engineering, FTL Seals Technology, Novotema, and SFC Koenig) the Gast platform, the Micropump platform, and the Material Processing Technologies platform (comprised of Quadro, Fitzpatrick, Microfluidics, and Matcon). The Fire & Safety/Diversified Products segment produces firefighting pumps and controls, valves, monitors, nozzles, rescue tools, lifting bags and other components and systems for the fire and rescue industry, engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications, and precision equipment for dispensing, metering, and mixing colorants and paints used in a variety of retail and commercial businesses around the world. The Fire & Safety/Diversified Products segment is comprised of the Fire & Safety platform (comprised of Class 1, Hale, Akron Brass, AWG Fittings, Godiva, Dinglee, Hurst Jaws of Life, Lukas, and Vetter), the BandIt platform, and the Dispensing platform. Our 2017 financial results were as follows: S [/INST] Positive. </s>

IDEX CORP /DE/

2019-02-28

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. 2018 Overview and Outlook IDEX is an applied solutions company specializing in the manufacture of fluid and metering technologies, health and science technologies and fire, safety and other diversified products built to customers’ specifications. IDEX’s products are sold in niche markets across a wide range of industries throughout the world. Accordingly, IDEX’s businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where it does business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in certain industries and overall industrial activity are important factors that influence the demand for IDEX’s products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains 13 platforms, where we focus on organic growth and strategic acquisitions. Each of our 13 platforms is also a reporting unit that we annually test goodwill for impairment. The Fluid & Metering Technologies segment designs, produces and distributes positive displacement pumps, flow meters, injectors and other fluid-handling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water and wastewater, agriculture and energy industries. The Fluid & Metering Technologies segment contains the Energy platform (comprised of Corken, Liquid Controls, SAMPI and Toptech), the Valves platform (comprised of Alfa Valvole, Richter and Aegis), the Water platform (comprised of Pulsafeeder, OBL, Knight, ADS, Trebor and iPEK), the Pumps platform (comprised of Viking and Warren Rupp) and the Agriculture platform (comprised of Banjo). The Health & Science Technologies segment designs, produces and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical and cosmetics, pneumatic components and sealing solutions, including very high precision, low-flow rate pumping solutions required in analytical instrumentation, clinical diagnostics and drug discovery, high performance molded and extruded sealing components, biocompatible medical devices and implantables, air compressors used in medical, dental and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, aerospace, telecommunications and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life sciences, research and defense markets and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Health & Science Technologies segment contains the Scientific Fluidics & Optics platform (comprised of Eastern Plastics, Rheodyne, Sapphire Engineering, Upchurch Scientific, ERC, CiDRA Precision Services, thinXXS, CVI Melles Griot, Semrock, AT Films and FLI), the Sealing Solutions platform (comprised of Precision Polymer Engineering, FTL Seals Technology, Novotema and SFC Koenig) the Gast platform, the Micropump platform and the Material Processing Technologies platform (comprised of Quadro, Fitzpatrick, Microfluidics and Matcon). The Fire & Safety/Diversified Products segment designs, produces and develops firefighting pumps, valves and controls, rescue tools, lifting bags and other components and systems for the fire and rescue industry, engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications and precision equipment for dispensing, metering, and mixing colorants and paints used in a variety of retail and commercial businesses around the world. The Fire & Safety/Diversified Products segment is comprised of the Fire & Safety platform (comprised of Class 1, Hale, Akron Brass, AWG Fittings, Godiva, Dinglee, Hurst Jaws of Life, Lukas and Vetter), the Band-It platform and the Dispensing platform. Our 2018 financial results were as follows: • Sales of $2.5 billion increased 9%, reflecting an 8% increase in organic sales and a 1% increase due to foreign currency translation. • Operating income of $569.1 million was up 13% and operating margin of 22.9% was up 90 basis points from the prior year. • Net income increased 22% to $410.6 million. • Diluted EPS of $5.29 increased $0.93, or 21%, compared to 2017. Our 2018 financial results, adjusted for $12.1 million of restructuring expense, compared to our 2017 financial results, adjusted for $8.5 million of restructuring expense and a $9.3 million gain on sale of a business, were as follows (these non-GAAP measures have been reconciled to U.S. GAAP measures in Item 6, “Selected Financial Data”): • Adjusted operating income of $581.2 million was up 16% and adjusted operating margin of 23.4% was up 150 basis points from the prior year. • Adjusted net income increased 26% to $419.6 million. • Adjusted EPS of $5.41 was 26% higher than prior year adjusted EPS of $4.31. Although trade tensions persist and the geopolitical environment remains uncertain, we are confident in our outlook given our market leading positions in our diversified portfolio and our track record of strong execution in volatile times. Consistent with our long-term strategic objective to grow faster than underlying market growth, we are projecting 4 to 5 percent organic revenue growth in 2019 and full year 2019 EPS is expected to be in the range of $5.60 to $5.80. Results of Operations The following is a discussion and analysis of our results of operations for each of the three years in the period ended December 31, 2018. For purposes of this Item, reference is made to the Consolidated Statements of Operations in Part II, Item 8, “Financial Statements and Supplementary Data.” Segment operating income excludes unallocated corporate operating expenses. Management’s primary measurements of segment performance are sales, operating income and operating margin. In the following discussion, and throughout this report, references to organic sales, a non-GAAP measure, refers to sales from continuing operations calculated according to generally accepted accounting principles in the United States but excludes (1) the impact of foreign currency translation and (2) sales from acquired or divested businesses during the first twelve months of ownership or divestiture. The portion of sales attributable to foreign currency translation is calculated as the difference between (a) the period-to-period change in organic sales and (b) the period-to-period change in organic sales after applying prior period foreign exchange rates to the current year period. Management believes that reporting organic sales provides useful information to investors by helping identify underlying growth trends in our business and facilitating easier comparisons of our revenue performance with prior and future periods and to our peers. The Company excludes the effect of foreign currency translation from organic sales because foreign currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends. The Company excludes the effect of acquisitions and divestitures because they can obscure underlying business trends and make comparisons of long-term performance difficult due to the varying nature, size and number of transactions from period to period and between the Company and its peers. Performance in 2018 Compared with 2017 Sales in 2018 were $2.5 billion, a 9% increase from last year. This increase reflects an 8% increase in organic sales and a 1% favorable impact from foreign currency translation. Sales to customers outside the U.S. represented approximately 51% of total sales in 2018 compared with 49% in 2017. In 2018, Fluid & Metering Technologies contributed 38% of sales and 42% of total segment operating income; Health & Science Technologies contributed 36% of sales and 32% of total segment operating income; and Fire & Safety/Diversified Products contributed 26% of sales and 26% of total segment operating income. Gross profit of $1.1 billion in 2018 increased $91.2 million, or 9%, from 2017, while gross margin increased 10 basis points to 45.0% in 2018 from 44.9% in 2017. The increase in gross profit and margin is primarily a result of productivity initiatives and volume leverage, partially offset by higher engineering costs. Selling, general and administrative (“SG&A”) expenses increased to $536.7 million in 2018 from $524.9 million in 2017. The $11.8 million increase is mainly attributable to a stamp duty tax in Switzerland associated with the restructuring of intercompany loans and higher stock compensation. As a percentage of sales, SG&A expenses were 21.6% for 2018 and 23.0% for 2017. In 2017, the Company divested its Faure Herman business for a pre-tax gain of $9.3 million. In 2018 and 2017, the Company incurred pre-tax restructuring expenses totaling $12.1 million and $8.5 million, respectively, as part of initiatives that support the implementation of key strategic efforts designed to facilitate long-term, sustainable growth through cost reduction actions primarily consisting of employee reductions and facility rationalization. Operating income of $569.1 million in 2018 increased from $502.6 million in 2017, primarily due to volume leverage, partially offset by the gain on the sale of a business in 2017 and higher restructuring costs in 2018. Operating margin of 22.9% in 2018 was up 90 basis points from 22.0% in 2017 primarily due to higher volume and productivity initiatives, partially offset by the gain on the sale of a business in 2017 and higher restructuring costs in 2018. Other (income) expense - net changed by $6.4 million, from expense of $2.4 million in 2017 to income of $4.0 million in 2018 mainly due to a foreign currency transaction gain on intercompany loans in 2018. Interest expense decreased to $44.1 million in 2018 from $44.9 million in 2017. The decrease was primarily due to slightly lower borrowings on the revolving credit facility during 2018 compared to 2017. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes increased to $118.4 million in 2018 compared to $118.0 million in 2017. The effective tax rate decreased to 22.4% in 2018 compared to 25.9% in 2017 due to the enactment of the Tax Cuts and Jobs Act (the “Tax Act”), including the one-time Transition Tax incurred in 2017 on the mandatory deemed repatriation of foreign earnings, the 14% decrease in the U.S. statutory income tax rate and the introduction of the Foreign-Derived Intangible Income (“FDII”) deduction, as well as the excess tax benefits related to share-based compensation. These amounts were offset by the removal of the domestic production activities deduction, the new Global Intangible Low-Taxed Income (“GILTI”) provision, increased limitation on the deductibility of executive compensation and the mix of global pre-tax income among jurisdictions. Net income for the year of $410.6 million increased from $337.3 million in 2017. Diluted earnings per share in 2018 of $5.29 increased $0.93 from $4.36 in 2017. Fluid & Metering Technologies Segment Sales of $951.6 million increased $70.6 million, or 8%, in 2018 compared with 2017. This increase reflected a 9% increase in organic sales and a 1% favorable impact from foreign currency translation, partially offset by a 2% decline from a divestiture (Faure Herman - October 2017). In 2018, sales were up 5% domestically and 12% internationally. Sales to customers outside the U.S. were approximately 43% of total segment sales in 2018 compared with 42% in 2017. Sales within our Pumps platform increased compared to 2017 due to strength in the North American industrial distribution market as well as strength in the oil and gas end market and lease automated custody transfer (“LACT”) products. Sales within the Water platform increased compared to 2017 due to strong international sales and increased project demand. Sales within our Agriculture platform increased year over year due to broad based demand across both OEM and distribution channels in North America and Europe. Sales within the Valves platform increased over 2017 primarily due to strong demand within the chemical end market in Europe and Asia. Sales within our Energy platform decreased slightly compared to 2017 primarily as a result of the divestiture of our Faure Herman business in October 2017, partially offset by strong truck builds and project gains in the LPG end market. Operating income and operating margin of $275.1 million and 28.9%, respectively, were higher than the $241.0 million and 27.4%, respectively, recorded in 2017, primarily due to higher volume and productivity initiatives, partially offset by higher restructuring expenses in 2018 and the divestiture in 2017. Health & Science Technologies Segment Sales of $896.4 million increased $76.3 million, or 9%, in 2018 compared with 2017. This increase reflected a 6% increase in organic sales, a 2% increase from acquisitions (FLI - July 2018 and thinXXS - December 2017) and a 1% favorable impact from foreign currency translation. In 2018, sales increased 7% domestically and 11% internationally. Sales to customers outside the U.S. were approximately 56% of total segment sales in 2018 and 55% in 2017. Sales within our Scientific Fluidics & Optics platform increased compared to 2017 due to new product introductions, market share gains, strong demand across our end markets, including IVD, biotechnology, semiconductor and defense and the Finger Lakes Instrumentation and thinXXS acquisitions. Sales within our Material Processing Technologies platform increased compared to 2017 primarily due to the timing of several large projects in 2018 and continued demand within the pharmaceutical end market in Asia, partially offset by the impact of strategic changes in product focus which resulted in discontinued product offerings in 2017. Sales within our Sealing Solutions platform increased compared to 2017 due to the extremely strong global demand in the semiconductor end market and strength in the energy, automotive and industrial end markets. Sales in our Gast platform increased compared to 2017 primarily due to the impact of OEM tailwinds and higher distribution volume as well as new product introductions. Sales within our Micropump platform increased compared to 2017 due to increasing demand in the printing end market. Operating income and operating margin of $205.7 million and 22.9%, respectively, in 2018 were up from $179.6 million and 21.9%, respectively, in 2017, primarily due to higher volume and productivity initiatives, partially offset by higher restructuring expenses in the current year related to site consolidations. Fire & Safety/Diversified Products Segment Sales of $637.0 million increased $49.5 million, or 8%, in 2018 compared with 2017. This increase reflected a 7% increase in organic sales and a 1% favorable impact from foreign currency translation. In 2018, sales increased 6% domestically and 11% internationally. Sales to customers outside the U.S. were approximately 53% of total segment sales in 2018 compared with 52% in 2017. Sales within our Dispensing platform increased compared to 2017 due to strong global demand led by the U.S. and Asia. Sales increased in our Band-It platform compared to 2017 due to market share gain across all global regions, strength in the energy, automotive and industrial end markets and several large project gains. Sales within our Fire & Safety platform increased compared to 2017 primarily due to OEM and distribution strength as well as strong demand for rescue tools across all geographies. Operating income of $168.6 million and operating margin of 26.5%, respectively, were higher than the $147.0 million and 25.0%, respectively, in 2017, primarily due to increased volume and productivity initiatives, partially offset by higher restructuring expenses in 2018. Performance in 2017 Compared with 2016 Sales in 2017 were $2.3 billion, an 8% increase from 2016. This increase reflects a 6% increase in organic sales and a 2% increase from acquisitions/divestitures (Acquisitions: thinXXS - December 2017; SFC Koenig - September 2016; AWG Fittings - July 2016 and Akron Brass - March 2016 / Divestitures: Faure Herman - October 2017; CVI Korea - December 2016; IETG - October 2016; CVI Japan - September 2016 and Hydra-Stop - July 2016). Sales to customers outside the U.S. represented approximately 49% of total sales in 2017 compared with 50% in 2016. In 2017, Fluid & Metering Technologies contributed 38% of sales and 42% of total segment operating income; Health & Science Technologies contributed 36% of sales and 32% of total segment operating income; and Fire & Safety/Diversified Products contributed 26% of sales and 26% of total segment operating income. Gross profit of $1.0 billion in 2017 increased $95.9 million, or 10%, from 2016, while gross margin increased 90 basis points to 44.9% in 2017 from 44.0% in 2016. The increase in gross profit and margin is primarily a result of increased sales volume and the dilutive impact in the prior year attributable to $14.7 million of fair value inventory step-up charges from 2016 acquisitions. SG&A expenses increased to $524.9 million in 2017 from $492.4 million in 2016. The $32.5 million increase is mainly attributable to $15.2 million of net incremental impact from acquisitions and divestitures as well as higher variable compensation and stock compensation expense. As a percentage of sales, SG&A expenses were 23.0% for 2017 and 23.3% for 2016. In 2017, the Company divested its Faure Herman business for a pre-tax gain of $9.3 million. In 2016, the Company divested four businesses during the year (Hydra-Stop - July 2016; CVI Japan - September 2016; IETG - October 2016; and CVI Korea - December 2016) for a pre-tax loss-net of $22.3 million. In 2017 and 2016, the Company incurred pre-tax restructuring expenses totaling $8.5 million and $3.7 million, respectively, as part of initiatives that support the implementation of key strategic efforts designed to facilitate long-term, sustainable growth through cost reduction actions primarily consisting of employee reductions and facility rationalization. Operating income of $502.6 million in 2017 increased from $412.4 million in 2016, primarily due to a gain on a divestiture in 2017 compared to a net loss on four divestitures in 2016, higher sales volume and the $14.7 million of fair value inventory step- up charges from 2016 acquisitions, partially offset by higher restructuring costs in 2017 and overall higher SG&A costs in 2017 due to higher variable and share-based compensation as well as outside consulting costs. Operating margin of 22.0% in 2017 was up 250 basis points from 19.5% in 2016 primarily due to the gain on the sale of a business in 2017 compared to a net loss on the sale of businesses in 2016, the dilutive impact in the prior year due to $14.7 million of fair value inventory step-up charges from 2016 acquisitions, as well as higher volume and productivity initiatives. Other (income) expense - net changed by $4.1 million, from income of $1.7 million in 2016 to expense of $2.4 million in 2017 mainly due to a $4.7 million foreign exchange gain on intercompany loans in the prior year that did not repeat in 2017 due to the fact that the Company entered into foreign currency exchange contracts to minimize the earnings impact associated with these intercompany loans. Interest expense decreased to $44.9 million in 2017 from $45.6 million in 2016. The decrease was primarily due to slightly lower borrowings in 2017 compared with 2016. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes increased to $118.0 million in 2017 compared to $97.4 million in 2016. The effective tax rate decreased to 25.9% in 2017 compared to 26.4% in 2016 due to the enactment of the Tax Cuts and Jobs Act (the “Tax Act”), a change in the permanent reinvestment assertion related to certain foreign subsidiaries as well as the incurrence of certain foreign income withholding taxes in the prior year. These amounts were offset by the prior year tax benefits on the divestitures of CVI Korea and CVI Japan, certain return-to-provision adjustments, a partial change in the assertion of permanent reinvestment of certain foreign earnings, as well as the mix of global pre-tax income among jurisdictions. Net income for the year of $337.3 million increased from $271.1 million in 2016. Diluted earnings per share in 2017 of $4.36 increased $0.83 from $3.53 in 2016. Fluid & Metering Technologies Segment Sales of $881.0 million increased $31.9 million, or 4%, in 2017 compared with 2016. This increase reflected a 6% increase in organic sales and a 2% decline from divestitures (Faure Herman - October 2017; IETG - October 2016; and Hydra-Stop - July 2016). In 2017, sales were up 7% domestically and down 1% internationally. Sales to customers outside the U.S. were approximately 42% of total segment sales in 2017 compared with 44% in 2016. Sales within our Energy platform decreased compared to 2016 primarily due to the impact of the 2017 divestiture as well as a large, non-recurring project in 2016 and weakness in the midstream oil and gas markets, partially offset by continued strength within the aviation market, increased market share in LPG mobile and increasing truck builds. Sales within our Pumps platform increased compared to 2016 due to strength in the upstream oil market and the improving economy as well as a strong U.S. distribution channel. Sales within the Water platform decreased slightly compared to 2016 primarily due to the Hydra-Stop and IETG divestitures, partially offset by increased municipal spending and share gain from new product development. Sales within our Agriculture platform increased year over year due to increased demand across both OEM and distribution channels as well as pre-season order strength in the fourth quarter of 2017. Sales within the Valves platform increased over 2016 as a result of strong global industrial markets as well as an uptick in chemical markets. Operating income and operating margin of $241.0 million and 27.4%, respectively, were higher than the $217.5 million and 25.6%, respectively, recorded in 2016, primarily due to productivity initiatives and higher volume. Health & Science Technologies Segment Sales of $820.1 million increased $75.3 million, or 10%, in 2017 compared with 2016. This increase reflected an 8% increase in organic sales, a 3% increase from acquisitions / divestitures (Acquisitions: thinXXS - December 2017 and SFC Koenig - September 2016 / Divestitures: CVI Korea - December 2016 and CVI Japan - September 2016) and 1% of favorable foreign currency translation. In 2017, sales increased 10% both domestically and internationally. Sales to customers outside the U.S. were approximately 55% of total segment sales in both 2017 and 2016. Sales within our Scientific Fluidics & Optics platform increased compared to 2016 due to strong demand in all primary end markets, including analytical instrumentation, in-vitro diagnostics and biotechnology, DNA sequencing and semiconductor, partially offset by the impact of the CVI Japan and CVI Korea divestitures in 2016. Sales within our Material Processing Technologies platform were relatively flat compared to the prior year primarily due to the impact of strategic changes in product focus which resulted in discontinued products, offset by global strength in the food and pharma end markets and a strong project funnel. Sales within our Sealing Solutions platform increased significantly compared to 2016 due to the full year impact of the SFC Koenig acquisition in 2016 as well as strength in the semiconductor market and an uptick in the oil and gas, mining and automotive markets. Sales in our Gast platform remained relatively flat year over year primarily due to the impact of OEM headwinds during the first half of 2017 offset by increasing demand in industrial and dental markets. Sales within our Micropump platform increased year over year due to solid demand in the North American industrial markets. Operating income and operating margin of $179.6 million and 21.9%, respectively, in 2017 were up from $153.7 million and 20.6%, respectively, in 2016, primarily due to higher volume and the dilutive impact of the inventory step-up charge related to the SFC Koenig acquisition in the prior year, partially offset by higher restructuring expenses in 2017, costs associated with site consolidations within the Material Processing Technologies and the Scientific Fluidics & Optics platforms as well as additional engineering investments and operational challenges as a result of the strong growth within the segment. Fire & Safety/Diversified Products Segment Sales of $587.5 million increased $67.5 million, or 13.0%, in 2017 compared with 2016. This increase reflected a 4% increase in organic sales and a 9% decline due to acquisitions (AWG Fittings - July 2016 and Akron Brass - March 2016). In 2017, sales increased 9% domestically and 17% internationally. Sales to customers outside the U.S. were approximately 52% of total segment sales in 2017 compared with 51% in 2016. Sales within our Dispensing platform decreased slightly compared to 2016 due to declining markets in Latin America and U.S. retail, partially offset by growing strength in Europe and Asia. Sales increased in our Band-It platform compared to the prior year as a result of rebounding energy markets as well as strength across the transportation and industrial markets and increasing demand in Asia and Latin America. Sales within our Fire & Safety platform increased significantly compared to 2016 primarily due to the full year impact of the prior year acquisitions as well as strength in municipal and North American OEM markets. Operating income of $147.0 million and operating margin of 25.0% were higher than the $123.6 million and 23.8%, respectively, in 2016, primarily due to higher volume and productivity, as well as the full year impact of the Akron Brass and AWG Fittings acquisitions on 2017 financial results and the inclusion of $7.5 million of fair value inventory step-up charges related to the acquisitions in the prior year period. Liquidity and Capital Resources Operating Activities Cash flows from operating activities increased $46.6 million, or 11%, to $479.3 million in 2018, primarily due to higher net income in 2018, partially offset by investments in working capital to support long-term growth. At December 31, 2018, working capital was $727.9 million and the Company’s current ratio was 3.0 to 1. At December 31, 2018, the Company’s cash and cash equivalents totaled $466.4 million, of which $326.5 million was held outside of the United States. Investing Activities Cash flows used in investing activities increased $26.7 million to $81.4 million in 2018, primarily due to $12.2 million of higher capital expenditures in 2018, $4.0 million spent on the purchase of intellectual property assets from Phantom Controls, Inc. (“Phantom”), $5.6 million of lower proceeds from the disposal of fixed assets in 2018, $21.8 million of proceeds from the sale of a business in 2017 which did not reoccur in 2018 and lower spending of $18.0 million on acquisitions in 2018 compared to 2017. Cash flows from operations were more than adequate to fund capital expenditures of $56.1 million and $43.9 million in 2018 and 2017, respectively. Capital expenditures were generally for machinery and equipment that supported growth, improved productivity, tooling, business system technology, replacement of equipment and investments in new facilities. Management believes that the Company has ample capacity in its plants and equipment to meet demand increases for future growth in the intermediate term. Financing Activities Cash flows used in financing activities increased $12.6 million to $290.0 million in 2018, primarily due to $16.3 of higher dividend payments and $144.9 million of higher purchases of common stock, partially offset by $156.3 million of lower repayments under the revolving credit facility (net of borrowings). On June 13, 2016, the Company completed a private placement of a $100 million aggregate principal amount of 3.20% Senior Notes due June 13, 2023 and a $100 million aggregate principal amount of 3.37% Senior Notes due June 13, 2025 (collectively, the “Notes”) pursuant to a Note Purchase Agreement, dated June 13, 2016 (the “Purchase Agreement”). Each series of Notes bears interest at the stated amount per annum, which is payable semi-annually in arrears on each June 13th and December 13th. The Notes are unsecured obligations of the Company and rank pari passu in right of payment with all of the Company’s other unsecured, unsubordinated debt. The Company may at any time prepay all, or any portion of the Notes; provided that such portion is greater than 5% of the aggregate principal amount of the Notes then outstanding. In the event of a prepayment, the Company will pay an amount equal to par plus accrued interest plus a make-whole amount. In addition, the Company may repurchase the Notes by making an offer to all holders of the Notes, subject to certain conditions. The Company maintains a revolving credit facility (the “Revolving Facility”), which is a $700.0 million unsecured, multi-currency bank credit facility expiring on June 23, 2020. At December 31, 2018, there was no balance outstanding under the Revolving Facility and $8.8 million of outstanding letters of credit, resulting in a net available borrowing capacity under the Revolving Facility at December 31, 2018 of $691.2 million. Borrowings under the Revolving Facility bear interest, at either an alternate base rate or an adjusted LIBOR rate plus, in each case, an applicable margin. This applicable margin is based on the Company’s senior, unsecured, long-term debt rating and can range from .005% to 1.50%. Based on the Company’s credit rating at December 31, 2018, the applicable margin was 1.10%. Interest is payable (a) in the case of base rate loans, quarterly, and (b) in the case of LIBOR rate loans, on the maturity date of the borrowing, or quarterly from the effective date for borrowings exceeding three months. The Company may request increases in the lending commitments under the Credit Agreement, but the aggregate lending commitments pursuant to such increases may not exceed $350.0 million. An annual Revolving Facility fee, also based on the Company’s credit rating, is currently 15 basis points and is payable quarterly. On December 9, 2011, the Company completed a public offering of $350.0 million 4.2% senior notes due December 15, 2021 (“4.2% Senior Notes”). The net proceeds from the offering of $346.2 million, after deducting a $0.9 million issuance discount, a $2.3 million underwriting commission and $0.6 million of offering expenses, were used to repay $306.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.2% Senior Notes bear interest at a rate of 4.2% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or part of the 4.2% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.2% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.2% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all of the Company’s assets. The terms of the 4.2% Senior Notes also require the Company to make an offer to repurchase the 4.2% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. On December 6, 2010, the Company completed a public offering of $300.0 million 4.5% senior notes due December 15, 2020 (“4.5% Senior Notes”). The net proceeds from the offering of $295.7 million, after deducting a $1.6 million issuance discount, a $1.9 million underwriting commission and $0.8 million of offering expenses, were used to repay $250.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.5% Senior Notes bear interest at a rate of 4.5% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or a portion of the 4.5% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.5% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.5% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all of the Company’s assets. The terms of the 4.5% Senior Notes also require the Company to make an offer to repurchase the 4.5% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. There are two key financial covenants that the Company is required to maintain in connection with the Revolving Facility and the Notes, a minimum interest coverage ratio of 3.0 to 1 and a maximum leverage ratio of 3.50 to 1. At December 31, 2018, the Company was in compliance with both of these financial covenants, as the Company’s interest coverage ratio was 15.65 to 1 and the leverage ratio was 1.27 to 1. There are no financial covenants relating to the 4.5% Senior Notes or 4.2% Senior Notes; however, both are subject to cross-default provisions. On December 1, 2015 the Company’s Board of Directors approved an increase of $300.0 million in the authorized level for repurchases of common stock. This followed the prior Board of Directors approved repurchase authorization of $400.0 million that was announced by the Company on November 6, 2014. Repurchases under the program will be funded with future cash flow generation or borrowings available under the Revolving Facility. During 2018, the Company purchased a total of 1.3 million shares at a cost of $173.9 million compared to 0.3 million shares purchased in 2017 at a cost of $29.1 million. As of December 31, 2018, the amount of share repurchase authorization remaining is $377.0 million. The Company believes current cash, cash from operations and cash available under the Revolving Facility will be sufficient to meet its operating cash requirements, planned capital expenditures, interest and principal payments on all borrowings, pension and postretirement funding requirements, authorized share repurchases and annual dividend payments to holders of the Company’s common stock for the next twelve months. Additionally, in the event that suitable businesses are available for acquisition upon acceptable terms, the Company may obtain all or a portion of the financing for these acquisitions through the incurrence of additional borrowings. As of December 31, 2018, there was no balance outstanding under the Revolving Facility and $8.8 million of outstanding letters of credit, resulting in a net available borrowing capacity under the Revolving Facility at December 31, 2018 of approximately $691.2 million. Contractual Obligations Our contractual obligations include pension and postretirement medical benefit plans, rental payments under operating leases, payments under capital leases and other long-term obligations arising in the ordinary course of business. There are no identifiable events or uncertainties, including the lowering of our credit rating, which would accelerate payment or maturity of any of these commitments or obligations. The following table summarizes our significant contractual obligations and commercial commitments at December 31, 2018 and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal and interest payments on outstanding borrowings. Additional detail regarding these obligations is provided in the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” (1) Includes interest payments based on contractual terms and current interest rates for variable debt. (2) Consists primarily of inventory commitments. (3) Comprises liabilities recorded on the balance sheet of $955.1 million and obligations not recorded on the balance sheet of $345.5 million. Critical Accounting Policies We believe that the application of the following accounting policies, which are important to our financial position and results of operations, require significant judgments and estimates on the part of management. For a summary of all of our accounting policies, including the accounting policies discussed below, see Note 1 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Revenue recognition - Revenue is recognized when control of the promised products or services is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for transferring those products or providing those services. A performance obligation is a promise in a contract to transfer a distinct product or service to the customer. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. Our performance obligations are satisfied at a point in time or over time as work progresses. Revenue from products and services transferred to customers at a point in time is recognized when obligations under the terms of the contract with our customer are satisfied. Generally, this occurs with the transfer of control of the asset, which is in line with shipping terms. Certain units recognize revenue over time because control transfers continuously to our customers. Revenue is recognized over time as work is performed based on the relationship between actual costs incurred to date for each contract and the total estimated costs for such contract at completion of the performance obligation (i.e. the cost-to-cost method) or is recognized ratably over the contract term. As a significant change in one or more of these estimates could affect the profitability of our contracts, we review and update our estimates regularly. Due to uncertainties inherent in the estimation process, it is reasonably possible that completion costs will be revised. Such revisions to costs and income are recognized in the period in which the revisions are determined as a cumulative catch-up adjustment. The impact of the adjustment on profit recorded to date on a contract is recognized in the period the adjustment is identified. If at any time the estimate of contract profitability indicates an anticipated loss on the contract, we recognize provisions for estimated losses on uncompleted contracts in the period in which such losses are determined. The Company records allowances for discounts, product returns and customer incentives at the time of sale as a reduction of revenue as such allowances can be reliably estimated based on historical experience and known trends. The Company also offers product warranties (primarily assurance-type) and accrues its estimated exposure for warranty claims at the time of sale based upon the length of the warranty period, warranty costs incurred and any other related information known to the Company. Goodwill, long-lived and intangible assets - The Company evaluates the recoverability of certain noncurrent assets utilizing various estimation processes. An impairment of a long-lived asset exists when the asset’s carrying amount exceeds its fair value and is recorded when the carrying amount is not recoverable through future operations. An impairment of an indefinite-lived intangible asset or goodwill exists when the carrying amount of the intangible asset or goodwill exceeds its fair value. Assessments of possible impairments of long-lived or indefinite-lived intangible assets or goodwill are made if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Additionally, testing for possible impairments of recorded indefinite-lived intangible asset balances and goodwill is performed annually. On October 31, or more frequently if triggering events occur, the Company compares the fair value of each reporting unit to the carrying amount of each reporting unit to determine if a goodwill impairment exists. The amount and timing of impairment charges for these assets require the estimation of future cash flows to determine the fair value of the related assets. In 2018 and 2017, the Company concluded that there were no long-lived assets with a fair value that was less than the carrying value. The Company’s business acquisitions result in recording goodwill and other intangible assets, which affect the amount of amortization expense and possible impairment expense that the Company will incur in future periods. The Company follows the guidance prescribed in ASC 350, Goodwill and Other Intangible Assets, to test goodwill and intangible assets for impairment. The Company determines the fair value of each reporting unit utilizing an income approach (discounted cash flows) weighted 50% and a market approach (consisting of a comparable public company multiples methodology) weighted 50%. To determine the reasonableness of the calculated fair values, the Company reviews the assumptions to ensure that neither the income approach nor the market approach yielded significantly different valuations. The key assumptions are updated every year for each reporting unit for the income and market approaches used to determine fair value. Various assumptions are utilized including forecasted operating results, annual operating plans, strategic plans, economic projections, anticipated future cash flows, the weighted average cost of capital, market data and market multiples. The assumptions that have the most significant effect on the fair value calculations are the weighted average cost of capital, market multiples, forecasted EBITDA and terminal growth rates. The 2018 and 2017 ranges for these three assumptions utilized by the Company are as follows: In assessing the fair value of the reporting units, the Company considers both the market approach and the income approach. Under the market approach, the fair value of the reporting unit is determined by the respective trailing twelve month EBITDA and the forward looking 2019 EBITDA (50% each), based on multiples of comparable public companies. The market approach is dependent on a number of significant management assumptions including forecasted EBITDA and selected market multiples. Under the income approach, the fair value of the reporting unit is determined based on the present value of estimated future cash flows. The income approach is dependent on a number of significant management assumptions including estimates of operating results, capital expenditures, net working capital requirements, long-term growth rates and discount rates. Weighting was equally attributed to both the market and income approaches (50% each) in arriving at the fair value of the reporting units. The Banjo trade name and the Akron Brass trade name are indefinite-lived intangible assets which are tested for impairment on an annual basis in accordance with ASC 350 or more frequently if events or changes in circumstances indicate that the assets might be impaired. The Company uses the relief-from-royalty method, a form of the income approach, to determine the fair value of these trade names. The relief-from-royalty method is dependent on a number of significant management assumptions, including estimates of revenues, royalty rates and discount rates. In 2018 and 2017, there were no events that occurred or circumstances that changed that would have required a review other than as of our annual test date. In 2018 and 2017, there were no impairment charges recorded. Defined benefit retirement plans - The plan obligations and related assets of the defined benefit retirement plans are presented in Note 16 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Level 1 assets are valued using unadjusted quoted prices for identical assets in active markets. Level 2 assets are valued using quoted prices or other observable inputs for similar assets. Level 3 assets are valued using unobservable inputs, but reflect the assumptions market participants would use in pricing the assets. Plan obligations and the annual pension expense are determined after consulting with actuaries on a number of key assumptions and on information provided by the Company. Key assumptions in the determination of the annual pension expense include the discount rate, the rate of salary increases and the estimated future return on plan assets. To the extent actual amounts differ from these assumptions and estimated amounts, results could be adversely affected. The Society of Actuaries releases annual updates to mortality tables, which update life expectancy assumptions. IDEX adopts these annual updates and, in consideration of these tables, we modified the mortality assumptions used in determining our pension and post-retirement benefit obligations as of December 31, 2018, which will have a related impact on our annual benefit expense in future years. New mortality tables may result in additional funding requirements dependent upon the funded status of our plans. These expectations presume all other assumptions remain constant and there are no changes to applicable funding regulations. Changes in the discount rate assumptions will impact the (gain) loss amortization and interest cost components of the projected benefit obligation (“PBO”), which in turn, may impact the Company’s funding decisions if the PBO exceeds plan assets. Each 100 basis point increase in the discount rate will cause a corresponding decrease in the PBO of approximately $25 million based upon the December 31, 2018 data. Each 100 basis point decrease in the discount rate will cause a corresponding increase in the PBO of approximately $31 million based upon the December 31, 2018 data.

<s>[INST] IDEX is an applied solutions company specializing in the manufacture of fluid and metering technologies, health and science technologies and fire, safety and other diversified products built to customers’ specifications. IDEX’s products are sold in niche markets across a wide range of industries throughout the world. Accordingly, IDEX’s businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where it does business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in certain industries and overall industrial activity are important factors that influence the demand for IDEX’s products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains 13 platforms, where we focus on organic growth and strategic acquisitions. Each of our 13 platforms is also a reporting unit that we annually test goodwill for impairment. The Fluid & Metering Technologies segment designs, produces and distributes positive displacement pumps, flow meters, injectors and other fluidhandling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water and wastewater, agriculture and energy industries. The Fluid & Metering Technologies segment contains the Energy platform (comprised of Corken, Liquid Controls, SAMPI and Toptech), the Valves platform (comprised of Alfa Valvole, Richter and Aegis), the Water platform (comprised of Pulsafeeder, OBL, Knight, ADS, Trebor and iPEK), the Pumps platform (comprised of Viking and Warren Rupp) and the Agriculture platform (comprised of Banjo). The Health & Science Technologies segment designs, produces and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical and cosmetics, pneumatic components and sealing solutions, including very high precision, lowflow rate pumping solutions required in analytical instrumentation, clinical diagnostics and drug discovery, high performance molded and extruded sealing components, biocompatible medical devices and implantables, air compressors used in medical, dental and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, aerospace, telecommunications and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life sciences, research and defense markets and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Health & Science Technologies segment contains the Scientific Fluidics & Optics platform (comprised of Eastern Plastics, Rheodyne, Sapphire Engineering, Upchurch Scientific, ERC, CiDRA Precision Services, thinXXS, CVI Melles Griot, Semrock, AT Films and FLI), the Sealing Solutions platform (comprised of Precision Polymer Engineering, FTL Seals Technology, Novotema and SFC Koenig) the Gast platform, the Micropump platform and the Material Processing Technologies platform (comprised of Quadro, Fitzpatrick, Microfluidics and Matcon). The Fire & Safety/Diversified Products segment designs, produces and develops firefighting pumps, valves and controls, rescue tools, lifting bags and other components and systems for the fire and rescue industry, engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications and precision equipment for dispensing, metering, and mixing colorants and paints used in a variety of retail and commercial businesses around the world. The Fire & Safety/Diversified Products segment is comprised of the Fire & Safety platform (comprised of Class 1, Hale, Akron Brass, AWG Fittings, Godiva, Dinglee, Hurst Jaws of Life, Lukas and Vetter), the BandIt platform and the Dispensing platform. Our 2018 financial results were as follows: Sales of $2.5 billion increased 9%, reflecting an 8% increase in organic sales and [/INST] Negative. </s>

IDEX CORP /DE/

2020-02-21

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and related notes in this annual report. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. Our actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of several factors, including those set forth under Item 1A, “Risk Factors” and elsewhere in this annual report. 2019 Overview IDEX is an applied solutions company specializing in the manufacture of fluid and metering technologies, health and science technologies and fire, safety and other diversified products built to customers’ specifications. IDEX’s products are sold in niche markets across a wide range of industries throughout the world. Accordingly, IDEX’s businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where it does business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in certain industries and overall industrial activity are important factors that influence the demand for IDEX’s products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains 13 platforms, where we focus on organic growth and strategic acquisitions. Each of our 13 platforms is also a reporting unit that we annually test goodwill for impairment. The Fluid & Metering Technologies segment designs, produces and distributes positive displacement pumps, flow meters, injectors and other fluid-handling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water and wastewater, agriculture and energy industries. The Fluid & Metering Technologies segment contains the Energy platform (comprised of Corken, Liquid Controls, SAMPI and Toptech), the Valves platform (comprised of Alfa Valvole, Richter and Aegis), the Water platform (comprised of Pulsafeeder, OBL, Knight, ADS, Trebor and iPEK), the Pumps platform (comprised of Viking and Warren Rupp) and the Agriculture platform (comprised of Banjo). The Health & Science Technologies segment designs, produces and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical and cosmetics, pneumatic components and sealing solutions, including very high precision, low-flow rate pumping solutions required in analytical instrumentation, clinical diagnostics and drug discovery, high performance molded and extruded sealing components, custom mechanical and shaft seals for a variety of end markets including food and beverage, marine, chemical, wastewater and water treatment, engineered hygienic mixers and valves for the global biopharmaceutical industry, biocompatible medical devices and implantables, air compressors used in medical, dental and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, aerospace, telecommunications and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life sciences, research and defense markets and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Health & Science Technologies segment contains the Scientific Fluidics & Optics platform (comprised of Eastern Plastics, Rheodyne, Sapphire Engineering, Upchurch Scientific, ERC, CiDRA Precision Services, thinXXS, CVI Melles Griot, Semrock, Advanced Thin Films and FLI), the Sealing Solutions platform (comprised of Precision Polymer Engineering, FTL Seals Technology, Novotema, SFC Koenig and Velcora) the Gast platform, the Micropump platform and the Material Processing Technologies platform (comprised of Quadro, Fitzpatrick, Microfluidics and Matcon). The Fire & Safety/Diversified Products segment designs, produces and develops firefighting pumps, valves and controls, rescue tools, lifting bags and other components and systems for the fire and rescue industry, engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications and precision equipment for dispensing, metering, and mixing colorants and paints used in a variety of retail and commercial businesses around the world. The Fire & Safety/Diversified Products segment is comprised of the Fire & Safety platform (comprised of Class 1, Hale, Akron Brass, AWG Fittings, Godiva, Dinglee, Hurst Jaws of Life, Lukas and Vetter), the Band-It platform and the Dispensing platform. Our 2019 financial results were as follows: • Sales of $2.5 billion were flat, reflecting a 1% increase in organic sales and a 1% increase due to acquisitions (Velcora - July 2019 and FLI - July 2018), offset by a 2% decrease due to foreign currency translation. • Operating income of $579.0 million was up 2% and operating margin of 23.2% was up 30 basis points from the prior year. • Net income increased 4% to $425.5 million. • Diluted EPS of $5.56 increased $0.27, or 5%, compared to 2018. Our 2019 financial results, adjusted for $21.0 million of restructuring expense and a $3.3 million fair value inventory step-up charge, compared to our 2018 financial results, adjusted for $12.1 million of restructuring expense, were as follows (these non-GAAP measures have been reconciled to U.S. GAAP measures in Item 6, “Selected Financial Data”): • Adjusted operating income of $603.4 million was up 4% and adjusted operating margin of 24.2% was up 80 basis points from the prior year. • Adjusted net income increased 6% to $444.2 million. • Adjusted EPS of $5.80 was 7% higher than prior year adjusted EPS of $5.41. Results of Operations The following is a discussion and analysis of our results of operations for the year ended December 31, 2019 compared to the year ended December 31, 2018. For discussion related to the results of operations for the year ended December 31, 2018 compared to the year ended December 31, 2017, refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s annual report on Form 10-K for the year ended December 31, 2018, which was filed with the SEC on February 28, 2019. For purposes of this Item, reference is made to the Consolidated Statements of Operations in Part II, Item 8, “Financial Statements and Supplementary Data.” Segment operating income excludes unallocated corporate operating expenses. Management’s primary measurements of segment performance are sales, operating income and operating margin. In the following discussion, and throughout this report, references to organic sales, a non-GAAP measure, refers to sales from continuing operations calculated according to U.S. GAAP but excludes (1) the impact of foreign currency translation and (2) sales from acquired or divested businesses during the first twelve months of ownership or divestiture. The portion of sales attributable to foreign currency translation is calculated as the difference between (a) the period-to-period change in organic sales and (b) the period-to-period change in organic sales after applying prior period foreign exchange rates to the current year period. Management believes that reporting organic sales provides useful information to investors by helping identify underlying growth trends in our business and facilitating easier comparisons of our revenue performance with prior and future periods and to our peers. The Company excludes the effect of foreign currency translation from organic sales because foreign currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends. The Company excludes the effect of acquisitions and divestitures because they can obscure underlying business trends and make comparisons of long-term performance difficult due to the varying nature, size and number of transactions from period to period and between the Company and its peers. Performance in 2019 Compared with 2018 Sales in 2019 were $2.5 billion, which was flat compared with last year. This reflects a 1% increase in organic sales and a 1% increase from acquisitions (Velcora - July 2019 and FLI - July 2018), offset by a 2% unfavorable impact from foreign currency translation. Sales to customers outside the U.S. represented approximately 50% of total sales in 2019 compared with 51% in 2018. In 2019, Fluid & Metering Technologies contributed 38% of sales and 44% of total segment operating income; Health & Science Technologies contributed 37% of sales and 31% of total segment operating income; and Fire & Safety/Diversified Products contributed 25% of sales and 25% of total segment operating income. Gross profit of $1.1 billion in 2019 increased $7.1 million, or 1%, from 2018, while gross margin increased 10 basis points to 45.1% in 2019 from 45.0% in 2018. The increase in gross profit and margin is primarily a due to price capture and productivity initiatives, partially offset by a fair value inventory step-up charge, inflation and higher engineering costs. Selling, general and administrative (“SG&A”) expenses decreased to $525.0 million in 2019 from $536.7 million in 2018. The $11.7 million decrease is primarily due to lower variable compensation expenses and tighter cost controls in 2019 as well as a stamp duty charge in Switzerland in 2018. As a percentage of sales, SG&A expenses were 21.2% for 2019 and 21.6% for 2018. In 2019 and 2018, the Company incurred pre-tax restructuring expenses totaling $21.0 million and $12.1 million, respectively, to facilitate long-term, sustainable growth through cost reduction actions, primarily consisting of employee reductions, facility rationalization and impairment charges. The restructuring expenses included severance benefits of $9.8 million, exit costs of $1.1 million and impairment charges of $10.1 million. In the second quarter of 2019, the Company began to evaluate strategic alternatives for one of its businesses in the HST segment. Prior to making a final decision on the options that were presented for this business, the business was informed in the third quarter of 2019 of the loss of its largest customer. As a result,the Company accelerated its restructuring activities for this business and a decision was made to wind down the business over time, requiring a $9.7 million impairment charge. In addition, in the fourth quarter of 2019, the Company completed the consolidation of one of its facilities into the Optics Center of Excellence in Rochester, New York, which resulted in a $0.4 million impairment charge. Operating income of $579.0 million in 2019 increased from $569.1 million in 2018, and operating margin of 23.2% in 2019 was up 30 basis points from 22.9% in 2018. Both operating income and operating margin increased compared to 2018 primarily due to price capture, productivity initiatives and tighter cost controls in 2019, partially offset by inflation and sales mix. Other (income) expense - net changed by $5.7 million, from income of $4.0 million in 2018 to expense of $1.8 million in 2019 mainly due to foreign currency transaction gains in 2018 that did not repeat in 2019. Interest expense increased to $44.3 million in 2019 from $44.1 million in 2018. The increase was primarily due to interest on debt assumed in the Velcora acquisition, which has been subsequently retired. The provision for income taxes is based upon estimated annual tax rates for the year applied to federal, state and foreign income. The provision for income taxes decreased to $107.4 million in 2019 compared to $118.4 million in 2018. The effective tax rate decreased to 20.2% in 2019 compared to 22.4% in 2018 due to an increase in the excess tax benefits related to share-based compensation, a partial change in the assertion of permanent reinvestment of certain foreign tax earnings in 2018, and the mix of global pre-tax income among jurisdictions. Net income for the year of $425.5 million increased from $410.6 million in 2018. Diluted earnings per share in 2019 of $5.56 increased $0.27 from $5.29 in 2018. Fluid & Metering Technologies Segment Sales of $957.0 million increased $5.5 million, or 1%, in 2019 compared with 2018. This increase reflected a 2% increase in organic sales, partially offset by a 1% unfavorable impact from foreign currency translation. In 2019, sales were flat domestically and up 1% internationally. Sales to customers outside the U.S. were approximately 43% of total segment sales in both 2019 and 2018. Sales within our Valves platform increased compared to 2018 due to strength in the chemical end market. Sales within our Pumps platform increased compared to 2018 due to strength in the North American industrial market in the first half of the year and lease automated custody transfer (“LACT”) product growth. Sales within our Energy platform increased slightly compared to 2018 due to market demand stability, despite lower capital investment as a result of declines in fuel prices. Sales within our Water platform were flat compared to 2018 as municipal markets remained fairly consistent. Sales within our Agriculture platform decreased compared to 2018 due to challenging market conditions from geopolitical uncertainty and depressed commodity prices. Operating income and operating margin of $285.3 million and 29.8%, respectively, were higher than the $275.1 million and 28.9%, respectively, recorded in 2018, primarily due to increased volume, price capture and productivity initiatives. Health & Science Technologies Segment Sales of $914.4 million increased $18.0 million, or 2%, in 2019 compared with 2018. This increase reflected a 1% increase in organic sales and a 2% increase from acquisitions (Velcora - July 2019 and FLI - July 2018), partially offset by a 1% unfavorable impact from foreign currency translation. In 2019, sales increased 5% domestically and were flat internationally. Sales to customers outside the U.S. were approximately 55% of total segment sales in 2019 compared with 56% in 2018. Sales in our Gast platform increased compared to 2018 due to strong demand related to our targeted growth initiatives. Sales within our Scientific Fluidics & Optics platform increased compared to 2018 due to new product introductions and strong demand across our end markets primarily in vitro diagnostics (“IVD”) and biotechnology. Sales within our Sealing Solutions platform were flat compared to 2018 due to the Velcora acquisition, offset by weakness in the semiconductor and industrial markets. Sales within our Material Processing Technologies platform decreased compared to 2018 due to project timing. Sales within our Micropump platform decreased compared to 2018 due to end market demand volatility. Operating income and operating margin of $200.2 million and 21.9%, respectively, in 2019 were down from $205.7 million and 22.9%, respectively, in 2018, primarily due to the impairment charges and the fair value inventory step-up charge, partially offset by price capture and tighter cost controls in 2019. Fire & Safety/Diversified Products Segment Sales of $626.8 million decreased $10.3 million, or 2%, in 2019 compared with 2018. This decrease reflected flat organic sales and a 2% unfavorable impact from foreign currency translation. In 2019, sales increased 2% domestically and decreased 5% internationally. Sales to customers outside the U.S. were approximately 52% of total segment sales in 2019 compared with 53% in 2018. Sales within our Dispensing platform decreased compared to 2018 due to the timing of large projects in 2018 that did not reoccur in 2019. Sales in our Band-It platform increased compared to 2018 due to strength in transportation markets, partially offset by weakness in the industrial end market. Sales within our Fire & Safety platform increased compared to 2018 primarily due to OEM and distribution strength as well as strong demand for new product introductions. Operating income of $165.3 million and operating margin of 26.4%, respectively, were lower than the $168.6 million and 26.5%, respectively, in 2018, primarily due to volume declines and sales mix in the Dispensing platform. Liquidity and Capital Resources Operating Activities Cash flows from operating activities increased $48.7 million, or 10.2%, to $528.1 million in 2019, primarily due to higher earnings and favorable operating working capital, partially offset by lower income taxes payable and lower incentive compensation. At December 31, 2019, working capital was $903.6 million and the Company’s current ratio was 3.5 to 1. At December 31, 2019, the Company’s cash and cash equivalents totaled $632.6 million, of which $350.9 million was held outside of the United States. Investing Activities Cash flows used in investing activities increased $55.6 million to $137.0 million in 2019, primarily due to $87.2 million spent on the acquisition of Velcora in 2019 compared to $20.2 million spent on the acquisition of FLI in 2018, partially offset by lower capital expenditures in 2019 and $4.0 million spent on the purchase of intellectual property assets from Phantom in 2018. Cash flows from operations were more than adequate to fund capital expenditures of $50.9 million and $56.1 million in 2019 and 2018, respectively. Capital expenditures were generally for machinery and equipment that supported growth, improved productivity, tooling, business system technology, replacement of equipment and investments in new facilities. Management believes that the Company has ample capacity in its plants and equipment to meet demand increases for future growth in the intermediate term. Financing Activities Cash flows used in financing activities decreased $62.4 million to $227.6 million in 2019, primarily as a result of lower share repurchases in 2019, partially offset by higher debt repayments due to the repayment of debt assumed in the Velcora acquisition and higher dividends paid in 2019. On June 13, 2016, the Company completed a private placement of a $100 million aggregate principal amount of 3.20% Senior Notes due June 13, 2023 and a $100 million aggregate principal amount of 3.37% Senior Notes due June 13, 2025 (collectively, the “Notes”) pursuant to a Note Purchase Agreement, dated June 13, 2016 (the “Purchase Agreement”). Each series of Notes bears interest at the stated amount per annum, which is payable semi-annually in arrears on each June 13th and December 13th. The Notes are unsecured obligations of the Company and rank pari passu in right of payment with all of the Company’s other unsecured, unsubordinated debt. The Company may at any time prepay all, or any portion of the Notes; provided that such portion is greater than 5% of the aggregate principal amount of the Notes then outstanding. In the event of a prepayment, the Company will pay an amount equal to par plus accrued interest plus a make-whole amount. In addition, the Company may repurchase the Notes by making an offer to all holders of the Notes, subject to certain conditions. On May 31, 2019, the Company entered into a credit agreement (the “Credit Agreement”) along with certain of its subsidiaries, as borrowers (the “Borrowers”), Bank of America, N.A., as administrative agent, swing line lender and an issuer of letters of credit, with other agents party thereto. The Credit Agreement consists of a revolving credit facility (the “Revolving Facility”), which is an $800.0 million unsecured, multi-currency bank credit facility expiring on May 30, 2024. The Credit Agreement replaced the Company’s prior five-year, $700 million credit agreement, dated as of June 23, 2015, which was due to expire in June 2020. At December 31, 2019, there was no balance outstanding under the Revolving Facility and $8.5 million of outstanding letters of credit, resulting in a net available borrowing capacity under the Revolving Facility of $791.5 million. Borrowings under the Revolving Facility bear interest, at either an alternate base rate or adjusted LIBOR plus, in each case, an applicable margin. Such applicable margin is based on the better of the Company’s senior, unsecured, long-term debt rating or the Company’s applicable leverage ratio. Interest is payable (a) in the case of base rate loans, quarterly, and (b) in the case of LIBOR loans, on the last day of the applicable interest period selected, or every three months from the effective date of such interest period for interest periods exceeding three months. The Company may request increases in the lending commitments under the Credit Agreement, but the aggregate lending commitments pursuant to such increases may not exceed $400 million. The Company has the right, subject to certain conditions set forth in the Credit Agreement, to designate certain foreign subsidiaries of the Company as borrowers under the Credit Agreement. In connection with any such designation, the Company is required to guarantee the obligations of any such subsidiaries under the Credit Agreement. On December 9, 2011, the Company completed a public offering of $350.0 million 4.2% senior notes due December 15, 2021 (“4.2% Senior Notes”). The net proceeds from the offering of $346.2 million, after deducting a $0.9 million issuance discount, a $2.3 million underwriting commission and $0.6 million of offering expenses, were used to repay $306.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.2% Senior Notes bear interest at a rate of 4.2% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or part of the 4.2% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.2% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.2% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all of the Company’s assets. The terms of the 4.2% Senior Notes also require the Company to make an offer to repurchase the 4.2% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. On December 6, 2010, the Company completed a public offering of $300.0 million 4.5% senior notes due December 15, 2020 (“4.5% Senior Notes”). The net proceeds from the offering of $295.7 million, after deducting a $1.6 million issuance discount, a $1.9 million underwriting commission and $0.8 million of offering expenses, were used to repay $250.0 million of outstanding bank indebtedness, with the balance used for general corporate purposes. The 4.5% Senior Notes bear interest at a rate of 4.5% per annum, which is payable semi-annually in arrears on each June 15 and December 15. The Company may redeem all or a portion of the 4.5% Senior Notes at any time prior to maturity at the redemption prices set forth in the Note Indenture governing the 4.5% Senior Notes. The Company may issue additional debt from time to time pursuant to the Indenture. The Indenture and 4.5% Senior Notes contain covenants that limit the Company’s ability to, among other things, incur certain liens securing indebtedness, engage in certain sale-leaseback transactions, and enter into certain consolidations, mergers, conveyances, transfers or leases of all or substantially all of the Company’s assets. The terms of the 4.5% Senior Notes also require the Company to make an offer to repurchase the 4.5% Senior Notes upon a change of control triggering event (as defined in the Indenture) at a price equal to 101% of their principal amount plus accrued and unpaid interest, if any. There are two key financial covenants that the Company is required to maintain in connection with the Revolving Facility and the Notes, a minimum interest coverage ratio of 3.0 to 1 and a maximum leverage ratio of 3.50 to 1. In the case of the leverage ratio, there is an option to increase the ratio to 4.00 for 12 months in connection with certain acquisitions. At December 31, 2019, the Company was in compliance with both of these financial covenants, as the Company’s interest coverage ratio was 16.04 to 1 and the leverage ratio was 1.23 to 1. There are no financial covenants relating to the 4.5% Senior Notes or 4.2% Senior Notes; however, both are subject to cross-default provisions. On December 1, 2015 the Company’s Board of Directors approved an increase of $300.0 million in the authorized level for repurchases of common stock. This followed the prior Board of Directors approved repurchase authorization of $400.0 million that was announced by the Company on November 6, 2014. Repurchases under the program will be funded with future cash flow generation or borrowings available under the Revolving Facility. During 2019, the Company repurchased a total of 389 thousand shares at a cost of $54.7 million compared to 1.3 million shares repurchased in 2018 at a cost of $173.9 million. As of December 31, 2019, the amount of share repurchase authorization remaining is $322.3 million. The Company believes current cash, cash from operations and cash available under the Revolving Facility will be sufficient to meet its operating cash requirements, planned capital expenditures, interest and principal payments on all borrowings, pension and postretirement funding requirements, authorized share repurchases and annual dividend payments to holders of the Company’s common stock for the next twelve months. Additionally, in the event that suitable businesses are available for acquisition upon acceptable terms, the Company may obtain all or a portion of the financing for these acquisitions through the incurrence of additional borrowings. As of December 31, 2019, there was no balance outstanding under the Revolving Facility and $8.5 million of outstanding letters of credit, resulting in a net available borrowing capacity under the Revolving Facility at December 31, 2019 of approximately $791.5 million. Contractual Obligations Our contractual obligations include pension and postretirement medical benefit plans, rental payments under operating leases, payments under capital leases and other long-term obligations arising in the ordinary course of business. There are no identifiable events or uncertainties, including the lowering of our credit rating, which would accelerate payment or maturity of any of these commitments or obligations. The following table summarizes our significant contractual obligations and commercial commitments at December 31, 2019 and the future periods in which such obligations are expected to be settled in cash. In addition, the table reflects the timing of principal and interest payments on outstanding borrowings. Additional detail regarding these obligations is provided in the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” (1) Includes interest payments based on contractual terms and current interest rates for variable debt. (2) Consists primarily of inventory commitments. (3) Comprises liabilities recorded on the balance sheet of $1,034.9 million and obligations not recorded on the balance sheet of $297.7 million. Critical Accounting Policies and Estimates We believe that the application of the following accounting policies, which are important to our financial position and results of operations, require significant judgments and estimates on the part of management. For a summary of all of our accounting policies, including the accounting policies discussed below, see Note 1 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Revenue recognition - Revenue is recognized when control of products or services is transferred to our customers in an amount that reflects the consideration we expect to be entitled to in exchange for transferring those products or providing those services. A performance obligation is a promise in a contract to transfer a distinct product or service to the customer. A contract’s transaction price is allocated to each performance obligation and recognized as revenue when, or as, the performance obligation is satisfied. Our performance obligations are satisfied at a point in time or over time as work progresses. Revenue from products and services transferred to customers at a point in time is recognized when obligations under the terms of the contract with our customer are satisfied. Generally, this occurs with the transfer of control of the asset, which is in line with shipping terms. Certain units recognize revenue over time because control transfers continuously to our customers. Revenue is recognized over time as work is performed based on the relationship between actual costs incurred to date for each contract and the total estimated costs for such contract at completion of the performance obligation (i.e. the cost-to-cost method) or is recognized ratably over the contract term. As a significant change in one or more of these estimates could affect the profitability of our contracts, we review and update our estimates regularly. Due to uncertainties inherent in the estimation process, it is reasonably possible that completion costs will be revised. Such revisions to costs and income are recognized in the period in which the revisions are determined as a cumulative catch-up adjustment. The impact of the adjustment on profit recorded to date on a contract is recognized in the period the adjustment is identified. If at any time the estimate of contract profitability indicates an anticipated loss on the contract, we recognize provisions for estimated losses on uncompleted contracts in the period in which such losses are determined. The Company records allowances for discounts and product returns at the time of sale as a reduction of revenue as such allowances can be reliably estimated based on historical experience and known trends. The Company also offers product warranties (primarily assurance-type) and accrues its estimated exposure for warranty claims at the time of sale based upon the length of the warranty period, warranty costs incurred and any other related information known to the Company. Goodwill, long-lived and intangible assets - The Company evaluates the recoverability of certain noncurrent assets utilizing various estimation processes. An impairment of a long-lived asset exists when the asset’s carrying amount exceeds its fair value and is recorded when the carrying amount is not recoverable through future operations. An impairment of an indefinite-lived intangible asset or goodwill exists when the carrying amount of the intangible asset or goodwill exceeds its fair value. Assessments of possible impairments of long-lived or indefinite-lived intangible assets or goodwill are made if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. Additionally, testing for possible impairments of recorded indefinite-lived intangible asset balances and goodwill is performed annually. On October 31, or more frequently if triggering events occur, the Company compares the fair value of each reporting unit to the carrying amount of each reporting unit to determine if a goodwill impairment exists. The amount and timing of impairment charges for these assets require the estimation of future cash flows to determine the fair value of the related assets. In the second quarter of 2019, the Company began to evaluate strategic alternatives for one of its businesses in the HST segment. Prior to making a final decision on the options that were presented for this business, the business was informed in the third quarter of 2019 of the loss of its largest customer. As a result, the Company accelerated its restructuring activities for this business and a decision was made to wind down the business over time. This event required an interim impairment test be performed on the long-lived tangible assets of the business, which resulted in an impairment charge of $9.7 million, consisting of $6.1 million related to a customer relationships intangible asset, $1.0 million related to an unpatented technology intangible asset, $2.0 million related to property, plant and equipment and $0.6 million related to a building right-of-use asset. In the fourth quarter of 2019, the Company completed the consolidation of one of its facilities into the Optics Center of Excellence in Rochester, New York, which resulted in an impairment charge of $0.4 million related to a building right-of-use asset. These charges were recorded as Restructuring expense in the Consolidated Statements of Operations. In 2018, there were no events that occurred or circumstances that changed that would have required a review other than as of our annual test date and the Company concluded that there were no long-lived assets with a fair value that was less than the carrying value. The Company’s business acquisitions result in recording goodwill and other intangible assets, which affect the amount of amortization expense and possible impairment expense that the Company will incur in future periods. The Company follows the guidance prescribed in ASC 350, Goodwill and Other Intangible Assets, to test goodwill and intangible assets for impairment. The Company determines the fair value of each reporting unit utilizing an income approach (discounted cash flows) weighted 50% and a market approach (consisting of a comparable public company multiples methodology) weighted 50%. To determine the reasonableness of the calculated fair values, the Company reviews the assumptions to ensure that neither the income approach nor the market approach yielded significantly different valuations. The key assumptions are updated every year for each reporting unit for the income and market approaches used to determine fair value. Various assumptions are utilized including forecasted operating results, annual operating plans, strategic plans, economic projections, anticipated future cash flows, the weighted average cost of capital, market data and market multiples. The assumptions that have the most significant effect on the fair value calculations are the weighted average cost of capital, market multiples, forecasted EBITDA and terminal growth rates. The 2019 and 2018 ranges for these three assumptions utilized by the Company are as follows: In assessing the fair value of the reporting units, the Company considers both the market approach and the income approach. Under the market approach, the fair value of the reporting unit is determined by the respective trailing twelve month EBITDA and the forward looking 2020 EBITDA (50% each), based on multiples of comparable public companies. The market approach is dependent on a number of significant management assumptions including forecasted EBITDA and selected market multiples. Under the income approach, the fair value of the reporting unit is determined based on the present value of estimated future cash flows. The income approach is dependent on a number of significant management assumptions including estimates of operating results, capital expenditures, net working capital requirements, long-term growth rates and discount rates. Weighting was equally attributed to both the market and income approaches (50% each) in arriving at the fair value of the reporting units. The Banjo trade name and the Akron Brass trade name are indefinite-lived intangible assets which are tested for impairment on an annual basis in accordance with ASC 350 or more frequently if events or changes in circumstances indicate that the assets might be impaired. The Company uses the relief-from-royalty method, a form of the income approach, to determine the fair value of these trade names. The relief-from-royalty method is dependent on a number of significant management assumptions, including estimates of revenues, royalty rates and discount rates. Defined benefit retirement plans - The plan obligations and related assets of the defined benefit retirement plans are presented in Note 17 of the Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data.” Level 1 assets are valued using unadjusted quoted prices for identical assets in active markets. Level 2 assets are valued using quoted prices or other observable inputs for similar assets. Level 3 assets are valued using unobservable inputs, but reflect the assumptions market participants would use in pricing the assets. Plan obligations and the annual pension expense are determined after consulting with actuaries on a number of key assumptions and on information provided by the Company. Key assumptions in the determination of the annual pension expense include the discount rate, the rate of salary increases and the estimated future return on plan assets. To the extent actual amounts differ from these assumptions and estimated amounts, results could be adversely affected. The Society of Actuaries releases annual updates to mortality tables, which update life expectancy assumptions. IDEX adopts these annual updates and, in consideration of these tables, we modified the mortality assumptions used in determining our pension and post-retirement benefit obligations as of December 31, 2019, which will have a related impact on our annual benefit expense in future years. New mortality tables may result in additional funding requirements dependent upon the funded status of our plans. These expectations presume all other assumptions remain constant and there are no changes to applicable funding regulations. Changes in the discount rate assumptions will impact the (gain) loss amortization and interest cost components of the projected benefit obligation (“PBO”), which in turn, may impact the Company’s funding decisions if the PBO exceeds plan assets. Each 100 basis point increase in the discount rate will cause a corresponding decrease in the PBO of approximately $25 million based upon the December 31, 2019 data. Each 100 basis point decrease in the discount rate will cause a corresponding increase in the PBO of approximately $31 million based upon the December 31, 2019 data.

<s>[INST] 2019 Overview IDEX is an applied solutions company specializing in the manufacture of fluid and metering technologies, health and science technologies and fire, safety and other diversified products built to customers’ specifications. IDEX’s products are sold in niche markets across a wide range of industries throughout the world. Accordingly, IDEX’s businesses are affected by levels of industrial activity and economic conditions in the U.S. and in other countries where it does business and by the relationship of the U.S. dollar to other currencies. Levels of capacity utilization and capital spending in certain industries and overall industrial activity are important factors that influence the demand for IDEX’s products. The Company has three reportable business segments: Fluid & Metering Technologies, Health & Science Technologies and Fire & Safety/Diversified Products. Within our three reportable segments, the Company maintains 13 platforms, where we focus on organic growth and strategic acquisitions. Each of our 13 platforms is also a reporting unit that we annually test goodwill for impairment. The Fluid & Metering Technologies segment designs, produces and distributes positive displacement pumps, flow meters, injectors and other fluidhandling pump modules and systems and provides flow monitoring and other services for the food, chemical, general industrial, water and wastewater, agriculture and energy industries. The Fluid & Metering Technologies segment contains the Energy platform (comprised of Corken, Liquid Controls, SAMPI and Toptech), the Valves platform (comprised of Alfa Valvole, Richter and Aegis), the Water platform (comprised of Pulsafeeder, OBL, Knight, ADS, Trebor and iPEK), the Pumps platform (comprised of Viking and Warren Rupp) and the Agriculture platform (comprised of Banjo). The Health & Science Technologies segment designs, produces and distributes a wide range of precision fluidics, rotary lobe pumps, centrifugal and positive displacement pumps, roll compaction and drying systems used in beverage, food processing, pharmaceutical and cosmetics, pneumatic components and sealing solutions, including very high precision, lowflow rate pumping solutions required in analytical instrumentation, clinical diagnostics and drug discovery, high performance molded and extruded sealing components, custom mechanical and shaft seals for a variety of end markets including food and beverage, marine, chemical, wastewater and water treatment, engineered hygienic mixers and valves for the global biopharmaceutical industry, biocompatible medical devices and implantables, air compressors used in medical, dental and industrial applications, optical components and coatings for applications in the fields of scientific research, defense, biotechnology, aerospace, telecommunications and electronics manufacturing, laboratory and commercial equipment used in the production of micro and nano scale materials, precision photonic solutions used in life sciences, research and defense markets and precision gear and peristaltic pump technologies that meet exacting original equipment manufacturer specifications. The Health & Science Technologies segment contains the Scientific Fluidics & Optics platform (comprised of Eastern Plastics, Rheodyne, Sapphire Engineering, Upchurch Scientific, ERC, CiDRA Precision Services, thinXXS, CVI Melles Griot, Semrock, Advanced Thin Films and FLI), the Sealing Solutions platform (comprised of Precision Polymer Engineering, FTL Seals Technology, Novotema, SFC Koenig and Velcora) the Gast platform, the Micropump platform and the Material Processing Technologies platform (comprised of Quadro, Fitzpatrick, Microfluidics and Matcon). The Fire & Safety/Diversified Products segment designs, produces and develops firefighting pumps, valves and controls, rescue tools, lifting bags and other components and systems for the fire and rescue industry, engineered stainless steel banding and clamping devices used in a variety of industrial and commercial applications and precision equipment for dispensing, metering, and mixing colorants and paints used in a variety of retail and commercial businesses around the world. The Fire & Safety/Diversified Products segment is comprised of the Fire & Safety platform (comprised of Class 1, Hale, Akron Brass, AWG Fittings, Godiva, Dinglee [/INST] Positive. </s>

CHURCH & DWIGHT CO INC /DE/

2015-02-20

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW The Company’s Business The Company develops, manufactures, markets and sells a broad range of household, personal care and specialty products. The Company sells its consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores, and websites, all of which sell the products to consumers. The Company also sells specialty products to industrial customers and distributors. The Company focuses its consumer products marketing efforts principally on its “power brands.” These well-recognized brand names include ARM & HAMMER (used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent), TROJAN condoms, lubricants and vibrators, OXICLEAN stain removers, cleaning solutions, laundry detergent, dishwashing detergent and bleach alternatives, SPINBRUSH battery-operated and manual toothbrushes, FIRST RESPONSE home pregnancy and ovulation test kits, NAIR depilatories, ORAJEL oral analgesics, XTRA laundry detergent, and L’IL CRITTERS and VITAFUSION gummy dietary supplements. The Company considers four of these brands to be “mega brands”: ARM & HAMMER, OXICLEAN, TROJAN, and L’IL CRITTERS and VITAFUSION, and is giving greatest focus to the growth of these brands. The Company operates its business in three segments: Consumer Domestic, Consumer International and SPD. The Consumer Domestic segment includes the power brands noted above and other household and personal care products such as SCRUB FREE, KABOOM and ORANGE GLO cleaning products, ARRID antiperspirant, CLOSE-UP and AIM toothpastes and SIMPLY SALINE nasal saline moisturizer. The Consumer International segment primarily sells a variety of personal care products, some of which use the same brand names as the Company’s domestic product lines, in international markets including Canada, France, Australia, the United Kingdom, Mexico and Brazil. The SPD segment is the largest U.S. producer of sodium bicarbonate, which it sells together with other specialty inorganic chemicals for a variety of industrial, institutional, medical and food applications. This segment also sells a range of animal nutrition and specialty cleaning products. In 2014, the Consumer Domestic, Consumer International and SPD segments represented approximately 75%, 16% and 9%, respectively, of the Company’s consolidated net sales. 2014 Financial Highlights Key fiscal year 2014 financial results include: · 2014 net sales grew 3.2% over fiscal year 2013, with gains in all three of the Company’s segments, primarily due to volume growth and the impact of the 2014 acquisition of the Lil’ Drug Store brands, partially offset by higher promotional spending and currency fluctuations. · Gross margin decreased 90 basis points to 44.1% in fiscal year 2014 from 45.0% in fiscal year 2013, reflecting higher promotional spending in support of new and existing products, higher commodity costs and currency fluctuations. · Operating margin decreased 10 basis points to 19.4% in fiscal year 2014 from 19.5% in fiscal year 2013, reflecting a lower gross margin and slightly higher marketing costs, partially offset by lower selling, general and administrative expenses (“SG&A”). · The Company achieved diluted net earnings per share in fiscal year 2014 of $3.01, an increase of approximately 8.0% from fiscal year 2013 diluted net earnings per share of $2.79. · Cash from operations was $540.3, a $40.7 increase from the prior year, which includes the deferral of a $36 payment relating to December 2012 estimated federal tax paid in the first quarter of 2013 as a result of Hurricane Sandy relief. · The Company returned $646 to its stockholders through dividends and share repurchases. Strategic Goals, Challenges and Initiatives The Company’s ability to generate sales depends on consumer demand for its products and retail customers’ decisions to carry its products, which are, in part, affected by general economic conditions in its markets. In 2014, many of the markets in which the CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Company operates continued to experience general economic softness and weak or inconsistent consumer demand. Although the Company’s consumer products generally are consumer staples and less vulnerable to decreases in discretionary spending than other products, the continued economic downturn has reduced demand in many categories, particularly those in personal care, and affected Company sales in recent periods. Some customers have responded to economic conditions by increasing their private label offerings (primarily in the dietary supplements, diagnostic kits and oral analgesics categories), and consolidating the product selections they offer to the top few leading brands in each category. In addition, an increasing portion of the Company’s product categories are being sold by club stores, dollar stores and mass merchandisers. These customer actions have placed downward pressure on the Company’s sales and gross margins. The Company expects a competitive marketplace in 2015 due to new product introductions by competitors and continuing aggressive competitive pricing pressures. In the U.S., an improving unemployment rate and higher disposable income due to low gasoline prices are expected to have a positive effect on consumption patterns in the second half of 2015. To continue to deliver attractive results for stockholders in this environment, the Company intends to continue to aggressively pursue several key strategic initiatives: maintain competitive marketing and trade spending, tightly control its cost structure, continue to develop and launch new and differentiated products, and pursue strategic acquisitions. The Company also intends to continue to grow its product sales geographically (in an attempt to mitigate the impact of weakness in any one area), and maintain an offering of premium and value brand products (to appeal to a wide range of consumers). The Company continues to experience heightened competitive activity in certain product categories from other larger multinational competitors, some of which have greater resources. Such activities have included new product introductions, more aggressive product claims and marketing challenges, as well as increased promotional spending. Since the 2012 introduction in the U.S. of unit dose laundry detergent by various manufacturers, including the Company, there has been significant product and price competition in the laundry detergent category, contributing to an overall category decline. During 2012, 2013 and 2014 the category declined by 0.6%, 3.2% and 2.9%, respectively. In 2014, P&G, one of the Company’s major competitors and the market leader in premium laundry detergent, including unit dose laundry detergent, reconfigured certain of its product offerings and related marketing and pricing strategies and launched various products to compete more directly with the Company’s core ARM & HAMMER, XTRA and OXICLEAN power brands. For example, P&G launched a lower-priced line of laundry detergents to compete directly with the Company’s core value laundry detergents, and launched a versatile stain remover to compete with OXICLEAN, the Company’s pre-wash additive. The Company responded to these competitive pressures by, among other things, focusing on strengthening its key brands, including increased focus on the ARM & HAMMER, OXICLEAN, TROJAN and L’IL CRITTERS and VITAFUSION mega brands, which each span various product categories, including premium and value household products, and represented approximately 60% of the Company’s sales and profits in 2014, through the launch of innovative new products and strong sales execution supported by increased marketing and trade spending. These mega brands have advantages over other power brands, including the ability to leverage research and development and marketing investments and lower overhead costs across mega brand categories. For example, the Company’s 2014 responsive product introductions include the simultaneous launch of OXICLEAN branded products into the mid/premium tier laundry detergent segment, and auto dish detergent category and bleach alternatives with continued support of, and innovation in, the Company’s base ARM &HAMMER and OXICLEAN businesses, to create scale and maximize marketing efforts. In 2015, the Company intends to continue to heavily invest in the OXICLEAN brand as 2015 marks the second year of the Company’s goal to establish OXICLEAN as a mega brand in multiple categories. Mega brand launches and launches of other products are anticipated to contribute more incremental new product revenue than the introduction of new products has in prior years, and a significant portion of those revenues will include expansion into new categories with premium household products, supported by increased levels of slotting, trade promotions and incremental marketing support and planned ongoing technology investment. There can be no assurance that these measures will be successful. Despite challenging economic conditions and customer responses to these conditions, the Company was able to grow market share in six of nine of its “power brands” in 2014, including in the laundry detergent category. The Company’s global product portfolio consists of both premium (60% of total worldwide consumer revenue in 2014) and value (40% of total worldwide consumer revenue in 2014) brands, which it believes enables it to succeed in a range of economic environments. The Company’s value brands have performed strongly during economic downturns, and the Company intends to continue to develop a portfolio of appealing new products to build loyalty among cost-conscious consumers. Over the past 15 years, the Company has diversified from an almost exclusively U.S. business to a global company with approximately 16% of sales derived from foreign countries in 2014. The Company has operations in six countries (Canada, Mexico, U.K., France, Australia and Brazil) and exports to over 90 other countries. In 2014, the Company benefited from its concentration in North America in light of the economic downturn in Europe; however, the Company has continued and will continue to focus on CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) selectively expanding its global business. Net sales generated outside of the United States are exposed to foreign currency exchange rate fluctuations as well as political uncertainty which could impact future operating results. The Company also continues to focus on controlling its costs. The Company experienced continued high raw material and energy costs throughout 2014. Historically, the Company has been able to mitigate the effects of cost increases primarily by implementing cost reduction programs and, to a lesser extent, by passing along some of these cost increases to customers. The Company has also entered into set pricing and pre-buying arrangements with certain suppliers and hedge agreements for diesel fuel. The Company expects by the second half of 2015 to benefit from macro trends, including an improving U.S. economy, lower commodity prices and productivity programs. Additionally, maintaining tight controls on overhead costs has been a hallmark of the Company and has enabled it to effectively navigate recent challenging economic conditions. The identification and integration of strategic acquisitions are an important component of the Company’s overall strategy. Acquisitions have added significantly to Company sales and profits over the last decade. However, the failure to effectively integrate any acquisition or achieve expected synergies may cause the Company to incur material asset write-downs. The Company actively seeks acquisitions that fit its guidelines, and its strong financial position provides it with flexibility to take advantage of acquisition opportunities. In addition, the Company’s ability to quickly integrate acquisitions and leverage existing infrastructure has enabled it to establish a strong track record in making accretive acquisitions. Since 2001, the Company has acquired eight of its nine “power brands”. The Company believes it is positioned to meet the ongoing challenges described above due to its strong financial condition, experience operating in challenging environments and continued focus on key strategic initiatives: maintaining competitive marketing and trade spending, managing its cost structure, continuing to develop and launch new and differentiated products, and pursuing strategic acquisitions. This focus, together with the strength of the Company’s portfolio of premium and value brands, has enabled the Company to succeed in a range of economic environments, and is expected to position the Company to continue to increase stockholder value over the long-term. Moreover, the generation of a significant amount of cash from operations, as a result of net income and effective working capital management, combined with an investment grade credit rating provides the Company with the financial flexibility to pursue acquisitions, drive new product development, make capital expenditures to support organic growth and gross margin improvements, return cash to stockholders through dividends and share buy backs, and reduce outstanding debt, positioning it to continue to create stockholder value. For information regarding risks and uncertainties that could materially adversely affect the Company’s business, results of operations and financial condition, see “Risk Factors” in Item 1A of this Annual Report. Recent Developments Acquisitions Lil’ Drug Store Brands Acquisition On September 19, 2014, the Company acquired certain feminine care brands, including REPHRESH and REPLENS, from Lil’ Drug Store Products, Inc., (the “Lil’ Drug Store Brands Acquisition”) for cash consideration of $215.7. The Company paid for the acquisition with additional debt. The annual sales of the acquired brands are approximately $46.0. These feminine care brands are managed within the Consumer Domestic and Consumer International segments. VI-COR Acquisition On January 2, 2015, the Company acquired certain assets of Varied Industries Corporation (the “VI-COR Acquisition”), a manufacturer and seller of feed ingredients for cows, beef cattle, poultry and other livestock. The total purchase price was approximately $75, which is subject to adjustment based on the closing working capital of VI-COR, and a $5 payment after one year if certain operating performance is achieved. The Company financed the acquisition with available cash. VI-COR’s annual sales are approximately $25. These brands will be managed within the Specialty Products segment. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Dividend Increase and Share Repurchase Authorization On January 28, 2015 the Board declared an 8% increase in the regular quarterly dividend from $0.31 to $0.335 per share, equivalent to an annual dividend of $1.34 per share payable to stockholders of record as of February 10, 2015. The increase raises the annual dividend payout from $168 to approximately $177. On January 28, 2015, the Board authorized the 2015 Share Repurchase Program which replaces the Company’s 2014 Share Repurchase Program. In 2014, the Company purchased 6.9 million shares at an aggregate cost of approximately $479 of which $393 was purchased under the 2014 Share Repurchase Program and $86 was purchased under the evergreen share repurchase program, under which the Company may, from time to time, repurchase shares of Common Stock to reduce or eliminate dilution associated with issuances of Common Stock under the Company’s incentive plans. As part of the evergreen share repurchase program, in early January 2015, the Company purchased 0.5 million shares of Common Stock at a cost of approximately $41.2. The Company used cash on hand to fund the purchase price. As part of the 2015 Share Repurchase Program and the evergreen share repurchase program, in February 2015, the Company entered into an accelerated share repurchase contract with a commercial bank to purchase $215 of the Company’s common stock. The Company paid $215 to the bank, inclusive of fees, and received an initial delivery of approximately 2.6 million shares. The contract will be settled by mid-May 2015. If the Company is required to deliver value to the bank at the end of the purchase period, the Company, at its option, may elect to settle in shares of Common Stock or cash. Of the 2015 share repurchases, approximately $88.0 was purchased under the Company’s evergreen share repurchase program. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the U.S. (GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. By their nature, these judgments are subject to uncertainty. They are based on the Company’s historical experience, its observation of trends in industry, information provided by its customers and information available from other outside sources, as appropriate. The Company’s significant accounting policies and estimates are described below. Revenue Recognition and Promotional and Sales Return Reserves Virtually all of the Company’s revenue represents sales of finished goods inventory and is recognized when received or picked up by the Company’s customers. The reserves for consumer and trade promotion liabilities and sales returns are established based on the Company’s best estimate of the amounts necessary to settle future and existing claims on products sold as of the balance sheet date. Promotional reserves are provided for sales incentives, such as coupons to consumers, and sales incentives provided to customers (such as slotting, cooperative advertising, incentive discounts based on volume of sales and other arrangements made directly with customers). All such costs are netted against sales. Slotting costs are recorded when the product is delivered to the customer. Cooperative advertising costs are recorded when the customer places the advertisement for the Company’s products. Discounts relating to price reduction arrangements are recorded when the related sale takes place. Costs associated with end-aisle or other in-store displays are recorded when product that is subject to the promotion is sold. The Company relies on historical experience and forecasted data to determine the required reserves. For example, the Company uses historical experience to project coupon redemption rates to determine reserve requirements. Based on the total face value of Consumer Domestic coupons redeemed over the past several years, if the actual rate of redemptions were to deviate by 0.1% from the rate for which reserves are accrued in the financial statements, an approximately $5.4 difference in the reserve required for coupons would result. With regard to other promotional reserves and sales returns, the Company uses experience-based estimates, customer and sales organization inputs and historical trend analysis in arriving at the reserves required. If the Company’s estimates for promotional activities and sales returns were to change by 10% the impact to promotional spending and sales return accruals would be approximately $6.2. While management believes that its promotional and sales returns reserves are reasonable and that appropriate judgments have been made, estimated amounts could differ materially from actual future obligations. During the twelve months ended December 31, 2014, 2013 and 2012, the Company reduced promotion liabilities by approximately $6.7, $3.7 and $4.0, respectively, based on a change in estimate as a result of actual experience and updated information. These adjustments are immaterial relative to the amount of trade promotion expense incurred annually by the Company. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Impairment of goodwill, trade names and other intangible assets and property, plant and equipment Carrying values of goodwill, trade names and other indefinite lived intangible assets are reviewed periodically for possible impairment. For finite intangible assets, the Company assesses business triggering events. The Company’s impairment analysis is based on a discounted cash flow approach that requires significant judgment with respect to unit volume, revenue and expense growth rates, and the selection of an appropriate discount rate. Management uses estimates based on expected trends in making these assumptions. With respect to goodwill, impairment occurs when the carrying value of the reporting unit exceeds the discounted present value of cash flows for that reporting unit. For trade names and other intangible assets, an impairment charge is recorded for the difference between the carrying value and the net present value of estimated future cash flows, which represents the estimated fair value of the asset. Judgment is required in assessing whether assets may have become impaired between annual valuations. Indicators such as unexpected adverse economic factors, unanticipated technological change, distribution losses, or competitive activities and acts by governments and courts may indicate that an asset has become impaired. The result of the Company’s annual goodwill impairment test determined that the estimated fair value substantially exceeded the carrying values of all reporting units. In addition, there were no goodwill impairment charges for each of the years in the three-year period ended December 31, 2014. The Company recognized intangible asset impairment charges within SG&A for each of the years in the three-year period ended December 31, 2014 as follows: The impairment charges recorded in 2014 and 2013 were a result of actual and projected reductions in sales and profitability as a result of increased competition. The amount of the impairment charges was determined by comparing the estimated fair value of the assets to their carrying amount. Fair value was estimated based on a “relief from royalty” or “excess earnings” discounted cash flow method, which contains numerous variables that are subject to change as business conditions change, and therefore could impact fair values in the future. The Company determined that the fair value of all other intangible assets as of December 31, 2014 exceeded their respective carrying values based upon the forecasted cash flows and profitability. In 2014, the results of the Company’s annual impairment test for indefinite lived trade names resulted in a personal care trade name whose fair value exceeded its carrying value by 11%. This trade name is valued at approximately $37 and is considered an important asset to the Company. The Company continues to monitor performance and should there be any significant change in forecasted assumptions or estimates, including sales, profitability and discount rate, the Company may be required to recognize an impairment charge. It is possible that the Company’s conclusions regarding impairment or recoverability of goodwill or other intangible assets could change in future periods if, for example, (i) the businesses or brands do not perform as projected, (ii) overall economic conditions in 2015 or future years vary from current assumptions (including changes in discount rates), (iii) business conditions or strategies change from current assumptions, (iv) investors require higher rates of return on equity investments in the marketplace or (v) enterprise values of comparable publicly traded companies, or actual sales transactions of comparable companies, were to decline, resulting in lower multiples of revenues and EBITDA. A future impairment charge for goodwill or intangible assets could have a material effect on the Company’s consolidated financial position or results of operations. Property, plant and equipment and other long-lived assets are reviewed whenever events or changes in circumstances occur that indicate possible impairment. The Company’s impairment review is based on an undiscounted cash flow analysis at the lowest level at which cash flows of the long-lived assets are largely independent of other groups of Company assets and liabilities. The analysis requires management judgment with respect to changes in technology, the continued success of product lines, and future volume, revenue and expense growth rates. The Company conducts annual reviews to identify idle and underutilized equipment, and reviews business plans for possible impairment implications. Impairment occurs when the carrying value of the asset exceeds the future undiscounted cash flows. When an impairment is indicated, the estimated future cash flows are then discounted to determine the estimated fair value of the asset and an impairment charge is recorded for the difference between the carrying value and fair value. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) The Company recognized charges related to plant impairment and equipment obsolescence, which occurs in the ordinary course of business for each of the years in the three-year period, ended December 31, 2014 as follows: The impairment charges in 2014 and 2013, and the Consumer Domestic and SPD impairment charges in 2012 are due to idling of equipment. The 2012 Consumer International charge is due to the cancelation of a software project. The estimates and assumptions used in connection with impairment analyses are consistent with the business plans and estimates that the Company uses to manage its business operations. Nevertheless, future outcomes may differ materially from management’s estimates. If the Company’s products fail to achieve estimated volume and pricing targets, market conditions unfavorably change or other significant estimates are not realized, then the Company’s revenue and cost forecasts may not be achieved, and the Company may be required to recognize additional impairment charges. Inventory valuation When appropriate, the Company writes down the carrying value of its inventory to the lower of cost or market (net realizable value, which reflects any costs to sell or dispose). The Company identifies any slow moving, obsolete or excess inventory to determine whether an adjustment is required to establish a new carrying value. The determination of whether inventory items are slow moving, obsolete or in excess of needs requires estimates and assumptions about the future demand for the Company’s products, technological changes, and new product introductions. In addition, the Company’s allowance for obsolescence may be impacted by the reduction of the number of stock keeping units (SKUs). The Company evaluates its inventory levels and expected usage on a periodic basis and records adjustments as required. Adjustments to inventory to reflect a reduction in net realizable value were $8.3 at December 31, 2014, and $10.1 at December 31, 2013. Valuation of pension and postretirement benefit costs The Company’s pension costs relate solely to its international operations. Both pension and postretirement benefit costs are developed from actuarial valuations. Inherent in benefit cost valuations are key assumptions provided by the Company to its actuaries, including the discount rate and expected long-term rate of return on plan assets. Material changes in the Company’s international pension and domestic/international postretirement benefit costs may occur in the future due to changes in these assumptions as well as fluctuations in plan assets. The discount rate is subject to change each year, consistent with changes in applicable high-quality, long-term corporate bond indices. Based on the expected duration of the benefit payments for the Company’s pension plans and postretirement plans, the Company refers to an applicable index and expected term of benefit payments to select a discount rate at which it believes the plan benefits could be effectively settled. The Company’s weighted average discount rate for its international pension plans as of December 31, 2014 is 3.54% as compared to 4.48% used at December 31, 2013. Based on the published rate as of December 31, 2014 that matched estimated cash flows for the plans, the Company used a weighted average discount rate of 3.77% for its postretirement plans as compared to 4.56% used at December 31, 2013. The expected long-term rate of return on international pension plan assets is selected by taking into account the historical trend, the expected duration of the projected benefit obligation for the plans, the asset mix of the plans and known economic and market conditions at the time of valuation. Based on these factors, the Company’s weighted average expected long-term rate of return for assets of its pension plans for 2014 was 6.16%, compared to 5.45% used in 2013. A 50 basis point change in the expected long-term rate of return would result in an approximate $0.5 change in pension expense for 2015. As noted above, changes in assumptions used by management may result in material changes in the Company’s pension and postretirement benefit costs. In 2014, other comprehensive income reflected a $1.3 increase in its remaining pension plan obligations and a $4.4 increase for postretirement benefit plans. The changes are related to the change in discount rates for all plans and other actuarial assumptions. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) The Company made cash contributions of approximately $3.3 to its pension plans in 2014. The Company estimates it will be required to make cash contributions to its pension plans of approximately $2.4 in 2015 to offset 2015 benefit payments and administrative costs in excess of investment returns. On December 31, 2014, the Company terminated an international defined benefit pension plan under which approximately 280 participants, including approximately 100 active employees, have accrued benefits. The Company anticipates completing the termination of this plan by the end of the second quarter of 2015, once regulatory approvals are obtained. To effect the termination, the Company estimates, based on December 31, 2014 valuations, that the plan has sufficient assets to purchase annuities for retired participants and make certain deposits to the existing defined contribution plan of active employee participants. The Company estimates that it will incur a one-time non-cash expense of approximately $8 to $11 ($6 to $8 after tax) in 2015 when the plan settlement is completed. This expense is primarily attributable to pension settlement accounting rules which require accelerated recognition of actuarial losses that were to be amortized over the expected benefit lives of participants. The estimated expense is subject to change based on valuations at the actual date of settlement. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized to reflect the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the differences are expected to be recovered or settled. Management provides a valuation allowance against deferred tax assets for amounts which are not considered “more likely than not” to be realized. The Company records liabilities for potential assessments in various tax jurisdictions under U.S. GAAP guidelines. The liabilities relate to tax return positions that, although supportable by the Company, may be challenged by the tax authorities and do not meet the minimum recognition threshold required under applicable accounting guidance for the related tax benefit to be recognized in the income statement. The Company adjusts this liability as a result of changes in tax legislation, interpretations of laws by courts, rulings by tax authorities, changes in estimates and the expiration of the statute of limitations. Many of the judgments involved in adjusting the liability involve assumptions and estimates that are highly uncertain and subject to change. In this regard, settlement of any issue, or an adverse determination in litigation, with a taxing authority could require the use of cash and result in an increase in the Company’s annual tax rate. Conversely, favorable resolution of an issue with a taxing authority would be recognized as a reduction to the Company’s annual tax rate. New Accounting Pronouncements In May 2014, the Financial Accounting Standards Board issued new guidance that clarifies the principles for recognizing revenue. The new guidance provides that an entity should recognize revenue for the transfer of goods or services equal to the amount that it expects to receive for those goods or services. The new guidance is effective for annual and interim periods beginning after December 15, 2016, and allows companies to apply the requirements retrospectively, either to all prior periods presented or through a cumulative adjustment in the year of adoption. Early adoption is not allowed. The Company is currently evaluating the impact, if any, that the adoption of the new guidance will have on its consolidated financial position, results of operations or cash flows. There have been no other accounting pronouncements issued but not yet adopted by the Company which are expected to have a material impact on the Company’s consolidated financial position, results of operations or cash flows. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2014, 2013 AND 2012 The discussion of results of operations at the consolidated level presented below is followed by a more detailed discussion of results of operations by segment. The discussion of the Company’s consolidated results of operations and segment operating results is presented on a historical basis for the years ending December 31, 2014, 2013, and 2012. The segment discussion also addresses certain product line information. The Company’s operating units are consistent with its reportable segments. Consolidated results 2014 compared to 2013 Net Sales Net sales for the year ended December 31, 2014 were $3,297.6, an increase of $103.3, or approximately 3.2% as compared to 2013 net sales. The components of the net sales increase are as follows: (1) On September 19, 2014, the Company acquired certain feminine care brands from Lil’ Drug Store Products Inc. (“Lil’ Drug Store Brands Acquisition”). Net sales of the brands acquired in the Lil’ Drug Store Brands Acquisition are included in the Company’s results since the date of acquisition. All three segments reported volume increases. The unfavorable price/mix in the Consumer Domestic segment, primarily due to new product introductory costs and a higher level of trade and coupon promotion for existing products, was partially offset by favorable price/mix in SPD. Gross Profit The Company’s gross profit for 2014 was $1,452.9, a $14.9 increase as compared to the same period in 2013 due to the effect of higher sales volume, productivity improvement programs and the impact of the Lil’ Drug Store Brands Acquisition, partially offset by the costs associated with new product launches, higher commodity costs and currency fluctuations. Gross margin was 44.1% in 2014 as compared to 45.0% in 2013. Gross margin was lower due to higher trade promotion, coupon, slotting, commodity costs and currency fluctuations, partially offset by the positive impact of productivity improvement programs. Operating Costs Marketing expenses for 2014 were $416.9, an increase of $17.1 as compared to 2013 due primarily to expenses in support of new product launches and increased expenses in certain other power brands. Marketing expenses as a percentage of net sales were 12.6% in 2014 as compared to 12.5% in 2013. SG&A expenses for 2014 were $394.8, a decrease of $21.2 as compared to 2013 due primarily to lower compensation costs and employee benefit costs, lower legal costs, lower intangible asset impairment charges and lower cease use charges associated with the Company’s Princeton, New Jersey leased buildings, partially offset by higher intangible amortization expense, in part due to the Lil’ Drug Store Brands Acquisition. Additionally, in 2013 the Company incurred costs related to the integration of the gummy dietary supplements business, which were not incurred in 2014. SG&A as a percentage of net sales was 12.1% in 2014 as compared to 13.0% in 2013. Other Income and Expenses Equity in earnings of affiliates for 2014 was $11.6 as compared to $2.8 in 2013. The increase in earnings was due primarily to profit improvement from Armand and a smaller loss at Natronx. Also, in the second quarter of 2013, the Company recorded an impairment charge associated with one of its affiliates. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Interest expense in 2014 was $27.4, a decrease of $0.3 compared to 2013. Taxation The 2014 tax rate was 33.8% as compared to 34.0% in 2013. 2013 compared to 2012 Net Sales Net sales for the year ended December 31, 2013 were $3,194.3, an increase of $272.4 or approximately 9.3% as compared to 2012 net sales. The components of the net sales increase are as follows: (1) On October 1, 2012, the Company acquired the L’IL CRITTERS and VITAFUSION gummy dietary supplement business. Net sales of these product lines are included in the Company’s results since the date of acquisition. The volume change primarily reflects increased product sales in the Consumer Domestic and Consumer International segments partially offset by lower SPD sales. Lower price/mix in Consumer Domestic and SPD was partially offset by favorable price/mix in Consumer International. Sales in the first quarter of 2012 were negatively impacted due to a timing shift in customer orders from the first quarter of 2012 to the fourth quarter of 2011 in anticipation of the January 1, 2012 information systems upgrade in the U.S. Gross Profit The Company’s gross profit for 2013 was $1,438.0, a $146.6 increase as compared to the same period in 2012 due primarily to contributions from its gummy dietary supplement business, higher sales volume and productivity improvement programs. These increases were partially offset by higher trade promotion and an unfavorable product mix. Commodity costs for the Company were unchanged in 2013 as compared to 2012. Gross margin was 45.0% in 2013 as compared to 44.2% in 2012. Gross margin was higher due to the positive impact of productivity improvement programs and higher sales volume, partially offset by higher trade promotion and coupon costs and unfavorable product mix. Operating Costs Marketing expenses for 2013 were $399.8, an increase of $42.5 as compared to 2012 due primarily to the gummy dietary supplement business, higher spending in support of certain power brands and new product launches. Marketing expenses as a percentage of net sales were 12.5% in 2013 as compared to 12.2% in 2012. SG&A expenses for 2013 were $416.0, an increase of $27.0 as compared to 2012 due primarily to operating costs associated with the acquisition of the L’IL CRITTERS and VITAFUSION gummy dietary supplement business, higher research and development and compensation costs and intangible asset impairment charges, partially offset by lower legal expenses. SG&A as a percentage of net sales was 13.0% in 2013 as compared to 13.3% in 2012. Other Income and Expenses Equity in earnings of affiliates for 2013 was $2.8 as compared to $8.9 in 2012. The decrease is due primarily to an impairment charge recorded in the second quarter of 2013 associated with one of the Company’s affiliates and lower earnings from Armand as a result of increased raw material costs. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Interest expense in 2013 increased $13.7 compared to 2012 principally due to debt incurred to finance the acquisition of the L’IL CRITTERS and VITAFUSION gummy dietary supplement business at the beginning of the fourth quarter of 2012 and interest associated with the financing lease obligation for the Company’s global headquarters that was fully occupied in January 2013. Taxation The 2013 tax rate was 34.0% as compared to 35.5% in 2012. The effective tax rate for 2013 was favorably affected by a lower effective state tax rate and tax benefits relating to the federal research tax credit for 2013 and the retroactive extension of the federal research tax credit to January 2012 that occurred in the first quarter of 2013. The 2012 tax rate reflects no federal research tax credit. Segment results for 2014, 2013 and 2012 The Company operates three reportable segments: Consumer Domestic, Consumer International and SPD. These segments are determined based on differences in the nature of products and organizational and ownership structures. The results of the Lil Drug Store Brands Acquisition are reflected in the Consumer Domestic and Consumer International segments. The Company also has a Corporate segment. Segment Products Consumer Domestic Household and personal care products Consumer International Primarily personal care products SPD Specialty chemical products The Corporate segment income consists of equity in earnings (losses) of affiliates. As of December 31, 2014, the Company held 50% ownership interests in each of Armand and ArmaKleen, respectively, and a one-third ownership interest in Natronx. The Company’s equity in earnings (losses) of Armand, ArmaKleen and Natronx for the twelve months ended December 31, 2014, 2013 and 2012 is included in the Corporate segment. Some of the subsidiaries that are included in the Consumer International segment manufacture and sell personal care products to the Consumer Domestic segment. These sales are eliminated from the Consumer International segment results set forth below. Segment net sales and income before income taxes for each of the three years ended December 31, 2014, 2013 and 2012 were as follows: (1) Intersegment sales from Consumer International to Consumer Domestic, which are not reflected in the table, were $1.9, $2.2 and $3.4 for the years ended December 31, 2014, 2013 and 2012, respectively. (2) In determining income before income taxes, the Company allocated interest expense, investment earnings, and other income (expense) among the segments based upon each segment’s relative Income from Operations. (3) Corporate segment consists of equity in earnings (losses) of affiliates from Armand, ArmaKleen and Natronx. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Product line revenues for external customers for the years ended December 31, 2014, 2013 and 2012 were as follows: Household Products include deodorizing, cleaning and laundry products. Personal Care Products include condoms, pregnancy kits, oral care products, skin care products and gummy dietary supplements. Consumer Domestic 2014 compared to 2013 Consumer Domestic net sales in 2014 were $2,471.6, an increase of $58.1 or 2.4% compared to net sales of $2,413.5 in 2013. The components of the net sales change are the following: (1)Associated with net sales of the brands acquired in the Lil’ Drug Store Brands Acquisition since the date of acquisition. The increase in net sales includes the new product launches of ARM & HAMMER CLUMP & SEAL clumping cat litter and OXICLEAN liquid laundry detergent, and higher sales of OXICLEAN laundry additive products, TROJAN products, VITAFUSION gummy dietary supplements and ORAJEL oral analgesics, partially offset by lower sales in XTRA laundry detergent, L’IL CRITTER gummy dietary supplements and ARM & HAMMER powder and unit dose laundry detergents. Since the 2012 introduction in the U.S. of unit dose laundry detergent by various manufacturers, including the Company, there has been significant product and price competition in the laundry detergent category, contributing to an overall category decline. During 2013, the category declined by 3.2%. In 2014, the Procter & Gamble Company, one of the Company’s major competitors and the market leader in laundry detergent, took several competitive actions, including launching a lower-priced line of laundry detergents that competes directly with the Company’s core value laundry detergents. This, together with expected ongoing weak consumer spending and aggressive price competition by other laundry competitors that somewhat abated as of the end of December 2014, has negatively impacted the Company’s laundry detergent business. Over the last twelve months, the category declined 2.9%. The Company is vigorously combating these pressures through, among other things, significant new product introductions and increased marketing spending. There is no assurance that the category will not decline further and that the Company will be able to offset any such category decline. Consumer Domestic income before income taxes for 2014 was $502.8, a $1.8 increase as compared to 2013. The increase is due to higher sales volumes, manufacturing costs savings resulting from productivity improvement projects and lower SG&A costs, partially offset by the impact of introductory and higher trade promotion, coupon and marketing costs in support of new product launches and existing products, higher commodity costs and an intangible asset impairment charge. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) 2013 compared to 2012 Consumer Domestic net sales in 2013 were $2,413.5, an increase of $256.6 or 11.9% compared to net sales of $2,156.9 in 2012. The components of the net sales change are the following: (1) On October 1, 2012, the Company acquired the L’IL CRITTERS and VITAFUSION gummy dietary supplement business. Net sales of these acquired product lines subsequent to the acquisition are included in the Company’s results. The increase in net sales reflects sales from the gummy dietary supplement business and higher sales of ARM & HAMMER liquid laundry detergent, OXICLEAN laundry additives, TROJAN products and FIRST RESPONSE diagnostic kits, partially offset by sales declines in ARM & HAMMER powder laundry detergent, XTRA liquid laundry detergent, SPINBRUSH battery operated toothbrushes, and ARM & HAMMER cat litter. Sales in the first quarter of 2012 were negatively impacted due to a timing shift in customer orders from the first quarter of 2012 to the fourth quarter of 2011 in anticipation of the January 1, 2012 information systems upgrade in the U.S. Consumer Domestic income before income taxes for 2013 was $501.0, a $72.2 increase as compared to 2012. The increase is due primarily to the contribution from the acquisition of the L’IL CRITTERS and VITAFUSION gummy dietary supplement business (net of higher interest expense), the impact of higher sales volumes and lower manufacturing costs resulting from productivity improvement projects, partially offset by higher trade promotion and coupon costs, the effect of unfavorable product mix and higher marketing and SG&A expenses. Consumer International 2014 compared to 2013 Consumer International net sales in 2014 were $535.2, an increase of $2.4 or 0.5% as compared to 2013. The components of the net sales change are the following: (1) Associated with net sales of the brands acquired in the Lil’ Drug Store Brands Acquisition since the date of acquisition. Higher sales in 2014 occurred primarily in Europe and Mexico. Consumer International income before income taxes was $64.7 in 2014, an increase of $0.2 compared to 2013 due primarily to higher volumes and prices offset by the effect of foreign exchange rate changes and higher trade promotion, commodity and marketing costs. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) 2013 compared to 2012 Consumer International net sales in 2013 were $532.8, an increase of $22.7 or 4.5% as compared to 2012. The components of the net sales change are the following: (1) On October 1, 2012, the Company acquired the L’IL CRITTERS and VITAFUSION gummy dietary supplement business. Net sales of these product lines subsequent to the acquisition are included in the Consumer International results. Higher sales in 2013 occurred primarily in Mexico, Canada, Brazil, United Kingdom and U.S. exports. Consumer International income before income taxes was $64.5 in 2013, a decrease of $6.5 compared to 2012 caused by unfavorable foreign exchange rates, a trade name impairment charge and marketing expenses, partially offset by the contribution from the acquisition of the L’IL CRITTERS and VITAFUSION gummy dietary supplement business, higher sales volume and favorable price/mix. Specialty Products 2014 compared to 2013 SPD net sales were $290.8 for 2014, an increase of $42.8, or 17.3% as compared to 2013. The components of the net sales change are the following: The sales increase in 2014 reflects higher sales volume of animal nutrition products and performance products. The animal nutrition business’s strong performance is primarily related to the strength of the U.S. dairy industry, which has experienced all time high milk prices and low input commodity costs, prompting dairy producers to feed more animal nutrition products and produce higher volumes of milk per cow. SPD income before income taxes was $45.8 in 2014, an increase of $16.4 as compared to 2013. The increase in income before income taxes for 2014 is due primarily to higher sales volume and sales prices and lower SG&A costs. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) 2013 compared to 2012 SPD net sales were $248.0 for 2013, a decrease of $6.9, or 2.7% as compared to 2012. The components of the net sales change are the following: The sales decrease in 2013 reflects reduced product sales of animal nutrition products, partially offset by higher bulk sales of sodium bicarbonate. Colder than normal weather during the second quarter of 2013 negatively impacted demand from the dairy industry. In addition, the decrease in net sales of 2013 was offset by the adverse impact in the first quarter of 2012 of a timing shift in customer orders from the first quarter of 2012 to the fourth quarter of 2011 in anticipation of the January 1, 2012 information systems upgrade in the U.S. SPD income before income taxes was $29.5 in 2013, a decrease of $4.3 as compared to 2012. The decrease in the income before income taxes for 2013 is due primarily to lower selling prices for animal nutrition products, partially offset by lower SG&A expenses. Corporate The Corporate segment reflects the administrative costs of the production, planning and logistics functions which are included in SG&A expenses in the operating segments but are elements of cost of sales in the Company’s Consolidated Statements of Income. Such amounts were $26.7, $31.3, and $29.4 for 2014, 2013 and 2012, respectively. Also included in Corporate are equity in earnings (losses) of affiliates from Armand, ArmaKleen and Natronx. The increase in equity in earnings of affiliates in 2014 is primarily due to a $3.2 impairment charge associated with one of the Company’s affiliates in 2013 and profitability from Armand. Liquidity and capital resources As of December 31, 2014, the Company had $423.0 in cash and cash equivalents, approximately $450 available through the revolving facility under its Credit Agreement and its commercial paper program, and a commitment increase feature under the Credit Agreement that enables the Company to borrow up to an additional $500, subject to lending commitments of the participating lenders and certain conditions as described in the Credit Agreement. To preserve its liquidity, the Company invests its cash primarily in prime money market funds and short term bank deposits. As of December 31, 2014, the amount of cash and cash equivalents included in the Company’s assets, that was held by foreign subsidiaries was approximately $245.3. From an income tax perspective, the Company has undistributed earnings from foreign subsidiaries of approximately $315.4, at December 31, 2014, for which U.S. deferred taxes have not been provided. If these funds are needed for operations in the U.S., the Company will be required to accrue and pay taxes in the U.S. to repatriate these funds. The Company’s intent is to permanently reinvest these funds outside the U.S., and the Company does not currently expect to repatriate them to fund operations in the U.S. However, the Company continues to monitor external events or circumstances and may change its intention to remit undistributed earnings if it can be achieved in a manner that results in a tax-neutral impact to the Company. External events or circumstances include movement in interest or currency exchange rates. For example, if the exchange rate between the Euro/USD declined, the Company would re-evaluate its intentions to remit earnings of approximately $200, which approximates $70 of cash and cash equivalents held by foreign subsidiaries. On December 19, 2014, the Company replaced its former $500 credit facility with a $600 unsecured revolving credit facility (as amended, the “Credit Agreement”). Under the Credit Agreement, the Company has the ability to increase its borrowing up to an additional $500, subject to lender commitments and certain conditions as described in the Credit Agreement. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) The Credit Agreement supports the Company’s $500 commercial paper program (the “Program”). Total combined borrowing for both the Credit Agreement and the Program may not exceed $600. Unless extended, the Credit Agreement will terminate and all amounts outstanding thereunder will be due and payable on December 19, 2019. On December 9, 2014, the Company closed an underwritten public offering of $300 aggregate principal amount of 2.45% Senior Notes due December 15, 2019 (the “2019 Notes”). The 2019 Notes were issued under the first supplemental indenture (the “First Supplemental Indenture”), dated December 9, 2014, to the indenture dated December 9, 2014 (the “Base Indenture”), between the Company and Wells Fargo Bank, N.A., as trustee. Interest on the 2019 Notes is payable semi-annually, beginning June 15, 2015. The 2019 Notes will mature on December 15, 2019, unless earlier retired or redeemed pursuant to the terms of the First Supplemental Indenture. On September 26, 2012, the Company closed an underwritten public offering of $400 aggregate principal amount of 2.875% Senior Notes due 2022 (the “2022 Notes”). The 2022 Notes were issued under the second supplemental indenture, dated September 26, 2012 (the “BNY Mellon Second Supplemental Indenture”), to the indenture dated December 15, 2010 (the “BNY Mellon Base Indenture”) between the Company and The Bank of New York Mellon Trust Company, N.A., as trustee. Interest on the 2022 Notes is payable semi-annually, beginning April 1, 2013. The 2022 Notes will mature on October 1, 2022, unless earlier retired or redeemed pursuant to the terms of the BNY Mellon Second Supplemental Indenture. The Company used $250 from commercial paper issuances, along with the $400 of 2022 Notes and cash, to purchase the L’IL CRITTERS and VITAFUSION gummy dietary supplement business on October 1, 2012. On December 15, 2010, the Company completed an underwritten public offering of $250 aggregate principal amount of 3.35% Senior Notes due 2015 (the “2015 Notes”). The 2015 Notes were issued under the BNY Mellon Base Indenture, and a first supplemental indenture, (the “BNY Mellon First Supplemental Indenture”), dated December 15, 2010, between the Company and BNY Mellon, as trustee. On December 30, 2010, the proceeds of the offering were utilized to retire the outstanding $250 principal amount of the Company’s 6% Senior Subordinated Notes due 2012. Interest on the 2015 Notes is payable on June 15 and December 15 of each year, beginning June 15, 2011. The 2015 Notes will mature on December 15, 2015, unless earlier retired or redeemed pursuant to the terms of the BNY Mellon First Supplemental Indenture. The current economic environment presents risks that could have adverse consequences for the Company’s liquidity. (See “Unfavorable economic conditions could adversely affect demand for the Company’s products” under “Risk Factors” in Item 1A of this Annual Report.) The Company does not anticipate that current economic conditions will adversely affect its ability to comply with the financial covenant in the Credit Agreement because the Company currently is, and anticipates that it will continue to be, in compliance with the maximum leverage ratio requirement under the Credit Agreement. On January 28, 2015, the Board declared an 8% increase in the regular quarterly dividend from $0.31 to $0.335 per share, equivalent to an annual dividend of $1.34 per share as of February 10, 2015. The decision raises the annual dividend payout from $168 to approximately $177. On January 29, 2014, the Board authorized the 2014 Share Repurchase Program. The 2014 Share Repurchase Program replaced the Company’s share repurchase program announced on November 5, 2012. In addition, the Board authorized an evergreen share repurchase program, under which the Company may repurchase, from time to time, Common Stock to reduce or eliminate dilution associated with issuances of Common Stock under the Company’s incentive plans. In 2014, the Company purchased 6.9 million shares of its Common Stock at an aggregate cost of approximately $479. Approximately $393 was purchased under the 2014 Share Repurchase Program and $86 was purchased under the evergreen share repurchase program. As part of the evergreen share repurchase program, in early January 2015, the Company purchased 0.5 million shares of Common Stock at a cost of approximately $41.2. The Company used cash on hand to fund the purchase price. On January 28, 2015, the Board authorized the 2015 Share Repurchase Program. The 2015 Share Repurchase Program replaced the 2014 Share Repurchase Program and the Company continued its evergreen share repurchase program. As part of the 2015 Share Repurchase Program and the evergreen share repurchase program, in early February 2015, the Company entered into an accelerated share repurchase contract with a commercial bank to purchase $215 of Common Stock. The Company paid $215 to the bank and received an initial delivery of approximately 2.6 million shares of Common Stock. The contract will be settled by mid-May 2015. If the Company is required to deliver value to the commercial bank at the end of the purchase period, the Company, at its option, may elect to settle in shares of Common Stock or cash. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Of the 2015 share repurchases, approximately $88.0 was purchased under the Company’s evergreen share repurchase program. The Company anticipates that its cash from operations, together with its current borrowing capacity, will be sufficient to meet its capital expenditure program costs, which are expected to be approximately $70.0 in 2015, fund its share repurchase programs to the extent implemented by management and pay dividends at the latest approved rate. Cash, together with the Company’s current borrowing capacity, may be used for acquisitions that would complement the Company’s existing product lines or geographic markets. The Company did not have any mandatory fixed rate debt principal payments in 2014. In 2015, the Company is required to pay $250.0 for the 2015 Notes (net of discounts) when the notes mature on December 15, 2015. The Company expects to use cash generated from operations to retire the debt. Net Debt The Company had outstanding total debt of $1,095.2 and cash of $423.0 at December 31, 2014, resulting in net debt of $672.2 at December 31, 2014. This compares to total debt of $803.3 and cash of $496.9, resulting in net debt of $306.4 at December 31, 2013. Net debt is defined as total debt, minus cash and cash equivalents. Cash Flow Analysis 2014 compared to 2013 Net Cash Provided by Operating Activities - The Company’s net cash provided by operating activities in 2014 increased $40.7 to $540.3 as compared to 2013 due to higher net income and a slight increase in working capital. Net cash provided by operating activities in 2013 was negatively affected by the deferred payment of the fourth quarter 2012 federal tax obligation of $36.0 as allowed by the IRS due to the impact of Hurricane Sandy. Net Cash Used in Investing Activities - Net cash used in investing activities during 2014 was $288.4, principally reflecting the $215.7 paid for the Lil’ Drug Store Brands Acquisition and $70.5 of property, plant and equipment expenditures. Net Cash (Used in) Provided by Financing Activities - Net cash used in financing activities during 2014 was $306.6, primarily reflecting $478.8 of repurchases of Common Stock, $167.5 of cash dividend payments and $6.7 net repayments of short-term debt offset by an increase in long-term debt of $299.8 for the 2019 Notes, and $51.2 of proceeds and tax benefits from stock option exercises. 2013 compared to 2012 Net Cash Provided by Operating Activities - The Company’s net cash provided by operating activities in 2013 decreased $24.0 to $499.6 as compared to 2012. The Company was able to defer its fourth quarter 2012 federal tax payment of $36.0 to the first quarter of 2013 as allowed by the IRS due to the impact of Hurricane Sandy, which accounted for the decrease in net cash provided by operating activities in 2013. Partially offsetting the decrease was a reduction in working capital (higher accounts payable and accrued expenses, partially offset by higher accounts receivable). Net Cash Used in Investing Activities - Net cash used in investing activities during 2013 was $77.1, principally reflecting $67.1 of property, plant and equipment expenditures and a $6.4 investment in Natronx. Net Cash Provided by (Used in) Financing Activities - Net cash used in financing activities during 2013 was $259.8, primarily reflecting $100.0 of repayments of commercial paper, $50.1 of repurchases of Common Stock and $155.2 of cash dividends, partially offset by $35.1 of proceeds and tax benefits from stock option exercises and the receipt of an incentive payment of $10.9 related to the financing lease for the Company’s new corporate headquarters. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Financial Covenant “Consolidated EBITDA” (referred to below as “Adjusted EBITDA” and defined in the Credit Agreement that was revised in December 2014) is a component of the financial covenant contained in the Credit Agreement. The financial covenant includes a leverage ratio (total debt to Adjusted EBITDA), which, if not met, could result in an event of default and trigger the early termination of the Credit Agreement. Adjusted EBITDA may not be comparable to similarly titled measures used by other entities and should not be considered as an alternative to cash flows from operating activities determined in accordance with accounting principles generally accepted in the U.S. The Company’s leverage ratio for the twelve months ended December 31, 2014 was 1.5, which is below the maximum of 3.5 permitted under the Credit Agreement. The reconciliation of Net Cash Provided by Operating Activities (the most directly comparable U.S. GAAP financial measure) to Adjusted EBITDA for 2014 is as follows: Commitments as of December 31, 2014 The table below summarizes the Company’s material contractual obligations and commitments as of December 31, 2014. (1) Represents interest on the Company’s 3.35% Senior Notes due in 2015, 2.45% Senior Notes due in 2019 and 2.875% Senior Notes due in 2022. (2) Letters of credit with several banks guarantee payment for items such as insurance claims in the event of the Company’s insolvency. Performance bonds are principally for required municipal property improvements. (3) Pension contributions are based on actuarial assessments of government regulated employer funding requirements. These requirements are not projected beyond one year since they fluctuate with the change in plan assets, assumptions and demographics. (4) The Company has outstanding purchase obligations with suppliers at the end of 2014 for raw, packaging and other materials and services in the normal course of business. These purchase obligation amounts represent only those items which are based on agreements that are enforceable and legally binding, and do not represent total anticipated purchases. (5) Other includes payments for stadium naming rights for a period of 20 years until December 2032. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) The Company has excluded from the table above uncertain tax liabilities due to the uncertainty of the amount per period of payment. The Company’s liabilities for uncertain income tax positions are $4.0 as of December 31, 2014. (See Note 10 to the consolidated financial statements included in this Annual Report). Off-Balance Sheet Arrangements The Company does not have off-balance sheet financing or unconsolidated special purpose entities. OTHER ITEMS Market risk Concentration of Risk A group of three customers accounted for approximately 36%, 35% and 34% of consolidated net sales in 2014, 2013 and 2012, respectively, of which a single customer, Wal-Mart, accounted for approximately 25%, 24% and 24% in 2014, 2013 and 2012, respectively. Interest Rate Risk The Company had outstanding total debt at December 31, 2014, of $1,096.2, of which 87% has a fixed weighted average interest rate of 2.87% and the remaining 13% constituted principally commercial paper issued by the Company that currently has a weighted average interest rate of less than 0.5%. In December 2014, the Company entered into interest rate swap agreements on an aggregate notional amount of $300 to convert the fixed interest rate on the 2019 Notes to a variable interest rate. Diesel Fuel Hedges The Company uses independent freight carriers to deliver its products. These carriers currently charge the Company a basic rate per mile for diesel fuel price increases. During 2013 and 2014, the Company entered into hedge agreements with financial counterparties to mitigate the volatility of diesel fuel prices, and not to speculate in the future price of diesel fuel. Under the hedge agreements, the Company agreed to pay a fixed price per gallon of diesel fuel determined at the time the agreements were executed and to receive a floating rate payment that is determined on a monthly basis based on the average price of the Department of Energy’s Diesel Fuel Index during the applicable month and is designed to offset any increase or decrease in fuel costs that the Company pays to it common carriers. The agreements covered approximately 57% of the Company’s 2014 diesel fuel requirements and are expected to cover approximately 63% and 16% of the Company’s estimated diesel fuel requirements for 2015 and 2016, respectively. These diesel fuel hedge agreements qualify for hedge accounting. Therefore, changes in the fair value of such agreements are recorded under Accumulated Other Comprehensive Income on the balance sheet. Foreign Currency The Company is subject to exposure from fluctuations in foreign currency exchange rates, primarily U.S. Dollar/Euro, U.S. Dollar/British Pound, U.S. Dollar/Canadian Dollar, U.S. Dollar/Mexican Peso, U.S. Dollar/Australian Dollar, U.S. Dollar/Brazilian Real and U.S. Dollar/Chinese Yuan. The Company, from time to time, enters into forward exchange contracts to reduce the impact of foreign exchange rate fluctuations related to anticipated but not yet committed intercompany sales or purchases denominated in the U.S. Dollar, Canadian Dollar, British Pound and Euro. The Company entered into forward exchange contracts to protect it from the risk that, due to changes in currency exchange rates, it would be adversely affected by net cash outflows. The face value of the unexpired contracts as of December 31, 2014 totaled $53.3. The contracts qualified as foreign currency cash flow hedges, and, therefore, changes in the fair value of the contracts were recorded in Other Comprehensive Income (Loss) and reclassified to earnings when the hedged transaction affected earnings. Equity Derivatives The Company has entered into equity derivative contracts covering its own stock in order to minimize its liability, resulting from changes in quoted fair values of Company stock, to participants in its Executive Deferred Compensation Plan who have investments under that plan in a notional Company stock fund. The contracts are typically settled in cash. Since the equity derivatives do not qualify for hedge accounting, the Company is required to mark the agreements to market throughout the life of the agreements and record changes in fair value in the consolidated statement of income. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data)

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW The Company’s Business The Company develops, manufactures, markets and sells a broad range of household, personal care and specialty products. The Company sells its consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores, and websites, all of which sell the products to consumers. The Company also sells specialty products to industrial customers and distributors. The Company focuses its consumer products marketing efforts principally on its “power brands.” These wellrecognized brand names include ARM & HAMMER (used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent), TROJAN condoms, lubricants and vibrators, OXICLEAN stain removers, cleaning solutions, laundry detergent, dishwashing detergent and bleach alternatives, SPINBRUSH batteryoperated and manual toothbrushes, FIRST RESPONSE home pregnancy and ovulation test kits, NAIR depilatories, ORAJEL oral analgesics, XTRA laundry detergent, and L’IL CRITTERS and VITAFUSION gummy dietary supplements. The Company considers four of these brands to be “mega brands”: ARM & HAMMER, OXICLEAN, TROJAN, and L’IL CRITTERS and VITAFUSION, and is giving greatest focus to the growth of these brands. The Company operates its business in three segments: Consumer Domestic, Consumer International and SPD. The Consumer Domestic segment includes the power brands noted above and other household and personal care products such as SCRUB FREE, KABOOM and ORANGE GLO cleaning products, ARRID antiperspirant, CLOSEUP and AIM toothpastes and SIMPLY SALINE nasal saline moisturizer. The Consumer International segment primarily sells a variety of personal care products, some of which use the same brand names as the Company’s domestic product lines, in international markets including Canada, France, Australia, the United Kingdom, Mexico and Brazil. The SPD segment is the largest U.S. producer of sodium bicarbonate, which it sells together with other specialty inorganic chemicals for a variety of industrial, institutional, medical and food applications. This segment also sells a range of animal nutrition and specialty cleaning products. In 2014, the Consumer Domestic, Consumer International and SPD segments represented approximately 75%, 16% and 9%, respectively, of the Company’s consolidated net sales. 2014 Financial Highlights Key fiscal year 2014 financial results include: · 2014 net sales grew 3.2% over fiscal year 2013, with gains in all three of the Company’s segments, primarily due to volume growth and the impact of the 2014 acquisition of the Lil’ Drug Store brands, partially offset by higher promotional spending and currency fluctuations. · Gross margin decreased 90 basis points to 44.1% in fiscal year 2014 from 45.0% in fiscal year 2013, reflecting higher promotional spending in support of new and existing products, higher commodity costs and currency fluctuations. · Operating margin decreased 10 basis points to 19.4% in fiscal year 2014 from 19.5% in fiscal year 2013, reflecting a lower gross margin and slightly higher marketing costs, partially offset by lower selling, general and administrative expenses (“SG&A”). · The Company achieved diluted net earnings per share in fiscal year 2014 of $3.01, an increase of approximately 8.0% from fiscal year 2013 diluted net earnings per share of $2.79. [/INST] Positive. </s>

CHURCH & DWIGHT CO INC /DE/

2016-02-19

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW The Company’s Business The Company develops, manufactures, markets and sells a broad range of household, personal care and specialty products. The Company sells its consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores, and websites, all of which sell the products to consumers. The Company also sells specialty products to industrial customers and distributors. The Company focuses its consumer products marketing efforts principally on its ten “power brands.” These well-recognized brand names include ARM & HAMMER, used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent; TROJAN condoms, lubricants and vibrators; OXICLEAN stain removers, cleaning solutions, laundry detergent, dishwashing detergent and bleach alternatives; SPINBRUSH battery-operated and manual toothbrushes; FIRST RESPONSE home pregnancy and ovulation test kits; NAIR depilatories; ORAJEL oral analgesic; XTRA laundry detergent; L’IL CRITTERS and VITAFUSION gummy dietary supplements; and BATISTE dry shampoos. The Company considers four of these brands to be “mega brands”: ARM & HAMMER, OXICLEAN, TROJAN, and L’IL CRITTERS and VITAFUSION, and is giving greatest focus to the growth of these brands. The Company operates its business in three segments: Consumer Domestic, Consumer International and SPD. The Consumer Domestic segment includes the power brands noted above and other household and personal care products such as SCRUB FREE, KABOOM and ORANGE GLO cleaning products, ARRID antiperspirant, CLOSE-UP and AIM toothpastes and SIMPLY SALINE nasal saline moisturizer. The Consumer International segment primarily sells a variety of personal care products, some of which use the same brand names as the Company’s domestic product lines, in international markets including Canada, France, Australia, the United Kingdom, Mexico and Brazil. The SPD segment is the largest U.S. producer of sodium bicarbonate, which it sells together with other specialty inorganic chemicals for a variety of industrial, institutional, medical and food applications. This segment also sells a range of animal nutrition and specialty cleaning products. In 2015, the Consumer Domestic, Consumer International and SPD segments represented approximately 76%, 15% and 9%, respectively, of the Company’s consolidated net sales. 2015 Financial Highlights Key fiscal year 2015 financial results include: · 2015 net sales grew 2.9% over fiscal year 2014, with gains in all three of the Company’s segments, primarily due to volume growth and the impact of the 2014 acquisition of the Lil’ Drug Store brands and the January 2015 acquisition of substantially all of the assets of Varied Industries Corporation (the “VI-COR Acquisition”), partially offset by currency fluctuations. · Gross margin increased 40 basis points to 44.5% in fiscal year 2015 from 44.1% in fiscal year 2014, reflecting the favorable impact of the Lil’ Drug Store Brands and VI-COR acquisitions, higher volumes and lower commodity costs partially offset by unfavorable foreign exchange rates. · Operating margin increased 50 basis points to 19.9% in fiscal year 2015 from 19.4% in fiscal year 2014, reflecting a higher gross margin and slightly lower marketing costs, partially offset by higher selling, general and administrative expenses (“SG&A”). · During the second quarter, the Company settled its previously announced termination of an international pension plan and recorded an $8.9 charge in SG&A. · Also during the second quarter, the Company recorded a $17.0 impairment charge associated with its remaining investment in Natronx. · The Company reported diluted net earnings per share in fiscal year 2015 of $3.07, an increase of approximately 2.0% from fiscal year 2014 diluted net earnings per share of $3.01. · Cash provided by operations was $606.1, a $65.8 increase from the prior year, which includes higher cash earnings and improved working capital. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) · The Company returned $538.4 to its stockholders through dividends and share repurchases. Strategic Goals, Challenges and Initiatives The Company’s ability to generate sales depends on consumer demand for its products and retail customers’ decisions to carry its products, which are, in part, affected by general economic conditions in its markets. In 2015, many of the markets in which the Company operates continued to experience general economic softness and weak or inconsistent consumer demand. Although the Company’s consumer products generally are consumer staples and less vulnerable to decreases in discretionary spending than other products, the continued economic downturn has reduced demand in many categories, particularly those in personal care, and affected Company sales in recent periods. Some customers have responded to economic conditions by increasing their private label offerings (primarily in the dietary supplements, diagnostic kits and oral analgesics categories), and consolidating the product selections they offer to the top few leading brands in each category. In addition, an increasing portion of the Company’s product categories are being sold by club stores, dollar stores and mass merchandisers. These customer actions have placed downward pressure on the Company’s sales and gross margins. The Company expects a competitive marketplace in 2016 due to new product introductions by competitors and continuing aggressive competitive pricing pressures. In the U.S., an improving unemployment rate and higher disposable income due to low gasoline prices are expected to have a positive effect on consumption patterns. To continue to deliver attractive results for stockholders in this environment, the Company intends to continue to aggressively pursue several key strategic initiatives: maintain competitive marketing and trade spending, tightly control its cost structure, continue to develop and launch new and differentiated products, and pursue strategic acquisitions. The Company also intends to continue to grow its product sales geographically (in an attempt to mitigate the impact of weakness in any one area), and maintain an offering of premium and value brand products (to appeal to a wide range of consumers). The Company continues to experience heightened competitive activity in certain product categories from other larger multinational competitors, some of which have greater resources. Such activities have included new product introductions, more aggressive product claims and marketing challenges, as well as increased promotional spending. Since the introduction in the U.S. of unit dose laundry detergent by various manufacturers, including the Company, there has been significant product and price competition in the laundry detergent category. For example, P&G, one of the Company’s major competitors and the market leader in laundry detergent markets a lower-priced line of laundry detergents that competes directly with the Company’s core value laundry detergents. Additionally, Henkel has entered the U.S. market with Persil, its leading worldwide premium laundry detergent. While it is too early to assess what impact this will have on the premium laundry category or the Company’s laundry detergent business, the introduction of Persil could precipitate greater price competition in the category and distribution pressure with a potential adverse impact on OXICLEAN laundry detergent. The Company continues to evaluate and vigorously combat the pressures in the laundry detergent category through, among other things, new product introductions and increased marketing spending. While the category grew 1.6% in 2015, after experiencing declines in 2013 and 2014, there is no assurance the category will not decline and that the Company will be able to offset any such decline. The Company has responded to these competitive pressures by, among other things, focusing on strengthening its key brands, including increased focus on the ARM & HAMMER, OXICLEAN, TROJAN and L’IL CRITTERS and VITAFUSION mega brands through the launch of innovative new products, which span various product categories, including premium and value household products supported by increased marketing and trade spending. Together, they represented approximately 60% of the Company’s sales and profits in 2015. These mega brands have advantages over other power brands, including the ability to leverage research and development and marketing investments and lower overhead costs across mega brand categories. For example, the Company’s 2014 responsive product introductions include the simultaneous launch of OXICLEAN branded products into the mid/premium tier laundry detergent segment, and auto dish detergent category and bleach alternatives with continued support of, and innovation in, the Company’s base ARM & HAMMER and OXICLEAN businesses, to create scale and maximize marketing efforts. In 2015, the Company continued to heavily invest in the OXICLEAN brand as 2015 marked the second year of the Company’s goal to establish OXICLEAN as a mega brand in multiple categories. Mega brand launches and launches of other products are anticipated to contribute more incremental new product revenue than the introduction of new products has in prior years, and a significant portion of those revenues will include expansion into new categories with premium household products, supported by increased levels of slotting, trade promotions and incremental marketing support and planned ongoing technology investment. There can be no assurance that these measures will be successful. Despite challenging economic conditions and customer responses to these conditions, the Company was able to grow market share in seven of 10 of its “power brands” in 2015, including in the laundry detergent category. The Company’s global product portfolio consists of both premium (60% of total worldwide consumer revenue in 2015) and value (40% of total worldwide consumer CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) revenue in 2015) brands, which it believes enables it to succeed in a range of economic environments. The Company’s value brands have performed strongly during economic downturns, and the Company intends to continue to develop a portfolio of appealing new products to build loyalty among cost-conscious consumers. Over the past 15 years, the Company has diversified from an almost exclusively U.S. business to a global company with approximately 15% of sales derived from foreign countries in 2015. The Company has operations in six countries (Canada, Mexico, U.K., France, Australia and Brazil) and exports to over 90 other countries. In 2015, the Company benefited from its concentration in North America in light of the economic downturn in Europe; however, the Company has continued and will continue to focus on selectively expanding its global business. Net sales generated outside of the United States are exposed to foreign currency exchange rate fluctuations as well as political uncertainty which could impact future operating results. The Company also continues to focus on controlling its costs. Historically, the Company has been able to mitigate the effects of cost increases primarily by implementing cost reduction programs and, to a lesser extent, by passing along some of these cost increases to customers. The Company has also entered into set pricing and pre-buying arrangements with certain suppliers and hedge agreements for diesel fuel. Additionally, maintaining tight controls on overhead costs has been a hallmark of the Company and has enabled it to effectively navigate recent challenging economic conditions. The identification and integration of strategic acquisitions are an important component of the Company’s overall strategy. Acquisitions have added significantly to Company sales and profits over the last decade. This is evidenced by the Lil’ Drug Store Brands and VI-COR acquisitions. However, the failure to effectively integrate any acquisition or achieve expected synergies may cause the Company to incur material asset write-downs. The Company actively seeks acquisitions that fit its guidelines, and its strong financial position provides it with flexibility to take advantage of acquisition opportunities. In addition, the Company’s ability to quickly integrate acquisitions and leverage existing infrastructure has enabled it to establish a strong track record in making accretive acquisitions. Since 2001, the Company has acquired nine of its ten “power brands”. The Company believes it is positioned to meet the ongoing challenges described above due to its strong financial condition, experience operating in challenging environments and continued focus on key strategic initiatives: maintaining competitive marketing and trade spending, managing its cost structure, continuing to develop and launch new and differentiated products, and pursuing strategic acquisitions. This focus, together with the strength of the Company’s portfolio of premium and value brands, has enabled the Company to succeed in a range of economic environments, and is expected to position the Company to continue to increase stockholder value over the long-term. Moreover, the generation of a significant amount of cash from operations, as a result of net income and effective working capital management, combined with an investment grade credit rating provides the Company with the financial flexibility to pursue acquisitions, drive new product development, make capital expenditures to support organic growth and gross margin improvements, return cash to stockholders through dividends and share buy backs, and reduce outstanding debt, positioning it to continue to create stockholder value. For information regarding risks and uncertainties that could materially adversely affect the Company’s business, results of operations and financial condition, see “Risk Factors” in Item 1A of this Annual Report. Recent Developments TOPPIK Acquisition On January 4, 2016, the Company acquired Spencer Forrest, Inc., the maker of TOPPIK (“Toppik Acquisition”), the leading brand of hair building fibers for people with thinning hair, for approximately $175.0, which is subject to adjustment based on the closing working capital. The Company financed the acquisition with commercial paper. Toppik’s annual sales are approximately $30.0. This brand will be managed within the Consumer Domestic and Consumer International segments. Dividend Increase On February 2, 2016, the Board declared a 6% increase in the regular quarterly dividend from $0.335 to $0.355 per share, equivalent to an annual dividend of $1.42 per share payable to stockholders of record as of February 16, 2016. The increase raises the annual dividend payout from $175 to approximately $185, and maintains the Company’s payout of dividends relative to net income at approximately 40%. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the U.S. (GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. By their nature, these judgments are subject to uncertainty. They are based on the Company’s historical experience, its observation of trends in industry, information provided by its customers and information available from other outside sources, as appropriate. The Company’s significant accounting policies and estimates are described below. Revenue Recognition and Promotional and Sales Return Reserves Virtually all of the Company’s revenue represents sales of finished goods inventory and is recognized when received or picked up by the Company’s customers. The reserves for consumer and trade promotion liabilities and sales returns are established based on the Company’s best estimate of the amounts necessary to settle future and existing claims on products sold as of the balance sheet date. Promotional reserves are provided for sales incentives, such as coupons to consumers, and sales incentives provided to customers (such as slotting, cooperative advertising, incentive discounts based on volume of sales and other arrangements made directly with customers). All such costs are netted against sales. Slotting costs are recorded when the product is delivered to the customer. Cooperative advertising costs are recorded when the customer places the advertisement for the Company’s products. Discounts relating to price reduction arrangements are recorded when the related sale takes place. Costs associated with end-aisle or other in-store displays are recorded when product that is subject to the promotion is sold. The Company relies on historical experience and forecasted data to determine the required reserves. For example, the Company uses historical experience to project coupon redemption rates to determine reserve requirements. Based on the total face value of Consumer Domestic coupons redeemed over the past several years, if the actual rate of redemptions were to deviate by 0.1% from the rate for which reserves are accrued in the financial statements, an approximately $4.8 difference in the reserve required for coupons would result. With regard to other promotional reserves and sales returns, the Company uses experience-based estimates, customer and sales organization inputs and historical trend analysis in arriving at the reserves required. If the Company’s estimates for promotional activities and sales returns were to change by 10% the impact to promotional spending and sales return accruals would be approximately $5.8. While management believes that its promotional and sales returns reserves are reasonable and that appropriate judgments have been made, estimated amounts could differ materially from actual future obligations. During the twelve months ended December 31, 2015, 2014 and 2013, the Company reduced promotion liabilities by approximately $4.3, $6.7 and $3.7, respectively, based on a change in estimate as a result of actual experience and updated information. These adjustments are immaterial relative to the amount of trade promotion expense incurred annually by the Company. Impairment of goodwill, trade names and other intangible assets Carrying values of goodwill, trade names and other indefinite lived intangible assets are reviewed periodically for possible impairment. For finite intangible assets, the Company assesses business triggering events. The Company’s impairment analysis is based on a discounted cash flow approach that requires significant judgment with respect to unit volume, revenue and expense growth rates, and the selection of an appropriate discount rate. Management uses estimates based on expected trends in making these assumptions. With respect to goodwill, impairment occurs when the carrying value of the reporting unit exceeds the discounted present value of cash flows for that reporting unit. For trade names and other intangible assets, an impairment charge is recorded for the difference between the carrying value and the net present value of estimated future cash flows, which represents the estimated fair value of the asset. Judgment is required in assessing whether assets may have become impaired between annual valuations. Indicators such as unexpected adverse economic factors, unanticipated technological change, distribution losses, or competitive activities and acts by governments and courts may indicate that an asset has become impaired. The result of the Company’s annual goodwill impairment test determined that the estimated fair value substantially exceeded the carrying values of all reporting units. In addition, there were no goodwill impairment charges for each of the years in the three-year period ended December 31, 2015. The Company recognized intangible asset impairment charges within SG&A for each of the years in the three-year period ended December 31, 2015 as follows: CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) The impairment charges recorded in 2014 and 2013 were a result of actual and projected reductions in sales and profitability as a result of increased competition. The amount of the impairment charges was determined by comparing the estimated fair value of the assets to their carrying amount. Fair value was estimated based on a “relief from royalty” or “excess earnings” discounted cash flow method, which contains numerous variables that are subject to change as business conditions change, and therefore could impact fair values in the future. The Company determined that the fair value of all other intangible assets as of December 31, 2015 exceeded their respective carrying values based upon the forecasted cash flows and profitability. In 2014, the results of the Company’s annual impairment test for indefinite lived trade names resulted in a personal care trade name whose fair value exceeded its carrying value by 11%. In 2015, the fair value of this asset exceeded its carrying value by approximately 20%, based on improved and forecasted performance. This trade name’s carrying value is valued at approximately $37.0 as of December 31, 2015, and is considered an important asset to the Company. The Company continues to monitor performance and should there be any significant change in forecasted assumptions or estimates, including sales, profitability and discount rate, the Company may be required to recognize an impairment charge. It is possible that the Company’s conclusions regarding impairment or recoverability of goodwill or other intangible assets could change in future periods if, for example, (i) the businesses or brands do not perform as projected, (ii) overall economic conditions in 2016 or future years vary from current assumptions (including changes in discount rates), (iii) business conditions or strategies change from current assumptions, (iv) investors require higher rates of return on equity investments in the marketplace or (v) enterprise values of comparable publicly traded companies, or actual sales transactions of comparable companies, were to decline, resulting in lower multiples of revenues and EBITDA. A future impairment charge for goodwill or intangible assets could have a material effect on the Company’s consolidated financial position or results of operations. Inventory valuation When appropriate, the Company writes down the carrying value of its inventory to the lower of cost or market (net realizable value, which reflects any costs to sell or dispose). The Company identifies any slow moving, obsolete or excess inventory to determine whether an adjustment is required to establish a new carrying value. The determination of whether inventory items are slow moving, obsolete or in excess of needs requires estimates and assumptions about the future demand for the Company’s products, technological changes, and new product introductions. In addition, the Company’s allowance for obsolescence may be impacted by the reduction of the number of stock keeping units (SKUs). The Company evaluates its inventory levels and expected usage on a periodic basis and records adjustments as required. Adjustments to inventory to reflect a reduction in net realizable value were $12.6 at December 31, 2015, and $8.3 at December 31, 2014. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized to reflect the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the differences are expected to be recovered or settled. Management provides a valuation allowance against deferred tax assets for amounts which are not considered “more likely than not” to be realized. The Company records liabilities for potential assessments in various tax jurisdictions under U.S. GAAP guidelines. The liabilities relate to tax return positions that, although supportable by the Company, may be challenged by the tax authorities and do not meet the minimum recognition threshold required under applicable accounting guidance for the related tax benefit to be recognized in the income statement. The Company adjusts this liability as a result of changes in tax legislation, interpretations of laws by courts, rulings by tax authorities, changes in estimates and the expiration of the statute of limitations. Many of the judgments involved in adjusting the liability involve assumptions and estimates that are highly uncertain and subject to change. In this regard, settlement of any issue, or an adverse determination in litigation, with a taxing authority could require the use of cash and result in an increase in the Company’s annual tax rate. Conversely, favorable resolution of an issue with a taxing authority would be recognized as a reduction to the Company’s annual tax rate. New Accounting Pronouncements Refer to Note 1 to the Consolidated Financial Statements for recently adopted accounting pronouncements and recently issued accounting pronouncements not yet adopted as of December 31, 2015. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2015, 2014 AND 2013 The discussion of results of operations at the consolidated level presented below is followed by a more detailed discussion of results of operations by segment. The discussion of the Company’s consolidated results of operations and segment operating results is presented on a historical basis for the years ended December 31, 2015, 2014, and 2013. The segment discussion also addresses certain product line information. The Company’s operating units are consistent with its reportable segments. Consolidated results 2015 compared to 2014 Net Sales Net sales for the year ended December 31, 2015 were $3,394.8, an increase of $97.2, or approximately 2.9% compared to 2014 net sales. The components of the net sales increase are as follows: (1) On September 19, 2014, the Company acquired certain brands in the Lil’ Drug Store Brands Acquisition (the (“Lil’ Drug Store Brands Acquisition”) and on January 2, 2015, the Company acquired certain assets of Varied Industries Corporation (the “VI-COR Acquisition”). Net sales of these acquisitions are included in the Company’s results since the date of acquisition. All three segments reported volume increases and favorable price/mix for the year ended December 31, 2015. Gross Profit The Company’s gross profit for 2015 was $1,511.8, a $58.9 increase compared to 2014. Gross margin was 44.5% in 2015 compared to 44.1% in 2014, a 40 basis points (“bps”) increase. The increase is due to 30 bps associated with higher volume, price and mix, favorable impact associated with the Lil’ Drug Store Brands and VI-COR acquisitions of 40 bps, lower commodity costs of 70 bps, partially offset by higher manufacturing costs (net of productivity programs and including higher than anticipated start-up costs associated with the Company’s new vitamin manufacturing facility) of 70 bps and unfavorable foreign exchange rates of 30 bps. The higher volume, price and mix favorability included higher trade promotion and couponing to continue to support proven consumer trial generating activities for the OXICLEAN megabrand. Operating Costs Marketing expenses for 2015 were $417.5, an increase of $0.6 compared to 2014. The reason the increase was small was due to shifting some marketing funds to trade promotion and couponing to continue to support proven consumer trial generating activities for the OXICLEAN megabrand. Marketing expenses as a percentage of net sales decreased 30 bps to 12.3% in 2015 compared to 12.6% in 2014. This is due to 30 bps from leverage of expenses on higher sales. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Selling, general and administrative expenses (“SG&A”) expenses for 2015 were $420.1, an increase of $25.3 or 6.4% compared to 2014 due primarily to both on-going and one-time costs associated with the Lil’ Drug Store Brands and VI-COR acquisitions, higher compensation related costs, higher legal and research and development expenses and an $8.9 pension settlement charge in the second quarter of 2015. The increase was partially offset by lower foreign exchange rates. SG&A as a percentage of net sales increased 20 bps to 12.3% in 2015 compared to 12.1% in 2014. The increase is due to higher costs of 50 bps, including 25 bps associated with the pension charge, partially offset by 30 bps of leverage associated with higher sales. Other Income and Expenses Equity in earnings of affiliates for 2015 was a loss of $5.8 compared to earnings of $11.6 in 2014. The decrease in earnings was primarily due to a $17.0 impairment charge associated with the Company’s remaining investment in Natronx recorded in the second quarter of 2015. This charge is primarily a result of lower than expected demand for the joint venture’s products as a result of a shift in the electric utility industry from coal-fired to natural gas-supplied power plants, continued delays in the implementation of updated federal regulations, and indirectly, the recent U.S. Supreme Court ruling against the Environmental Protection Agency (“EPA”) where the court stated that the EPA failed to properly consider the costs to implement the regulations. We believe that the foregoing factors will likely further delay the demand for these products. Interest expense in 2015 was $30.5, an increase of $3.1 compared to 2014 due to a higher amount of average debt outstanding. Taxation The 2015 tax rate was 35.4% compared to 33.8% in 2014. The 2015 tax rate was negatively impacted by a valuation allowance recorded in connection with the Natronx impairment charge. The tax rate for 2014 was favorably impacted by discrete adjustments related to uncertain income tax positions. 2014 compared to 2013 Net Sales Net sales for the year ended December 31, 2014 were $3,297.6, an increase of $103.3, or approximately 3.2% compared to 2013 net sales. The components of the net sales increase are as follows: (1) On September 19, 2014, the Company acquired certain feminine care brands from Lil’ Drug Store Products Inc. Net sales of the brands acquired in the Lil’ Drug Store Brands Acquisition are included in the Company’s results since the date of acquisition. All three segments reported volume increases for the year ended December 31, 2014. The unfavorable price/mix in the Consumer Domestic segment, primarily due to new product introductory costs and a higher level of trade and coupon promotion for existing products was partially offset by favorable price/mix in SPD. Gross Profit The Company’s gross profit for 2014 was $1,452.9, a $14.9 increase compared to the same period in 2013 due to the effect of higher sales volume, productivity improvement programs and the impact of the Lil’ Drug Store Brands Acquisition, partially offset by the costs associated with new product launches, higher commodity costs and currency fluctuations. Gross margin was 44.1% in 2014 compared to 45.0% in 2013. Gross margin was lower due to higher trade promotion, coupon, slotting, commodity costs and currency fluctuations, partially offset by the positive impact of productivity improvement programs. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Operating Costs Marketing expenses for 2014 were $416.9, an increase of $17.1 compared to 2013 due primarily to expenses in support of new product launches and increased expenses in certain other power brands. Marketing expenses as a percentage of net sales were 12.6% in 2014 compared to 12.5% in 2013. SG&A expenses for 2014 were $394.8, a decrease of $21.2 compared to 2013 due primarily to lower compensation costs and employee benefit costs, lower legal costs, lower intangible asset impairment charges and lower cease use charges associated with the Company’s Princeton, New Jersey leased buildings, partially offset by higher intangible amortization expense, in part due to the Lil’ Drug Store Brands Acquisition. Additionally, in 2013 the Company incurred costs related to the integration of the gummy dietary supplements business, which were not incurred in 2014. SG&A as a percentage of net sales was 12.1% in 2014 compared to 13.0% in 2013. Other Income and Expenses Equity in earnings of affiliates for 2014 was $11.6 compared to $2.8 in 2013. The increase in earnings was due primarily to profit improvement from Armand and a smaller loss at Natronx. Also, in the second quarter of 2013, the Company recorded an impairment charge associated with one of its affiliates. Interest expense in 2014 was $27.4, a decrease of $0.3 compared to 2013. Taxation The 2014 tax rate was 33.8% compared to 34.0% in 2013. Segment results for 2015, 2014 and 2013 The Company operates three reportable segments: Consumer Domestic, Consumer International and SPD. These segments are determined based on differences in the nature of products and organizational and ownership structures. The Company also has a Corporate segment. Segment Products Consumer Domestic Household and personal care products Consumer International Primarily personal care products SPD Specialty chemical products The Corporate segment income consists of equity in earnings (losses) of affiliates. As of December 31, 2015, the Company held 50% ownership interests in each of Armand and ArmaKleen, respectively, and a one-third ownership interest in Natronx. The Company’s equity in earnings (losses) of Armand, ArmaKleen and Natronx for the twelve months ended December 31, 2015, 2014 and 2013 is included in the Corporate segment. Some of the subsidiaries that are included in the Consumer International segment manufacture and sell personal care products to the Consumer Domestic segment. These sales are eliminated from the Consumer International segment results set forth below. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Segment net sales and income before income taxes for each of the three years ended December 31, 2015, 2014 and 2013 were as follows: (1) Intersegment sales from Consumer International to Consumer Domestic, which are not reflected in the table, were $5.3, $1.9 and $2.2 for the years ended December 31, 2015, 2014 and 2013, respectively. (2) In determining income before income taxes, the Company allocated interest expense and investment earnings among the segments based upon each segment’s relative Income from Operations. (3) Corporate segment consists of equity in earnings (losses) of affiliates from Armand, ArmaKleen and Natronx. Product line revenues for external customers for the years ended December 31, 2015, 2014 and 2013 were as follows: Household Products include deodorizing, cleaning and laundry products. Personal Care Products include condoms, pregnancy kits, oral care products, skin care products and gummy dietary supplements. Consumer Domestic 2015 compared to 2014 Consumer Domestic net sales in 2015 were $2,581.6, an increase of $110.0 or 4.5% compared to net sales of $2,471.6 in 2014. The components of the net sales change are the following: (1) On September 19, 2014, the Company acquired certain feminine care brands from Lil’ Drug Store Products Inc. Net sales of the brands acquired in the Lil’ Drug Store Brands Acquisition are included in the Company’s results since the date of acquisition. The increase in net sales in 2015 includes sales from the Lil’ Drug Store Brands Acquisition, higher sales from the new product launches of ARM & HAMMER CLUMP & SEAL cat litter product lines including the new lightweight variant launched in December 2014, ARM & HAMMER liquid laundry detergent, and BATISTE dry shampoo and were offset by lower sales of SPINBRUSH toothbrushes, TROJAN condoms and XTRA laundry detergent. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Since the introduction in the U.S. of unit dose laundry detergent by various manufacturers, including the Company, there has been significant product and price competition in the laundry detergent category. For example P&G markets a lower-priced line of laundry detergents that competes directly with the Company’s core value laundry detergents and Henkel has entered the U.S. market with Persil, its leading worldwide premium laundry detergent. While it is too early to assess what impact this will have on the premium laundry category or the Company’s laundry detergent business, the introduction of Persil could precipitate greater price competition in the category and distribution pressure with a potential adverse impact on OXICLEAN laundry detergent. The Company continues to evaluate and vigorously combat the pressures in the laundry detergent category through, among other things, new product introductions and increased marketing spending. While the category grew 1.6% in 2015 after experiencing declines in 2013 and 2014, there is no assurance the category will not decline in the future and that the Company will be able to offset any such decline. Delays in the Company’s second quarter start-up of the new vitamin manufacturing facility resulted in the need to place certain retailers on allocation, which contributed to increased retailer frustration. By the end of the year, these issues were mainly resolved. If the Company were to lose a significant customer or if any sales of its products were to materially decrease due to customer service levels or real or perceived product quality or appearance issues, it could have a material adverse effect on the Company’s business, financial condition and results of operations. Consumer Domestic income before income taxes for 2015 was $529.4, a $26.6 increase compared to 2014. The increase is due primarily to the impact of higher sales volumes of $61.1 partially offset by higher SG&A costs of $24.1 and higher marketing expenses of $3.3. Higher manufacturing costs of $6.0 include vitamin manufacturing start-up costs, which were partially offset by productivity programs and lower commodity costs. 2014 compared to 2013 Consumer Domestic net sales in 2014 were $2,471.6, an increase of $58.1 or 2.4% compared to net sales of $2,413.5 in 2013. The components of the net sales change are the following: (1)Associated with net sales of the brands acquired in the Lil’ Drug Store Brands Acquisition since the date of acquisition. The increase in net sales includes the new product launches of ARM & HAMMER CLUMP & SEAL clumping cat litter and OXICLEAN liquid laundry detergent, and higher sales of OXICLEAN laundry additive products, TROJAN products, VITAFUSION gummy dietary supplements and ORAJEL oral analgesics, partially offset by lower sales in XTRA laundry detergent, L’IL CRITTER gummy dietary supplements and ARM & HAMMER powder and unit dose laundry detergents. Since the introduction in the U.S. of unit dose laundry detergent by various manufacturers, including the Company, there has been significant product and price competition in the laundry detergent category. For example P&G markets a lower-priced line of laundry detergents that competes directly with the Company’s core value laundry detergents and Henkel has entered the U.S. market with Persil, its leading worldwide premium laundry detergent. While it is too early to assess what impact this will have on the premium laundry category or the Company’s laundry detergent business, the introduction of Persil could precipitate greater price competition in the category and distribution pressure with a potential adverse impact on OXICLEAN laundry detergent. The Company continues to evaluate and vigorously combat the pressures in the laundry detergent category through, among other things, new product introductions and increased marketing spending. While the category grew 1.6% in 2015 after experiencing declines in 2013 and 2014, there is no assurance the category will not decline in the future and that the Company will be able to offset any such decline. Consumer Domestic income before income taxes for 2014 was $502.8, a $1.8 increase compared to 2013. The increase is due to higher sales volumes, manufacturing costs savings resulting from productivity improvement projects and lower SG&A costs, partially offset by the impact of introductory and higher trade promotion, coupon and marketing costs in support of new product launches and existing products, higher commodity costs and an intangible asset impairment charge. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Consumer International 2015 compared to 2014 Consumer International net sales in 2015 were $501.0, a decrease of $34.2 or 6.4% as compared to 2014. The components of the net sales change are the following: (1) On September 19, 2014, the Company acquired certain feminine care brands from Lil’ Drug Store Products Inc. (“Lil’ Drug Store Brands Acquisition”). Net sales of the brands acquired in the Lil’ Drug Store Brands Acquisition are included in the Company’s results since the date of acquisition. The decrease in Consumer International net sales in 2015 was primarily due to the impact of unfavorable foreign exchange rates in 2015 compared to 2014, which offset higher sales in Europe, Australia and Mexico. Consumer International income before income taxes was $54.5 in 2015, a decrease of $10.2 compared to 2014 due primarily to unfavorable foreign exchange rates of $20.8, an $8.9 pension settlement charge, and higher marketing costs of $7.3, as well as, higher trade promotion, commodity and marketing costs, partially offset by higher volumes of $19.7 and favorable price/mix of $6.1. 2014 compared to 2013 Consumer International net sales in 2014 were $535.2, an increase of $2.4 or 0.5% compared to 2013. The components of the net sales change are the following: (1) Associated with net sales of the brands acquired in the Lil’ Drug Store Brands Acquisition since the date of acquisition. Higher sales in 2014 occurred primarily in Europe and Mexico. Consumer International income before income taxes was $64.7 in 2014, an increase of $0.2 compared to 2013 due primarily to higher volumes and prices offset by the effect of foreign exchange rate changes and higher trade promotion, commodity and marketing costs. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Specialty Products 2015 compared to 2014 SPD net sales were $312.2 for 2015, an increase of $21.4, or 7.3% compared to 2014. The components of the net sales change are the following: (1) On January 2, 2015, the Company acquired certain assets of Varied Industries Corporation. Net sales are included in the Company’s results since the date of the VI-COR Acquisition. The sales increase in 2015 reflects the impact of the VICOR Acquisition, as well as, higher sales volume of performance products partially offset by lower animal nutrition products and foreign exchange fluctuations. SPD income before income taxes was $57.3 in 2015, an increase of $11.5 compared to 2014. The increase in income before income taxes for 2015 is due primarily to higher sales volume of $18.8 and lower manufacturing costs of $10.1, partially offset by unfavorable foreign exchange rates of $6.8, SG&A of $9.1 and higher marketing expenses of $1.3. 2014 compared to 2013 SPD net sales were $290.8 for 2014, an increase of $42.8, or 17.3% compared to 2013. The components of the net sales change are the following: The sales increase in 2014 reflects higher sales volume of animal nutrition products and performance products. The animal nutrition business’s strong performance is primarily related to the strength of the U.S. dairy industry, which has experienced all time high milk prices and low input commodity costs, prompting dairy producers to feed more animal nutrition products and produce higher volumes of milk per cow. SPD income before income taxes was $45.8 in 2014, an increase of $16.4 compared to 2013. The increase in income before income taxes for 2014 is due primarily to higher sales volume and sales prices and lower SG&A costs. Corporate The Corporate segment reflects the administrative costs of the production, planning and logistics functions which are included in SG&A expenses in the operating segments but are elements of cost of sales in the Company’s Consolidated Statements of Income. Such amounts were $32.6, $26.7 and $31.3 for 2015, 2014 and 2013, respectively. Also included in Corporate are equity in earnings (losses) of affiliates from Armand, ArmaKleen and Natronx. The decrease in equity in earnings of affiliates in 2015 is primarily due to the $17.0 Natronx impairment charge recorded in the second quarter of 2015. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Liquidity and capital resources On December 4, 2015, the Company replaced its former $600.0 unsecured revolving credit facility with a $1,000.0 unsecured revolving credit facility (as amended from time to time, the “Credit Agreement”). Under the Credit Agreement, the Company has the ability to increase its borrowing up to an additional $600.0, subject to lender commitments and certain conditions as described in the Credit Agreement. Borrowings under the Credit Agreement are available for general corporate purposes and are used to support the Company’s $500.0 commercial paper program (the “Program”). Total combined borrowing for both the Credit Agreement and the Program may not exceed $1,000.0. Unless extended, the Credit Agreement will terminate and all amounts outstanding thereunder will be due and payable on December 4, 2020. As of December 31, 2015, the Company had $330.0 in cash and cash equivalents, approximately $641.0 available through the revolving facility under its Credit Agreement and its commercial paper program, and a commitment increase feature under the Credit Agreement that enables the Company to borrow up to an additional $600.0, subject to lending commitments of the participating lenders and certain conditions as described in the Credit Agreement. To preserve its liquidity, the Company invests its cash primarily in prime money market funds and short term bank deposits. During the second quarter of 2015, the Company liquidated its subsidiary in the Netherlands and decided that the earnings of its subsidiary in France would no longer be permanently reinvested outside of the U.S. As a result, the Company repatriated cash of $93.0. The funds repatriated were used to reduce outstanding commercial paper. As a result of liquidating its subsidiary in the Netherlands, the Company recorded a tax benefit of $2.7 in the Consolidated Statement of Income and a deferred tax benefit of $11.6 through Accumulated Other Comprehensive Income in the second quarter of 2015. As of December 31, 2015, there remains $136.3 of cash and cash equivalents held by the foreign subsidiaries that is considered to be permanently reinvested outside of the U.S. These funds are not needed for operations in the U.S. If they were, the Company would be required to accrue and pay taxes in the U.S. to repatriate these funds. The Company’s intent is to permanently reinvest these funds outside the U.S., and the Company does not currently expect to repatriate them to fund U.S. operations. On December 9, 2014, the Company closed an underwritten public offering of $300.0 aggregate principal amount of 2.45% Senior Notes due December 15, 2019 (the “2019 Notes”). The 2019 Notes were issued under the first supplemental indenture (the “First Supplemental Indenture”), dated December 9, 2014, to the indenture dated December 9, 2014 (the “Base Indenture”), between the Company and Wells Fargo Bank, N.A., as trustee. Interest on the 2019 Notes is payable semi-annually, beginning June 15, 2015. The 2019 Notes will mature on December 15, 2019, unless earlier retired or redeemed pursuant to the terms of the First Supplemental Indenture. On September 26, 2012, the Company closed an underwritten public offering of $400.0 aggregate principal amount of 2.875% Senior Notes due 2022 (the “2022 Notes”). The 2022 Notes were issued under the second supplemental indenture, dated September 26, 2012 (the “BNY Mellon Second Supplemental Indenture”) to the indenture dated December 15, 2010 (the “BNY Mellon Base Indenture”) between the Company and The Bank of New York Mellon Trust Company, N.A., as trustee. Interest on the 2022 Notes is payable semi-annually, beginning April 1, 2013. The 2022 Notes will mature on October 1, 2022, unless earlier retired or redeemed pursuant to the terms of the BNY Mellon Second Supplemental Indenture. On December 15, 2010, the Company completed an underwritten public offering of $250.0 aggregate principal amount of 3.35% Senior Notes due 2015 (the “2015 Notes”). On December 15, 2015, the 2015 Notes matured. The 2015 Notes and accrued interest were repaid using primarily commercial paper borrowings. The current economic environment presents risks that could have adverse consequences for the Company’s liquidity. (See “Unfavorable economic conditions could adversely affect demand for the Company’s products” under “Risk Factors” in Item 1A of this Annual Report.) The Company does not anticipate that current economic conditions will adversely affect its ability to comply with the financial covenant in the Credit Agreement because the Company currently is, and anticipates that it will continue to be, in compliance with the maximum leverage ratio requirement under the Credit Agreement. On February 2, 2016, the Board declared a 6% increase in the regular quarterly dividend from $0.335 to $0.355 per share, equivalent to an annual dividend of $1.42 per share as of February 16, 2015. The decision raises the annual dividend payout from $175.0 to approximately $185.0, and maintains the Company’s payout of dividends relative to net income at approximately 40%. On January 28, 2015, the Board authorized a new share repurchase program, under which the Company may repurchase up to $500 in shares of Common Stock (the “2015 Share Repurchase Program”). The 2015 Share Repurchase Program replaced the 2014 Share Repurchase Program. The Company also continued its evergreen share repurchase program, authorized by the Board on CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) January 29, 2014, under which the Company may repurchase, from time to time, Common Stock to reduce or eliminate dilution associated with issuances of Common Stock under the Company’s incentive plans. In 2015, the Company purchased approximately 4.4 million shares of Common Stock for $363.1, of which $88.0 was purchased under the evergreen share repurchase program and $275.1 was purchased under the 2015 Share Repurchase Program, including an accelerated share repurchase contract with a commercial bank to repurchase 2.6 million shares of Common Stock at a cost of $215.0. In connection with the Company’s 2015 Share Repurchase Program and its evergreen repurchase program, on February 8, 2016, the Company initiated open market purchases with the objective of purchasing up to a total of $200. The Company anticipates all of the purchases will be completed during the first quarter of 2016. The Company anticipates that its cash from operations, together with its current borrowing capacity, will be sufficient to meet its capital expenditure program costs, which are expected to be approximately $55.0 in 2016, fund its share repurchase programs to the extent implemented by management and pay dividends at the latest approved rate. Cash, together with the Company’s current borrowing capacity, may be used for acquisitions that would complement the Company’s existing product lines or geographic markets. The Company does not have any mandatory fixed rate debt principal payments in 2016. Cash Flow Analysis 2015 compared to 2014 Net Cash Provided by Operating Activities - The Company’s primary source of liquidity is the strong cash flow provided by operating activities, which is dependent on the level of net income and changes in working capital. The Company’s net cash provided by operating activities in 2015 increased by $65.8 to $606.1 compared to 2014 due to higher cash earnings (net income plus non-cash expenses such as depreciation, amortization, non-cash compensation and asset impairment charges) and lower working capital. The decrease in working capital is primarily due to lower accounts receivable as a result of factoring $37.8 to a bank and higher accounts payable and accrued expenses due to the timing of invoice payments. This was partially offset by higher inventory in support of higher sales. The Company measures working capital effectiveness based on its cash conversion cycle. The Company's cash conversion cycle (defined as days in accounts receivable plus days in inventory less days in accounts payable) which is calculated using a 2 period average method, improved 5 days from the prior year amount of 32 days to 27 days at December 31, 2015 due primarily to improved accounts receivable of 4 days and accounts payable of 2 days. Inventory increased 1 day from 49 to 50 days. The improvement in the Company's cash conversion cycle reflects the Company's continued focus on reducing its average working capital requirements. Net Cash Used in Investing Activities - Net cash used in investing activities during 2015 was $141.2, principally reflecting $74.9 for the VI-COR Acquisition and $61.8 for property, plant and equipment expenditures, in part due to the Company’s new gummy dietary supplement manufacturing facility in York, Pennsylvania. Net Cash Used in Financing Activities - Net cash used in financing activities 2015 was $535.0, primarily reflecting $363.1 of repurchases of Common Stock, $175.3 of cash dividend payments and repayment of a $250.0 bond that matured in 2015, partially offset by higher commercial paper and short term borrowings of $211.7 and $44.3 of proceeds and tax benefits from stock option exercises. 2014 compared to 2013 Net Cash Provided by Operating Activities - The Company’s net cash provided by operating activities in 2014 increased $40.7 to $540.3 compared to 2013 due to higher net income and a slight increase in working capital. Net cash provided by operating activities in 2013 was negatively affected by the deferred payment of the fourth quarter 2012 federal tax obligation of $36.0 as allowed by the IRS due to the impact of Hurricane Sandy. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Net Cash Used in Investing Activities - Net cash used in investing activities during 2014 was $288.4, principally reflecting the $215.7 paid for the Lil’ Drug Store Brands Acquisition and $70.5 of property, plant and equipment expenditures. Net Cash (Used in) Provided by Financing Activities - Net cash used in financing activities during 2014 was $306.6, primarily reflecting $478.8 of repurchases of Common Stock, $167.5 of cash dividend payments and $6.7 net repayments of short-term debt offset by an increase in long-term debt of $299.8 for the 2019 Notes, and $51.2 of proceeds and tax benefits from stock option exercises. Financial Covenant “Consolidated EBITDA” (referred to below as “Adjusted EBITDA” and defined in the Credit Agreement that was revised in December 2015) is a component of the financial covenant contained in the Credit Agreement. The financial covenant includes a leverage ratio (total funded debt to Adjusted EBITDA), which, if not met, could result in an event of default and trigger the early acceleration of amounts owing under the Credit Agreement and the early termination of commitments under the Credit Agreement. Adjusted EBITDA may not be comparable to similarly titled measures used by other entities and should not be considered as an alternative to cash flows from operating activities determined in accordance with accounting principles generally accepted in the U.S. The Company’s leverage ratio for the twelve months ended December 31, 2015 was 1.4, which is below the maximum of 3.5 permitted under the Credit Agreement. The reconciliation of Net Cash Provided by Operating Activities (the most directly comparable U.S. GAAP financial measure) to Adjusted EBITDA for 2015 is as follows: Commitments as of December 31, 2015 The table below summarizes the Company’s material contractual obligations and commitments as of December 31, 2015. (1) Represents interest on the Company’s 2.45% Senior Notes due in 2019 and 2.875% Senior Notes due in 2022. (2) Letters of credit with several banks guarantee payment for items such as insurance claims in the event of the Company’s insolvency. Performance bonds are principally for required municipal property improvements. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) (3) Pension contributions are based on actuarial assessments of government regulated employer funding requirements. These requirements are not projected beyond one year since they fluctuate with the change in plan assets, assumptions and demographics. (4) The Company has outstanding purchase obligations with suppliers at the end of 2015 for raw, packaging and other materials and services in the normal course of business. These purchase obligation amounts represent only those items which are based on agreements that are enforceable and legally binding, and do not represent total anticipated purchases. (5) Other includes payments for stadium naming rights for a period of 20 years until December 2032. Off-Balance Sheet Arrangements The Company does not have off-balance sheet financing or unconsolidated special purpose entities. OTHER ITEMS Market risk Concentration of Risk A group of three customers accounted for approximately 35%, 36% and 35% of consolidated net sales in 2015, 2014 and 2013, respectively, of which a single customer, Wal-Mart, accounted for approximately 24%, 25% and 24% in 2015, 2014 and 2013, respectively. Interest Rate Risk The Company had outstanding total debt at December 31, 2015, of $1,050.0, net of debt issuance costs, of which 66% has a fixed weighted average interest rate of 2.69% and the remaining 34% constituted principally commercial paper issued by the Company that currently has a weighted average interest rate of less than 0.8%. In December 2014, the Company entered into interest rate swap agreements on an aggregate notional amount of $300.0 to convert the fixed interest rate on the 2019 Notes to a floating rate of three-month LIBOR plus a fixed spread of 0.756%. Other Market Risks The Company is also subject to market risks relating to its diesel fuel costs, fluctuations in foreign currency exchange rates, and changes in the market price of the Common Stock. Refer to Note 3 to the Consolidated Financial Statements for a discussion of these market risks and the derivatives used to manage the risks associated with changing diesel fuel prices, foreign exchange rates and the price of the Company’s common stock.

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW The Company’s Business The Company develops, manufactures, markets and sells a broad range of household, personal care and specialty products. The Company sells its consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores, and websites, all of which sell the products to consumers. The Company also sells specialty products to industrial customers and distributors. The Company focuses its consumer products marketing efforts principally on its ten “power brands.” These wellrecognized brand names include ARM & HAMMER, used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent; TROJAN condoms, lubricants and vibrators; OXICLEAN stain removers, cleaning solutions, laundry detergent, dishwashing detergent and bleach alternatives; SPINBRUSH batteryoperated and manual toothbrushes; FIRST RESPONSE home pregnancy and ovulation test kits; NAIR depilatories; ORAJEL oral analgesic; XTRA laundry detergent; L’IL CRITTERS and VITAFUSION gummy dietary supplements; and BATISTE dry shampoos. The Company considers four of these brands to be “mega brands”: ARM & HAMMER, OXICLEAN, TROJAN, and L’IL CRITTERS and VITAFUSION, and is giving greatest focus to the growth of these brands. The Company operates its business in three segments: Consumer Domestic, Consumer International and SPD. The Consumer Domestic segment includes the power brands noted above and other household and personal care products such as SCRUB FREE, KABOOM and ORANGE GLO cleaning products, ARRID antiperspirant, CLOSEUP and AIM toothpastes and SIMPLY SALINE nasal saline moisturizer. The Consumer International segment primarily sells a variety of personal care products, some of which use the same brand names as the Company’s domestic product lines, in international markets including Canada, France, Australia, the United Kingdom, Mexico and Brazil. The SPD segment is the largest U.S. producer of sodium bicarbonate, which it sells together with other specialty inorganic chemicals for a variety of industrial, institutional, medical and food applications. This segment also sells a range of animal nutrition and specialty cleaning products. In 2015, the Consumer Domestic, Consumer International and SPD segments represented approximately 76%, 15% and 9%, respectively, of the Company’s consolidated net sales. 2015 Financial Highlights Key fiscal year 2015 financial results include: · 2015 net sales grew 2.9% over fiscal year 2014, with gains in all three of the Company’s segments, primarily due to volume growth and the impact of the 2014 acquisition of the Lil’ Drug Store brands and the January 2015 acquisition of substantially all of the assets of Varied Industries Corporation (the “VICOR Acquisition”), partially offset by currency fluctuations. · Gross margin increased 40 basis points to 44.5% in fiscal year 2015 from 44.1% in fiscal year 2014, reflecting the favorable impact of the Lil’ Drug Store Brands and VICOR acquisitions, higher volumes and lower commodity costs partially offset by unfavorable foreign exchange rates. · Operating margin increased 50 basis points to 19.9% in fiscal year 2015 from 19.4% in fiscal year 2014, reflecting a higher gross margin and slightly lower marketing costs, partially offset by higher selling, general and administrative expenses (“SG&A”). · During the second quarter, the Company settled its previously [/INST] Negative. </s>

CHURCH & DWIGHT CO INC /DE/

2017-02-24

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW The Company’s Business The Company develops, manufactures, markets and sells a broad range of household, personal care and specialty products. The Company sells its consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores, and websites, all of which sell the products to consumers. The Company also sells specialty products to industrial customers and distributors. The Company focuses its consumer products marketing efforts principally on its ten “power brands.” These well-recognized brand names include ARM & HAMMER, used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent; TROJAN condoms, lubricants and vibrators; OXICLEAN stain removers, cleaning solutions, laundry detergent, dishwashing detergent and bleach alternatives; SPINBRUSH battery-operated and manual toothbrushes; FIRST RESPONSE home pregnancy and ovulation test kits; NAIR depilatories; ORAJEL oral analgesic; XTRA laundry detergent; L’IL CRITTERS and VITAFUSION gummy dietary supplements; and BATISTE dry shampoos. The Company operates its business in three segments: Consumer Domestic, Consumer International and SPD. The Consumer Domestic segment includes the power brands noted above and other household and personal care products such as SCRUB FREE, KABOOM and ORANGE GLO cleaning products, ARRID antiperspirant, CLOSE-UP and AIM toothpastes and SIMPLY SALINE nasal saline moisturizer. The Consumer International segment primarily sells a variety of personal care products, some of which use the same brand names as the Company’s domestic product lines, in international markets including Canada, France, Australia, the United Kingdom, Mexico and Brazil. The SPD segment is the largest U.S. producer of sodium bicarbonate, which it sells together with other specialty inorganic chemicals for a variety of industrial, institutional, medical and food applications. This segment also sells a range of animal nutrition and specialty cleaning products. In 2016, the Consumer Domestic, Consumer International and SPD segments represented approximately 77%, 15% and 8%, respectively, of the Company’s consolidated net sales. 2016 Financial Highlights Key fiscal year 2016 financial results include: • 2016 net sales grew 2.9% over fiscal year 2015, with gains in the Consumer Domestic and Consumer International segments, primarily due to volume growth in both the Consumer Domestic and Consumer International segments, helped in part by the January 2016 acquisition of Spencer Forrest, Inc. (“Spencer Forrest”), the maker of TOPPIK, (the “Toppik Acquisition”), partially offset by lower sales of animal productivity products. • On December 22, 2016, the Company completed the Anusol Acquisition, acquiring the ANUSOL and RECTINOL businesses from Johnson & Johnson, Inc. for $130. Total annual sales for ANUSOL and RECTINOL were $24 in 2016. • Gross margin increased 100 basis points to 45.5% in fiscal year 2016 from 44.5% in fiscal year 2015, primarily due to lower manufacturing and commodity costs. • Operating margin increased 80 basis points to 20.7% in fiscal year 2016 from 19.9% in fiscal year 2015, reflecting a higher gross margin and slightly lower marketing costs, partially offset by higher selling, general and administrative expenses (“SG&A”). • The Company reported diluted net earnings per share in fiscal year 2016 of $1.75, an increase of approximately 14.0% from fiscal year 2015 diluted net earnings per share of $1.54. • Cash provided by operations was $655.3, a $49.2 increase from the prior year, due to higher cash earnings and improved working capital. • The Company returned $583.0 to its stockholders through dividends and share repurchases. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Strategic Goals, Challenges and Initiatives The Company’s ability to generate sales depends on consumer demand for its products and retail customers’ decisions to carry its products, which are, in part, affected by general economic conditions in its markets. In 2016, many of the markets in which the Company operates continued to experience pricing pressures, general economic softness and weak or inconsistent consumer demand. Although the Company’s consumer products generally are consumer staples and less vulnerable to decreases in discretionary spending than other products, the continued economic downturn has reduced demand in many categories, particularly those in personal care, and affected Company sales in recent periods. Some customers have responded to economic conditions by increasing their private label offerings (primarily in the dietary supplements, diagnostic kits and oral analgesics categories), and consolidating the product selections they offer to the top few leading brands in each category. In addition, an increasing portion of the Company’s product categories are being sold by club stores, dollar stores and mass merchandisers. These customer actions have placed downward pressure on the Company’s sales and gross margins. The Company expects a competitive marketplace in 2017 due to new product introductions by competitors and continuing aggressive competitive pricing pressures. In the U.S., an improving unemployment rate and higher disposable income due to low gasoline prices are expected to have a positive effect on consumption patterns. To continue to deliver attractive results for stockholders in this environment, the Company intends to continue to aggressively pursue several key strategic initiatives: maintain competitive marketing and trade spending, tightly control its cost structure, continue to develop and launch new and differentiated products, and pursue strategic acquisitions. The Company also intends to continue to grow its product sales geographically (in an attempt to mitigate the impact of weakness in any one area), and maintain an offering of premium and value brand products (to appeal to a wide range of consumers). There continues to be significant product and price competition in the laundry detergent category. For example, P&G markets a lower-priced line of laundry detergents, Simply Tide, which competes directly with the Company’s core value laundry detergents. P&G has significantly increased its discounting of Simply Tide which could have a broad negative impact on the laundry category pricing and profitability. In addition, in 2016, Henkel entered the U.S. market with Persil, its leading worldwide premium laundry detergent, and on September 1, 2016 completed its acquisition of Sun Products, the maker of All, Wisk, Sun, and private label laundry detergents. While it is too early to assess what impact this will have on the Company’s laundry detergent business, the introduction of Persil and Henkel’s increased scale and market share could precipitate greater price competition in the category and distribution pressure with a potential adverse impact on the Company’s laundry detergent business. Moreover, the unit dose laundry detergent segment is the fastest growing segment in the laundry detergent category, having grown to approximately 16% of the category since its introduction in 2012, and the Company faces pressure to achieve its proportionate share of the segment with a potential adverse impact on its share of the laundry detergent category. The Company continues to evaluate and vigorously combat these pressures through, among other things, new product introductions and increased marketing and trade spending. Additionally, while the category grew 3.3% for the 52 weeks ended December 17, 2016 and 1.6% for the 52 weeks ended December 19, 2015, after experiencing declines in 2013 and 2014, there is no assurance the category will not decline in the future and that the Company will be able to offset any such decline. The Company has responded to these competitive pressures by, among other things, focusing on strengthening its key brands, including increased focus on the ARM & HAMMER, OXICLEAN, TROJAN, L’IL CRITTERS and VITAFUSION and BATISTE brands through the launch of innovative new products, which span various product categories, including premium and value household products supported by increased marketing and trade spending. There can be no assurance that these measures will be successful. In 2016, the Company was able to grow market share in four of 10 of its “power brands” in measured channels. The Company’s global product portfolio consists of both premium (60% of total worldwide consumer revenue in 2016) and value (40% of total worldwide consumer revenue in 2016) brands, which it believes enables it to succeed in a range of economic environments. The Company intends to continue to develop a portfolio of appealing new products to build loyalty among cost-conscious consumers. Over the past 16 years, the Company has diversified from an almost exclusively U.S. business to a global company with approximately 16% of sales derived from foreign countries in 2016. The Company has operations in six countries (Canada, Mexico, U.K., France, Australia and Brazil) and exports to over 90 other countries. In 2016, the Company benefited from its concentration in North America in light of the economic downturn in Europe; however, the Company has focused and will continue to focus on selectively expanding its global business. Net sales generated outside of the United States are exposed to foreign currency exchange rate fluctuations as well as political uncertainty which could impact future operating results. The Company also continues to focus on controlling its costs. Historically, the Company has been able to mitigate the effects of cost increases primarily by implementing cost reduction programs and, to a lesser extent, by passing along some of these cost CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) increases to customers. The Company has also entered into set pricing and pre-buying arrangements with certain suppliers and hedge agreements for diesel fuel. Additionally, maintaining tight controls on overhead costs has been a hallmark of the Company and has enabled it to effectively navigate recent challenging economic conditions. The identification and integration of strategic acquisitions are an important component of the Company’s overall strategy. Acquisitions have added significantly to Company sales and profits over the last decade. This is evidenced by the Company’s 2015 acquisition of certain assets of Varied Industries Corporation (the “VI-COR Acquisition”) and 2016 acquisitions of Spencer Forrest, Inc., the maker of TOPPIK, and the ANUSOL and RECTINOL businesses from Johnson & Johnson in the Anusol Acquisition. However, the failure to effectively integrate any acquisition or achieve expected synergies may cause the Company to incur material asset write-downs. The Company actively seeks acquisitions that fit its guidelines, and its strong financial position provides it with flexibility to take advantage of acquisition opportunities. In addition, the Company’s ability to quickly integrate acquisitions and leverage existing infrastructure has enabled it to establish a strong track record in making accretive acquisitions. Since 2001, the Company has acquired nine of its ten “power brands”. The Company believes it is positioned to meet the ongoing challenges described above due to its strong financial condition, experience operating in challenging environments and continued focus on key strategic initiatives: maintaining competitive marketing and trade spending, managing its cost structure, continuing to develop and launch new and differentiated products, and pursuing strategic acquisitions. This focus, together with the strength of the Company’s portfolio of premium and value brands, has enabled the Company to succeed in a range of economic environments, and is expected to position the Company to continue to increase stockholder value over the long-term. Moreover, the generation of a significant amount of cash from operations, as a result of net income and effective working capital management, combined with an investment grade credit rating provides the Company with the financial flexibility to pursue acquisitions, drive new product development, make capital expenditures to support organic growth and gross margin improvements, return cash to stockholders through dividends and share buy backs, and reduce outstanding debt, positioning it to continue to create stockholder value. For information regarding risks and uncertainties that could materially adversely affect the Company’s business, results of operations and financial condition, see “Risk Factors” in Item 1A of this Annual Report. Recent Developments Stock Split On August 4, 2016, the Company announced a two-for-one stock split of the Company’s common stock (“Common Stock”). The stock split was structured in the form of a 100% stock dividend, payable on September 1, 2016 to stockholders of record as of August 15, 2016. All applicable amounts in the consolidated financial statements and related disclosures have been retroactively adjusted to reflect the stock split. Share Repurchase Program On November 2, 2016, the Board authorized a new share repurchase program, under which the Company may repurchase up to $500.0 in shares of Common Stock (the “2016 Share Repurchase Program”). The 2016 Share Repurchase Program replaced the 2015 Share Repurchase Program and does not have an expiration. The Company will continue its evergreen share repurchase program, under which the Company may repurchase, from time to time, Common Stock to reduce or eliminate dilution associated with issuances of Common Stock under the Company’s incentive plans. Toppik Acquisition On January 4, 2016, the Company acquired Spencer Forrest, Inc., the maker of TOPPIK, the leading brand of hair building fibers for people with thinning hair in the Toppik Acquisition. The total purchase price was $175.3. The Company financed the acquisition with short-term borrowings. This brand is managed within the Consumer Domestic and Consumer International segments. Anusol and Rectinol Acquisitions On December 22, 2016, the Company acquired the ANUSOL and RECTINOL businesses from Johnson & Johnson, Inc. for $130. These are the number one or number two hemorrhoid care brands in each market in which they operate, primarily in the U.K., Canada, Australia and South Africa with total annual sales of $24 in 2016. The acquisition was funded with short-term borrowings and will be managed in the Consumer International segment. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Viviscal Acquisition On January 17, 2017, the Company acquired the VIVISCAL business from Lifes2Good Holdings Limited for approximately $160. Viviscal is the number one hair care supplement brand both in the U.S. and the U.K. with global annual sales of $44 in 2016. This brand is complementary to the Company’s global BATISTE dry shampoo and TOPPIK hair care business. The acquisition was funded with short-term borrowings and will be managed in the Consumer Domestic and Consumer International segments. Dividend Increase On February 7, 2017, the Board of Directors declared a 7% increase in the regular quarterly dividend from $0.1775 to $0.19 per share, equivalent to an annual dividend of $0.76 per share payable to stockholders of record as of February 21, 2017. The increase raises the annual dividend payout from $183 to approximately $195, and maintains the Company’s payout of dividends relative to net income at approximately 40%. Brazil’s Chemical Business During fourth quarter of 2016, the Company decided to sell its Brazilian chemical business to focus on its Brazilian consumer business, resulting in a plant impairment charge of $4.9 recognized in the fourth quarter of 2016 based upon an anticipated selling price. During the first quarter of 2017, the Company signed an agreement to sell the business, resulting in an approximate $5.0 expense for severance and other charges. Sales for the Brazilian chemical business in 2016 were approximately $22.0. The Company anticipates the transaction to close during the first quarter. International Pension Plan Termination In 2016 the Company authorized the termination of an international defined benefit pension plan under which approximately 336 participants, including 53 active employees, have accrued benefits. The Company anticipates completing the termination of this plan by the end of the second quarter of 2017, once regulatory approvals are obtained. In addition to plan assets, the Company will need to make a one-time payment of $20.0 to $26.0 ($14.0 to $19.0 after tax) to purchase annuities for participants. The Company estimates that it will incur a one-time expense of $49.0 to $55.0 ($40.0 to $45.0 after tax) in 2017 when the plan settlement is completed. This expense primarily includes the effect of the additional cash payment required at settlement and pension settlement accounting rules which require accelerated recognition of actuarial losses that were to be amortized over the expected benefit lives of participants. The estimated expense is subject to change based on valuations at the actual date of settlement. Upon the termination of these plans in 2017, the Company will have no further obligations with respect to material defined benefit pension plans. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) CRITICAL ACCOUNTING POLICIES AND ESTIMATES The Company’s Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the U.S. (GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. By their nature, these judgments are subject to uncertainty. They are based on the Company’s historical experience, its observation of trends in industry, information provided by its customers and information available from other outside sources, as appropriate. The Company’s significant accounting policies and estimates are described below. Revenue Recognition and Promotional and Sales Return Reserves Virtually all of the Company’s revenue represents sales of finished goods inventory and is recognized when received or picked up by the Company’s customers. The reserves for consumer and trade promotion liabilities and sales returns are established based on the Company’s best estimate of the amounts necessary to settle future and existing claims on products sold as of the balance sheet date. Promotional reserves are provided for sales incentives, such as coupons to consumers, and sales incentives provided to customers (such as slotting, cooperative advertising, incentive discounts based on volume of sales and other arrangements made directly with customers). All such costs are netted against sales. Slotting costs are recorded when the product is delivered to the customer. Cooperative advertising costs are recorded when the customer places the advertisement for the Company’s products. Discounts relating to price reduction arrangements are recorded when the related sale takes place. Costs associated with end-aisle or other in-store displays are recorded when product that is subject to the promotion is sold. The Company relies on historical experience and forecasted data to determine the required reserves. For example, the Company uses historical experience to project coupon redemption rates to determine reserve requirements. Based on the total face value of Consumer Domestic coupons redeemed over the past several years, if the actual rate of redemptions were to deviate by 0.1% from the rate for which reserves are accrued in the financial statements, an approximately $4.1 difference in the reserve required for coupons would result. With regard to other promotional reserves and sales returns, the Company uses experience-based estimates, customer and sales organization inputs and historical trend analysis in arriving at the reserves required. If the Company’s estimates for promotional activities and sales returns were to change by 10% the impact to promotional spending and sales return accruals would be approximately $6.4. While management believes that its promotional and sales returns reserves are reasonable and that appropriate judgments have been made, estimated amounts could differ materially from actual future obligations. During the twelve months ended December 31, 2016, 2015 and 2014, the Company reduced promotion liabilities by approximately $5.4, $4.3 and $6.7, respectively, based on a change in estimate as a result of actual experience and updated information. These adjustments are immaterial relative to the amount of trade promotion expense incurred annually by the Company. Impairment of goodwill, trade names and other intangible assets Carrying values of goodwill, trade names and other indefinite lived intangible assets are reviewed periodically for possible impairment. For finite intangible assets, the Company assesses business triggering events. The Company’s impairment analysis is based on a discounted cash flow approach that requires significant judgment with respect to unit volume, revenue and expense growth rates, and the selection of an appropriate discount rate. Management uses estimates based on expected trends in making these assumptions. With respect to goodwill, impairment occurs when the carrying value of the reporting unit exceeds the discounted present value of cash flows for that reporting unit. For trade names and other intangible assets, an impairment charge is recorded for the difference between the carrying value and the net present value of estimated future cash flows, which represents the estimated fair value of the asset. Judgment is required in assessing whether assets may have become impaired between annual valuations. Indicators such as unexpected adverse economic factors, unanticipated technological change, distribution losses, or competitive activities and acts by governments and courts may indicate that an asset has become impaired. The result of the Company’s annual goodwill impairment test determined that the estimated fair value substantially exceeded the carrying values of all reporting units. In addition, there were no goodwill impairment charges for each of the years in the three-year period ended December 31, 2016. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) In 2014, the Company recorded an impairment charge of $5.0 for an intangible asset related to the Consumer Domestic segment. The impairment charge recorded in 2014 was a result of actual and projected reductions in sales and profitability as a result of increased competition. The amount of the impairment charges was determined by comparing the estimated fair value of the asset to its carrying amount. Fair value was estimated based on a “relief from royalty” or “excess earnings” discounted cash flow method, which contains numerous variables that are subject to change as business conditions change, and therefore could impact fair values in the future. The Company determined that the fair value of all other intangible assets as of December 31, 2016 exceeded their respective carrying values based upon the forecasted cash flows and profitability. It is possible that the Company’s conclusions regarding impairment or recoverability of goodwill or other intangible assets could change in future periods if, for example, (i) the businesses or brands do not perform as projected, (ii) overall economic conditions in 2017 or future years vary from current assumptions (including changes in discount rates), (iii) business conditions or strategies change from current assumptions, (iv) investors require higher rates of return on equity investments in the marketplace or (v) enterprise values of comparable publicly traded companies, or actual sales transactions of comparable companies, were to decline, resulting in lower multiples of revenues and EBITDA. A future impairment charge for goodwill or intangible assets could have a material effect on the Company’s consolidated financial position or results of operations. Inventory valuation When appropriate, the Company writes down the carrying value of its inventory to the lower of cost or market (net realizable value, which reflects any costs to sell or dispose). The Company identifies any slow moving, obsolete or excess inventory to determine whether an adjustment is required to establish a new carrying value. The determination of whether inventory items are slow moving, obsolete or in excess of needs requires estimates and assumptions about the future demand for the Company’s products, technological changes, and new product introductions. In addition, the Company’s allowance for obsolescence may be impacted by the reduction of the number of stock keeping units (SKUs). The Company evaluates its inventory levels and expected usage on a periodic basis and records adjustments as required. Adjustments to inventory to reflect a reduction in net realizable value were $10.5 at December 31, 2016, $12.6 at December 31, 2015, and $8.3 at December 31, 2014. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized to reflect the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the differences are expected to be recovered or settled. Management provides a valuation allowance against deferred tax assets for amounts which are not considered “more likely than not” to be realized. The Company records liabilities for potential assessments in various tax jurisdictions under U.S. GAAP guidelines. The liabilities relate to tax return positions that, although supportable by the Company, may be challenged by the tax authorities and do not meet the minimum recognition threshold required under applicable accounting guidance for the related tax benefit to be recognized in the income statement. The Company adjusts this liability as a result of changes in tax legislation, interpretations of laws by courts, rulings by tax authorities, changes in estimates and the expiration of the statute of limitations. Many of the judgments involved in adjusting the liability involve assumptions and estimates that are highly uncertain and subject to change. In this regard, settlement of any issue, or an adverse determination in litigation, with a taxing authority could require the use of cash and result in an increase in the Company’s annual tax rate. Conversely, favorable resolution of an issue with a taxing authority would be recognized as a reduction to the Company’s annual tax rate. New Accounting Pronouncements Refer to Note 1 to the Consolidated Financial Statements for recently adopted accounting pronouncements and recently issued accounting pronouncements not yet adopted as of December 31, 2016. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2016, 2015 AND 2014 The discussion of results of operations at the consolidated level presented below is followed by a more detailed discussion of results of operations by segment. The discussion of the Company’s consolidated results of operations and segment operating results is presented on a historical basis for the years ended December 31, 2016, 2015, and 2014. The segment discussion also addresses certain product line information. The Company’s operating units are consistent with its reportable segments. Consolidated results 2016 compared to 2015 Net Sales Net sales for the year ended December 31, 2016 were $3,493.1, an increase of $98.3, or approximately 2.9% compared to 2015 net sales. The components of the net sales increase are as follows: (1) On January 4, 2016, the Company completed the Toppik Acquisition, acquiring Spencer Forrest, Inc., the maker of TOPPIK, the leading brand of hair building fibers for people with thinning hair. Net sales of this acquisition are included in the Company’s results since the date of acquisition. Volume growth in Consumer Domestic and Consumer International was partially offset by lower SPD volume. The Company’s gross profit for 2016 was $1,590.6, a $78.8 increase compared to 2015. Gross margin was 45.5% in 2016 compared to 44.5% in 2015, a 100 basis points (“bps”) increase. The increase is due to lower manufacturing costs of 70 bps (including productivity programs and the absence of start-up costs incurred in 2015 associated with the Company’s new vitamin manufacturing facility), lower commodity costs of 60 bps, and the impact of the higher margin acquired business of 30 bps, partially offset by unfavorable foreign exchange rates of 30 bps, a plant impairment charge of 20 bps at an international subsidiary and unfavorable price/volume mix of 10 bps. Operating Costs Marketing expenses for 2016 were $427.2, an increase of $9.7 compared to 2015. Marketing expenses as a percentage of net sales decreased 10 bps to 12.2% in 2016 as compared to 2015 due to 40 bps of leverage on higher net sales partially offset by 30 bps on higher expenses. Selling, general and administrative expenses (“SG&A”) expenses for 2016 were $439.2, an increase of $19.1 or 4.5% compared to 2015. The increase is primarily due to costs associated with the Toppik Acquisition and higher compensation costs, partially offset by a pension plan charge recorded in 2015. SG&A as a percentage of net sales increased 30 bps to 12.6% in 2016 compared to 12.3% in 2015. The increase is due to higher costs of 60 bps, partially offset by 30 bps of leverage associated with higher sales. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Other Income and Expenses Equity in earnings of affiliates increased by $15.0 in 2016 as compared to 2015. The increase in earnings during 2016 was due primarily to a $17.0 impairment charge in 2015 associated with the Company’s remaining investment in Natronx. Interest expense in 2016 was $27.7, a decrease of $2.8 compared to 2015 due to a lower amount of average debt outstanding. Taxation The 2016 tax rate was 35.0% compared to 35.4% in 2015. The 2015 tax rate was negatively impacted by a valuation allowance recorded in connection with the Natronx impairment charge. 2015 compared to 2014 Net Sales Net sales for the year ended December 31, 2015 were $3,394.8, an increase of $97.2, or approximately 2.9% compared to 2014 net sales. The components of the net sales increase are as follows: (1) On September 19, 2014, the Company acquired certain brands in the Lil’ Drug Store Brands Acquisition (the “Lil’ Drug Store Brands Acquisition”) and on January 2, 2015, the Company acquired certain assets of Varied Industries Corporation (the “VI-COR Acquisition”). Net sales of these acquisitions are included in the Company’s results since the date of acquisition. All three segments reported volume increases and favorable price/mix for the year ended December 31, 2015. Gross Profit The Company’s gross profit for 2015 was $1,511.8, a $58.9 increase compared to 2014. Gross margin was 44.5% in 2015 compared to 44.1% in 2014, a 40 basis points (“bps”) increase. The increase is due to 30 bps associated with higher volume, price and mix, favorable impact associated with the Lil’ Drug Store Brands and VI-COR acquisitions of 40 bps, lower commodity costs of 70 bps, partially offset by higher manufacturing costs (net of productivity programs and including higher than anticipated start-up costs associated with the Company’s new vitamin manufacturing facility) of 70 bps and unfavorable foreign exchange rates of 30 bps. The higher volume, price and mix favorability included higher trade promotion and couponing to continue to support proven consumer trial generating activities for the OXICLEAN megabrand. Operating Costs Marketing expenses for 2015 were $417.5, an increase of $0.6 compared to 2014. The reason the increase was small was due to shifting some marketing funds to trade promotion and couponing to continue to support proven consumer trial generating activities for the OXICLEAN megabrand. Marketing expenses as a percentage of net sales decreased 30 bps to 12.3% in 2015 compared to 12.6% in 2014. This is due to 30 bps from leverage of expenses on higher sales. Selling, general and administrative expenses (“SG&A”) expenses for 2015 were $420.1, an increase of $25.3 or 6.4% compared to 2014 due primarily to both on-going and one-time costs associated with the Lil’ Drug Store Brands and VI-COR acquisitions, higher compensation related costs, higher legal and research and development expenses and an $8.9 pension settlement charge in the second quarter of 2015. The increase was partially offset by lower foreign exchange rates. SG&A as a percentage of net sales increased 20 bps to 12.3% in 2015 compared to 12.1% in 2014. The increase is due to higher costs of 50 bps, including 25 bps associated with the pension charge, partially offset by 30 bps of leverage associated with higher sales. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Other Income and Expenses Equity in earnings of affiliates for 2015 was a loss of $5.8 compared to earnings of $11.6 in 2014. The decrease in earnings was primarily due to a $17.0 impairment charge associated with the Company’s remaining investment in Natronx recorded in the second quarter of 2015. This charge is primarily a result of lower than expected demand for the joint venture’s products as a result of a shift in the electric utility industry from coal-fired to natural gas-supplied power plants, continued delays in the implementation of updated federal regulations, and indirectly, the recent U.S. Supreme Court ruling against the Environmental Protection Agency (“EPA”) where the court stated that the EPA failed to properly consider the costs to implement the regulations. We believe that the foregoing factors will likely further delay the demand for these products. Interest expense in 2015 was $30.5, an increase of $3.1 compared to 2014 due to a higher amount of average debt outstanding. Taxation The 2015 tax rate was 35.4% compared to 33.8% in 2014. The 2015 tax rate was negatively impacted by a valuation allowance recorded in connection with the Natronx impairment charge. The tax rate for 2014 was favorably impacted by discrete adjustments related to uncertain income tax positions. Segment results for 2016, 2015 and 2014 The Company operates three reportable segments: Consumer Domestic, Consumer International and SPD. These segments are determined based on differences in the nature of products and organizational and ownership structures. The Company also has a Corporate segment. Segment Products Consumer Domestic Household and personal care products Consumer International Primarily personal care products SPD Specialty chemical products The Corporate segment income consists of equity in earnings (losses) of affiliates. As of December 31, 2016, the Company held 50% ownership interests in each of Armand and ArmaKleen”, respectively, and a one-third ownership interest in Natronx. The Company’s equity in earnings (losses) of Armand and ArmaKleen for the year ended December 31, 2016 and Armand, ArmaKleen and Natronx for the years ended December 31, 2015 and 2014 are included in the Corporate segment. Some of the subsidiaries that are included in the Consumer International segment manufacture and sell personal care products to the Consumer Domestic segment. These sales are eliminated from the Consumer International segment results set forth below. Segment net sales and income before income taxes for each of the three years ended December 31, 2016, 2015 and 2014 were as follows: (1) Intersegment sales from Consumer International to Consumer Domestic, which are not reflected in the table, were $3.4, $5.3 and $1.9 for the years ended December 31, 2016, 2015 and 2014, respectively. (2) In determining income before income taxes, the Company allocated interest expense and investment earnings among the segments based upon each segment’s relative Income from Operations. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) (3) Corporate segment consists of equity in earnings (losses) of affiliates from Armand and ArmaKleen in 2016 and Armand, ArmaKleen and Natronx in 2015 and 2014. Product line revenues for external customers for the years ended December 31, 2016, 2015 and 2014 were as follows: Household Products include deodorizing, cleaning and laundry products. Personal Care Products include condoms, pregnancy kits, oral care products, skin care products, hair care products and gummy dietary supplements. Consumer Domestic 2016 compared to 2015 Consumer Domestic net sales in 2016 were $2,677.8, an increase of $96.2 or 3.7% compared to net sales of $2,581.6 in 2015. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Toppik Acquisition since the date of acquisition. The increase in net sales for 2016, reflects higher sales of ARM & HAMMER liquid and unit dose detergents, VITAFUSION gummy vitamins, OXICLEAN laundry additive ARM & HAMMER Cat Litter products and BATISTE dry shampoo, partially offset by lower sales of XTRA laundry detergent and L’IL CRITTERS gummy vitamins. There continues to be significant product and price competition in the laundry detergent category. For example, P&G markets a lower-priced line of laundry detergents, Simply Tide, which competes directly with the Company’s core value laundry detergents. P&G has significantly increased its discounting of Simply Tide which could have a broad negative impact on the laundry category pricing and profitability. In addition, in 2016, Henkel entered the U.S. market with Persil, its leading worldwide premium laundry detergent, and on September 1, 2016 completed its acquisition of Sun Products, the maker of All, Wisk, Sun, and private label laundry detergents. While it is too early to assess what impact this will have on the Company’s laundry detergent business, the introduction of Persil and Henkel’s increased scale and market share could precipitate greater price competition in the category and distribution pressure with a potential adverse impact on the Company’s laundry detergent business. Moreover, the unit dose laundry detergent segment is the fastest growing segment in the laundry detergent category, having grown to approximately 16% of the category since the introduction of this form in 2012, and the Company faces pressure to achieve its proportionate share of the segment with a potential adverse impact on its share of the laundry detergent category. The Company continues to evaluate and vigorously combat these pressures through, among other things, new product introductions and increased marketing and trade spending. Additionally, while the category grew 3.3% for the 52 weeks ended December 17, 2016 and 1.6% for the 52 weeks ended December 19, 2015, after experiencing declines in 2013 and 2014, there is no assurance the category will not decline in the future and that the Company will be able to offset any such decline. Consumer Domestic income before income taxes for 2016 was $590.6, a $61.2 increase as compared to 2015. The increase is due primarily to the impact of higher sales volumes of $70.1, favorable commodity and manufacturing costs of $40.3, partially offset by higher SG&A costs of $24.7, unfavorable price/mix of $17.2, and higher marketing expenses of $8.7. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) 2015 compared to 2014 Consumer Domestic net sales in 2015 were $2,581.6, an increase of $110.0 or 4.5% compared to net sales of $2,471.6 in 2014. The components of the net sales change are the following: (1) On September 19, 2014, the Company acquired certain feminine care brands from Lil’ Drug Store Products Inc. Net sales of the brands acquired in the Lil’ Drug Store Brands Acquisition are included in the Company’s results since the date of acquisition. The increase in net sales in 2015 includes sales from the Lil’ Drug Store Brands Acquisition, higher sales from the new product launches of ARM & HAMMER CLUMP & SEAL cat litter product lines including the new lightweight variant launched in December 2014, ARM & HAMMER liquid laundry detergent, and BATISTE dry shampoo and were offset by lower sales of SPINBRUSH toothbrushes, TROJAN condoms and XTRA laundry detergent. Since the introduction in the U.S. of unit dose laundry detergent by various manufacturers, including the Company, there has been significant product and price competition in the laundry detergent category. For example P&G markets a lower-priced line of laundry detergents that competes directly with the Company’s core value laundry detergents and Henkel has entered the U.S. market with Persil, its leading worldwide premium laundry detergent. While it is too early to assess what impact this will have on the premium laundry category or the Company’s laundry detergent business, the introduction of Persil could precipitate greater price competition in the category and distribution pressure with a potential adverse impact on OXICLEAN laundry detergent. The Company continues to evaluate and vigorously combat the pressures in the laundry detergent category through, among other things, new product introductions and increased marketing spending. While the category grew 1.6% in 2015 after experiencing declines in 2013 and 2014, there is no assurance the category will not decline in the future and that the Company will be able to offset any such decline. Delays in the Company’s second quarter start-up of the new vitamin manufacturing facility resulted in the need to place certain retailers on allocation, which contributed to increased retailer frustration. By the end of the year, these issues were mainly resolved. If the Company were to lose a significant customer or if any sales of its products were to materially decrease due to customer service levels or real or perceived product quality or appearance issues, it could have a material adverse effect on the Company’s business, financial condition and results of operations. Consumer Domestic income before income taxes for 2015 was $529.4, a $26.6 increase compared to 2014. The increase is due primarily to the impact of higher sales volumes of $61.1 partially offset by higher SG&A costs of $24.1 and higher marketing expenses of $3.3. Higher manufacturing costs of $6.0 include vitamin manufacturing start-up costs, which were partially offset by productivity programs and lower commodity costs. Consumer International 2016 compared to 2015 Consumer International net sales in 2016 were $525.2, an increase of $24.2 or 4.8% as compared to 2015. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Toppik Acquisition since the date of acquisition. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Excluding the impact of unfavorable foreign exchange rates, higher sales for the year occurred in exports, Canada, Mexico, and Europe. The BATISTE, ARM & HAMMER, OXICLEAN, FEMFRESH, STERIMAR, and TROJAN brands had strong sales growth. Consumer International income before income taxes was $66.3 in 2016, an increase of $11.8 compared to 2015 due primarily to higher volumes of $23.4, favorable price/mix of $7.5 and lower SG&A of $1.4, partially offset by unfavorable foreign exchange rates of $12.2, higher marketing costs of $6.2, and higher manufacturing costs of $2.3. Last year’s results included an $8.9 pension settlement charge. 2015 compared to 2014 Consumer International net sales in 2015 were $501.0, a decrease of $34.2 or 6.4% as compared to 2014. The components of the net sales change are the following: (1) On September 19, 2014, the Company acquired certain feminine care brands from Lil’ Drug Store Products Inc. (“Lil’ Drug Store Brands Acquisition”). Net sales of the brands acquired in the Lil’ Drug Store Brands Acquisition are included in the Company’s results since the date of acquisition. The decrease in Consumer International net sales in 2015 was primarily due to the impact of unfavorable foreign exchange rates in 2015 compared to 2014, which offset higher sales in Europe, Australia and Mexico. Consumer International income before income taxes was $54.5 in 2015, a decrease of $10.2 compared to 2014 due primarily to unfavorable foreign exchange rates of $20.8, an $8.9 pension settlement charge, and higher marketing costs of $7.3, as well as, higher trade promotion, commodity and marketing costs, partially offset by higher volumes of $19.7 and favorable price/mix of $6.1. Specialty Products 2016 compared to 2015 SPD net sales were $290.1 for 2016, a decrease of $22.1, or 7.1% compared to 2015. The components of the net sales change are the following: The net sales decrease in 2016 reflects lower sales in the animal productivity business driven primarily by continued low milk prices and a strong year ago results comparison. The low milk prices are principally due to an excess global supply of milk and weak exports due to a strong U.S. dollar. SPD income before income taxes was $39.8 in 2016, a decrease of $17.5 compared to 2015. The decrease in income before income taxes for 2016 is due primarily to lower sales volume of $8.7, a plant impairment charge of $4.9, higher manufacturing costs of $4.1, and higher SG&A of $2.8 partially offset by lower other expense of $2.3 mainly as a result of foreign exchange rate changes. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) 2015 compared to 2014 SPD net sales were $312.2 for 2015, an increase of $21.4, or 7.3% compared to 2014. The components of the net sales change are the following: (1) On January 2, 2015, the Company acquired certain assets of Varied Industries Corporation. Net sales are included in the Company’s results since the date of the VI-COR Acquisition. The sales increase in 2015 reflects the impact of the VI-COR Acquisition, as well as, higher sales volume of performance products partially offset by lower animal nutrition products and foreign exchange fluctuations. SPD income before income taxes was $57.3 in 2015, an increase of $11.5 compared to 2014. The increase in income before income taxes for 2015 is due primarily to higher sales volume of $18.8 and lower manufacturing costs of $10.1, partially offset by unfavorable foreign exchange rates of $6.8, SG&A of $9.1 and higher marketing expenses of $1.3. Corporate The Corporate segment reflects the administrative costs of the production, planning and logistics functions which are included in SG&A expenses in the operating segments but are elements of cost of sales in the Company’s Consolidated Statements of Income. Such amounts were $36.6, $32.6 and $26.7 for 2016, 2015 and 2014, respectively. Also included in corporate segment are the equity in earnings (losses) of affiliates from Armand and ArmaKleen in 2016 and Armand, ArmaKleen and Natronx in 2015 and 2014. The increase in equity in earnings of affiliates in 2016 is primarily due to the $17.0 Natronx impairment charge recorded in the second quarter of 2015. Liquidity and capital resources On December 4, 2015, the Company replaced its former $600.0 unsecured revolving credit facility with a $1,000.0 unsecured revolving credit facility (as amended from time to time, the “Credit Agreement”). Under the Credit Agreement, the Company has the ability to increase its borrowing up to an additional $600.0, subject to lender commitments and certain conditions as described in the Credit Agreement. Borrowings under the Credit Agreement are available for general corporate purposes and are used to support the Company’s $1,000.0 commercial paper program (the “Program”). Unless extended, the Credit Agreement will terminate and all amounts outstanding thereunder will be due and payable on December 4, 2020. As of December 31, 2016, the Company had $187.8 in cash and cash equivalents, approximately $576.0 available through the revolving facility under its Credit Agreement and its commercial paper program, and a commitment increase feature under the Credit Agreement that enables the Company to borrow up to an additional $600.0, subject to lending commitments of the participating lenders and certain conditions as described in the Credit Agreement. To preserve its liquidity, the Company invests its cash primarily in government money market funds and short term bank deposits. During 2015, the Company liquidated its subsidiary in the Netherlands and decided that the earnings of its subsidiary in France would no longer be permanently reinvested outside of the U.S. As a result, the Company repatriated cash of $93.0. The funds repatriated were used to reduce outstanding commercial paper. As a result of liquidating its subsidiary in the Netherlands, the Company recorded a tax benefit of $2.7 in the Consolidated Statement of Income and a deferred tax benefit of $11.6 through Accumulated Other Comprehensive Income in the second quarter of 2015. As of December 31, 2016, there remains $150.1 of cash and cash equivalents held by the foreign subsidiaries that is considered to be permanently reinvested outside of the U.S. These funds are not needed for operations in the U.S. If they were, the Company would be required to accrue and pay taxes in the U.S. to repatriate these funds. The Company’s intent is to permanently reinvest these funds outside the U.S., and the Company does not currently expect to repatriate them to fund U.S. operations. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) On December 9, 2014, the Company issued $300.0 aggregate principal amount of 2.45% Senior Notes due December 15, 2019 (the “2019 Notes”). The 2019 Notes were issued under the first supplemental indenture (the “First Supplemental Indenture”), dated December 9, 2014, to the indenture dated December 9, 2014 (the “Base Indenture”), between the Company and Wells Fargo Bank, N.A., as trustee. Interest on the 2019 Notes is payable semi-annually, beginning June 15, 2015. The 2019 Notes will mature on December 15, 2019, unless earlier retired or redeemed pursuant to the terms of the First Supplemental Indenture. On September 26, 2012, the Company issued $400.0 aggregate principal amount of 2.875% Senior Notes due 2022 (the “2022 Notes”). The 2022 Notes were issued under the second supplemental indenture, dated September 26, 2012 (the “BNY Mellon Second Supplemental Indenture”) to the indenture dated December 15, 2010 (the “BNY Mellon Base Indenture”) between the Company and The Bank of New York Mellon Trust Company, N.A., as trustee. Interest on the 2022 Notes is payable semi-annually, beginning April 1, 2013. The 2022 Notes will mature on October 1, 2022, unless earlier retired or redeemed pursuant to the terms of the BNY Mellon Second Supplemental Indenture. The current economic environment presents risks that could have adverse consequences for the Company’s liquidity. (See “Unfavorable economic conditions could adversely affect demand for the Company’s products” under “Risk Factors” in Item 1A of this Annual Report.) The Company does not anticipate that current economic conditions will adversely affect its ability to comply with the financial covenant in the Credit Agreement because the Company currently is, and anticipates that it will continue to be, in compliance with the maximum leverage ratio requirement under the Credit Agreement. On February 7, 2017, the Board declared a 7% increase in the regular quarterly dividend from $0.1775 to $0.19 per share, equivalent to an annual dividend of $0.76 per share payable to stockholders of record as of February 21, 2017. The increase raises the annual dividend payout from $183 to approximately $195, and maintains the Company’s payout of dividends relative to net income at approximately 40%. On November 2, 2016, the Board authorized a new share repurchase program, under which the Company may repurchase up to $500.0 in shares of Common Stock (the “2016 Share Repurchase Program”). The 2016 Share Repurchase Program does not have an expiration and replaced the 2015 Share Repurchase Program. The Company also continued its evergreen share repurchase program, authorized by the Board on January 29, 2014, under which the Company may repurchase, from time to time, Common Stock to reduce or eliminate dilution associated with issuances of Common Stock under the Company’s incentive plans. In 2016, the Company purchased approximately 9.0 million shares of Common Stock for $400.0, of which $103.0 was purchased under the evergreen share repurchase program, $200.0 was purchased under the 2016 Share Repurchase Program, and $97.0 was purchased under the 2015 Share Repurchase Program. As a result of the Company’s purchases, there remained $300.0 under the 2016 Share Repurchase Program as of December 31, 2016. The Company anticipates that its cash from operations, together with its current borrowing capacity, will be sufficient to meet its capital expenditure program costs, which are expected to be approximately $55.0 in 2017, fund its share repurchase programs to the extent implemented by management and pay dividends at the latest approved rate. Cash, together with the Company’s current borrowing capacity, may be used for acquisitions that would complement the Company’s existing product lines or geographic markets. The Company does not have any mandatory fixed rate debt principal payments in 2017. Cash Flow Analysis 2016 compared to 2015 Net Cash Provided by Operating Activities - The Company’s primary source of liquidity is its cash flow provided by operating activities, which is dependent on the level of net income and changes in working capital. The Company’s net cash provided by operating activities in 2016 increased by $49.2 to $655.3 as compared to $606.1 in 2015 due to a reduction in working capital and higher cash earnings (net income plus non-cash expenses such as depreciation, amortization, non-cash compensation and asset impairment charges). The change in working capital is primarily due to higher accounts receivable, including the impact of factoring CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) an additional $22.3 to a bank, a decrease in inventories and higher accounts payable and accrued expenses. The Company measures working capital effectiveness based on its cash conversion cycle. The following table presents the Company’s cash conversion cycle information for the quarters ended December 31, 2016 and 2015: The Company's cash conversion cycle (defined as the sum of DSO and DIO less DPO) which is calculated using a 2 period average method, improved 6 days from the prior year amount of 27 days to 21 days at December 31, 2016 due primarily to improved DSO of 3 days from 33 to 30 days due to factoring. DIO increased 1 day from 50 to 51 days. DPO improved by 4 days as the Company continues to extend payment terms with its suppliers. The improvement in the Company's cash conversion cycle reflects the Company's continued focus on reducing its average working capital requirements. Net Cash Used in Investing Activities - Net cash used in investing activities during 2016 was $354.6, principally reflecting $305.3 for acquisitions and $49.8 for property, plant and equipment expenditures. Net Cash Used in Financing Activities - Net cash used in financing activities during 2016 was $439.6, primarily reflecting $400.0 of repurchases of the Company’s Common Stock and $183.0 of cash dividend payments, partially offset by $80.5 of proceeds and tax benefits from stock option exercises, and $65.5 of additional commercial paper borrowings, and an additional $3.4 of short term borrowings at an international subsidiary. 2015 compared to 2014 Net Cash Provided by Operating Activities - The Company’s primary source of liquidity is the strong cash flow provided by operating activities, which is dependent on the level of net income and changes in working capital. The Company’s net cash provided by operating activities in 2015 increased by $65.8 to $606.1 compared to 2014 due to higher cash earnings (net income plus non-cash expenses such as depreciation, amortization, non-cash compensation and asset impairment charges) and lower working capital. The decrease in working capital is primarily due to lower accounts receivable as a result of factoring $37.8 to a bank and higher accounts payable and accrued expenses due to the timing of invoice payments. This was partially offset by higher inventory in support of higher sales. The Company measures working capital effectiveness based on its cash conversion cycle. The Company's cash conversion cycle (defined as days in accounts receivable plus days in inventory less days in accounts payable) which is calculated using a 2 period average method, improved 5 days from the prior year amount of 32 days to 27 days at December 31, 2015 due primarily to improved accounts receivable of 4 days and accounts payable of 2 days. Inventory increased 1 day from 49 to 50 days. The improvement in the Company's cash conversion cycle reflects the Company's continued focus on reducing its average working capital requirements. Net Cash Used in Investing Activities - Net cash used in investing activities during 2015 was $141.2, principally reflecting $74.9 for the VI-COR Acquisition and $61.8 for property, plant and equipment expenditures, in part due to the Company’s new gummy dietary supplement manufacturing facility in York, Pennsylvania. Net Cash Used in Financing Activities - Net cash used in financing activities 2015 was $535.0, primarily reflecting $363.1 of repurchases of Common Stock, $175.3 of cash dividend payments and repayment of a $250.0 bond that matured in 2015, partially offset by higher commercial paper and short term borrowings of $211.7 and $44.3 of proceeds and tax benefits from stock option exercises. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Commitments as of December 31, 2016 The table below summarizes the Company’s material contractual obligations and commitments as of December 31, 2016. (1) Represents interest on the Company’s 2.45% Senior Notes due in 2019 and 2.875% Senior Notes due in 2022. (2) Letters of credit with several banks guarantee payment for items such as insurance claims in the event of the Company’s insolvency. Performance bonds are principally for required municipal property improvements. (3) The Company has outstanding purchase obligations with suppliers at the end of 2016 for raw, packaging and other materials and services in the normal course of business. These purchase obligation amounts represent only those items which are based on agreements that are enforceable and legally binding, and do not represent total anticipated purchases. (4) Other includes payments for stadium naming rights for a period of 20 years until December 2032. Off-Balance Sheet Arrangements The Company does not have off-balance sheet financing or unconsolidated special purpose entities. OTHER ITEMS Market risk Concentration of Risk A group of three customers accounted for approximately 35%, 35% and 36% of consolidated net sales in 2016, 2015 and 2014, respectively, of which a single customer, Wal-Mart, accounted for approximately 24%, 24% and 25% in 2016, 2015 and 2014, respectively. Interest Rate Risk The Company had outstanding total debt at December 31, 2016, of $1,120.2, net of debt issuance costs, of which 62% has a fixed weighted average interest rate of 2.7% and the remaining 38% constituted principally commercial paper issued by the Company that currently has a weighted average interest rate of approximately 1.0%. In December 2014, the Company entered into interest rate swap agreements on an aggregate notional amount of $300.0 to convert the fixed interest rate on the 2019 Notes to a floating rate of three-month LIBOR plus a fixed spread of 0.756%. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Other Market Risks The Company is also subject to market risks relating to its diesel fuel costs, fluctuations in foreign currency exchange rates, and changes in the market price of the Common Stock. Refer to Note 3 to the Consolidated Financial Statements for a discussion of these market risks and the derivatives used to manage the risks associated with changing diesel fuel prices, foreign exchange rates and the price of the Company’s common stock.

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW The Company’s Business The Company develops, manufactures, markets and sells a broad range of household, personal care and specialty products. The Company sells its consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores, and websites, all of which sell the products to consumers. The Company also sells specialty products to industrial customers and distributors. The Company focuses its consumer products marketing efforts principally on its ten “power brands.” These wellrecognized brand names include ARM & HAMMER, used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent; TROJAN condoms, lubricants and vibrators; OXICLEAN stain removers, cleaning solutions, laundry detergent, dishwashing detergent and bleach alternatives; SPINBRUSH batteryoperated and manual toothbrushes; FIRST RESPONSE home pregnancy and ovulation test kits; NAIR depilatories; ORAJEL oral analgesic; XTRA laundry detergent; L’IL CRITTERS and VITAFUSION gummy dietary supplements; and BATISTE dry shampoos. The Company operates its business in three segments: Consumer Domestic, Consumer International and SPD. The Consumer Domestic segment includes the power brands noted above and other household and personal care products such as SCRUB FREE, KABOOM and ORANGE GLO cleaning products, ARRID antiperspirant, CLOSEUP and AIM toothpastes and SIMPLY SALINE nasal saline moisturizer. The Consumer International segment primarily sells a variety of personal care products, some of which use the same brand names as the Company’s domestic product lines, in international markets including Canada, France, Australia, the United Kingdom, Mexico and Brazil. The SPD segment is the largest U.S. producer of sodium bicarbonate, which it sells together with other specialty inorganic chemicals for a variety of industrial, institutional, medical and food applications. This segment also sells a range of animal nutrition and specialty cleaning products. In 2016, the Consumer Domestic, Consumer International and SPD segments represented approximately 77%, 15% and 8%, respectively, of the Company’s consolidated net sales. 2016 Financial Highlights Key fiscal year 2016 financial results include: 2016 net sales grew 2.9% over fiscal year 2015, with gains in the Consumer Domestic and Consumer International segments, primarily due to volume growth in both the Consumer Domestic and Consumer International segments, helped in part by the January 2016 acquisition of Spencer Forrest, Inc. (“Spencer Forrest”), the maker of TOPPIK, (the “Toppik Acquisition”), partially offset by lower sales of animal productivity products. On December 22, 2016, the Company completed the Anusol Acquisition, acquiring the ANUSOL and RECTINOL businesses from Johnson & Johnson, Inc. for $130. Total annual sales for ANUSOL and RECTINOL were $24 in 2016. Gross margin increased 100 basis points to 45.5% in fiscal year 2016 from 44.5% in fiscal year 2015, primarily due to lower manufacturing and commodity costs. Operating margin increased 80 basis points to 20.7% in fiscal year 2016 from 19.9% in fiscal year 2015, reflecting a higher gross margin and slightly lower marketing costs, partially offset by higher selling, general and administrative expenses (“SG&A”). The Company reported diluted net earnings per share in fiscal year 2016 of $1.75, an increase [/INST] Negative. </s>

CHURCH & DWIGHT CO INC /DE/

2018-02-23

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW Our Business We develop, manufacture and market a broad range of consumer household and personal care and specialty products focused on animal productivity, chemicals and cleaners. We focus our consumer products marketing efforts principally on our 11 “power brands.” These well-recognized brand names include ARM & HAMMER, used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent; TROJAN condoms, lubricants and vibrators; OXICLEAN stain removers, cleaning solutions, laundry detergent, dishwashing detergent and bleach alternatives; SPINBRUSH battery-operated and manual toothbrushes; FIRST RESPONSE home pregnancy and ovulation test kits; NAIR depilatories; ORAJEL oral analgesic; XTRA laundry detergent; L’IL CRITTERS and VITAFUSION gummy dietary supplements, BATISTE dry shampoos and in 2017 added WATERPIK water flossers and replacement showerheads. We sell our consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores and websites and other e-commerce channels, all of which sell the products to consumers. We sell our specialty products to industrial customers, livestock producers and through distributors. We operate our business in three segments: Consumer Domestic, Consumer International and SPD. The segments are based on differences in the nature of products and organizational and ownership structures. In 2017, the Consumer Domestic, Consumer International and SPD segments represented approximately 76%, 16% and 8%, respectively, of our consolidated net sales. 2017 Financial Highlights Key fiscal year 2017 financial results include: • 2017 net sales grew 8.1% over fiscal year 2016, with gains in all three segments, primarily due to volume growth across all segments, helped in part by the August 2017 acquisition of Waterpik and the May 2017 acquisition of Agro Biosciences in SPD. • Gross margin increased 30 basis points to 45.8% in fiscal year 2017 from 45.5% in fiscal year 2016, primarily due to favorable volume and lower manufacturing and commodity costs. • Operating margin decreased 130 basis points to 19.4% in fiscal year 2017 from 20.7% in fiscal year 2016, reflecting higher selling, general and administrative expenses (“SG&A”), partially offset by a higher gross margin and slightly lower marketing costs. • We reported diluted net earnings per share in fiscal year 2017 of $2.90, an increase of approximately 66% from fiscal year 2016 diluted net earnings per share of $1.75. The current year includes a one-time favorable adjustment of $1.06 associated with the Tax Cuts and Jobs Act. • Cash provided by operations was $681.5, a $26.2 increase from the prior year, due to higher cash earnings partially offset by higher working capital. • We returned $590.4 to our stockholders through dividends and share repurchases. Strategic Goals, Challenges and Initiatives Our ability to generate sales depends on consumer demand for our products and retail customers’ decisions to carry our products, which are, in part, affected by general economic conditions in our markets. Although our consumer products generally are consumer staples and less vulnerable to decreases in discretionary spending than other products, in 2017, many of the product categories in which we operate continued to experience pricing pressures, and weak or inconsistent consumer demand. Some customers have responded to economic conditions by increasing their private label offerings (primarily in the dietary supplements, diagnostic kits and CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) oral analgesics categories), and consolidating the product selections they offer to the top few leading brands in each category. In addition, an increasing portion of our product categories is being sold by club stores, dollar stores, mass merchandisers and internet-based retailers. These factors have placed downward pressure on our sales and gross margins. We expect a competitive marketplace in 2018 due to new product introductions by competitors and continuing aggressive competitive pricing pressures. In this environment, we intend to continue to aggressively pursue several key strategic initiatives: maintain competitive marketing and trade spending, tightly control our cost structure, continue to develop and launch new and differentiated products, and pursue strategic acquisitions. We also intend to continue to grow our product sales globally and maintain an offering of premium and value brand products to appeal to a wide range of consumers. There continues to be significant product and price competition in the premium and deep value laundry detergent categories and more recently, product competition in the gummy vitamin category. For example, in the laundry detergent category, P&G and Henkel, the two largest laundry detergent companies in the U.S., are engaged in aggressive pricing promotions, and retailers are continuing to de-emphasize the deep value tier of laundry detergents, which is where XTRA competes. In addition, the gummy vitamin category has grown from eight competitors to 30 in the last five years. We continue to evaluate and vigorously combat these pressures through, among other things, new product introductions and increased marketing and trade spending. However, there is no assurance the categories will not decline in the future and that we will be able to offset any such decline. We are continuously focused on strengthening our key brands, such as ARM & HAMMER, OXICLEAN, TROJAN, L’IL CRITTERS and VITAFUSION, BATISTE and WATERPIK, through the launch of innovative new products, which span various product categories, including premium and value household products supported by increased marketing and trade spending. There can be no assurance that these measures will be successful. In 2017, we were able to grow market share in seven of 11 of our “power brands” in measured channels. Our global product portfolio consists of both premium (60% of total worldwide consumer revenue in 2017) and value (40% of total worldwide consumer revenue in 2017) brands, which we believe enables us to succeed in a range of economic environments. We intend to continue to develop a portfolio of appealing new products to build loyalty among cost-conscious consumers. Over the past 17 years, we have diversified from an almost exclusively U.S. business to a global company with approximately 17% of sales derived from foreign countries in 2017. We have operations in six countries (Canada, Mexico, U.K., France, Australia, and Brazil), recently established a subsidiary in Germany and export to over 130 other countries. In 2017, we benefited from our expanded global footprint; however, we have focused and will continue to focus on selectively expanding our global business. Net sales generated outside of the U.S. are exposed to foreign currency exchange rate fluctuations as well as political uncertainty which could impact future operating results. We also continue to focus on controlling our costs. Historically, we have been able to mitigate the effects of cost increases primarily by implementing cost reduction programs and, to a lesser extent, by passing along some of these cost increases to customers. We have also entered into set pricing and pre-buying arrangements with certain suppliers and hedge agreements for diesel fuel. Additionally, maintaining tight controls on overhead costs has been a hallmark of ours and has enabled us to effectively navigate recent challenging economic conditions. The identification and integration of strategic acquisitions are an important component of our overall strategy. Acquisitions have added significantly to our sales and profits over the last decade. This is recently evidenced by our 2015 acquisition of certain assets of Varied Industries Corporation (the “VI-COR Acquisition”), 2016 acquisitions of Spencer Forrest, Inc., the maker of TOPPIK (the “TOPPIK Acquisition”), and the ANUSOL and RECTINOL businesses from Johnson & Johnson (the “ANUSOL Acquisition”) and 2017 acquisitions of VIVISCAL from Lifes2Good Holdings Limited (the “Viviscal Acquisition”), Agro BioSciences, Inc. (the “Agro Acquisition”), and WATERPIK from Pik Holdings, Inc. (the “Waterpik Acquisition”). However, the failure to effectively integrate any acquisition or achieve expected synergies may cause us to incur material asset write-downs. We actively seek acquisitions that fit our guidelines, and our strong financial position provides us with flexibility to take advantage of acquisition opportunities. In addition, our ability to quickly integrate acquisitions and leverage existing infrastructure has enabled us to establish a strong track record in making accretive acquisitions. Since 2001, we have acquired 10 of our 11 “power brands”. We believe we are positioned to meet the ongoing challenges described above due to our strong financial condition, experience operating in challenging environments and continued focus on key strategic initiatives: maintaining competitive marketing and trade spending, managing our cost structure, continuing to develop and launch new and differentiated products, and pursuing strategic acquisitions. This focus, together with the strength of our portfolio of premium and value brands, has enabled us to succeed in a range of economic environments, and is expected to position us to continue to increase stockholder value over the long-term. Moreover, the generation of a significant amount of cash from operations, as a result of net income and effective working capital management, CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) combined with an investment grade credit rating provides us with the financial flexibility to pursue acquisitions, drive new product development, make capital expenditures to support organic growth and gross margin improvements, return cash to stockholders through dividends and share buy backs, and reduce outstanding debt, positioning us to continue to create stockholder value. For information regarding risks and uncertainties that could materially adversely affect our business, results of operations and financial condition, see “Risk Factors” in Item 1A of this Annual Report. Recent Developments U.S. Tax Reform On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act significantly changes the U.S. corporate income tax regime by, among other things, lowering U.S. corporate income tax rates to 21%. However, the Tax Act eliminates the domestic manufacturing deduction and moves toward a territorial system, which also eliminates the ability to credit certain foreign taxes that existed prior to enactment of the Tax Act. There are also certain transitional impacts of the Tax Act. As part of the transition to the new territorial tax system, the Tax Act imposes a one-time repatriation tax on a deemed repatriation of historical earnings of foreign subsidiaries. We intend to repatriate some of our non-U.S. earnings and pay the associated repatriation tax. In addition, the reduction of the U.S. corporate tax rate caused us to adjust our U.S. deferred tax assets and liabilities to the lower federal base rate of 21%. These transitional impacts resulted in a provisional net credit of approximately $273 for the quarter and year ended December 31, 2017. The credit is primarily due to the adjustment to the U.S. deferred tax asset and liabilities. The changes included in the Tax Act are broad and complex. The final transitional impacts of the Tax Act may differ from the above estimate, possibly materially, due to, among other things, changes in interpretations of the Tax Act, any legislative action to address questions that arise because of the Tax Act, any changes in accounting standards for income taxes or related interpretations in response to the Tax Act, or any updates or changes to estimates we have utilized to calculate the transitional impacts. The Commission has issued guidance that allows for a measurement period of up to one year after the enactment date of the Tax Act to finalize the recording of the related tax impacts. We currently anticipate finalizing and recording any resulting adjustments by the end of the measurement period. Accelerated Share Repurchase Program In December of 2017, we entered into an accelerated share repurchase (“ASR”) contract with a commercial bank to purchase $200 million of the Common Stock. On January 4, 2018, we paid $200 million to the bank and received a total of 4.1 million shares during the first quarter of 2018. We used cash on hand plus borrowing to fund the initial purchase price. Share Repurchase Program On November 1, 2017, the Board authorized a new share repurchase program, under which we may repurchase up to $500.0 in shares of Common Stock (the “2017 Share Repurchase Program”). The 2017 Share Repurchase Program does not have an expiration and replaced the 2016 Share Repurchase Program. We will continue our evergreen share repurchase program, under which we may repurchase, from time to time, Common Stock to reduce or eliminate dilution associated with issuances of Common Stock under our incentive plans. As a result of the $100 million purchased in the fourth quarter of 2017, there remains $400 million under the 2017 Share Repurchase Program as of December 31, 2017. Water Pik, Inc. Acquisition On August 7, 2017, we acquired Pik Holdings, Inc. (“Waterpik”), a water-jet technology company that designs and sells both oral water flossers and replacement shower heads (the “Waterpik Acquisition”). The total purchase price was $1,024.6 (net of cash acquired), which was subject to a working capital adjustment. Waterpik’s annual sales were approximately $265.0 for the trailing twelve months through June 30, 2017. We financed the Waterpik Acquisition with proceeds from our underwritten public offering of $1,425.0 aggregate principal amount of Senior Notes (as defined below) completed on July 25, 2017. Subsequent to the Waterpik Acquisition, Waterpik is managed by the Consumer Domestic and Consumer International segments. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Agro BioSciences, Inc. Acquisition On May 1, 2017, we acquired Agro BioSciences, Inc. (the “Agro Acquisition”), an innovator and leader in developing custom probiotic products for poultry, cattle and swine. The total purchase price was approximately $75.0, which was subject to a working capital adjustment, and an additional payment of up to $25.0 after three years based on sales performance. Agro BioSciences, Inc.’s annual sales were approximately $11.0 in 2016. The acquisition was funded with short-term borrowings and is managed by the Specialty Products Division (“SPD”) segment. Viviscal Acquisition On January 17, 2017, we acquired the VIVISCAL business from Lifes2Good Holdings Limited for approximately $160. Viviscal is the number one hair care supplement brand both in the U.S. and the U.K. with global annual sales of $44 in 2016. This brand is complementary to our global BATISTE dry shampoo and TOPPIK hair care business. The acquisition was funded with short-term borrowings and is managed in the Consumer Domestic and Consumer International segments. Dividend Increase On February 5, 2018, the Board of Directors declared a 14% increase in the regular quarterly dividend from $0.19 to $0.2175 per share, equivalent to an annual dividend of $0.87 per share payable to stockholders of record as of February 15, 2018. The increase raises the annual dividend payout from $190 to approximately $215. International Pension Plan Termination In 2016, we authorized the termination of an international defined benefit pension plan under which approximately 336 participants, including 53 active employees, had accrued benefits. We completed the termination of this plan in the second quarter of 2017. In addition to plan assets, we made a one-time payment of $7.5 to purchase annuities for participants. We recorded a one-time SG&A expense of $39.2 ($31.5 after tax) in the Consumer International segment in the second quarter of 2017. This expense primarily included the effect of the additional cash payment required at settlement and pension settlement accounting rules which require accelerated recognition of actuarial losses that were to be amortized over the expected benefit lives of participants. As of June 30, 2017, we had no further obligations with respect to material defined benefit pension plans. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the U.S. (GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. By their nature, these judgments are subject to uncertainty. They are based on our historical experience, our observation of trends in industry, information provided by our customers and information available from other outside sources, as appropriate. Our significant accounting policies and estimates are described below. Revenue Recognition and Promotional and Sales Return Reserves Virtually all of our revenue represents sales of finished goods inventory and is recognized when received or picked up by our customers. The reserves for consumer and trade promotion liabilities and sales returns are established based on our best estimate of the amounts necessary to settle future and existing claims on products sold as of the balance sheet date. Promotional reserves are provided for sales incentives, such as coupons to consumers, and sales incentives provided to customers (such as slotting, cooperative advertising, incentive discounts based on volume of sales and other arrangements made directly with customers). All such costs are netted against sales. Slotting costs are recorded when the product is delivered to the customer. Cooperative advertising costs are recorded when the customer places the advertisement for our products. Discounts relating to price reduction arrangements are recorded when the related sale takes place. Costs associated with end-aisle or other in-store displays are recorded when product that is subject to the promotion is sold. We rely on historical experience and forecasted data to determine the required reserves. For example, we use historical experience to project coupon redemption rates to determine reserve requirements. Based on the total face value of Consumer Domestic coupons redeemed over the past several years, if the actual rate of redemptions were to deviate by 0.1% from the rate for which reserves are accrued in the financial statements, an approximately $3.4 difference in the reserve required for coupons would result. With regard to other promotional reserves and sales returns, we use experience-based estimates, customer and sales organization inputs and historical trend analysis in arriving at the reserves required. If our estimates for promotional activities and sales returns were to change by 10% the impact to promotional spending and sales return accruals would be approximately $7.8. While management believes that its promotional and sales returns reserves are reasonable and that appropriate judgments have been made, estimated amounts could differ materially from actual future obligations. During the twelve months ended December 31, 2017, 2016 and 2015, we reduced promotion liabilities by approximately $0.6, $5.4 and $4.3, respectively, based on a change in estimate as a result of actual experience and updated information. These adjustments are immaterial relative to the amount of trade promotion expense incurred annually by us. Impairment of goodwill, trade names and other intangible assets Carrying values of goodwill, trade names and other indefinite lived intangible assets are reviewed periodically for possible impairment. For finite intangible assets, we assess business triggering events. Our impairment analysis is based on a discounted cash flow approach that requires significant judgment with respect to unit volume, revenue and expense growth rates, and the selection of an appropriate discount rate. Management uses estimates based on expected trends in making these assumptions. With respect to goodwill, impairment occurs when the carrying value of the reporting unit exceeds the discounted present value of cash flows for that reporting unit. For trade names and other intangible assets, an impairment charge is recorded for the difference between the carrying value and the net present value of estimated future cash flows, which represents the estimated fair value of the asset. Judgment is required in assessing whether assets may have become impaired between annual valuations. Indicators such as unexpected adverse economic factors, unanticipated technological change, distribution losses, or competitive activities and acts by governments and courts may indicate that an asset has become impaired. The result of our annual goodwill impairment test determined that the estimated fair value substantially exceeded the carrying values of all reporting units. In addition, there were no goodwill impairment charges for each of the years in the three-year period ended December 31, 2017. Fair value for indefinite lived intangible assets was estimated based on a “relief from royalty” or “excess earnings” discounted cash flow method, which contains numerous variables that are subject to change as business conditions change, and therefore could impact fair values in the future. We determined that the fair value of all other intangible assets for each of the years in the three-year period ended December 31, 2017 exceeded their respective carrying values based upon the forecasted cash flows and profitability. There is a personal care trade name that, based on recent performance, has experienced sales and profit declines that have eroded a significant portion of the excess between fair and carrying value which could potentially result in an impairment of the asset. In 2017, this excess has been reduced to approximately $34.0 or 12% due in large part to an increased competitive market environment therefore resulting in reduced cash flow projections. As a result, this indefinite-lived intangible asset is more susceptible to impairment risk. While management can and has implemented strategies to address the risk, significant changes in operating plans or adverse CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) changes in the future could reduce the underlying cash flows used to estimate fair values and could result in a decline in fair value that could trigger future impairment charges of this asset. It is possible that our conclusions regarding impairment or recoverability of goodwill or other intangible assets could change in future periods if, for example, (i) the businesses or brands do not perform as projected, (ii) overall economic conditions in 2018 or future years vary from current assumptions (including changes in discount rates), (iii) business conditions or strategies change from current assumptions, (iv) investors require higher rates of return on equity investments in the marketplace or (v) enterprise values of comparable publicly traded companies, or actual sales transactions of comparable companies, were to decline, resulting in lower multiples of revenues and EBITDA. A future impairment charge for goodwill or intangible assets could have a material effect on our consolidated financial position or results of operations. Inventory valuation When appropriate, we write down the carrying value of our inventory to the lower of cost or market (net realizable value, which reflects any costs to sell or dispose). We identify any slow moving, obsolete or excess inventory to determine whether an adjustment is required to establish a new carrying value. The determination of whether inventory items are slow moving, obsolete or in excess of needs requires estimates and assumptions about the future demand for our products, technological changes, and new product introductions. In addition, our allowance for obsolescence may be impacted by the reduction of the number of stock keeping units (SKUs). We evaluate our inventory levels and expected usage on a periodic basis and record adjustments as required. Adjustments to inventory to reflect a reduction in net realizable value were $12.8 at December 31, 2017, $10.5 at December 31, 2016, and $12.6 at December 31, 2015. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized to reflect the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the differences are expected to be recovered or settled. Management provides a valuation allowance against deferred tax assets for amounts which are not considered “more likely than not” to be realized. We record liabilities for potential assessments in various tax jurisdictions under U.S. GAAP guidelines. The liabilities relate to tax return positions that, although supportable by us, may be challenged by the tax authorities and do not meet the minimum recognition threshold required under applicable accounting guidance for the related tax benefit to be recognized in the income statement. We adjust this liability as a result of changes in tax legislation, interpretations of laws by courts, rulings by tax authorities, changes in estimates and the expiration of the statute of limitations. Many of the judgments involved in adjusting the liability involve assumptions and estimates that are highly uncertain and subject to change. In this regard, settlement of any issue, or an adverse determination in litigation, with a taxing authority could require the use of cash and result in an increase in our annual tax rate. Conversely, favorable resolution of an issue with a taxing authority would be recognized as a reduction to our annual tax rate. New Accounting Pronouncements Refer to Note 1 to the Consolidated Financial Statements for recently adopted accounting pronouncements and recently issued accounting pronouncements not yet adopted as of December 31, 2017. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2017, 2016 AND 2015 The discussion of results of operations at the consolidated level presented below is followed by a more detailed discussion of results of operations by segment. The discussion of our consolidated results of operations and segment operating results is presented on a historical basis for the years ended December 31, 2017, 2016, and 2015. The segment discussion also addresses certain product line information. Our operating units are consistent with our reportable segments. Consolidated results 2017 compared to 2016 Net Sales Net sales for the year ended December 31, 2017 were $3,776.2, an increase of $283.1, or 8.1% compared to 2016 net sales. The components of the net sales increase are as follows: (1) On January 17, 2017, we acquired the Viviscal business (the “Viviscal Acquisition”), on May 1, 2017, we acquired Agro BioSciences, Inc. (the “Agro Acquisition”) and on August 7, 2017, we acquired Waterpik (the “Waterpik Acquisition”). Net sales of these acquisitions are included in our results since the date of acquisition. In March 2017, we sold our chemical business in Brazil. All three segments reported volume increases. Both Consumer Domestic and Consumer International experienced unfavorable price/mix. Our gross profit for 2017 was $1,729.6, a $139.0 increase compared to 2016. Gross margin was 45.8% in 2017 compared to 45.5% in 2016, a 30 basis points (“bps”) increase. The increase is due to the impact of higher margins on acquired businesses representing 80 bps, favorable volume of 70 bps, and lower manufacturing costs of 40 bps, partially offset by unfavorable price/mix of 140 bps (primarily due to higher promotion and coupon costs), higher commodity costs of 30 bps, and the impact of unfavorable foreign exchange rates of 10 bps. Gross margin in 2016 included a plant impairment charge of 20 bps at an international subsidiary. Operating Costs Marketing expenses for 2017 were $454.2, an increase of $27.0 compared to 2016. Acquired businesses contributed modestly to the increase. Marketing expenses as a percentage of net sales decreased 20 bps to 12.0% in 2017 as compared to 2016 due to 90 bps of leverage on higher net sales partially offset by 70 bps on higher expenses. Selling, general and administrative expenses (“SG&A”) expenses for 2017 were $542.7, an increase of $103.5 or 23.6% compared to 2016. The increase is primarily due to the $39.2 international pension settlement charge, transition and ongoing CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) acquisition-related costs, higher information system and legal costs and costs associated with selling the chemical business in Brazil. SG&A as a percentage of net sales increased 180 bps to 14.4% in 2017 compared to 12.6% in 2016. The increase is due to higher costs of 280 bps, partially offset by 100 bps of leverage associated with higher sales. The pension charge contributed 110 bps to the increase. Other Income and Expenses Equity in earnings of affiliates increased by $1.6 in 2017 as compared to 2016. The increase in earnings during 2017 was due primarily to profit improvement from Armand Products due to lower raw material costs. Interest expense in 2017 was $52.6, an increase of $24.9 compared to 2016 due to a higher amount of average debt outstanding associated with the $1,425.0 aggregate principal amount of Senior Notes completed on July 25, 2017. Taxation The 2017 tax rate was -7.3% compared to 35.0% in 2016. The 2017 tax rate was positively impacted by 39.4% as a result of the Tax Act and 2.2% related to the adoption of the new accounting standard which modifies how companies account for certain aspects of share-based payment awards to employees. Previously, this tax benefit related to the adoption of the new accounting standard was accounted for in our Stockholders’ Equity section of the Balance Sheet. Starting in 2017, the tax benefit has been accounted for as a reduction of income tax expense. The new tax law is expected to reduce our future tax burden by lowering the effective tax rate to approximately 24-25%. This estimate is based on our current understanding of the new Tax Act which may change as regulations are finalized. 2016 compared to 2015 Net Sales Net sales for the year ended December 31, 2016 were $3,493.1, an increase of $98.3, or approximately 2.9% compared to 2015 net sales. The components of the net sales increase are as follows: (1) On January 4, 2016, we completed the Toppik Acquisition, acquiring Spencer Forrest, Inc., the maker of TOPPIK, the leading brand of hair building fibers for people with thinning hair. Net sales of this acquisition are included in our results since the date of acquisition. Volume growth in Consumer Domestic and Consumer International was partially offset by lower SPD volume. Our gross profit for 2016 was $1,590.6, a $78.8 increase compared to 2015. Gross margin was 45.5% in 2016 compared to 44.5% in 2015, a 100 basis points (“bps”) increase. The increase is due to lower manufacturing costs of 70 bps (including productivity programs and the absence of start-up costs incurred in 2015 associated with our new vitamin manufacturing facility), lower commodity costs of 60 bps, and the impact of the higher margin acquired business of 30 bps, partially offset by unfavorable foreign exchange rates of 30 bps, a plant impairment charge of 20 bps at an international subsidiary and unfavorable price/volume mix of 10 bps. Operating Costs Marketing expenses for 2016 were $427.2, an increase of $9.7 compared to 2015. Marketing expenses as a percentage of net sales decreased 10 bps to 12.2% in 2016 as compared to 2015 due to 40 bps of leverage on higher net sales partially offset by 30 bps on higher expenses. Selling, general and administrative expenses (“SG&A”) expenses for 2016 were $439.2, an increase of $19.1 or 4.5% compared to 2015. The increase is primarily due to costs associated with the Toppik Acquisition and higher compensation costs, partially offset CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) by a pension plan charge recorded in 2015. SG&A as a percentage of net sales increased 30 bps to 12.6% in 2016 compared to 12.3% in 2015. The increase is due to higher costs of 60 bps, partially offset by 30 bps of leverage associated with higher sales. Other Income and Expenses Equity in earnings of affiliates increased by $15.0 in 2016 as compared to 2015. The increase in earnings during 2016 was due primarily to a $17.0 impairment charge in 2015 associated with our remaining investment in Natronx. Interest expense in 2016 was $27.7, a decrease of $2.8 compared to 2015 due to a lower amount of average debt outstanding. Taxation The 2016 tax rate was 35.0% compared to 35.4% in 2015. The 2015 tax rate was negatively impacted by a valuation allowance recorded in connection with the Natronx impairment charge. Segment results for 2017, 2016 and 2015 We operate three reportable segments: Consumer Domestic, Consumer International and SPD. These segments are determined based on differences in the nature of products and organizational and ownership structures. We also have a Corporate segment. Segment Products Consumer Domestic Household and personal care products Consumer International Primarily personal care products SPD Specialty chemical products The Corporate segment income consists of equity in earnings (losses) of affiliates. As of December 31, 2017, we held 50% ownership interests in each of Armand and ArmaKleen, respectively, and a one-third ownership interest in Natronx. Our equity in earnings (losses) of Armand and ArmaKleen for the year ended December 31, 2017 and 2016 and Armand, ArmaKleen and Natronx for the years ended December 31, 2015 are included in the Corporate segment. Some of the subsidiaries that are included in the Consumer International segment manufacture and sell personal care products to the Consumer Domestic segment. These sales are eliminated from the Consumer International segment results set forth below. Segment net sales and income before income taxes for each of the three years ended December 31, 2017, 2016 and 2015 were as follows: (1) Intersegment sales from Consumer International to Consumer Domestic, which are not reflected in the table, were $4.5, $3.4 and $5.3 for the years ended December 31, 2017, 2016 and 2015, respectively. (2) In determining income before income taxes, we allocated interest expense and investment earnings among the segments based upon each segment’s relative Income from Operations. (3) Corporate segment consists of equity in earnings (losses) of affiliates from Armand and ArmaKleen in 2017 and 2016 and Armand, ArmaKleen and Natronx in 2015. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Product line revenues for external customers for the years ended December 31, 2017, 2016 and 2015 were as follows: Household Products include deodorizing, cleaning and laundry products. Personal Care Products include condoms, pregnancy kits, oral care products, skin care products, hair care products and gummy dietary supplements. Consumer Domestic 2017 compared to 2016 Consumer Domestic net sales in 2017 were $2,854.9, an increase of $177.1 or 6.6% compared to net sales of $2,677.8 in 2016. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Viviscal Acquisition and the Waterpik Acquisition since the date of acquisition. The increase in net sales for 2017, reflects the impact of acquisitions, higher sales of ARM & HAMMER liquid and unit dose detergents, BATISTE dry shampoo, OXICLEAN stain fighters and ARM & HAMMER cat litter, partially offset by lower sales of TROJAN condoms, XTRA laundry detergent and gummy vitamins. There continues to be significant product and price competition in the premium and deep value laundry detergent categories and more recently, product competition in the gummy vitamin category. For example, in the laundry detergent category, P&G and Henkel, the two largest laundry detergent companies in the U.S., are engaged in aggressive pricing promotions, and retailers are continuing to de-emphasize the deep value tier of laundry detergents, which is where XTRA competes. In addition, the gummy vitamin category has grown from eight competitors to 30 in the last five years. We continue to evaluate and vigorously combat these pressures through, among other things, new product introductions and increased marketing and trade spending. However, there is no assurance the categories will not decline in the future and that we will be able to offset any such decline. Consumer Domestic income before income taxes for 2017 was $606.4, a $15.8 increase as compared to 2016. The increase is due primarily to the impact of higher sales volumes of $146.5, favorable commodity and manufacturing costs of $15.1, partially offset by unfavorable price/mix of $90.5, higher marketing expenses of $18.9, higher interest expense of $20.7, and higher SG&A costs of $15.8. 2016 compared to 2015 Consumer Domestic net sales in 2016 were $2,677.8, an increase of $96.2 or 3.7% compared to net sales of $2,581.6 in 2015. The components of the net sales change are the following: CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) (1) Includes net sales of the brands acquired in the Toppik Acquisition since the date of acquisition. The increase in net sales for 2016, reflects higher sales of ARM & HAMMER liquid and unit dose detergents, VITAFUSION gummy vitamins, OXICLEAN laundry additive ARM & HAMMER Cat Litter products and BATISTE dry shampoo, partially offset by lower sales of XTRA laundry detergent and L’IL CRITTERS gummy vitamins. There continues to be significant product and price competition in the laundry detergent category. For example, P&G markets a lower-priced line of laundry detergents, Simply Tide, which competes directly with our core value laundry detergents. P&G has significantly increased its discounting of Simply Tide which could have a broad negative impact on the laundry category pricing and profitability. In addition, in 2016, Henkel entered the U.S. market with Persil, its leading worldwide premium laundry detergent, and on September 1, 2016 completed its acquisition of Sun Products, the maker of All, Wisk, Sun, and private label laundry detergents. While it is too early to assess what impact this will have on our laundry detergent business, the introduction of Persil and Henkel’s increased scale and market share could precipitate greater price competition in the category and distribution pressure with a potential adverse impact on our laundry detergent business. Moreover, the unit dose laundry detergent segment is the fastest growing segment in the laundry detergent category, having grown to approximately 16% of the category since the introduction of this form in 2012, and we face pressure to achieve our proportionate share of the segment with a potential adverse impact on our share of the laundry detergent category. We continue to evaluate and vigorously combat these pressures through, among other things, new product introductions and increased marketing and trade spending. Additionally, while the category grew 3.3% for the 52 weeks ended December 17, 2016 and 1.6% for the 52 weeks ended December 19, 2015, after experiencing declines in 2013 and 2014, there is no assurance the category will not decline in the future and that we will be able to offset any such decline. Consumer Domestic income before income taxes for 2016 was $590.6, a $61.2 increase as compared to 2015. The increase is due primarily to the impact of higher sales volumes of $70.1, favorable commodity and manufacturing costs of $40.3, partially offset by higher SG&A costs of $24.7, unfavorable price/mix of $17.2, and higher marketing expenses of $8.7. Consumer International 2017 compared to 2016 Consumer International net sales in 2017 were $621.1, an increase of $95.9 or 18.3% as compared to 2016. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Anusol Acquisition, the Viviscal Acquisition and the Waterpik Acquisition since the date of acquisition. Excluding the impact of foreign exchange rates, higher sales for the year occurred in exports, Canada, Australia, Europe and Mexico. The addition of the acquired business contributed significantly to the sales growth. Of the existing brands, BATISTE, STERIMAR, FEMFRESH, OXICLEAN and ARM & HAMMER cat litter brands had strong sales growth. Consumer International income before income taxes was $32.0 in 2017, a decrease of $34.3 compared to 2016 due primarily to the pension settlement charge of $39.2, higher other SG&A costs of $29.7, higher marketing costs of $7.4, unfavorable manufacturing and commodity costs of $6.9, unfavorable foreign exchange rates of $4.0, and unfavorable price/mix of $2.3, partially offset by higher sales volumes of $57.9. 2016 compared to 2015 CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Consumer International net sales in 2016 were $525.2, an increase of $24.2 or 4.8% as compared to 2015. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Toppik Acquisition since the date of acquisition. Excluding the impact of unfavorable foreign exchange rates, higher sales for the year occurred in exports, Canada, Mexico, and Europe. The BATISTE, ARM & HAMMER, OXICLEAN, FEMFRESH, STERIMAR, and TROJAN brands had strong sales growth. Consumer International income before income taxes was $66.3 in 2016, an increase of $11.8 compared to 2015 due primarily to higher volumes of $23.4, favorable price/mix of $7.5 and lower SG&A of $1.4, partially offset by unfavorable foreign exchange rates of $12.2, higher marketing costs of $6.2, and higher manufacturing costs of $2.3. Last year’s results included an $8.9 pension settlement charge. Specialty Products 2017 compared to 2016 SPD net sales were $300.2 for 2017, an increase of $10.1, or 3.5% compared to 2016. The components of the net sales change are the following: (1) Includes net sales of the Agro Acquisition since the date of acquisition and is negatively impacted by the sale of the Brazilian chemical business. Excluding the impact of the acquisition and divestiture, the net sales increase in 2017 was driven primarily by improved price and volumes in the animal productivity business where U.S. dairy farm profitability throughout 2017 was higher than the prior year. SPD income before income taxes was $43.5 in 2017, an increase of $3.7 compared to 2016. The increase in income before income taxes for 2017 is due primarily to higher sales volume of $13.0, favorable price/product mix of $7.0, lower costs associated with selling the Brazilian chemical business of $4.9, and lower costs associated with the Natronx joint venture of $1.7, partially offset by higher SG&A costs of $14.0 and higher manufacturing costs of $7.4. 2016 compared to 2015 SPD net sales were $290.1 for 2016, a decrease of $22.1, or 7.1% compared to 2015. The components of the net sales change are the following: CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) The net sales decrease in 2016 reflects lower sales in the animal productivity business driven primarily by continued low milk prices and a strong year ago results comparison. The low milk prices are principally due to an excess global supply of milk and weak exports due to a strong U.S. dollar. SPD income before income taxes was $39.8 in 2016, a decrease of $17.5 compared to 2015. The decrease in income before income taxes for 2016 is due primarily to lower sales volume of $8.7, a plant impairment charge of $4.9, higher manufacturing costs of $4.1, and higher SG&A of $2.8 partially offset by lower other expense of $2.3 mainly as a result of foreign exchange rate changes. Corporate The Corporate segment reflects the reclassification of administrative costs of the production, planning and logistics functions which are included in SG&A expenses in the operating segments but are elements of cost of sales in our Consolidated Statements of Income. Such amounts were $32.8, $36.6 and $32.6 for 2017, 2016 and 2015, respectively. Also included in corporate segment are the equity in earnings (losses) of affiliates from Armand and ArmaKleen in 2017 and 2016 and Armand, ArmaKleen and Natronx in 2015. The increase in equity in earnings of affiliates in 2016 is primarily due to the $17.0 Natronx impairment charge recorded in the second quarter of 2015. Liquidity and capital resources On December 4, 2015, we replaced our former $600.0 unsecured revolving credit facility with a $1,000.0 unsecured revolving credit facility (as amended from time to time, the “Credit Agreement”). Under the Credit Agreement, we have the ability to increase our borrowing up to an additional $600.0, subject to lender commitments and certain conditions as described in the Credit Agreement. Borrowings under the Credit Agreement are available for general corporate purposes and are used to support our $1,000.0 commercial paper program (the “Program”), which was increased from $500.0 on February 23, 2017. Unless extended, the Credit Agreement will terminate and all amounts outstanding thereunder will be due and payable on December 4, 2020. As of December 31, 2017, we had $278.9 in cash and cash equivalents, approximately $728 available through the revolving facility under our Credit Agreement and our commercial paper program, and a commitment increase feature under the Credit Agreement that enables us to borrow up to an additional $600.0, subject to lending commitments of the participating lenders and certain conditions as described in the Credit Agreement. To preserve our liquidity, we invest our cash primarily in government money market funds and short term bank deposits. During 2015, we liquidated our subsidiary in the Netherlands and decided that the earnings of our subsidiary in France would no longer be permanently reinvested outside of the U.S. As a result, we repatriated cash of $93.0. The funds repatriated were used to reduce outstanding commercial paper. As a result of liquidating our subsidiary in the Netherlands, we recorded a tax benefit of $2.7 in the Consolidated Statement of Income and a deferred tax benefit of $11.6 through Accumulated Other Comprehensive Income in the second quarter of 2015. As a result of tax reform, we have decided to repatriate excess cash held at our foreign subsidiaries in 2018. We estimate we will repatriate approximately $150 of the $194 held outside the U.S. We financed the Waterpik Acquisition with a portion of the proceeds from an underwritten public offering of $1,425.0 aggregate principal amount of Senior Notes completed on July 25, 2017, consisting of $300.0 aggregate principal amount of Floating Rate Senior Notes due 2019, $300.0 aggregate principal amount of 2.45% Senior Notes due 2022, $425.0 aggregate principal amount of 3.15% Senior Notes due 2027 and $400.0 aggregate principal amount of 3.95% Senior Notes due 2047 (collectively, the “Senior Notes”). The Floating Rate Senior Notes will bear interest at a rate, reset quarterly, equal to three-month U.S. dollar London Interbank Offered Rate (“LIBOR”) plus 0.15%. The remaining proceeds of the offering of the Senior Notes were used to pay down in its entirety and terminate our $200.0 term loan borrowed in the second quarter of 2017 and to repay a portion of our outstanding commercial paper borrowings. On December 9, 2014, we issued $300.0 aggregate principal amount of 2.45% Senior Notes due December 15, 2019 (the “2019 Notes”). The 2019 Notes were issued under the first supplemental indenture (the “First Supplemental Indenture”), dated December 9, 2014, to the indenture dated December 9, 2014 (the “Base Indenture”), between us and Wells Fargo Bank, N.A., as trustee. The 2019 Notes will mature on December 15, 2019, unless earlier retired or redeemed pursuant to the terms of the First Supplemental Indenture. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) On September 26, 2012, we issued $400.0 aggregate principal amount of 2.875% Senior Notes due 2022 (the “2022 Notes”). The 2022 Notes were issued under the second supplemental indenture, dated September 26, 2012 (the “BNY Mellon Second Supplemental Indenture”) to the indenture dated December 15, 2010 (the “BNY Mellon Base Indenture”) between us and The Bank of New York Mellon Trust Company, N.A., as trustee. The 2022 Notes will mature on October 1, 2022, unless earlier retired or redeemed pursuant to the terms of the BNY Mellon Second Supplemental Indenture. The current economic environment presents risks that could have adverse consequences for our liquidity. (See “Unfavorable economic conditions could adversely affect demand for our products” under “Risk Factors” in Item 1A of this Annual Report.) We do not anticipate that current economic conditions will adversely affect our ability to comply with the financial covenant in the Credit Agreement because we currently are, and anticipate that we will continue to be, in compliance with the maximum leverage ratio requirement under the Credit Agreement. On February 5, 2018, the Board of Directors declared a 14% increase in the regular quarterly dividend from $0.19 to $0.2175 per share, equivalent to an annual dividend of $0.87 per share payable to stockholders of record as of February 15, 2018. The increase raises the annual dividend payout from $190 to approximately $215. On November 1, 2017, the Board authorized a new share repurchase program, under which we may repurchase up to $500.0 in shares of Common Stock (the “2017 Share Repurchase Program”). The 2017 Share Repurchase Program does not have an expiration and replaced the 2016 Share Repurchase Program. We also continued our evergreen share repurchase program, authorized by the Board on January 29, 2014, under which we may repurchase, from time to time, Common Stock to reduce or eliminate dilution associated with issuances of Common Stock under our incentive plans. In 2017, we purchased approximately 8.2 million shares of Common Stock for $400.0, of which $125.0 was purchased under the evergreen share repurchase program, $100.0 was purchased under the 2017 Share Repurchase Program, and $175.0 was purchased under the 2016 Share Repurchase Program. As a result of our purchases, there remained $400.0 under the 2017 Share Repurchase Program as of December 31, 2017. In December of 2017, we entered an accelerated share repurchase (“ASR”) contract with a commercial bank to purchase $200 million of the Common Stock. On January 4, 2018, we paid $200 million to the bank and received a total of 4.1 million shares during the first quarter of 2018. We used cash on hand plus borrowing to fund the initial purchase price. We anticipate that our cash from operations, together with our current borrowing capacity, will be sufficient to meet our capital expenditure program costs, which are expected to be approximately $70.0 in 2018, fund our share repurchase programs to the extent implemented by management and pay dividends at the latest approved rate. Cash, together with our current borrowing capacity, may be used for acquisitions that would complement our existing product lines or geographic markets. We do not have any mandatory fixed rate debt principal payments in 2018. Cash Flow Analysis 2017 compared to 2016 Net Cash Provided by Operating Activities - Our primary source of liquidity is our cash flow provided by operating activities, which is dependent on the level of net income and changes in working capital. Our net cash provided by operating activities in 2017 increased by $26.2 to $681.5 as compared to $655.3 in 2016 due to higher cash earnings (net income plus non-cash expenses such as depreciation, amortization, non-cash compensation and asset impairment charges) partially offset by slightly higher working capital. The change in working capital is primarily due to, an increase in inventories and a smaller increase in accounts payable and accrued expenses. We measure working capital effectiveness based on our cash conversion cycle. The following table presents our cash conversion cycle information for the quarters ended December 31, 2017 and 2016: CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Our cash conversion cycle (defined as the sum of DSO and DIO less DPO) which is calculated using a two period average method, improved three days from the prior year amount of 21 days to 18 days at December 31, 2017 due primarily to improved DPO of five days from 60 to 65 days, as we continue to extend payment terms with our suppliers, partially offset by DSO which increased one day from 30 to 31 days and DIO which increased one day from 51 to 52. The improvement in our cash conversion cycle reflects our continued focus on reducing our average working capital requirements. Net Cash Used in Investing Activities - Net cash used in investing activities during 2017 was $1,303.4, principally reflecting $1,260.0 for acquisitions and $45.0 for property, plant and equipment expenditures. Net Cash Provided by (Used in) Financing Activities - Net cash provided by financing activities during 2017 was $698.9, primarily reflecting $1,621.3 of long-term debt borrowings and $42.1 of proceeds from stock option exercises partially offset by $400.0 of repurchases of our Common Stock, $200.0 of long-term debt repayments, $190.4 of cash dividend payments, $151.3 of net commercial paper repayments, $17.8 of financing costs and $4.5 of short-term debt repayments at an international subsidiary. 2016 compared to 2015 Net Cash Provided by Operating Activities - Our primary source of liquidity is our cash flow provided by operating activities, which is dependent on the level of net income and changes in working capital. Our net cash provided by operating activities in 2016 increased by $49.2 to $655.3 as compared to $606.1 in 2015 due to a reduction in working capital and higher cash earnings (net income plus non-cash expenses such as depreciation, amortization, non-cash compensation and asset impairment charges). The change in working capital is primarily due to higher accounts receivable, including the impact of factoring an additional $22.3 to a bank, a decrease in inventories and higher accounts payable and accrued expenses. Net Cash Used in Investing Activities - Net cash used in investing activities during 2016 was $354.6, principally reflecting $305.3 for acquisitions and $49.8 for property, plant and equipment expenditures. Net Cash Used in Financing Activities - Net cash used in financing activities during 2016 was $439.6, primarily reflecting $400.0 of repurchases of our Common Stock and $183.0 of cash dividend payments, partially offset by $80.5 of proceeds and tax benefits from stock option exercises, and $65.5 of additional commercial paper borrowings, and an additional $3.4 of short term borrowings at an international subsidiary. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Commitments as of December 31, 2017 The table below summarizes our material contractual obligations and commitments as of December 31, 2017. (1) Represents interest on our 2.45% Senior Notes due in 2019 and 2022, 2.875% Senior Notes due in 2022, 3.15% Senior Notes due 2027 and 3.95% Senior Notes due 2047. (2) Letters of credit with several banks guarantee payment for items such as insurance claims in the event of our insolvency. Performance bonds are principally for required municipal property improvements. (3) We have outstanding purchase obligations with suppliers at the end of 2017 for raw, packaging and other materials and services in the normal course of business. These purchase obligation amounts represent only those items which are based on agreements that are enforceable and legally binding, and do not represent total anticipated purchases. (4) Other includes payments for stadium naming rights for a period of 20 years until December 2032. Off-Balance Sheet Arrangements We do not have off-balance sheet financing or unconsolidated special purpose entities. OTHER ITEMS Market risk Concentration of Risk A group of three customers accounted for approximately 36%, 35% and 35% of consolidated net sales in 2017, 2016 and 2015, respectively, of which a single customer, Wal-Mart, accounted for approximately 24%, 24% and 24% in 2017, 2016 and 2015, respectively. Interest Rate Risk We had outstanding total debt at December 31, 2017, of $2,374.3, net of debt issuance costs, of which 76% has a fixed weighted average interest rate of 3.0% and the remaining 24% was constituted of commercial paper issued by the Company that currently has a weighted average interest rate of approximately 1.6% and the Floating Rate Senior Notes due 2019 entered into on July 25, 2017 with a current rate of approximately 1.5%. In December 2014, we entered into interest rate swap agreements on an aggregate notional amount of $300.0 to convert the fixed interest rate on the 2019 Notes to a floating rate of three-month LIBOR plus a fixed spread of 0.756%. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Other Market Risks We are also subject to market risks relating to our diesel fuel costs, fluctuations in foreign currency exchange rates, and changes in the market price of the Common Stock. Refer to Note 3 to the Consolidated Financial Statements for a discussion of these market risks and the derivatives used to manage the risks associated with changing diesel fuel prices, foreign exchange rates and the price of our common stock.

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW Our Business We develop, manufacture and market a broad range of consumer household and personal care and specialty products focused on animal productivity, chemicals and cleaners. We focus our consumer products marketing efforts principally on our 11 “power brands.” These wellrecognized brand names include ARM & HAMMER, used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent; TROJAN condoms, lubricants and vibrators; OXICLEAN stain removers, cleaning solutions, laundry detergent, dishwashing detergent and bleach alternatives; SPINBRUSH batteryoperated and manual toothbrushes; FIRST RESPONSE home pregnancy and ovulation test kits; NAIR depilatories; ORAJEL oral analgesic; XTRA laundry detergent; L’IL CRITTERS and VITAFUSION gummy dietary supplements, BATISTE dry shampoos and in 2017 added WATERPIK water flossers and replacement showerheads. We sell our consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores and websites and other ecommerce channels, all of which sell the products to consumers. We sell our specialty products to industrial customers, livestock producers and through distributors. We operate our business in three segments: Consumer Domestic, Consumer International and SPD. The segments are based on differences in the nature of products and organizational and ownership structures. In 2017, the Consumer Domestic, Consumer International and SPD segments represented approximately 76%, 16% and 8%, respectively, of our consolidated net sales. 2017 Financial Highlights Key fiscal year 2017 financial results include: 2017 net sales grew 8.1% over fiscal year 2016, with gains in all three segments, primarily due to volume growth across all segments, helped in part by the August 2017 acquisition of Waterpik and the May 2017 acquisition of Agro Biosciences in SPD. Gross margin increased 30 basis points to 45.8% in fiscal year 2017 from 45.5% in fiscal year 2016, primarily due to favorable volume and lower manufacturing and commodity costs. Operating margin decreased 130 basis points to 19.4% in fiscal year 2017 from 20.7% in fiscal year 2016, reflecting higher selling, general and administrative expenses (“SG&A”), partially offset by a higher gross margin and slightly lower marketing costs. We reported diluted net earnings per share in fiscal year 2017 of $2.90, an increase of approximately 66% from fiscal year 2016 diluted net earnings per share of $1.75. The current year includes a onetime favorable adjustment of $1.06 associated with the Tax Cuts and Jobs Act. Cash provided by operations was $681.5, a $26.2 increase from the prior year, due to higher cash earnings partially offset by higher working capital. We returned $590.4 to our stockholders through dividends and share repurchases. Strategic Goals, Challenges and Initiatives Our ability to generate sales depends on consumer demand for our products and retail customers’ decisions to carry our products, which are, in part, affected by general economic conditions in our markets. Although our consumer products generally are consumer staples and less vulnerable to decreases in discretionary spending than other products, in 2017, many of the product categories in which we operate continued to experience pricing pressures, and weak or inconsistent consumer demand. Some customers have responded to economic conditions by increasing their private label offerings (primarily in the di [/INST] Positive. </s>

CHURCH & DWIGHT CO INC /DE/

2019-02-21

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW Our Business We develop, manufacture and market a broad range of consumer household and personal care and specialty products focused on animal productivity, chemicals and cleaners. We focus our consumer products marketing efforts principally on our 11 “power brands.” These well-recognized brand names include ARM & HAMMER, used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent; TROJAN condoms, lubricants and vibrators; OXICLEAN stain removers, cleaning solutions, laundry detergent and bleach alternatives; SPINBRUSH battery-operated and manual toothbrushes; FIRST RESPONSE home pregnancy and ovulation test kits; NAIR depilatories; ORAJEL oral analgesic; XTRA laundry detergent; L’IL CRITTERS and VITAFUSION gummy dietary supplements, BATISTE dry shampoos and WATERPIK water flossers and replacement showerheads. We sell our consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores and websites and other e-commerce channels, all of which sell the products to consumers. We sell our specialty products to industrial customers, livestock producers and through distributors. We operate our business in three segments: Consumer Domestic, Consumer International and SPD. The segments are based on differences in the nature of products and organizational and ownership structures. In 2018, the Consumer Domestic, Consumer International and SPD segments represented approximately 76%, 17% and 7%, respectively, of our consolidated net sales. 2018 Financial Highlights Key fiscal year 2018 financial results include: • 2018 net sales grew 9.8% over fiscal year 2017, with gains in all three segments, primarily due to volume growth in Consumer Domestic and Consumer International, helped in part by the August 2017 acquisition of Waterpik and partially offset by volume declines in Specialty Products. • Gross margin decreased 140 basis points to 44.4% in fiscal year 2018 from 45.8% in fiscal year 2017, primarily due to higher commodity, transportation and manufacturing costs. • Operating margin decreased 30 basis points to 19.1% in fiscal year 2018 from 19.4% in fiscal year 2017, reflecting lower gross margin, partially offset by lower selling, general and administrative expenses and lower marketing costs. • We reported diluted net earnings per share in fiscal year 2018 of $2.27, a decrease of approximately 21.7% from fiscal year 2017 diluted net earnings per share of $2.90. The prior year includes a one-time favorable adjustment of $1.06 associated with the Tax Cuts and Jobs Act. • Cash provided by operations was $763.6, an $82.1 increase from the prior year, due to higher cash earnings and lower working capital. • We returned $413.3 to our stockholders through dividends and share repurchases. Strategic Goals, Challenges and Initiatives Our ability to generate sales depends on consumer demand for our products and retail customers’ decisions to carry our products, which are, in part, affected by general economic conditions in our markets. Although our consumer products generally are consumer staples and less vulnerable to decreases in discretionary spending than other products, in 2018, many of the product categories in which we operate continued to experience pricing pressures, and weak or inconsistent consumer demand. Some customers have responded to economic conditions by increasing their private label offerings (primarily in the dietary supplements, diagnostic kits and oral analgesics categories), and consolidating the product selections they offer to the top few leading brands in each category. In CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) addition, an increasing portion of our product categories is being sold by club stores, dollar stores, mass merchandisers and internet-based retailers. These factors have placed downward pressure on our sales and gross margins. We expect a competitive marketplace in 2019 due to new product introductions by competitors and continuing competitive pricing pressures. In this environment, we intend to continue to aggressively pursue several key strategic initiatives: maintain competitive marketing and trade spending, tightly control our cost structure, continue to develop and launch new and differentiated products, and pursue strategic acquisitions. We also intend to continue to grow our product sales globally and maintain an offering of premium and value brand products to appeal to a wide range of consumers. We derive a substantial percentage of our revenues from sales of laundry detergent. The continued customer demand for these products are critical to our future success. As a result, any commercialization, delays or reduction of sales of these products, in the event that our diversification efforts discussed below are not successful, could have a material adverse effect on our business, financial condition and operating results. In addition, there continues to be significant product competition in the gummy vitamin category. The category has grown from eight competitors to 30 in the last five years. We continue to evaluate and vigorously combat these pressures through, among other things, new product introductions and increased marketing and trade spending. However, there is no assurance that the category will not decline in the future and that we will be able to offset any such decline. We are continuously focused on strengthening our key brands, such as ARM & HAMMER, OXICLEAN, TROJAN, L’IL CRITTERS and VITAFUSION, BATISTE and WATERPIK, through the launch of innovative new products, which span various product categories, including premium and value household products supported by increased marketing and trade spending. There can be no assurance that these measures will be successful. In the domestic business, seven out of 11 “power brands” met or exceeded category growth for the full year 2018. Our global product portfolio consists of both premium (65% of total worldwide consumer revenue in 2018) and value (35% of total worldwide consumer revenue in 2018) brands, which we believe enables us to succeed in a range of economic environments. We intend to continue to develop a portfolio of appealing new products to build loyalty among cost-conscious consumers. Over the past two decades, we have diversified from an almost exclusively U.S. business to a global company with approximately 18% of sales derived from foreign countries in 2018. We have operations in seven countries (Canada, Mexico, U.K., France, Germany, Australia, and Brazil) and export to over 130 other countries. In 2018, we benefited from our expanded global footprint and expect to continue to focus on selectively expanding our global business. If we are unable to expand our business internationally at the rate that we expect, we may not realize the operational benefits that we anticipate. Although we believe ongoing international expansion represents a significant opportunity to grow our business, our increasing activity in global markets exposes us to additional complexity and uncertainty. Net sales generated outside of the U.S. are exposed to foreign currency exchange rate fluctuations as well as political uncertainty which could impact future operating results. Moreover, the current domestic and international political environment, including existing and potential changes to U.S. policies related to global trade and tariffs, have resulted in uncertainty regarding the global economy. The impact of U.S. tariffs, primarily on WATERPIK products, was a component of increased cost of sale during the year ended December 31, 2018. The implementation of more restrictive trade policies, such as higher tariffs or new barriers to entry, in countries in which we manufacture or sell large quantities of products and services could negatively impact our business, results of operations and financial condition. We also continue to focus on controlling our costs. Historically, we have been able to mitigate the effects of cost increases primarily by implementing cost reduction programs and, to a lesser extent, by passing along some of these cost increases to customers. We have also entered into set pricing and pre-buying arrangements with certain suppliers and hedge agreements for diesel fuel. To combat higher input costs and tariffs, in 2018, we announced price increases on approximately 30% of our portfolio. Should additional price increases be warranted, we cannot be certain they will be accepted by our customers. Additionally, maintaining tight controls on overhead costs has been a hallmark of ours and has enabled us to effectively navigate recent challenging economic conditions. The identification and integration of strategic acquisitions are an important component of our overall strategy and product category diversification. Acquisitions have added significantly to our sales and profits and product category diversification over the last decade. This is recently evidenced by our 2015 acquisition of certain assets of Varied Industries Corporation (the “VI-COR Acquisition”), 2016 acquisitions of Spencer Forrest, Inc., the maker of TOPPIK (the “TOPPIK Acquisition”), and the ANUSOL and RECTINOL businesses from Johnson & Johnson (the “ANUSOL Acquisition”) and 2017 acquisitions of VIVISCAL from Lifes2Good Holdings Limited (the “Viviscal Acquisition”), Agro BioSciences, Inc. (the “Agro Acquisition”), WATERPIK from Pik Holdings, Inc. (the “Waterpik Acquisition”), and 2018 acquisition of Passport Food Safety Solutions, Inc. (the “Passport Acquisition”). However, the failure to effectively integrate any acquisition or achieve expected synergies may cause us to incur material asset write-downs. We actively seek acquisitions that fit our guidelines, and our strong financial position provides us with CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) flexibility to take advantage of acquisition opportunities. In addition, our ability to quickly integrate acquisitions and leverage existing infrastructure has enabled us to establish a strong track record in making accretive acquisitions. Since 2001, we have acquired 10 of our 11 “power brands”. We believe we are positioned to meet the ongoing challenges described above due to our strong financial condition, experience operating in challenging environments and continued focus on key strategic initiatives: maintaining competitive marketing and trade spending, managing our cost structure, continuing to develop and launch new and differentiated products, and pursuing strategic acquisitions. This focus, together with the strength of our portfolio of premium and value brands, has enabled us to succeed in a range of economic environments, and is expected to position us to continue to increase stockholder value over the long-term. Moreover, the generation of a significant amount of cash from operations, as a result of net income and effective working capital management, combined with an investment grade credit rating provides us with the financial flexibility to pursue acquisitions, drive new product development, make capital expenditures to support organic growth and gross margin improvements, return cash to stockholders through dividends and share buy backs, and reduce outstanding debt, positioning us to continue to create stockholder value. For information regarding risks and uncertainties that could materially adversely affect our business, results of operations and financial condition, see “Risk Factors” in Item 1A of this Annual Report. Recent Developments Accelerated Share Repurchase Program In December of 2017, we entered into an accelerated share repurchase (“ASR”) contract with a commercial bank to purchase $200.0 of our Common Stock. In the first quarter of 2018, we settled the ASR contract and purchased approximately 4.1 million shares of Common Stock for $200.0, of which approximately $110.0 was purchased under the evergreen share repurchase program and $90.0 was purchased under the 2017 Share Repurchase Program. As a result of our purchases, there remained $310.0 of share repurchase availability under the 2017 Share Repurchase Program as of December 31, 2018. In connection with the evergreen repurchase program, in January 2019, we executed open market purchases of $100.0 of our Common Stock. Passport Acquisition On March 8, 2018, we purchased Passport Food Safety Solutions, Inc. (“Passport”). Passport sells products for pre-and post-harvest treatment of poultry, swine, and beef. The total purchase price was approximately $50.0, which is subject to an additional payment of up to $25.0 based on sales performance through 2020. Passport’s annual sales were approximately $21.0 in 2017. The Passport Acquisition was funded with short-term borrowings and is managed in the SPD segment. Dividend Increase On February 5, 2019, the Board declared a 5% increase in the regular quarterly dividend from $0.2175 to $0.2275 per share, equivalent to an annual dividend of $0.91 per share payable to stockholders of record as of February 15, 2019. The increase raises the annual dividend payout from $213.3 to approximately $222.0. On February 5, 2018, the Board of Directors declared a 14% increase in the regular quarterly dividend from $0.19 to $0.2175 per share, equivalent to an annual dividend of $0.87 per share payable to stockholders of record as of February 15, 2018. The increase raised the annual dividend payout from approximately $190 to $213.3. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the U.S. (GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. By their nature, these judgments are subject to uncertainty. They are based on our historical experience, our observation of trends in industry, information provided by our customers and information available from other outside sources, as appropriate. Our significant accounting policies and estimates are described below. Revenue Recognition and Promotional and Sales Return Reserves Virtually all of our revenue represents sales of finished goods inventory and is recognized when received or picked up by our customers. The reserves for consumer and trade promotion liabilities and sales returns are established based on our best estimate of the amounts necessary to settle future and existing claims on products sold as of the balance sheet date. Promotional reserves are provided for sales incentives, such as coupons to consumers, and sales incentives provided to customers (such as slotting, cooperative advertising, incentive discounts based on volume of sales and other arrangements made directly with customers). All such costs are netted against sales. Slotting costs are recorded when the product is delivered to the customer. Cooperative advertising costs are recorded when the customer places the advertisement for our products. Discounts relating to price reduction arrangements and coupons are recorded when the related sale takes place. Costs associated with end-aisle or other in-store displays are recorded when product that is subject to the promotion is sold. We rely on historical experience and forecasted data to determine the required reserves. For example, we use historical experience to project coupon redemption rates to determine reserve requirements. Based on the total face value of Consumer Domestic coupons redeemed over the past several years, if the actual rate of redemptions were to deviate by 0.1% from the rate for which reserves are accrued in the financial statements, a difference of approximately $3.1 in the reserve required for coupons would result. With regard to other promotional reserves and sales returns, we use experience-based estimates, customer and sales organization inputs and historical trend analysis in arriving at the reserves required. If our estimates for promotional activities and sales returns reserves were to change by 10% the impact to promotional spending and sales return accruals would be approximately $6.4. While management believes that its promotional and sales returns reserves are reasonable and that appropriate judgments have been made, estimated amounts could differ materially from actual future obligations. Reserve adjustments made in 2018, 2017 and 2016 are immaterial relative to the amount of trade promotion expense incurred annually by us. Impairment of goodwill, trade names and other intangible assets Carrying values of goodwill and indefinite-lived tradenames are reviewed periodically for possible impairment. Finite intangible assets are assessed when there are business triggering events. Our impairment analysis is based on a discounted cash flow approach that requires significant judgment with respect to unit volume, revenue and expense growth rates, and the selection of an appropriate discount rate. Management uses estimates based on expected trends in making these assumptions. With respect to goodwill, impairment occurs when the carrying value of the reporting unit exceeds the discounted present value of cash flows for that reporting unit. For trade names and other intangible assets, an impairment charge is recorded for the difference between the carrying value and the net present value of estimated future cash flows, which represents the estimated fair value of the asset. Judgment is required in assessing whether assets may have become impaired between annual valuations. Indicators such as unexpected adverse economic factors, unanticipated technological change, distribution losses, or competitive activities and acts by governments and courts may indicate that an asset has become impaired. The result of our annual goodwill impairment test determined that the estimated fair value substantially exceeded the carrying values of all reporting units. In addition, there were no goodwill impairment charges for each of the years in the three-year period ended December 31, 2018. Fair value for indefinite lived intangible assets was estimated based on a “relief from royalty” or “excess earnings” discounted cash flow method, which contains numerous variables that are subject to change as business conditions change, and therefore could impact fair values in the future. We determined that the fair value of all other intangible assets for each of the years in the three-year period ended December 31, 2018 exceeded their respective carrying values based upon the forecasted cash flows and profitability. In 2017 there was a personal care trade name that, based on recent performance, had experienced sales and profit declines that had eroded a significant portion of the excess between fair and carrying value, which could potentially result in an impairment of the asset. In 2017, this excess had been reduced due in large part to an increased competitive market environment therefore resulting in reduced cash flow projections. The performance of the tradename improved in 2018, thereby increasing the excess between fair value and carrying value. This indefinite-lived intangible asset could still be susceptible to impairment risk. While management can and has implemented strategies to address the risk, significant changes in operating plans or adverse changes in the future could reduce the underlying cash flows used to estimate fair values and could result in a decline in fair value that could trigger future impairment charges of this asset. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) It is possible that our conclusions regarding impairment or recoverability of goodwill or other intangible assets could change in future periods if, for example, (i) the businesses or brands do not perform as projected, (ii) overall economic conditions in 2018 or future years vary from current assumptions (including changes in discount rates), (iii) business conditions or strategies change from current assumptions, (iv) investors require higher rates of return on equity investments in the marketplace or (v) enterprise values of comparable publicly traded companies, or actual sales transactions of comparable companies, were to decline, resulting in lower multiples of revenues and EBITDA. A future impairment charge for goodwill or intangible assets could have a material effect on our consolidated financial position or results of operations. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized to reflect the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the differences are expected to be recovered or settled. Management provides a valuation allowance against deferred tax assets for amounts which are not considered “more likely than not” to be realized. We record liabilities for potential assessments in various tax jurisdictions under U.S. GAAP guidelines. The liabilities relate to tax return positions that, although supportable by us, may be challenged by the tax authorities and do not meet the minimum recognition threshold required under applicable accounting guidance for the related tax benefit to be recognized in the income statement. We adjust this liability as a result of changes in tax legislation, interpretations of laws by courts, rulings by tax authorities, changes in estimates and the expiration of the statute of limitations. Many of the judgments involved in adjusting the liability involve assumptions and estimates that are highly uncertain and subject to change. In this regard, settlement of any issue, or an adverse determination in litigation, with a taxing authority could require the use of cash and result in an increase in our annual tax rate. Conversely, favorable resolution of an issue with a taxing authority would be recognized as a reduction to our annual tax rate. New Accounting Pronouncements Refer to Note 1 to the Consolidated Financial Statements for recently adopted accounting pronouncements and recently issued accounting pronouncements not yet adopted as of December 31, 2018. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2018, 2017 AND 2016 The discussion of results of operations at the consolidated level presented below is followed by a more detailed discussion of results of operations by segment. The discussion of our consolidated results of operations and segment operating results is presented on a historical basis for the years ended December 31, 2018, 2017, and 2016. The segment discussion also addresses certain product line information. Our operating units are consistent with our reportable segments. Consolidated results 2018 compared to 2017 Net Sales Net sales for the year ended December 31, 2018 were $4,145.9, an increase of $369.7, or 9.8% compared to 2017 net sales. The components of the net sales increase are as follows: (1) On March 8, 2018, we completed the Passport Acquisition. On January 17, 2017, we completed the Viviscal Acquisition. On May 1, 2017, we completed the Agro Acquisition. On August 7, 2017, we completed the Waterpik Acquisition. Net sales of these acquisitions are included in our results since the dates of acquisition. In March 2017, we sold our chemical business in Brazil. The volume change primarily reflects increased product sales in both the Consumer Domestic and Consumer International segments, with volume declines in Specialty Products. All three segments experienced favorable price/product mix. Our gross profit for 2018 was $1,840.8, a $111.2 increase compared to 2017. Gross margin was 44.4% in 2018 compared to 45.8% in 2017, a 140 basis points (“bps”) decrease. The decrease is due to the impact of higher commodity costs and transportation costs of 170 bps and higher manufacturing costs of 80 bps, partially offset by productivity programs of 80 bps, favorable volume price/product mix of 20 bps, and the impact of favorable foreign exchange rates of 10 bps. Operating Costs Marketing expenses for 2018 were $483.2, an increase of $29.0 compared to 2017. Acquired businesses contributed modestly to the increase. Marketing expenses as a percentage of net sales decreased 30 bps to 11.7% in 2018 as compared to 2017 due to 100 bps of leverage on higher net sales partially offset by 70 bps on higher expenses. Selling, general and administrative expenses (“SG&A”) expenses for 2018 were $565.9, an increase of $23.2 or 4.3% compared to 2017. The prior year includes the $39.2 international pension settlement charge. The increase is primarily due to transition and ongoing acquisition-related costs, higher compensation, information system (in part in support of new technologies and security CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) upgrades) and R&D costs. SG&A as a percentage of net sales decreased 80 bps to 13.6% in 2018 compared to 14.4% in 2017. The decrease is due to 130 bps of leverage associated with higher sales, partially offset by higher costs of 50 bps. The comparison is helped by approximately 100 bps associated with the 2017 pension settlement charge. Other Income and Expenses Equity in earnings of affiliates decreased by $1.6 in 2018 as compared to 2017. The decrease in earnings during 2018 was due primarily to lower DCAD sales. Other expense increased by $3.6 in 2018 as compared to 2017 primarily due to the effect of changes in foreign exchange rates. Interest expense in 2018 was $79.4, an increase of $26.8 compared to 2017 primarily due to a higher amount of average debt outstanding associated with the $1,425.0 aggregate principal amount of Senior Notes issued on July 25, 2017. Taxation The 2018 tax rate was 21.0% compared to -7.3% in 2017. The 2017 tax rate was positively impacted by 39.4% as a result of the Tax Act, which lowered the U.S. corporate income tax rate to 21% starting in 2018 and resulted in a negative tax rate for 2017. 2017 compared to 2016 Net Sales Net sales for the year ended December 31, 2017 were $3,776.2, an increase of $283.1, or 8.1% compared to 2016 net sales. The components of the net sales increase are as follows: (1) On January 17, 2017, we completed the Viviscal Acquisition, on May 1, 2017, we completed the Agro Acquisition and on August 7, 2017, we completed the Waterpik Acquisition. Net sales of these acquisitions are included in our results since the dates of acquisition. In March 2017, we sold our chemical business in Brazil. All three segments reported volume increases. Both Consumer Domestic and Consumer International experienced unfavorable price/product mix. Our gross profit for 2017 was $1,729.6, a $139.0 increase compared to 2016. Gross margin was 45.8% in 2017 compared to 45.5% in 2016, a 30 bps increase. The increase was due to the impact of higher margins on acquired businesses representing 80 bps, favorable volume of 70 bps, and lower manufacturing costs of 40 bps, partially offset by unfavorable price/product mix of 140 bps (primarily due to higher promotion and coupon costs), higher commodity costs of 30 bps, and the impact of unfavorable foreign exchange rates of 10 bps. Gross margin in 2016 included a plant impairment charge of 20 bps at an international subsidiary. Operating Costs Marketing expenses for 2017 were $454.2, an increase of $27.0 compared to 2016. Acquired businesses contributed modestly to the increase. Marketing expenses as a percentage of net sales decreased 20 bps to 12.0% in 2017 as compared to 2016 due to 90 bps of leverage on higher net sales partially offset by 70 bps on higher expenses. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) SG&A expenses for 2017 were $542.7, an increase of $103.5 or 23.6% compared to 2016. The increase was primarily due to the $39.2 international pension settlement charge, transition and ongoing acquisition-related costs, higher information system and legal costs and costs associated with selling the chemical business in Brazil. SG&A as a percentage of net sales increased 180 bps to 14.4% in 2017 compared to 12.6% in 2016. The increase was due to higher costs of 280 bps, partially offset by 100 bps of leverage associated with higher sales. The pension charge contributed 110 bps to the increase. Other Income and Expenses Equity in earnings of affiliates increased by $1.6 in 2017 as compared to 2016. The increase in earnings during 2017 was due primarily to profit improvement from Armand Products due to lower raw material costs. Interest expense in 2017 was $52.6, an increase of $24.9 compared to 2016 due to a higher amount of average debt outstanding associated with the $1,425.0 aggregate principal amount of Senior Notes issued on July 25, 2017. Taxation The 2017 tax rate was -7.3% compared to 35.0% in 2016. The 2017 tax rate was positively impacted by 39.4% as a result of the Tax Act and 2.2% related to the adoption of the new accounting standard which modifies how companies account for certain aspects of share-based payment awards to employees. Previously, this tax benefit related to the adoption of the new accounting standard was accounted for in our Stockholders’ Equity section of the Balance Sheet. Starting in 2017, the tax benefit has been accounted for as a reduction of income tax expense. Segment results for 2018, 2017 and 2016 We operate three reportable segments: Consumer Domestic, Consumer International and SPD. These segments are determined based on differences in the nature of products and organizational and ownership structures. We also have a Corporate segment. Segment Products Consumer Domestic Household and personal care products Consumer International Primarily personal care products SPD Specialty chemical products The Corporate segment income consists of equity in earnings of affiliates. As of December 31, 2018, we held 50% ownership interests in each of Armand and ArmaKleen, respectively. Our equity in earnings of Armand and ArmaKleen for the year ended December 31, 2018, 2017 and 2016 are included in the Corporate segment. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Some of the subsidiaries that are included in the Consumer International segment manufacture and sell personal care products to the Consumer Domestic segment. These sales are eliminated from the Consumer International segment results set forth below. Segment net sales and income before income taxes for each of the three years ended December 31, 2018, 2017 and 2016 were as follows: (1) Intersegment sales from Consumer International to Consumer Domestic, which are not reflected in the table, were $5.7, $4.5 and $3.4 for the years ended December 31, 2018, 2017 and 2016, respectively. (2) In determining Income before Income Taxes, interest expense, investment earnings and certain aspects of other income and expense were allocated among segments based upon each segment’s relative Income from Operations. (3) Corporate segment consists of equity in earnings of affiliates from Armand and ArmaKleen in 2018, 2017 and 2016. Product line revenues for external customers for the years ended December 31, 2018, 2017 and 2016 were as follows: Household Products include deodorizing, cleaning and laundry products. Personal Care Products include condoms, pregnancy kits, oral care products, skin care products, hair care products and gummy dietary supplements. Consumer Domestic 2018 compared to 2017 Consumer Domestic net sales in 2018 were $3,129.9, an increase of $275.0 or 9.6% compared to net sales of $2,854.9 in 2017. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Viviscal Acquisition and the Waterpik Acquisition since the date of acquisition. The increase in net sales for 2018 reflects the impact of acquisitions and higher sales of ARM & HAMMER liquid and unit dose detergents, ARM & HAMMER cat litter, BATISTE dry shampoo, OXICLEAN stain fighters and gummy vitamins, partially offset by lower sales of KABOOM cleaning products. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) There continues to be significant product competition in the gummy vitamin category. The category has grown from eight competitors to 30 in the last five years. We continue to evaluate and vigorously combat these pressures through, among other things, new product introductions and increased marketing and trade spending. However, there is no assurance this category will not decline in the future and that we will be able to offset any such decline. Consumer Domestic income before income taxes for 2018 was $577.2, a $29.2 decrease as compared to 2017. The decrease is due primarily to the impact of higher SG&A costs of $56.1, unfavorable commodity and manufacturing costs of $49.6, higher interest and other expenses of $22.5, higher marketing expenses of $19.3 and unfavorable price/product mix of $11.8, partially offset by higher sales volumes of $130.3. 2017 compared to 2016 Consumer Domestic net sales in 2017 were $2,854.9, an increase of $177.1 or 6.6% compared to net sales of $2,677.8 in 2016. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Viviscal Acquisition and the Waterpik Acquisition since the dates of acquisition. The increase in net sales for 2017, reflects the impact of acquisitions, higher sales of ARM & HAMMER liquid and unit dose detergents, BATISTE dry shampoo, OXICLEAN stain fighters and ARM & HAMMER cat litter, partially offset by lower sales of TROJAN condoms, XTRA laundry detergent and gummy vitamins. There was significant product and price competition in the premium and deep value laundry detergent categories and more recently, product competition in the gummy vitamin category. For example, in the laundry detergent category, P&G and Henkel, the two largest laundry detergent companies in the U.S., were engaged in aggressive pricing promotions, and retailers were de-emphasizing the deep value tier of laundry detergents, which is where XTRA competes. In addition, the gummy vitamin category has grown from eight competitors to 30 in the last five years. We continue to evaluate and vigorously combat these pressures through, among other things, new product introductions and increased marketing and trade spending. However, there is no assurance that the categories will not decline in the future and that we will be able to offset any such decline. Consumer Domestic income before income taxes for 2017 was $606.4, a $15.8 increase as compared to 2016. The increase was due primarily to the impact of higher sales volumes of $146.5 and favorable commodity and manufacturing costs of $15.1, partially offset by unfavorable price/product mix of $90.5, higher marketing expenses of $18.9, higher interest expense of $20.7, and higher SG&A costs of $15.8. Consumer International 2018 compared to 2017 Consumer International net sales in 2018 were $709.5, an increase of $88.4 or 14.2% as compared to 2017. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Viviscal Acquisition and the Waterpik Acquisition since the dates of acquisition. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Excluding the impact of foreign exchange rates, higher sales for the year occurred in exports, Europe, Canada, Mexico and Australia. The addition of the acquired businesses contributed significantly to the sales growth. Of the existing brands, the net sales increase is due primarily to OXICLEAN, BATISTE, L’IL CRITTERS & VITAFUSION and NAIR in the export business, ARM & HAMMER clumping cat litter and BATISTE in Canada, OXICLEAN, ARM & HAMMER liquid laundry detergent and ARM & HAMMER dental care in Mexico and Waterpik in several countries. Consumer International income before income taxes was $81.5 in 2018, an increase of $49.5 compared to 2017 due primarily to lower costs as a result of the 2017 pension settlement of $39.2, higher sales volumes of $42.2, favorable foreign exchange rates of $3.8, and favorable price/product mix of $0.7, partially offset by higher other SG&A costs of $12.2, higher marketing costs of $9.4, unfavorable manufacturing and commodity costs of $9.6, and higher interest and other expenses of $5.2. 2017 compared to 2016 Consumer International net sales in 2017 were $621.1, an increase of $95.9 or 18.3% as compared to 2016. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Anusol Acquisition, the Viviscal Acquisition and the Waterpik Acquisition since the date of acquisition. Excluding the impact of foreign exchange rates, higher sales for the year occurred in exports, Canada, Australia, Europe and Mexico. The addition of the acquired businesses contributed significantly to the sales growth. Of the existing brands, BATISTE, STERIMAR, FEMFRESH, OXICLEAN and ARM & HAMMER cat litter brands had strong sales growth. Consumer International income before income taxes was $32.0 in 2017, a decrease of $34.3 compared to 2016 due primarily to the pension settlement charge of $39.2, higher SG&A costs of $29.7, higher marketing costs of $7.4, unfavorable manufacturing and commodity costs of $6.9, unfavorable foreign exchange rates of $4.0, and unfavorable price/product mix of $2.3, partially offset by higher sales volumes of $57.9. Specialty Products 2018 compared to 2017 SPD net sales were $306.5 for 2018, an increase of $6.3, or 2.1% compared to 2017. The components of the net sales change are the following: (1) Includes net sales of Passport and Agro BioSciences, Inc. since the dates of acquisition, partially offset by the sale of our Brazilian chemical business. Excluding the impact of the acquisitions and divestiture, the net sales decrease in 2018 was driven primarily by lower volumes in the animal productivity business, partially offset by higher broad-based pricing. Although demand for our products continues to grow in the poultry industry, demand in the dairy industry continues to be significantly reduced due to low milk prices. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) SPD income before income taxes was $51.6 in 2018, an increase of $8.1 compared to 2017. The increase in income before income taxes for 2018 is due primarily to favorable price/product mix of $9.1, lower costs associated with selling the Brazilian chemical business of $3.5, higher sales volume of $3.3, and lower manufacturing costs of $2.6, partially offset by higher SG&A costs of $7.4 and higher interest and other expenses of $2.7. 2017 compared to 2016 SPD net sales were $300.2 for 2017, an increase of $10.1, or 3.5% compared to 2016. The components of the net sales change are the following: (1) Includes net sales of the Agro Acquisition since the date of acquisition and is negatively impacted by the sale of the Brazilian chemical business. Excluding the impact of the acquisitions and divestiture, the net sales increase in 2017 was driven primarily by improved price and volumes in the animal productivity business where U.S. dairy farm profitability throughout 2017 was higher than the prior year. SPD income before income taxes was $43.5 in 2017, an increase of $3.7 compared to 2016. The increase in income before income taxes for 2017 was due primarily to higher sales volume of $13.0, favorable price/product mix of $7.0, lower costs associated with selling the Brazilian chemical business of $4.9, and lower costs associated with the Natronx joint venture of $1.7, partially offset by higher SG&A costs of $14.0 and higher manufacturing costs of $7.4. Corporate The Corporate segment reflects the reclassification of administrative costs of the production, planning and logistics functions which are included in SG&A expenses in the operating segments but are elements of cost of sales in our Consolidated Statements of Income. Such amounts were $44.0, $32.8 and $36.6 for 2018, 2017 and 2016, respectively. Also included in corporate segment are the equity in earnings of affiliates from Armand and ArmaKleen. Liquidity and capital resources On March 29, 2018, we replaced our former $1,000.0 unsecured revolving credit facility that was scheduled to terminate on December 4, 2020 with a new $1,000.0 unsecured revolving credit facility (the “Credit Agreement”). Under the Credit Agreement, we have the ability to increase our borrowing up to an additional $600.0, subject to lender commitments and certain conditions as described in the Credit Agreement. Borrowings under the Credit Agreement are available for general corporate purposes and are used to support our $1,000.0 commercial paper program. Unless extended, the Credit Agreement will terminate and all amounts outstanding thereunder will be due and payable on March 29, 2023. As of December 31, 2018, we had $316.7 in cash and cash equivalents, and approximately $997.0 available through the revolving facility under our Credit Agreement and our commercial paper program. To preserve our liquidity, we invest cash primarily in government money market funds, prime money market funds, short-term commercial paper and short-term bank deposits. As a result of the Tax Act, we repatriated excess cash held at our foreign subsidiaries in 2018. We repatriated approximately $150.0 of the $194.0 that was held outside the U.S as of December 31, 2017. For 2019, we estimate that we will repatriate approximately $35.0 of the $68.0 held outside the U.S as of December 31, 2018. We financed the Waterpik Acquisition with a portion of the proceeds from an underwritten public offering of $1,425.0 aggregate principal amount of Senior Notes completed on July 25, 2017, consisting of $300.0 aggregate principal amount of Floating Rate Senior Notes due 2019, $300.0 aggregate principal amount of 2.45% Senior Notes due 2022, $425.0 aggregate principal amount of CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) 3.15% Senior Notes due 2027 and $400.0 aggregate principal amount of 3.95% Senior Notes due 2047 (collectively, the “Senior Notes”). The Floating Rate Senior Notes, which matured and were repaid in full with cash on hand and commercial paper on January 25, 2019, bore interest at a rate, reset quarterly, equal to three-month U.S. Dollar London Interbank Offered Rate (“LIBOR”) plus 0.15%. On December 9, 2014, we issued $300.0 aggregate principal amount of 2.45% Senior Notes due December 15, 2019 (the “2019 Notes”). The 2019 Notes were issued under the first supplemental indenture (the “First Supplemental Indenture”), dated December 9, 2014, to the indenture dated December 9, 2014 (the “Base Indenture”), between us and Wells Fargo Bank, N.A., as trustee. The 2019 Notes will mature on December 15, 2019, unless earlier retired or redeemed pursuant to the terms of the First Supplemental Indenture. On September 26, 2012, we issued $400.0 aggregate principal amount of 2.875% Senior Notes due 2022 (the “2022 Notes”). The 2022 Notes were issued under the second supplemental indenture, dated September 26, 2012 (the “BNY Mellon Second Supplemental Indenture”) to the indenture dated December 15, 2010 (the “BNY Mellon Base Indenture”) between us and The Bank of New York Mellon Trust Company, N.A., as trustee. The 2022 Notes will mature on October 1, 2022, unless earlier retired or redeemed pursuant to the terms of the BNY Mellon Second Supplemental Indenture. The current economic environment presents risks that could have adverse consequences for our liquidity. See “Unfavorable economic conditions could adversely affect demand for our products” under “Risk Factors” in Item 1A of this Annual Report. We do not anticipate that current economic conditions will adversely affect our ability to comply with the financial covenant in the Credit Agreement because we currently are, and anticipate that we will continue to be, in compliance with the maximum leverage ratio requirement under the Credit Agreement. On February 5, 2019, the Board declared a 5% increase in the regular quarterly dividend from $0.2175 to $0.2275 per share, equivalent to an annual dividend of $0.91 per share payable to stockholders of record as of February 15, 2019. The increase raises the annual dividend payout from $213.3 to approximately $222.0. On November 1, 2017, the Board authorized a new share repurchase program, under which we may repurchase up to $500.0 in shares of Common Stock (the “2017 Share Repurchase Program”). The 2017 Share Repurchase Program does not have an expiration and replaced the 2016 Share Repurchase Program. We also continued our evergreen share repurchase program, authorized by the Board on January 29, 2014, under which we may repurchase, from time to time, Common Stock to reduce or eliminate dilution associated with issuances of Common Stock under our incentive plans. In December of 2017, we entered into an accelerated share repurchase (“ASR”) contract with a commercial bank to purchase $200.0 of Common Stock. In the first quarter of 2018, we settled the ASR contract and purchased approximately 4.1 million shares of Common Stock for $200.0, of which approximately $110.0 was purchased under the evergreen share repurchase program and $90.0 was purchased under the 2017 Share Repurchase Program. As a result of our purchases, there remained $310.0 of share repurchase availability under the 2017 Share Repurchase Program as of December 31, 2018. In connection with the evergreen repurchase program, in January 2019, we executed open market purchases of $100.0 of our Common Stock. We anticipate that our cash from operations, together with our current borrowing capacity, will be sufficient to meet our capital expenditure program costs, which are expected to be approximately $85.0 in 2018, fund our share repurchase programs to the extent implemented by management, pay the upcoming maturing notes and pay dividends at the latest approved rate. Cash, together with our current borrowing capacity, may be used for acquisitions that would complement our existing product lines or geographic markets. We did not have any mandatory fixed rate debt principal payments in 2018. We paid the $300.0 Floating Rate Senior Notes that matured on January 25, 2019 with cash on hand and commercial paper. The $300.0 Senior Notes (2.45%) will mature on December 15, 2019 and will be repaid with cash on hand plus if necessary, available borrowings. Cash Flow Analysis CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) 2018 compared to 2017 Net Cash Provided by Operating Activities - Our primary source of liquidity is our cash flow provided by operating activities, which is dependent on the level of net income and changes in working capital. Our net cash provided by operating activities in 2018 increased by $82.1 to $763.6 as compared to $681.5 in 2017 due to higher cash earnings (net income plus non-cash expenses such as depreciation, amortization, non-cash compensation and asset impairment charges) and lower working capital. The change in working capital is primarily due to an increase in accounts payable and accrued expenses and lower other current assets partially offset by higher inventories. We measure working capital effectiveness based on our cash conversion cycle. The following table presents our cash conversion cycle information for the quarters ended December 31, 2018 and 2017: Our cash conversion cycle (defined as the sum of DSO and DIO less DPO) at December 31, 2018, which is calculated using a two period average method, increased 4 days from the prior year amount of 18 days to 22 days at December 31, 2018 due primarily to an increase in DIO of six days. DPO increased one day from 65 to 66 days, and DSO decreased one day from 31 to 30 days. The increase in the cash conversion cycle is primarily due a certain recent acquisition, which currently requires a higher level of working capital. We continue to focus on reducing our working capital requirements. Net Cash Used in Investing Activities - Net cash used in investing activities during 2018 was $112.1, principally reflecting $60.4 for property, plant and equipment expenditures and $49.8 for the Passport Acquisition. Net Cash (Used in) Provided by Financing Activities - Net cash used in financing activities during 2018 was $609.0, primarily reflecting $200.0 of repurchases of our Common Stock, $213.3 of cash dividend payments, and $268.8 of debt payments, partially offset by $76.6 of proceeds from stock option exercises. 2017 compared to 2016 Net Cash Provided by Operating Activities - Our primary source of liquidity is our cash flow provided by operating activities, which is dependent on the level of net income and changes in working capital. Our net cash provided by operating activities in 2017 increased by $26.2 to $681.5 as compared to $655.3 in 2016 due to higher cash earnings (net income plus non-cash expenses such as depreciation, amortization, non-cash compensation and asset impairment charges) partially offset by slightly higher working capital. The change in working capital is primarily due to an increase in inventories and a smaller increase in accounts payable and accrued expenses. Net Cash Used in Investing Activities - Net cash used in investing activities during 2017 was $1,303.4, principally reflecting $1,260.0 for acquisitions and $45.0 for property, plant and equipment expenditures. Net Cash Provided by (Used in) Financing Activities - Net cash provided by financing activities during 2017 was $698.9, primarily reflecting $1,621.3 of long-term debt borrowings and $42.1 of proceeds from stock option exercises, partially offset by $400.0 of repurchases of our Common Stock, $200.0 of long-term debt repayments, $190.4 of cash dividend payments, $151.3 of net commercial paper repayments, $17.8 of financing costs and $4.5 of short-term debt repayments at an international subsidiary. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Commitments as of December 31, 2018 The table below summarizes our material contractual obligations and commitments as of December 31, 2018. (1) The Floating Rate Senior Notes matured and were repaid in full with cash on hand and commercial paper on January 25, 2019. (2) Represents interest on our 2.45% Senior Notes due in 2019 and 2022, 2.875% Senior Notes due in 2022, 3.15% Senior Notes due 2027 and 3.95% Senior Notes due 2047. (3) Letters of credit with several banks guarantee payment for items such as insurance claims in the event of our insolvency. (4) We have outstanding purchase obligations with suppliers at the end of 2018 for raw, packaging and other materials and services in the normal course of business. These purchase obligation amounts represent only those items which are based on agreements that are enforceable and legally binding, and do not represent total anticipated purchases. (5) Other includes payments for stadium naming rights for a period of 20 years until December 2032. Off-Balance Sheet Arrangements We do not have off-balance sheet financing or unconsolidated special purpose entities. OTHER ITEMS Market risk Concentration of Risk A group of three customers accounted for approximately 36%, 36% and 35% of consolidated net sales in 2018, 2017 and 2016, respectively, of which a single customer, Walmart, accounted for approximately 23%, 24% and 24% in 2018, 2017 and 2016, respectively. Interest Rate Risk We had outstanding total debt at December 31, 2018, of $2,107.1, net of debt issuance costs, of which 86% has a fixed weighted average interest rate of 3.0% and the remaining 14% was constituted primarily of the Floating Rate Senior Notes that matured and were repaid in full on January 25, 2019 with a current rate of approximately 2.64%. In December 2014, we entered into interest rate swap agreements on an aggregate notional amount of $300.0 to convert the fixed interest rate on the Notes due December 15, 2019 to a floating rate of three-month LIBOR plus a fixed spread of 0.756%. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Other Market Risks We are also subject to market risks relating to our diesel and other commodity costs, fluctuations in foreign currency exchange rates, and changes in the market price of the Common Stock. Refer to Note 3 to the Consolidated Financial Statements for a discussion of these market risks and the derivatives used to manage the risks associated with changing diesel fuel and other commodity prices, foreign exchange rates and the price of our Common Stock.

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW Our Business We develop, manufacture and market a broad range of consumer household and personal care and specialty products focused on animal productivity, chemicals and cleaners. We focus our consumer products marketing efforts principally on our 11 “power brands.” These wellrecognized brand names include ARM & HAMMER, used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent; TROJAN condoms, lubricants and vibrators; OXICLEAN stain removers, cleaning solutions, laundry detergent and bleach alternatives; SPINBRUSH batteryoperated and manual toothbrushes; FIRST RESPONSE home pregnancy and ovulation test kits; NAIR depilatories; ORAJEL oral analgesic; XTRA laundry detergent; L’IL CRITTERS and VITAFUSION gummy dietary supplements, BATISTE dry shampoos and WATERPIK water flossers and replacement showerheads. We sell our consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores and websites and other ecommerce channels, all of which sell the products to consumers. We sell our specialty products to industrial customers, livestock producers and through distributors. We operate our business in three segments: Consumer Domestic, Consumer International and SPD. The segments are based on differences in the nature of products and organizational and ownership structures. In 2018, the Consumer Domestic, Consumer International and SPD segments represented approximately 76%, 17% and 7%, respectively, of our consolidated net sales. 2018 Financial Highlights Key fiscal year 2018 financial results include: 2018 net sales grew 9.8% over fiscal year 2017, with gains in all three segments, primarily due to volume growth in Consumer Domestic and Consumer International, helped in part by the August 2017 acquisition of Waterpik and partially offset by volume declines in Specialty Products. Gross margin decreased 140 basis points to 44.4% in fiscal year 2018 from 45.8% in fiscal year 2017, primarily due to higher commodity, transportation and manufacturing costs. Operating margin decreased 30 basis points to 19.1% in fiscal year 2018 from 19.4% in fiscal year 2017, reflecting lower gross margin, partially offset by lower selling, general and administrative expenses and lower marketing costs. We reported diluted net earnings per share in fiscal year 2018 of $2.27, a decrease of approximately 21.7% from fiscal year 2017 diluted net earnings per share of $2.90. The prior year includes a onetime favorable adjustment of $1.06 associated with the Tax Cuts and Jobs Act. Cash provided by operations was $763.6, an $82.1 increase from the prior year, due to higher cash earnings and lower working capital. We returned $413.3 to our stockholders through dividends and share repurchases. Strategic Goals, Challenges and Initiatives Our ability to generate sales depends on consumer demand for our products and retail customers’ decisions to carry our products, which are, in part, affected by general economic conditions in our markets. Although our consumer products generally are consumer staples and less vulnerable to decreases in discretionary spending than other products, in 2018, many of the product categories in which we operate continued to experience pricing pressures, and weak or inconsistent consumer demand. Some customers have responded to economic conditions by increasing their private label offerings (primarily in the dietary supplements, diagnostic kits and oral analgesics categories), and consolidating the product selections [/INST] Positive. </s>

CHURCH & DWIGHT CO INC /DE/

2020-02-18

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW Our Business We develop, manufacture and market a broad range of consumer household and personal care and specialty products focused on animal and food production, chemicals and cleaners. We focus our consumer products marketing efforts principally on our 12 “power brands.” These well-recognized brand names include ARM & HAMMER, used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent; TROJAN condoms, lubricants and vibrators; OXICLEAN stain removers, cleaning solutions, laundry detergent and bleach alternatives; SPINBRUSH battery-operated and manual toothbrushes; FIRST RESPONSE home pregnancy and ovulation test kits; NAIR depilatories; ORAJEL oral analgesic; XTRA laundry detergent; L’IL CRITTERS and VITAFUSION gummy dietary supplements, BATISTE dry shampoos, WATERPIK water flossers and replacement showerheads and FLAWLESS hair removal products. We sell our consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores and websites and other e-commerce channels, all of which sell the products to consumers. We sell our specialty products to industrial customers, livestock producers and through distributors. We operate our business in three segments: Consumer Domestic, Consumer International and the Specialty Products Division (“SPD”). The segments are based on differences in the nature of products and organizational and ownership structures. In 2019, the Consumer Domestic, Consumer International and SPD segments represented approximately 76%, 17% and 7%, respectively, of our consolidated net sales. 2019 Financial Highlights Key 2019 financial results include: • 2019 net sales grew 5.1% over 2018, with gains in the Consumer Domestic and Consumer International segments, partially offset by net sales declines in SPD. The gains in Consumer Domestic and Consumer International are primarily due to favorable pricing pricing/product mix in Consumer Domestic and favorable volumes in Consumer International, partially offset by lower volumes in SPD. Consumer Domestic and Consumer International 2019 net sales were favorably impacted by the Flawless Acquisition, which occurred on May 1, 2019. • Gross margin increased 110 basis points to 45.5% in 2019 from 44.4% in 2018, primarily due to the impact of productivity programs, favorable volume price/product mix, and the Flawless Acquisition, partially offset by higher commodity and manufacturing costs. • Operating margin increased 20 basis points to 19.3% in 2019 from 19.1% in 2018, reflecting higher gross margin, partially offset by higher selling, general and administrative expenses and slightly higher marketing costs. • We reported diluted net earnings per share in 2019 of $2.44, an increase of approximately 7.5% from 2018 diluted net earnings per share of $2.27. • Cash provided by operations was $864.5, an $100.9 increase from the prior year, due to higher cash earnings and a larger reduction in working capital. • We returned $474.1 to our stockholders through dividends and share repurchases. Strategic Goals, Challenges and Initiatives Our ability to generate sales depends on consumer demand for our products and retail customers’ decisions to carry our products, which are, in part, affected by general economic conditions in our markets. While a vast majority of our products are consumer staples and less vulnerable to decreases in discretionary spending than other products, an increasing number of our products, particularly those from our recent acquisitions, are more durable in nature and are more likely to be affected by consumer decisions to control spending. Some customers have responded to economic conditions by increasing their private label offerings (primarily in the dietary supplements, diagnostic kits and oral analgesics categories), launching their own brands, and consolidating the product selections they offer to the top few leading CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) brands in each category. In addition, an increasing portion of our product categories is being sold by club stores, dollar stores, mass merchandisers and internet-based retailers. These factors have placed downward pressure on our sales and gross margins. We expect a competitive marketplace in 2020 due to new product introductions by competitors. In this environment, we intend to continue to aggressively pursue several key strategic initiatives: maintain competitive marketing and trade spending, tightly control our cost structure, continue to develop and launch new and differentiated products, and pursue strategic acquisitions. We also intend to continue to grow our product sales globally and maintain an offering of premium and value brand products to appeal to a wide range of consumers. We derive a substantial percentage of our revenues from sales of laundry detergent. The continued customer demand for these products are critical to our future success. As a result, any commercialization, delays or reduction of sales of these products, in the event that our diversification efforts discussed below are not successful, could have a material adverse effect on our business, financial condition and operating results. In addition, there continues to be significant product competition in the gummy vitamin category. The category has grown from six brands to over 50 in the last eight years. Moreover, condom usage has declined, as a result of a lower 18 to 24-year old population, alternate birth control options, less fear of HIV, less sex acts and, increased competition, all of which have contributed to lower demand for our product. We continue to evaluate and vigorously address these pressures through, among other things, new product introductions and increased marketing and trade spending. However, there is no assurance that the category will not decline in the future and that we will be able to offset any such decline. We are continuously focused on strengthening our key brands, such as ARM & HAMMER, OXICLEAN, TROJAN, L’IL CRITTERS and VITAFUSION, BATISTE, WATERPIK, and FLAWLESS, through the launch of innovative new products, which span various product categories, including premium and value household products supported by increased marketing and trade spending. There can be no assurance that these measures will be successful. In the domestic business, ten out of 12 “power brands” met or exceeded category growth for the full year 2019. Our global product portfolio consists of both premium (63% of total worldwide consumer revenue in 2019) and value (37% of total worldwide consumer revenue in 2019) brands, which we believe enables us to succeed in a range of economic environments. We intend to continue to develop a portfolio of appealing new products to build loyalty among cost-conscious consumers. Over the past two decades, we have diversified from an almost exclusively U.S. business to a global company with approximately 18% of sales derived from international countries in 2019. We have subsidiary operations in six countries (Canada, Mexico, U.K., France, Germany, and Australia) and sell to over 130 other countries. In 2019, we benefited from our expanded global footprint and expect to continue to focus on selectively expanding our global business. If we are unable to expand our business internationally at the rate that we expect, we may not realize the operational benefits that we anticipate. Although we believe ongoing international expansion represents a significant opportunity to grow our business, our increasing activity in global markets exposes us to additional complexity and uncertainty. Net sales generated outside of the U.S. are exposed to foreign currency exchange rate fluctuations as well as political uncertainty which could impact future operating results. Moreover, the current domestic and international political environment, including existing and potential changes to U.S. policies related to global trade and tariffs, have resulted in uncertainty regarding the global economy. The impact of U.S. tariffs on certain products was a component of increased cost of sale during the year ended December 31, 2019. The implementation of more restrictive trade policies, such as higher tariffs or new barriers to entry, in countries in which we manufacture or sell large quantities of products and services could negatively impact our business, results of operations and financial condition. We also continue to focus on controlling our costs. Historically, we have been able to mitigate the effects of cost increases primarily by implementing cost reduction programs and, to a lesser extent, by passing along some of these cost increases to customers. We have also entered into set pricing and pre-buying arrangements with certain suppliers and hedge agreements for diesel fuel and other commodities. Should we be required to address cost increases by increasing the prices that our customers pay for our products, we cannot be certain they will be accepted. Additionally, maintaining tight controls on overhead costs has been a hallmark of ours and has enabled us to effectively navigate recent challenging economic conditions. The identification and integration of strategic acquisitions are an important component of our overall strategy and product category diversification. Acquisitions have added significantly to our sales and profits and product category diversification over the last decade. This is evidenced by our 2015 acquisition of certain assets of Varied Industries Corporation (the “Vi-cor Acquisition”), 2016 acquisitions of Spencer Forrest, Inc., the maker of TOPPIK (the “Toppik Acquisition”), and the ANUSOL and RECTINOL businesses from Johnson & Johnson (the “Anusol Acquisition”), 2017 acquisitions of VIVISCAL from Lifes2Good Holdings Limited (the “Viviscal Acquisition”), Agro BioSciences, Inc. (the “Agro Acquisition”), and WATERPIK from Pik Holdings, Inc. (the “Waterpik Acquisition”), 2018 acquisition of Passport Food Safety Solutions, Inc. (the “Passport Acquisition”) and the Flawless Acquisition in 2019. However, the failure to effectively identify or integrate any acquisition or achieve expected synergies may cause us to incur material asset write-downs. We actively seek acquisitions that fit our guidelines, and our strong financial position provides us with flexibility to take advantage of acquisition opportunities. In addition, our ability to quickly integrate acquisitions and leverage existing infrastructure has enabled us to establish a strong track record in making accretive acquisitions. Since 2001, we have acquired 11 of our 12 “power brands”. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) We believe we are positioned to meet the ongoing challenges described above due to our strong financial condition, experience operating in challenging environments and continued focus on key strategic initiatives: maintaining competitive marketing and trade spending, managing our cost structure, continuing to develop and launch new and differentiated products, and pursuing strategic acquisitions. This focus, together with the strength of our portfolio of premium and value brands, has enabled us to succeed in a range of economic environments, and is expected to position us to continue to increase stockholder value over the long-term. Moreover, the generation of a significant amount of cash from operations, as a result of net income and effective working capital management, combined with an investment grade credit rating provides us with the financial flexibility to pursue acquisitions, drive new product development, make capital expenditures to support organic growth and gross margin improvements, return cash to stockholders through dividends and share buy backs, and reduce outstanding debt, positioning us to continue to create stockholder value. For information regarding risks and uncertainties that could materially adversely affect our business, results of operations and financial condition, see “Risk Factors” in Item 1A of this Annual Report. Recent Developments Flawless Acquisition On May 1, 2019, we closed on our previously announced Flawless Acquisition from Ideavillage. We paid $475.0 at closing and may make an additional contingent consideration payment up to a maximum of $425.0 in cash, based on a trailing twelve-month net sales target ending no later than December 31, 2021. The transaction was funded with proceeds from a three-year term loan and commercial paper borrowings. The Flawless hair removal business is managed in the Consumer Domestic and Consumer International segments and represents an addition to our specialty haircare portfolio which includes BATISTE dry shampoo, VIVISCAL hair thinning supplements, and TOPPIK hair fibers. Dividend Increase On January 31, 2020, the Board declared a 5.5% increase in the regular quarterly dividend from $0.2275 to $0.24 per share, equivalent to an annual dividend of $0.96 per share payable to stockholders of record as of February 14, 2020. The increase raises the annual dividend payout from $224.0 to approximately $237.0. On February 5, 2019, the Board declared a 5% increase in the regular quarterly dividend from $0.2175 to $0.2275 per share, equivalent to an annual dividend of $0.91 per share payable to stockholders of record as of February 15, 2019. The increase raised the annual dividend payout from $213.0 to $224.0. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the U.S. (GAAP). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. By their nature, these judgments are subject to uncertainty. They are based on our historical experience, our observation of trends in industry, information provided by our customers and information available from other outside sources, as appropriate. Our significant accounting policies and estimates are described below. Revenue Recognition and Promotional and Sales Return Reserves Virtually all of our revenue represents sales of finished goods inventory and is recognized when received or picked up by our customers. The reserves for consumer and trade promotion liabilities and sales returns are established based on our best estimate of the amounts necessary to settle future and existing claims on products sold as of the balance sheet date. Promotional reserves are provided for sales incentives, such as coupons to consumers, and sales incentives provided to customers (such as slotting, cooperative advertising, incentive discounts based on volume of sales and other arrangements made directly with customers). All such costs are netted against sales. Slotting costs are recorded when the product is delivered to the customer. Cooperative advertising costs are recorded when the customer places the advertisement for our products. Discounts relating to price reduction arrangements and coupons are recorded when the related sale takes place. Costs associated with end-aisle or other in-store displays are recorded when product that is subject to the promotion is sold. We rely on historical experience and forecasted data to determine the required reserves. For example, we use historical experience to project coupon redemption rates to determine reserve requirements. Based on the total face value of Consumer Domestic coupons redeemed over the past several years, if the actual rate of redemptions were to deviate by 0.1% from the rate for which reserves are accrued in the financial statements, a difference of approximately $1.2 in the reserve required for coupons would result. With regard to other promotional reserves and sales returns, we use experience-based estimates, customer and sales organization inputs and historical trend analysis in arriving at the reserves required. If our estimates for promotional activities and sales returns reserves were to change by 10% the impact to promotional spending and sales return accruals would be approximately $6.6. While management believes that its promotional and sales returns reserves are reasonable and that appropriate judgments have been made, estimated amounts could differ materially from actual future obligations. Impairment of goodwill, trade names and other intangible assets Carrying values of goodwill and indefinite-lived trade names are reviewed periodically for possible impairment. Finite intangible assets are assessed when there are business triggering events. Our impairment analysis is based on a discounted cash flow approach that requires significant judgment with respect to unit volume, revenue and expense growth rates, and the selection of an appropriate discount rate. Management uses estimates based on expected trends in making these assumptions. With respect to goodwill, impairment occurs when the carrying value of the reporting unit exceeds the discounted present value of cash flows for that reporting unit. For trade names and other intangible assets, an impairment charge is recorded for the difference between the carrying value and the net present value of estimated future cash flows, which represents the estimated fair value of the asset. Judgment is required in assessing whether assets may have become impaired between annual valuations. Indicators such as unexpected adverse economic factors, unanticipated technological change, distribution losses, or competitive activities and acts by governments and courts may indicate that an asset has become impaired. The result of our annual goodwill impairment test determined that the estimated fair value substantially exceeded the carrying values of all reporting units. In addition, there were no goodwill impairment charges for each of the years in the three-year period ended December 31, 2019. Fair value for indefinite lived intangible assets was estimated based on a “relief from royalty” or “excess earnings” discounted cash flow method, which contains numerous variables that are subject to change as business conditions change, and therefore could impact fair values in the future. We determined that the fair value of all other intangible assets for each of the years in the three-year period ended December 31, 2019 exceeded their respective carrying values based upon the forecasted cash flows and profitability. There are personal care trade names that, based on recent performance, had experienced sales and profit declines that had eroded a significant portion of the excess between fair and carrying value, which could potentially result in an impairment of the assets. These excesses had been reduced due in large part to an increased competitive market environment therefore resulting in reduced cash flow projections. These indefinite-lived intangible assets could still be susceptible to impairment risk. While management can and has implemented strategies to address the risk, significant changes in operating plans or adverse changes in the future could reduce the underlying cash flows used to estimate fair values and could result in a decline in fair value that could trigger future impairment charges of these assets. It is possible that our conclusions regarding impairment or recoverability of goodwill or other intangible assets could change in future periods if, for example, (i) the businesses or brands do not perform as projected, (ii) overall economic conditions in future years vary from current assumptions (including changes in discount rates), (iii) business conditions or strategies change from current assumptions, (iv) investors require higher rates of return on equity investments in the marketplace or (v) enterprise values of comparable publicly traded companies, or actual sales transactions of comparable companies, were to decline, resulting in lower multiples of revenues and EBITDA. A future impairment charge for goodwill or intangible assets could have a material effect on our consolidated financial position or results of operations. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized to reflect the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which the differences are expected to be recovered or settled. Management provides a valuation allowance against deferred tax assets for amounts which are not considered “more likely than not” to be realized. We record liabilities for potential assessments in various tax jurisdictions under U.S. GAAP guidelines. The liabilities relate to tax return positions that, although supportable by us, may be challenged by the tax authorities and do not meet the minimum recognition threshold required under applicable accounting guidance for the related tax benefit to be recognized in the income statement. We adjust this liability as a result of changes in tax legislation, interpretations of laws by courts, rulings by tax authorities, changes in estimates and the expiration of the statute of limitations. Many of the judgments involved in adjusting the liability involve assumptions and estimates that are highly uncertain and subject to change. In this regard, settlement of any issue, or an adverse determination in litigation, with a taxing authority could require the use of cash and result in an increase in our annual tax rate. Conversely, favorable resolution of an issue with a taxing authority would be recognized as a reduction to our annual tax rate. New Accounting Pronouncements Refer to Note 1 to the Consolidated Financial Statements for recently adopted accounting pronouncements and recently issued accounting pronouncements not yet adopted as of December 31, 2019. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2019, 2018 AND 2017 The discussion of results of operations at the consolidated level presented below is followed by a more detailed discussion of results of operations by segment. The discussion of our consolidated results of operations and segment operating results is presented on a historical basis for the years ended December 31, 2019, 2018, and 2017. The segment discussion also addresses certain product line information. Our operating segments are consistent with our reportable segments. Consolidated results 2019 compared to 2018 Net Sales Net sales for the year ended December 31, 2019 were $4,357.7, an increase of $211.8, or 5.1% compared to 2018 net sales. The components of the net sales increase are as follows: (1) On March 8, 2018, we completed the Passport Acquisition. On May 1, 2019, we completed the Flawless Acquisition. The results of these acquisitions are included in our results since the date of acquisition. During the second quarter of 2019, we sold our consumer business in Brazil. The volume change primarily reflects increased product sales in the Consumer International segment, with a volume decline in SPD and a slight decline in the Consumer Domestic segment. Price/mix was favorable in the Consumer Domestic and Consumer International segments, but was partially offset by slightly unfavorable price/mix in the SPD segment. Our gross profit for 2019 was $1,984.0, a $143.2 increase compared to 2018. Gross margin was 45.5% in 2019 compared to 44.4% in 2018, a 110 basis points (“bps”) increase. The increase is due to the impact of productivity programs of 120 bps, favorable volume price/product mix of 120 bps, and the impact of higher margins on acquired businesses of 50 bps, partially offset by higher manufacturing costs of 100 bps and commodity costs and transportation costs of 80 bps. Operating Costs Marketing expenses for 2019 were $515.0, an increase of $31.8 compared to 2018. The acquired businesses contributed modestly to the increase. Marketing expenses as a percentage of net sales increased 10 bps to 11.8% in 2019 as compared to 2018 due to 70 bps on higher expenses partially offset by 60 bps of leverage on higher net sales. Selling, general and administrative (“SG&A”) expenses for 2019 were $628.8, an increase of $62.9 or 11.1% compared to 2018. The increase is primarily due to transition and ongoing acquisition-related costs (including amortization expense and Flawless earnout adjustment), higher spending in information technology, research and development (“R&D”), and incentive compensation costs, and the charge associated with selling our consumer business in Brazil of $7.6, partially offset by the reduction in fair value of a $7.3 contingent consideration liability associated with the Passport Acquisition. SG&A as a percentage of net sales increased 80 bps to 14.4% in 2019 CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) compared to 13.6% in 2018. The increase is due to 150 bps on higher costs, partially offset by 70 bps of leverage associated with higher sales. Other Income and Expenses Equity in earnings of affiliates decreased by $2.6 in 2019 as compared to 2018. The decrease in earnings during 2019 was due primarily to lower profits from Armand Products. Other expense decreased by $2.8 in 2019 as compared to 2018 primarily due to the effect of changes in foreign exchange rates. Interest expense in 2019 was $73.6, a decrease of $5.8. The decrease is primarily due to the reclassification of a financing lease to an operating lease in connection with the adoption of the new lease accounting standard in 2019. Taxation The 2019 tax rate was 20.4% compared to 21.0% in 2018. 2018 compared to 2017 Net Sales Net sales for the year ended December 31, 2018 were $4,145.9, an increase of $369.7, or 9.8% compared to 2017 net sales. The components of the net sales increase are as follows: CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) On March 8, 2018, we completed the Passport Acquisition. On January 17, 2017, we completed the Viviscal Acquisition. On May 1, 2017, we completed the Agro Acquisition. On August 7, 2017, we completed the Waterpik Acquisition. Net sales of these acquisitions are included in our results since the dates of acquisition. In March 2017, we sold our chemical business in Brazil. The volume change primarily reflects increased product sales in both the Consumer Domestic and Consumer International segments, with volume declines in Specialty Products. All three segments experienced favorable price/product mix. Our gross profit for 2018 was $1,840.8, a $111.2 increase compared to 2017. Gross margin was 44.4% in 2018 compared to 45.8% in 2017, a 140 bps decrease. The decrease is due to the impact of higher commodity costs and transportation costs of 170 bps and higher manufacturing costs of 80 bps, partially offset by productivity programs of 80 bps, favorable volume price/product mix of 20 bps, and the impact of favorable foreign exchange rates of 10 bps. Operating Costs Marketing expenses for 2018 were $483.2, an increase of $29.0 compared to 2017. Acquired businesses contributed modestly to the increase. Marketing expenses as a percentage of net sales decreased 30 bps to 11.7% in 2018 as compared to 2017 due to 100 bps of leverage on higher net sales partially offset by 70 bps on higher expenses. SG&A expenses for 2018 were $565.9, an increase of $23.2 or 4.3% compared to 2017. The prior year includes the $39.2 international pension settlement charge. The increase is primarily due to transition and ongoing acquisition-related costs, higher compensation, information system (in part in support of new technologies and security upgrades) and R&D costs. SG&A as a percentage of net sales decreased 80 bps to 13.6% in 2018 compared to 14.4% in 2017. The decrease is due to 130 bps of leverage associated with higher sales, partially offset by higher costs of 50 bps. The comparison is helped by approximately 100 bps associated with the 2017 pension settlement charge. Other Income and Expenses Equity in earnings of affiliates decreased by $1.6 in 2018 as compared to 2017. The decrease in earnings during 2018 was due primarily to lower DCAD sales. Other expense increased by $3.6 in 2018 as compared to 2017 primarily due to the effect of changes in foreign exchange rates. Interest expense in 2018 was $79.4, an increase of $26.8 compared to 2017 primarily due to a higher amount of average debt outstanding associated with the $1,425.0 aggregate principal amount of Senior Notes issued on July 25, 2017. Taxation The 2018 tax rate was 21.0% compared to -7.3% in 2017. The 2017 tax rate was positively impacted by 39.4% as a result of the Tax Cuts and Jobs Act (the “Tax Act”), which lowered the U.S. corporate income tax rate to 21% starting in 2018 and resulted in a negative tax rate for 2017. Segment results for 2019, 2018 and 2017 We operate three reportable segments: Consumer Domestic, Consumer International and SPD. These segments are determined based on differences in the nature of products and organizational and ownership structures. We also have a Corporate segment. Segment Products Consumer Domestic Household and personal care products Consumer International Primarily personal care products SPD Specialty chemical products The Corporate segment income consists of equity in earnings of affiliates. As of December 31, 2019, we held 50% ownership interests in each of Armand and ArmaKleen, respectively. Our equity in earnings of Armand and ArmaKleen, totaling $6.6, $9.2 and $10.8 for the three years ending December 31, 2019, 2018 and 2017, respectively, are included in the Corporate segment. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Some of the subsidiaries that are included in the Consumer International segment manufacture and sell personal care products to the Consumer Domestic segment. These sales are eliminated from the Consumer International segment results set forth below. Segment net sales and income before income taxes for each of the three years ended December 31, 2019, 2018 and 2017 were as follows: (1) Intersegment sales from Consumer International to Consumer Domestic, which are not reflected in the table, were $10.5, $5.7 and $4.5 for the years ended December 31, 2019, 2018 and 2017, respectively. (2) In determining income before income taxes, interest expense, investment earnings and certain aspects of other income and expense were allocated among segments based upon each segment’s relative income from operations. (3) Corporate segment consists of equity in earnings of affiliates from Armand and ArmaKleen in 2019, 2018 and 2017. Product line revenues for external customers for the years ended December 31, 2019, 2018 and 2017 were as follows: Household Products include deodorizing, cleaning and laundry products. Personal Care Products include condoms, pregnancy kits, oral care products, skin care products, hair care products and gummy dietary supplements. Consumer Domestic 2019 compared to 2018 Consumer Domestic net sales in 2019 were $3,302.6, an increase of $172.1 or 5.5% compared to net sales of $3,129.9 in 2018. The components of the net sales change are the following: (1) Includes the Flawless Acquisition since the date of acquisition. The increase in net sales for 2019 reflects the impact of the Flawless Acquisition, higher sales of ARM & HAMMER liquid detergent, WATERPIK oral care products, ARM & HAMMER clumping cat litter, ARM & HAMMER scent booster, XTRA liquid laundry detergent, BATISTE dry shampoo, OXICLEAN® stain fighters, and VITAFUSION gummy vitamins partially offset by lower sales of TROJAN condoms and OXICLEAN® liquid laundry detergent. There continues to be significant product competition in the gummy vitamin category. The category has grown from six brands to over 50 in the last eight years. Moreover, condom usage has declined, as a result of a lower 18 to 24-year old population, alternate birth control CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) options, less fear of HIV, less sex acts and, increased competition, all of which have contributed to lower demand for our product. We continue to evaluate and vigorously address these pressures through, among other things, new product introductions and increased marketing and trade spending. However, there is no assurance this category will not decline in the future and that we will be able to offset any such decline. Consumer Domestic income before income taxes for 2019 was $645.8, a $68.6 increase as compared to 2018. The increase is due primarily to favorable price/mix of $137.0, and lower interest and other expenses of $4.7, partially offset by higher SG&A expenses of $47.7 (in large part due to the Flawless Acquisition contingent consideration charge and other costs associated with the Flawless Acquisition, higher spending in information technology, R&D, and incentive compensation costs), higher marketing expenses of $14.7, unfavorable manufacturing and distribution expenses of $8.2, and lower volumes of $2.5. 2018 compared to 2017 Consumer Domestic net sales in 2018 were $3,129.9, an increase of $275.0 or 9.6% compared to net sales of $2,854.9 in 2017. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Viviscal Acquisition and the Waterpik Acquisition since the date of acquisition. The increase in net sales for 2018 reflects the impact of acquisitions and higher sales of ARM & HAMMER liquid and unit dose detergents, ARM & HAMMER cat litter, BATISTE dry shampoo, OXICLEAN stain fighters and gummy vitamins, partially offset by lower sales of KABOOM cleaning products. There continues to be significant product competition in the gummy vitamin category. The category has grown from eight competitors to 30 in the last five years. We continue to evaluate and vigorously combat these pressures through, among other things, new product introductions and increased marketing and trade spending. However, there is no assurance this category will not decline in the future and that we will be able to offset any such decline. Consumer Domestic income before income taxes for 2018 was $577.2, a $29.2 decrease as compared to 2017. The decrease is due primarily to the impact of higher SG&A costs of $56.1, unfavorable commodity and manufacturing costs of $49.6, higher interest and other expenses of $22.5, higher marketing expenses of $19.3 and unfavorable price/product mix of $11.8, partially offset by higher sales volumes of $130.3. Consumer International 2019 compared to 2018 Consumer International net sales in 2019 were $756.3, an increase of $46.8 or 6.6% as compared to 2018. The components of the net sales change are the following: (1) Includes the Flawless Acquisition since the date of acquisition. During the second quarter of 2019, we sold our consumer business in Brazil. Excluding the impact of foreign exchange rates and the Flawless Acquisition, higher sales were driven primarily by VITAFUSION & L’IL CRITTERS gummy vitamins, BATISTE dry shampoo, FEMFRESH feminine hygiene portfolio, and STERIMAR nasal spray in the Global Markets Group business, ARM & HAMMER cat litter and liquid laundry detergent, BATISTE dry shampoo, GRAVOL anti-nauseant, OXICLEAN stain fighters, and TROJAN condoms in Canada, ARM & HAMMER liquid laundry detergent and STERIMAR nasal CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) spray in Mexico, and BATISTE dry shampoo in Germany. WATERPIK water flossers sales grew across the Global Markets Group business (formerly exports), U.K., Canada, Australia, and France. Consumer International income before income taxes was $74.0 in 2019, a decrease of $7.5 compared to 2018 due primarily to higher SG&A costs of $23.3 (including the charge to sell the consumer business in Brazil, higher spending in information technology, R&D, and incentive compensation costs), higher marketing expenses of $20.6, unfavorable manufacturing and commodity costs of $9.7, and unfavorable foreign exchange rates of $3.9, partially offset by higher sales volumes of $31.8, favorable price/product mix of $15.8, and lower interest and other expenses of $2.4. 2018 compared to 2017 Consumer International net sales in 2018 were $709.5, an increase of $88.4 or 14.2% as compared to 2017. The components of the net sales change are the following: (1) Includes net sales of the brands acquired in the Viviscal Acquisition and the Waterpik Acquisition since the dates of acquisition. Excluding the impact of foreign exchange rates, higher sales for the year occurred in exports, Europe, Canada, Mexico and Australia. The addition of the acquired businesses contributed significantly to the sales growth. Of the existing brands, the net sales increase is due primarily to OXICLEAN, BATISTE, L’IL CRITTERS & VITAFUSION and NAIR in the export business, ARM & HAMMER clumping cat litter and BATISTE in Canada, OXICLEAN, ARM & HAMMER liquid laundry detergent and ARM & HAMMER dental care in Mexico and Waterpik in several countries. Consumer International income before income taxes was $81.5 in 2018, an increase of $49.5 compared to 2017 due primarily to lower costs as a result of the 2017 pension settlement of $39.2, higher sales volumes of $42.2, favorable foreign exchange rates of $3.8, and favorable price/product mix of $0.7, partially offset by higher other SG&A costs of $12.2, higher marketing costs of $9.4, unfavorable manufacturing and commodity costs of $9.6, and higher interest and other expenses of $5.2. Specialty Products 2019 compared to 2018 SPD net sales were $298.8 for 2019, a decrease of $7.7, or 2.5% compared to 2018. The components of the net sales change are the following: (1) Includes net sales of Passport since the date of acquisition. Excluding the impact of the acquisitions, the net sales decrease in 2019 was primarily driven by lower volumes in the animal and food production business. Demand in the dairy industry was significantly reduced due to low dairy farm profitability, which improved in the fourth quarter of 2019. SPD income before income taxes was $47.2 in 2019, a decrease of $4.4 compared to 2018. The decrease in income before income taxes for 2019 is due primarily to higher SG&A costs of $6.8, lower sales volumes of $3.4, unfavorable manufacturing costs of $3.1, and unfavorable price/product mix of $0.2, partially offset by $7.3 due to the reduction in fair value of a contingent consideration liability associated with the Passport Acquisition, lower interest and other expenses of $1.5. and lower marketing expenses of $0.4. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) 2018 compared to 2017 SPD net sales were $306.5 for 2018, an increase of $6.3, or 2.1% compared to 2017. The components of the net sales change are the following: (1) Includes net sales of Passport and Agro BioSciences, Inc. since the dates of acquisition, partially offset by the sale of our Brazilian chemical business. Excluding the impact of the acquisitions and divestiture, the net sales decrease in 2018 was driven primarily by lower volumes in the animal productivity business, partially offset by higher broad-based pricing. Although demand for our products continues to grow in the poultry industry, demand in the dairy industry continues to be significantly reduced due to low milk prices. SPD income before income taxes was $51.6 in 2018, an increase of $8.1 compared to 2017. The increase in income before income taxes for 2018 is due primarily to favorable price/product mix of $9.1, lower costs associated with selling the Brazilian chemical business of $3.5, higher sales volume of $3.3, and lower manufacturing costs of $2.6, partially offset by higher SG&A costs of $7.4 and higher interest and other expenses of $2.7. Corporate The Corporate segment reflects the reclassification of administrative costs of the production, planning and logistics functions which are included in SG&A expenses in the operating segments but are elements of cost of sales in our Consolidated Statements of Income. Such amounts were $48.2, $44.0 and $32.8 for 2019, 2018 and 2017, respectively. Also included in corporate segment are the equity in earnings of affiliates from Armand and ArmaKleen, totaling $6.6, $9.2 and $10.8 for the three years ended December 31, 2019, 2018 and 2017, respectively. Liquidity and capital resources On May 1, 2019, we amended our $1,000.0 unsecured revolving credit facility (the “Credit Agreement”) to extend the term of the Credit Agreement from March 29, 2023 to March 29, 2024. Under the Credit Agreement, we have the ability to increase our borrowing up to an additional $600.0, subject to lender commitments and certain conditions as described in the Credit Agreement. Borrowings under the Credit Agreement are available for general corporate purposes and are used to support our $1,000.0 commercial paper program. On May 1, 2019, we entered into a $300.0 unsecured term loan credit facility with various banks, the proceeds of which were used to partially fund the Flawless Acquisition. Unless prepaid, the loan is due on May 1, 2022. The interest rate is U.S. Dollar London Interbank Offered Rate (“LIBOR”) plus an applicable margin based on our credit rating, which can range from 60 bps to 113 bps. As of December 31, 2019, we had $155.7 in cash and cash equivalents, and approximately $749.0 available through the revolving facility under our Credit Agreement and our commercial paper program. To preserve our liquidity, we invest cash primarily in government money market funds, prime money market funds, short-term commercial paper and short-term bank deposits. We financed the Waterpik Acquisition with a portion of the proceeds from an underwritten public offering of $1,425.0 aggregate principal amount of Senior Notes completed on July 25, 2017, consisting of $300.0 aggregate principal amount of Floating Rate Senior Notes due 2019, $300.0 aggregate principal amount of 2.45% Senior Notes due 2022, $425.0 aggregate principal amount of 3.15% Senior Notes due 2027 and $400.0 aggregate principal amount of 3.95% Senior Notes due 2047 (collectively, the “Senior Notes”). The Floating Rate Senior Notes, which matured and were repaid in full with cash on hand and commercial paper on January 25, 2019, bore interest at a rate, reset quarterly, equal to three-month LIBOR plus 0.15%. On December 9, 2014, we issued $300.0 aggregate principal amount of 2.45% Senior Notes due December 15, 2019 (the “2019 Notes”). These Notes were repaid in full in the fourth quarter of 2019 with cash on hand and proceeds from the issuance of commercial paper. On September 26, 2012, we issued $400.0 aggregate principal amount of 2.875% Senior Notes due 2022 (the “2022 Notes”). The 2022 Notes were issued under the second supplemental indenture, dated September 26, 2012 (the “BNY Mellon Second Supplemental Indenture”) to the indenture dated December 15, 2010 (the “BNY Mellon Base Indenture”) between us and The Bank of New York Mellon Trust CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Company, N.A., as trustee. These Notes will mature on October 1, 2022, unless earlier retired or redeemed pursuant to the terms of the BNY Mellon Second Supplemental Indenture. The current economic environment presents risks that could have adverse consequences for our liquidity. See “Unfavorable economic conditions could adversely affect demand for our products” under “Risk Factors” in Item 1A of this Annual Report. We do not anticipate that current economic conditions will adversely affect our ability to comply with the financial covenant in the Credit Agreement because we currently are, and anticipate that we will continue to be, in compliance with the maximum leverage ratio requirement under the Credit Agreement. On January 31, 2020, the Board declared a 5.5% increase in the regular quarterly dividend from $0.2275 to $0.24 per share, equivalent to an annual dividend of $0.96 per share payable to stockholders of record as of February 14, 2020. The increase raises the annual dividend payout from $224.0 to approximately $237.0. On November 1, 2017, the Board authorized a share repurchase program, under which we may repurchase up to $500.0 in shares of Common Stock (the “2017 Share Repurchase Program”). The 2017 Share Repurchase Program does not have an expiration date. We also continued our evergreen share repurchase program, authorized by the Board on January 29, 2014, under which we may repurchase, from time to time, Common Stock to reduce or eliminate dilution associated with issuances of Common Stock under our incentive plans. In November of 2017, we executed open market purchases of $100.0 of our Common Stock under the 2017 Share Repurchase Program. In the first quarter of 2018, we settled an accelerated share repurchase (“ASR”) contract and purchased approximately 4.1 million shares of Common Stock for $200.0, of which approximately $110.0 was purchased under the evergreen share repurchase program and $90.0 was purchased under the 2017 Share Repurchase Program. In January 2019, we executed open market purchases of $100.0 of our Common Stock, all of which were purchased under the evergreen share repurchase program. In September 2019, we executed open market purchases of $150.0 of our Common Stock of which $50.0 was purchased under the evergreen share repurchase program and $100.0 was purchased under the 2017 Share Repurchase Program. As a result of these Common Stock repurchases, there remains $210.0 of share repurchase availability under the 2017 Share Repurchase Program as of December 31, 2019. We anticipate that our cash from operations, together with our current borrowing capacity, will be sufficient to meet our capital expenditure program costs, which are expected to be approximately $90.0 in 2020, fund our share repurchase programs to the extent implemented by management, pay debt and interest as it comes due and pay dividends at the latest approved rate. We do not have any mandatory fixed rate debt principal payments due in 2020. Cash, together with our current borrowing capacity, may be used for acquisitions that would complement our existing product lines or geographic markets. Cash Flow Analysis CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) 2019 compared to 2018 Net Cash Provided by Operating Activities - Our primary source of liquidity is our cash flow provided by operating activities, which is dependent on the level of net income and changes in working capital. Our net cash provided by operating activities in 2019 increased by $100.9 to $864.5 as compared to $763.6 in 2018 due to higher cash earnings (net income plus non-cash expenses such as depreciation, amortization, deferred taxes, non-cash compensation and asset impairment and write-off charges) and a larger decrease in working capital. The change in working capital is primarily due to a larger increase in accounts payable and accrued expenses due to our continued program to extend payment terms with our suppliers, timing of payments and higher incentive compensation and profit sharing accruals and a smaller increase in inventory. The change in inventory is largely due to the Flawless acquisition. However, we measure working capital effectiveness based on our cash conversion cycle. The following table presents our cash conversion cycle information for the quarters ended December 31, 2019 and 2018: Our cash conversion cycle (defined as the sum of DSO plus DIO less DPO) at December 31, 2019, which is calculated using a two period average method, decreased 1 day from the prior year amount of 22 days to 21 days at December 31, 2019 due primarily to an increase in DPO of 3 days due to the timing of payments and term extensions with our suppliers, offset by an increase in DIO of 3 days from 58 to 61 days primarily due to the Flawless acquisition. We continue to focus on reducing our working capital requirements. Net Cash Used in Investing Activities - Net cash used in investing activities during 2019 was $553.5, primarily reflecting $475.0 for the Flawless Acquisition, and $73.7 for property, plant and equipment additions. Net Cash (Used in) Provided by Financing Activities - Net cash used in financing activities during the first twelve months of 2019 was $472.9, reflecting $250.0 of repurchases of our common stock (“Common Stock”), $224.1 of cash dividend payments, and $49.0 of net debt repayments, partially offset by $52.8 of proceeds from stock option exercises. 2018 compared to 2017 Net Cash Provided by Operating Activities - Our primary source of liquidity is our cash flow provided by operating activities, which is dependent on the level of net income and changes in working capital. Our net cash provided by operating activities in 2018 increased by $82.1 to $763.6 as compared to $681.5 in 2017 due to higher cash earnings (net income plus non-cash expenses such as depreciation, amortization, non-cash compensation and asset impairment charges) and lower working capital. The change in working capital is primarily due to an increase in accounts payable and accrued expenses and lower other current assets partially offset by higher inventories. Net Cash Used in Investing Activities - Net cash used in investing activities during 2018 was $112.1, principally reflecting $60.4 for property, plant and equipment expenditures and $49.8 for the Passport Acquisition. Net Cash (Used in) Provided by Financing Activities - Net cash used in financing activities during 2018 was $609.0, primarily reflecting $200.0 of repurchases of our Common Stock, $213.3 of cash dividend payments, and $268.8 of debt payments, partially offset by $76.6 of proceeds from stock option exercises. CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) Commitments as of December 31, 2019 The table below summarizes our material contractual obligations and commitments as of December 31, 2019. (1) Represents interest on our 2.45% Senior Notes due in 2022, 2.875% Senior Notes due in 2022, 3.15% Senior Notes due 2027 and 3.95% Senior Notes due 2047. (2) Letters of credit with several banks guarantee payment for items such as insurance claims in the event of our insolvency. (3) We have outstanding purchase obligations with suppliers at the end of 2019 for raw, packaging and other materials and services in the normal course of business. These purchase obligation amounts represent only those items which are based on agreements that are enforceable and legally binding, and do not represent total anticipated purchases. (4) Other includes payments for stadium naming rights for a period of 20 years until December 2032. Off-Balance Sheet Arrangements We do not have off-balance sheet financing or unconsolidated special purpose entities. OTHER ITEMS Market risk Concentration of Risk A group of three customers accounted for approximately 36%, 36% and 36% of consolidated net sales in 2019, 2018 and 2017, respectively, of which a single customer, Walmart, accounted for approximately 24%, 23% and 24% in 2019, 2018 and 2017, respectively. Interest Rate Risk We had outstanding total debt at December 31, 2019, of $2,063.1, net of debt issuance costs, of which 73% has a fixed weighted average interest rate of 3.1% and the remaining 27% was constituted of commercial paper issued by us that currently has a weighted average interest rate of approximately 1.92% and the Term loan due 2022 with a current rate of approximately 2.60%. In 2019, we entered into interest rate swap lock agreements to hedge the risk of changes in the interest payments attributable to changes in the benchmark LIBOR interest rate associated with anticipated issuances of debt. The notional amount of the interest rate swap locks is $300.0. These interest rate swap lock agreements have been designated as hedges of the changes in fair value of the underlying debt obligation attributable to changes in interest rates and are accounted for as fair value hedges. Other Market Risks We are also subject to market risks relating to our diesel and other commodity costs, fluctuations in foreign currency exchange rates, and changes in the market price of the Common Stock. Refer to Note 3 to the Consolidated Financial Statements for a discussion of these market CHURCH & DWIGHT CO., INC AND SUBSIDIARIES (Dollars in millions, except share and per share data) risks and the derivatives used to manage the risks associated with changing diesel fuel and other commodity prices, foreign exchange rates and the price of our Common Stock.

<s>[INST] Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Company’s consolidated financial statements. OVERVIEW Our Business We develop, manufacture and market a broad range of consumer household and personal care and specialty products focused on animal and food production, chemicals and cleaners. We focus our consumer products marketing efforts principally on our 12 “power brands.” These wellrecognized brand names include ARM & HAMMER, used in multiple product categories such as baking soda, cat litter, carpet deodorization and laundry detergent; TROJAN condoms, lubricants and vibrators; OXICLEAN stain removers, cleaning solutions, laundry detergent and bleach alternatives; SPINBRUSH batteryoperated and manual toothbrushes; FIRST RESPONSE home pregnancy and ovulation test kits; NAIR depilatories; ORAJEL oral analgesic; XTRA laundry detergent; L’IL CRITTERS and VITAFUSION gummy dietary supplements, BATISTE dry shampoos, WATERPIK water flossers and replacement showerheads and FLAWLESS hair removal products. We sell our consumer products under a variety of brands through a broad distribution platform that includes supermarkets, mass merchandisers, wholesale clubs, drugstores, convenience stores, home stores, dollar, pet and other specialty stores and websites and other ecommerce channels, all of which sell the products to consumers. We sell our specialty products to industrial customers, livestock producers and through distributors. We operate our business in three segments: Consumer Domestic, Consumer International and the Specialty Products Division (“SPD”). The segments are based on differences in the nature of products and organizational and ownership structures. In 2019, the Consumer Domestic, Consumer International and SPD segments represented approximately 76%, 17% and 7%, respectively, of our consolidated net sales. 2019 Financial Highlights Key 2019 financial results include: 2019 net sales grew 5.1% over 2018, with gains in the Consumer Domestic and Consumer International segments, partially offset by net sales declines in SPD. The gains in Consumer Domestic and Consumer International are primarily due to favorable pricing pricing/product mix in Consumer Domestic and favorable volumes in Consumer International, partially offset by lower volumes in SPD. Consumer Domestic and Consumer International 2019 net sales were favorably impacted by the Flawless Acquisition, which occurred on May 1, 2019. Gross margin increased 110 basis points to 45.5% in 2019 from 44.4% in 2018, primarily due to the impact of productivity programs, favorable volume price/product mix, and the Flawless Acquisition, partially offset by higher commodity and manufacturing costs. Operating margin increased 20 basis points to 19.3% in 2019 from 19.1% in 2018, reflecting higher gross margin, partially offset by higher selling, general and administrative expenses and slightly higher marketing costs. We reported diluted net earnings per share in 2019 of $2.44, an increase of approximately 7.5% from 2018 diluted net earnings per share of $2.27. Cash provided by operations was $864.5, an $100.9 increase from the prior year, due to higher cash earnings and a larger reduction in working capital. We returned $474.1 to our stockholders through dividends and share repurchases. Strategic Goals, Challenges and Initiatives Our ability to generate sales depends on consumer demand for our products and retail customers’ decisions to carry our products, which are, in part, affected by general economic conditions in our markets. While a vast majority of our products are consumer staples and less vulnerable to decreases in discretionary spending than other products, an increasing number of our products, particularly those from our recent acquisitions, are more durable in nature and [/INST] Negative. </s>

PRECISION CASTPARTS CORP

2015-05-28

2015-03-29

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (in millions, except per share data) Business overview Fiscal 2015 presented Precision Castparts Corp. ("PCC") with a number of opportunities as well as challenges. We continued to be well-positioned in the core commercial aerospace and industrial gas turbine ("IGT") markets, which provided us with sales and earnings growth throughout the fiscal year. However, beginning late in the third quarter, we experienced demand softness in our oil & gas and pipe markets, with customers deferring decisions on large projects and distribution demand falling almost to zero. Despite these dynamics, we believe the combination of our strong technical capabilities and improved cost structure places us in a solid position to serve our customers now and when increased demand returns. In the first quarter of fiscal 2015, we saw both solid operating results and a significant shift in customer order dynamics in our major end markets. Commercial aerospace activity was the biggest driver of growth as base aircraft production continued. We also saw an upward shift in orders from our customers in power markets. Continued expansion in interconnect pipe demand provided further upside. In the oil & gas market, we won sizeable new orders that leveraged our unique capabilities. We continued to grow total year-over-year sales and earnings in the second quarter of fiscal 2015, demonstrating solid leverage of our strong market share position in primary end markets. Commercial aerospace sales continued a steady upward trajectory fueled by the segment's strong presence on all major aircraft/engine platforms, both in production and in development. IGT orders also steadily improved as a result of solid positions on upgrade programs, higher content on new production turbines and higher spares requirements. The third quarter of fiscal 2015 included some clear achievements, but we also faced some real challenges in several of our end markets. On the plus side, we made solid progress on our production and development aircraft and engine programs. In addition, our growth in IGT outpaced the market, given our higher content on new and upgrade platforms, and provided a steady supply of spares to the installed base. On the other hand, the third quarter also presented us with rapid declines in demand from our oil & gas customers and continued destocking from one of our large aerospace customers. We continued to face sizable challenges in our oil & gas and pipe markets in the fourth quarter of fiscal 2015, which had a negative impact on our financial results. In response, we took multiple actions to adjust our operations to the realities of the demand environment by right-sizing our operations, evaluating our inventory positions, and making decisions to exit underperforming investments. We recognized $127 million in pre-tax charges related to asset and inventory valuation adjustments and $8 million related to restructuring activities. In addition, we recognized $174 million, pre-tax, of impairment charges primarily associated with the company’s ownership interest in Yangzhou Chengde Steel Tube Co., Ltd. (Chengde). Our capital allocation framework supports a multi-pronged strategy that prioritizes internal investment and value-creating acquisitions, with excess cash returned to shareholders in the form of share repurchases once the first two criteria are met. During fiscal 2015, we acquired two businesses for a total of approximately $637 million. The larger acquisition, Aerospace Dynamics International, broadens our large gantry capabilities and provides us with significant additional share on the Airbus A350 program. Subsequent to year-end, we acquired two small businesses, which expand our vertical integration capabilities. We continue to be very active on the acquisition front, with several potential opportunities in front of us. We delivered on our share repurchase program during fiscal 2015, returning $1.6 billion of cash to shareholders. During May 2015, the PCC Board of Directors added an additional $2.0 billion to our share repurchase authorization, which we expect to complete in the next 12 to 18 months, subject to market conditions, with the objective of lowering our share count over time. We remain committed to our value-creating capital deployment strategy, focused on growing the business organically and through acquisitions and on returning excess cash to shareholders via share repurchases. _________________________ (1) Source: Bloomberg Fiscal 2015 compared with fiscal 2014 Total sales for fiscal 2015 were $10,005 million, an increase of $472 million, or 5 percent, from fiscal 2014 sales of $9,533 million. Fiscal 2015 includes the contribution from seven businesses acquired after the beginning of fiscal 2014 and two businesses acquired in fiscal 2015. These acquisitions contributed more than $350 million of additional sales in fiscal 2015 compared to fiscal 2014. Excluding the impact of acquisitions and metal pricing, organic sales growth on a constant currency basis year-over-year was approximately 2 percent, despite the continuing impact of an aerospace customer's inventory actions and challenges in oil & gas and pipe markets. Lower market-driven pricing of raw material inputs negatively impacted external sales year-over-year as raw material input prices were approximately $50 million lower than a year ago. The cost of rutile (a primary raw material in titanium production) decreased approximately 12 percent; purchased titanium sponge decreased approximately 13 percent; and titanium revert decreased approximately 8 percent over the prior year. Although the market price of titanium 6-4 bulk increased 50 percent, as reported on metalprices.com, compared to the same period last year, our actual titanium prices decreased due to buy forwards and order lead times. Contractual material pass-through pricing increased sales by approximately $239 million in fiscal 2015 versus approximately $265 million in fiscal 2014, a decrease of $26 million. Contractual material pass-through pricing adjustments are calculated based on market prices such as those shown in the above table in trailing periods from one to twelve months. Including the impact of acquisitions, aerospace sales increased approximately $414 million, or 6 percent, over fiscal 2014, primarily within our Airframe Products segment. Commercial aircraft production rates continue to drive steady demand for airframe and engine components. Commercial and regional/business jet aerospace sales improved, while military demand declined. Aerospace sales increased from 69 percent of total sales in fiscal 2014 to 70 percent of total sales in fiscal 2015. Sales to our power markets increased approximately $54 million, or 3 percent, over the prior year, primarily as a result of further growth in IGT sales throughout the year and seamless interconnect pipe sales in the first half of fiscal 2015. IGT orders have steadily increased as a result of higher content on new and upgrade platforms and higher spares requirements. Partially offsetting this growth was declining demand from our oil & gas customers, particularly over the last half of the year. Sales to our power markets remained constant at 17 percent of total sales in both fiscal 2014 and 2015. General industrial and other sales were essentially flat when compared to the prior year, primarily due to higher sales to the industrial processing and automotive sectors, offset by lower sales to the mining and construction sectors. General industrial and other sales decreased from 14 percent of total sales in fiscal 2014 to 13 percent of total sales in fiscal 2015. Cost of goods sold was $6,752 million, or 67 percent of sales, in fiscal 2015, compared to $6,253 million, or 66 percent of sales, in fiscal 2014. Cost of goods sold was negatively impacted by inventory valuation adjustments and other asset impairment charges recognized during the fourth quarter of fiscal 2015 totaling $127 million. Contractual material pass-through pricing diluted gross margin by 0.8 percentage points in fiscal 2015 compared to 1.0 percentage point in fiscal 2014. Selling and administrative expenses were $641 million, or 6 percent of sales, in fiscal 2015, compared to $621 million, or 7 percent of sales, in fiscal 2014. The slightly lower year-over-year percentage was primarily due to lower legal expenses. Net income from continuing operations attributable to PCC for fiscal 2015 was $1,545 million, or $10.77 per share (diluted). By comparison, net income from continuing operations attributable to PCC for fiscal 2014 was $1,752 million, or $11.95 per share (diluted). Fiscal 2015 net income includes net charges of $265 million, or $1.85 per share (diluted), related to inventory valuation adjustments, asset impairment charges and restructuring activities. Fiscal 2015 net income attributable to PCC including discontinued operations was $1,530 million, or $10.66 per share (diluted), compared with net income of $1,777 million, or $12.12 per share (diluted) in fiscal 2014. Fiscal 2015 results include a net loss of $15 million, or $0.11 per share (diluted), from discontinued operations, compared to net income of $25 million, or $0.17 per share (diluted), in the prior year. Fiscal 2014 compared with fiscal 2013 Total sales for fiscal 2014 were $9,533 million, an increase of $1,186 million, or 14 percent, from fiscal 2013 sales of $8,347 million. Fiscal 2014 sales include the contribution from eleven businesses acquired after the beginning of fiscal 2013 and seven businesses acquired in fiscal 2014 that were not fully included in the prior year. These acquisitions contributed more than $1.2 billion of additional sales in fiscal 2014 compared to fiscal 2013. Contractual pass-through pricing and other changes in metal/revert pricing offset organic growth by approximately 3 percent year over year. Nickel prices decreased 15 percent, as reported on the London Metal Exchange (LME) compared to the same period last year. Lower external selling prices of nickel alloy from the Forged Products segment’s three primary nickel conversion mills reduced top-line revenues by approximately $142 million in fiscal 2014 versus fiscal 2013 and the falling price of revert and other alloys negatively impacted sales by approximately $55 million. Contractual material pass-through pricing increased sales by approximately $265 million in fiscal 2014 versus approximately $279 million in fiscal 2013, a decrease of $14 million. Contractual material pass-through pricing adjustments are calculated based on market prices such as those shown in the above table in trailing periods from one to twelve months. Including the impact of acquisitions, aerospace sales increased approximately $1,075 million, or 20 percent, over fiscal 2013, primarily within our Forged Products and Airframe Products segments. Commercial aircraft production rates continue to drive steady demand for airframe and engine components. The increase in commercial aerospace sales was partially offset by a decline in regional/business jet sales, while military aerospace sales were relatively flat. Aerospace sales increased from 65 percent of total sales in fiscal 2013 to 69 percent of total sales in fiscal 2014. Sales to our power markets increased approximately $35 million, or 2 percent, over the prior year, primarily as a result of higher seamless interconnect pipe sales, improved oil and gas shipments, and solid IGT sales performance. Sales to our power markets decreased from 20 percent of total sales in fiscal 2013 to 17 percent of total sales in fiscal 2014. General industrial and other sales increased approximately $76 million, or 6 percent, over fiscal 2013, primarily due to the contribution from TIMET, which was acquired in the third quarter of fiscal 2013. General industrial and other sales decreased from 15 percent of total sales in fiscal 2013 to 14 percent of total sales in fiscal 2014. Cost of goods sold was $6,253 million, or 66 percent of sales, in fiscal 2014 as compared to $5,654 million, or 68 percent of sales, in fiscal 2013. The improvement in the year-over-year percentage reflects the impact of lower raw material costs due to lower metal/revert pricing, and operational efficiencies, most notably at our TIMET facilities. Contractual material pass-through pricing diluted gross margin by 1.0 percentage point in fiscal 2014 compared to 1.1 percentage points in fiscal 2013. Selling and administrative expenses were $621 million, or 7 percent of sales, in fiscal 2014 compared to $534 million, or 6 percent of sales, in fiscal 2013. The higher year-over-year percentage was primarily due to higher stock-based compensation expense. Net income from continuing operations attributable to PCC for fiscal 2014 was $1,752 million, or $11.95 per share (diluted). By comparison, net income from continuing operations attributable to PCC for fiscal 2013 was $1,431 million, or $9.75 per share (diluted). Fiscal 2014 net income attributable to PCC including discontinued operations was $1,777 million, or $12.12 per share (diluted), compared with net income of $1,427 million, or $9.72 per share (diluted) in fiscal 2013. Fiscal 2014 results include net income of $25 million, or $0.17 per share (diluted), from discontinued operations, compared to a net loss of $4 million, or $0.03 per share (diluted), in fiscal 2013. Acquisitions Fiscal 2015 • On April 25, 2014, we acquired Aerospace Dynamics International ("ADI") for approximately $625 million. ADI is one of the premier suppliers in the aerospace industry, operating a wide range of high-speed machining centers. ADI has developed particular expertise in large complex components, hard-metal machining, and critical assemblies. ADI is located in Valencia, California, and employs approximately 625 people. The ADI acquisition was an asset purchase for tax purposes and operates as part of the Airframe Products segment. • During the second quarter of fiscal 2015, we completed a small acquisition in the Airframe Products segment. Fiscal 2014 • During the second quarter of fiscal 2014, we completed two small acquisitions in the Airframe Products segment. • On October 31, 2013, we acquired Permaswage, a world-leading designer and manufacturer of aerospace fluid fittings, for approximately $600 million in cash, funded by commercial paper borrowings. Permaswage's primary focus is the design and manufacture of permanent fittings used in fluid conveyance systems for airframe applications, as well as related installation tooling. The company operates manufacturing locations in Gardena, California; Paris, France; and Suzhou, China. The Permaswage acquisition was a stock purchase for tax purposes and operates as part of the Airframe Products segment. • During the third quarter of fiscal 2014, we completed two small acquisitions in the Forged Products segment. • During the fourth quarter of fiscal 2014, we completed a small acquisition in the Forged Products segment and a small acquisition in the Airframe Products segment. Fiscal 2013 • On April 2, 2012, we acquired RathGibson, LLC ("RathGibson"). RathGibson manufactures precision thin-wall, nickel-alloy and stainless steel welded and seamless tubing, with broad capabilities in length, wall thickness, and diameter. RathGibson's products are used in a multitude of oil & gas, chemical/petrochemical processing, and power generation applications, as well as in other commercial markets. RathGibson operates three facilities in Janesville, Wisconsin; North Branch, New Jersey; and Clarksville, Arkansas. The RathGibson acquisition was an asset purchase for tax purposes and operates as part of the Forged Products segment. • On May 18, 2012, we acquired Centra Industries, a state-of-the art aerostructures manufacturer located in Cambridge, Ontario, Canada. Centra manufactures a range of machined airframe components and assemblies, in both aluminum and hard metals. Core competencies include the high-speed machining of complex, high-precision structures, sub-assembly and kit integration. The Centra acquisition was a stock purchase for tax purposes and operates as part of the Airframe Products segment. • On June 15, 2012, we acquired Dickson Testing Company ("Dickson") and Aerocraft Heat Treating Company ("Aerocraft"). Dickson offers a full range of destructive testing services including: mechanical properties, metallurgical and chemical analyses and low-cycle fatigue testing. Dickson is located in South Gate, California. Aerocraft provides precision heat treating services for titanium and nickel alloy forgings and castings used in the aerospace industry, as well as other related services including straightening, de-twisting and forming. Aerocraft is located in Paramount, California. The acquisitions were asset purchases for tax purposes and operate as part of the Forged Products segment. • On August 7, 2012, we acquired Klune Industries ("Klune"), a manufacturer of complex aluminum, nickel, titanium and steel aerostructures. Klune focuses on complex forming, machining and assembly of aerostructure parts, in addition to offering significant expertise in a range of cold-formed sheet metal components. Klune operates facilities in North Hollywood, California; Spanish Fork, Utah; and Kent, Washington. The Klune acquisition was a stock purchase for tax purposes and operates as part of the Airframe Products segment. • On August 31, 2012, we acquired certain aerostructures business units from Heroux-Devtek Inc. (collectively referred to as "Progressive"). These aerostructures operations manufacture a wide variety of components and assemblies from aluminum, aluminum-lithium and titanium, such as bulkheads, wing ribs, spars, frames and engine mounts. The aerostructures operations include Progressive Incorporated in Arlington, Texas, as well as plants in Dorval (Montreal), Canada, and Queretaro, Mexico. The Progressive acquisition was an asset purchase for tax purposes and operates as part of the Airframe Products segment. • On October 24, 2012, we acquired Texas Honing, Inc. ("THI"). THI provides precision, tight-tolerance pipe processing services, including honing, boring, straightening and turning. THI's products are used in oil & gas drilling, completion and production applications, as well as other commercial markets. THI operates three facilities in the Houston, Texas area. The THI acquisition was a stock purchase for tax purposes and operates as part of the Forged Products segment. • On December 12, 2012, we acquired Synchronous Aerospace Group ("Synchronous"), a leading build-to-print supplier of highly complex mechanical assemblies for commercial aerospace and defense markets. Synchronous manufactures such mechanical assemblies as high-lift mechanisms and secondary flight controls, as well as structural components, including wing ribs, bulkheads, and track and beam assemblies. Synchronous has four primary locations: Santa Ana, California; Kent, Washington; Wichita, Kansas; and Tulsa, Oklahoma. The Synchronous acquisition was a stock purchase for tax purposes and operates as part of the Airframe Products segment. • On December 21, 2012, we completed the initial cash tender offer (the "Offer") for all of the outstanding shares of common stock of TIMET for $16.50 per share. Approximately 150,520,615 shares (representing approximately 86% of the outstanding shares) were validly tendered and not withdrawn from the Offer. The transaction resulted in a payment for such shares of approximately $2.5 billion in cash. On December 17, 2012, we issued $3.0 billion of senior, unsecured notes, and the majority of the proceeds were used to purchase the shares noted above. On January 7, 2013, we completed the acquisition of TIMET. Each remaining share of TIMET common stock not tendered in PCC's previous tender offer for TIMET shares (other than shares as to which holders properly exercise appraisal rights) was converted in the merger into the right to receive $16.50 per share without interest. As a result of the merger, TIMET common stock ceased to be traded on the New York Stock Exchange. TIMET, the largest titanium manufacturer in the U.S., offers a full range of titanium products, including ingot and slab, forging billet and mill forms. TIMET operates seven primary melting or mill facilities in Henderson, Nevada; Toronto, Ohio; Morgantown, Pennsylvania; Vallejo, California; Witton, England; Waunarlwydd, Wales; and Savoie, France. The TIMET acquisition was a stock purchase for tax purposes and operates as part of the Forged Products segment. • Over the course of fiscal 2013, we completed several additional minor acquisitions that provide us with expanded manufacturing capabilities. The above business acquisitions were accounted for under the acquisition method of accounting and, accordingly, the results of operations have been included in the Consolidated Statements of Income since the acquisition date. Discontinued operations Our financial statements were impacted by activities relating to the planned or completed divestiture of certain of our businesses. These businesses have been accounted for under discontinued operations guidance. Accordingly, any operating results of these businesses are presented in our Consolidated Statements of Income as discontinued operations, net of income tax, and all prior periods have been reclassified. Fiscal 2015 During the fourth quarter of fiscal 2015, we recognized a goodwill impairment charge of $13 million, pre-tax, related to three of our discontinued operations held for sale as the fair value, as determined by expected net proceeds, did not exceed the carrying value. We also recognized $3 million, pre-tax, of other asset impairment charges. During the fourth quarter of fiscal 2015, we decided to divest a small non-core business in the Forged Products segment and reclassified it to discontinued operations. During the second quarter of fiscal 2015, we decided to divest a small non-core business in the Forged Products segment and reclassified it to discontinued operations. Fiscal 2014 During the first quarter of fiscal 2014, we decided to divest a small non-core business in the Airframe Products segment and reclassified it to discontinued operations. During the fourth quarter of fiscal 2012, we decided to divest a small non-core business in the Airframe Products segment and reclassified it to discontinued operations. The sale of the business was completed in the first quarter of fiscal 2014. The transaction resulted in a gain of approximately $14 million (net of tax) and cash proceeds of $63 million. For tax purposes, the sale generated a capital loss that was offset by a valuation allowance. Fiscal 2013 During the second quarter of fiscal 2013, we decided to divest a small non-core business in the Forged Products segment and reclassified it to discontinued operations. The sale of the business was completed in the second quarter of fiscal 2013. The transaction resulted in a gain of approximately $2 million (net of tax) and cash proceeds of $6 million. During the first quarter of fiscal 2011, we decided to divest a small non-core business in the Airframe Products segment and reclassified it to discontinued operations. The sale of the business was completed in the second quarter of fiscal 2013. The transaction resulted in a loss of less than $1 million (net of tax) and proceeds of $25 million in cash and an unsecured, subordinated, convertible promissory note in the principal amount of $18 million. The promissory note was due on August 7, 2017 and paid interest quarterly based on the 5-year Treasury Note Constant Maturity Rate. The note, which allowed for early payment, was repaid in the first quarter of fiscal 2015. Subsequent events • During the first quarter of fiscal 2016, we completed two small acquisitions in the Forged Products segment. • On May 13, 2015, the Board of Directors approved a $2.0 billion expansion to the Company's existing program to repurchase shares of the Company’s common stock, effective immediately and continuing through June 30, 2017. The Company intends to repurchase outstanding shares from time to time in the open market, subject to market conditions. Fiscal 2016 outlook Based on data from The Airline Monitor as of February 2015, Boeing and Airbus aircraft deliveries are expected to moderately increase through calendar year 2015 as compared to 2014. Due to manufacturing lead times and scheduled build rates, our production volumes are approximately three to six months ahead of aircraft deliveries for mature programs. The Airline Monitor is projecting further growth in aircraft deliveries in calendar year 2016, and therefore we anticipate that our aerospace sales will continue to increase in fiscal 2016 compared to fiscal 2015. Looking at the key end market drivers for this fiscal 2016 plan, we expect mid-single digit revenue growth in commercial aerospace, driven by higher build rates on the Boeing 787 and Airbus A350, as well as growing activity on the LEAP engine, and share gains in our aerostructures operations. We have also factored in the announced build rate cuts on the Airbus A330. In military, we see fiscal 2016 looking much like fiscal 2015, with stable build rates and also stable activity in our spares sales. On the regional/business jet side, we anticipate continued healthy demand for mid to large cabin sizes, which will drive continued growth. We have a number of new platforms starting to ramp in fiscal 2016 and that are expected to yield a high single digit growth rate for the regional/business jet end market. In IGT, we expect continued strong growth driven by our position on the H-class platform and upgrade programs. Given the weak global oil & gas demand, we are anticipating volume and price pressures and expect declines in excess of 30 percent in this market for fiscal 2016. Within our general industrial and other markets, we are expecting fiscal 2016 to be similar to fiscal 2015, with risk of derivative impacts due to weakness in the oil & gas markets. We believe our plan for fiscal 2016 is balanced and achievable, targeting growth and margin expansion in the Investment Cast Products and Airframe Products segments over fiscal 2015 levels, while we expect the Forged Products segment will experience low single-digit sales decline with modest margin expansion. Financial results by segment We analyze our operating segments and manage our business across three reportable segments: Investment Cast Products, Forged Products and Airframe Products. _________________________ (1) Intercompany sales activity consists of each segment’s total intercompany sales activity, including intercompany sales activity within a segment and between segments. (2) Investment Cast Products: Includes intersegment sales activity of $39 million, $44 million and $52 million for fiscal 2015, 2014 and 2013, respectively. (3) Forged Products: Includes intersegment sales activity of $123 million, $128 million and $102 million for fiscal 2015, 2014 and 2013, respectively. (4) Airframe Products: Includes intersegment sales activity of $6 million, $7 million and $6 million for fiscal 2015, 2014 and 2013, respectively. Investment Cast Products The Investment Cast Products segment manufactures investment castings and provides related investment casting materials and alloys, for aircraft engines, IGT engines, airframes, armaments, medical prostheses, unmanned aerial vehicles and other industrial applications. Fiscal 2015 compared with fiscal 2014 Investment Cast Products' segment sales were $2,536 million for fiscal 2015, an increase of 3 percent from fiscal 2014 sales of $2,462 million. Commercial aerospace sales increased approximately 2 percent year-over-year, continuing a steady upward trajectory fueled by the segment's strong presence on all major aircraft/engine platforms, both in production and in development. Improved regional/business jet sales positively impacted segment sales; however, growth was partially offset by continued weak demand in military markets. In addition, the segment saw growth of approximately 8 percent in its power business, driven by higher content on IGT upgrade programs and new turbine designs, and growing spares demand. General industrial and other sales declined approximately 7 percent, primarily as a result of lower sales to the non-aerospace military sector. Fiscal 2015 sales also include $55 million of contractual pricing related to pass-through of raw material costs compared to $63 million in fiscal 2014, a decrease of $8 million. Operating income for the Investment Cast Products segment was $913 million or 36.0 percent of sales in fiscal 2015, compared to $874 million, or 35.5 percent of sales, in fiscal 2014. The segment's operating income as a percent of sales increased by 0.5 percentage points year-over-year. The segment's operations continued to deliver solid operating margins by effectively leveraging higher volumes. Contractual material pass-through pricing diluted operating margins by 0.8 percentage points in fiscal 2015 compared to 0.9 percentage points in fiscal 2014. The Investment Cast Products segment has solid content on most major aircraft production platforms. Fiscal 2016 sales gains are expected to be driven by the next step-up in commercial build rates on platforms such as the Boeing 787 and Airbus A350 and narrow-body re-engining. We expect to leverage higher commercial aerospace volumes by adding incremental capacity to meet higher demand and at the same time, improve our overall efficiency and cost structure. We expect IGT growth to continue into fiscal 2016 due to growth in high-efficiency, large-capacity new IGT platforms, IGT upgrade programs and higher spares activity. Overall, we expect mid-single digit sales growth with incremental operating margins above our typical 35 to 40 percent. Fiscal 2014 compared with fiscal 2013 Investment Cast Products' segment sales were $2,462 million for fiscal 2014, a decrease of 1 percent from fiscal 2013 sales of $2,480 million. Large commercial aerospace sales increased approximately 8 percent as the segment continued to see solid schedules in line with the current levels of base commercial aircraft production rates. However, growth was tempered by a double-digit decline in regional/business jet and military shipments. The segment's power business continued to see strong demand, driven by IGT upgrade programs, share gains, and spares sales. General industrial and other sales declined approximately 4 percent as a result of lower sales to the non-aerospace military sector. Fiscal 2014 sales also include $63 million of contractual pricing related to pass-through of raw material costs compared to $75 million in fiscal 2013, a decrease of $12 million. Operating income for the Investment Cast Products segment was $874 million or 35.5 percent of sales in fiscal 2014, compared to $838 million, or 33.8 percent of sales, in fiscal 2013. The segment's operating income as a percent of sales increased by 1.7 percentage points year-over-year despite a slight decline in sales. The segment's operations improved operating margins by consistently implementing new initiatives to reduce costs and improve productivity on steady, high-volume production. Contractual material pass-through pricing diluted operating margins by 0.9 percentage points in fiscal 2014 compared to 1.1 percentage points in fiscal 2013. Forged Products The Forged Products segment manufactures forged components from titanium and nickel-based alloys principally for the aerospace and power markets and manufactures nickel, titanium and cobalt-based alloys used to produce forged components for aerospace and non-aerospace markets which include products for oil and gas, chemical processing and pollution control applications. The segment also provides nickel superalloy and titanium revert management solutions, re-melting various material byproducts to be reused in casting, forging and fastener manufacturing processes. Forged Products’ sales to the aerospace and power markets are derived primarily from the same large engine customers served by the Investment Cast Products segment, with additional aerospace sales to manufacturers of landing gear and other airframe components. The Forged Products segment also produces interconnect pipe and downhole casings for the oil and gas industries. Fiscal 2015 compared with fiscal 2014 Forged Products segment sales were $4,259 million in fiscal 2015, an increase of 2 percent from fiscal 2014 sales of $4,189 million. Results for fiscal 2015 include contributions from three small acquisitions late in fiscal 2014 that were included in the prior year results. The segment experienced stable aerospace sales, increasing approximately $20 million, or 1 percent, year-over-year, with growth in regional/business jet sales offset by decreased military sales. Commercial aerospace sales were flat due to the continued destocking at a single aerospace customer. Sales to the power markets were also flat when compared to the prior year, driven by higher interconnect pipe sales in the first half of the year, offset by lower oil & gas demand in the last half of the year and lower IGT demand. General industrial and other sales increased approximately $49 million, or 6 percent, during fiscal 2015, primarily due to higher sales to the industrial process and marine equipment sectors, partially offset by lower sales to the mining sector. Lower market-driven pricing of raw material inputs negatively impacted external sales year-over-year as raw material input prices were approximately $50 million lower than a year ago. The cost of rutile decreased approximately 12 percent; purchased titanium sponge decreased approximately 13 percent; and titanium revert decreased approximately 8 percent over the prior year. Although the market price of titanium 6-4 bulk increased 50 percent, as reported on metalprices.com, compared to the same period last year, our actual titanium prices decreased due to buy forwards and order lead times. Fiscal 2015 sales also include $175 million of contractual pricing related to pass-through of raw material costs compared to $192 million in fiscal 2014, a decrease of $17 million (also included in market increases discussed above). Operating income for the Forged Products segment was $1,008 million, or 23.7 percent of sales, in fiscal 2015, compared to $1,075 million, or 25.7 percent of sales, in fiscal 2014. Operating income as a percent of sales decreased 2.0 percentage points compared to a year ago as a result of negative volume leverage and a weaker product mix in oil & gas markets, magnified by lower throughput associated with the decline in oil & gas and other distribution channels, which resulted in higher levels of inflation in year-end inventory balances. The contractual pass-through of raw material costs diluted operating margins by 1.0 percentage point in fiscal 2015 compared to 1.2 percentage points in fiscal 2014. Similar to the Investment Cast Products segment, the Forged Products segment is aligned with large commercial aerospace build rates. We expect increased demand in fiscal 2016 in aerospace and IGT markets, with TIMET share gains favorably impacting sales, partially offset by foreign currency headwinds. However, given the continued uncertainty in the oil and gas market, we cannot predict when this market will recover, and further sales reductions may occur. All those inputs net to our expectation for a low-single digit sales decline versus fiscal 2015. Furthermore, in March 2015, the TIMET Morgantown facility suffered a serious incident and an electron beam furnace will be out of commission for an extended period of time. We anticipate this will have a $25 million to $30 million negative impact to operating income in fiscal 2016. The segment will benefit from the impact of restructuring actions taken at the end of fiscal 2015. As is the case every year, we will perform maintenance during the second quarter, and in fiscal 2016, we have a planned press upgrade, which will result in an extended outage occurring at our Wyman-Gordon UK facility. Taking into consideration all of the factors above, we expect modest margin expansion at Forged Products versus fiscal 2015. Fiscal 2014 compared with fiscal 2013 Forged Products segment sales were $4,189 million in fiscal 2014, an increase of 18 percent from fiscal 2013 sales of $3,552 million. Results for fiscal 2013 include the benefit from the acquisitions of Aerocraft and Dickson for more than nine months, THI for five months, and TIMET for three months, versus a full year in fiscal 2014. The segment experienced aerospace sales growth of approximately $518 million, or 26 percent, year over year, driven primarily by the inclusion of TIMET and higher commercial aerospace demand. Similar to the Investment Cast Products segment, aerospace OEM business continued to be aligned with current commercial aircraft production rates. However, the reduced capacity and subsequent repair of the 29,000-ton press in Wyman-Gordon's Houston facility created a drag on sales in fiscal 2014. Sales to power markets improved approximately $29 million, or 3 percent, compared to fiscal 2013, driven by increased demand for seamless interconnect pipe and higher oil and gas shipments. General industrial and other sales increased approximately $90 million, or 13 percent, during fiscal 2014, driven almost entirely by the addition of TIMET. Lower market-driven pricing of raw material inputs had a significant negative impact on the segment's year-over-year sales. Nickel prices decreased 15 percent, as reported on the LME, compared to the same period in fiscal 2013. The decline in external selling prices of nickel alloy sales from the segment’s three primary nickel conversion mills reduced top-line revenues by approximately $142 million in fiscal 2014 versus fiscal 2013 and the falling price of revert and other alloys negatively impacted sales by approximately $55 million. Fiscal 2014 sales also include $192 million of contractual pricing related to pass-through of increased raw material costs compared to $194 million in fiscal 2013, a decrease of $2 million (also included in market increases discussed above). Operating income for the Forged Products segment was $1,075 million, or 25.7 percent of sales, in fiscal 2014, compared to $779 million, or 21.9 percent of sales, in fiscal 2013. Operating income as a percent of sales increased 3.8 percentage points compared to fiscal 2013, driven by higher seamless pipe shipments and operational improvements at TIMET as well as the base businesses. TIMET continued its rapid integration, aggressively improving its cost models and delivering significant value across its operations. The Forged Products segment achieved these results while also successfully rebuilding the 29,000-ton forging press in Houston. The contractual pass-through of raw material costs diluted operating margins by 1.2 percentage points in both fiscal 2014 and 2013. Airframe Products The Airframe Products segment manufactures highly engineered fasteners, fastener systems, fluid fittings, aerostructures and precision components, primarily for critical aerospace applications. The balance of the segment’s sales is derived from construction, automotive, heavy truck and general industrial markets. Fiscal 2015 compared with fiscal 2014 Airframe Products segment sales were $3,210 million in fiscal 2015, an 11 percent increase from fiscal 2014 sales of $2,882 million. Results for fiscal 2015 include contributions from Permaswage and three small acquisitions in fiscal 2014 and the results of ADI for nearly a full year. This segment experienced strong growth in aerospace sales of approximately $361 million, or 14 percent. Commercial aerospace sales, the chief driver of this segment, showed approximately 17 percent growth relative to the prior year. The fastener operations continue to maintain a high level of activity to meet aerospace production schedules and to benefit from the rapid integration of the most recent acquisitions. Similarly, the aerostructures operations saw further demand from a broad aerospace customer base, while ramping up production to support new contracts. General industrial and other sales decreased approximately $32 million, or 9 percent, when compared to the prior year, primarily due to lower sales to the construction and industrial process sectors, partially offset by higher sales to the automotive sector. Operating income for the Airframe Products segment was $968 million, or 30.2 percent of sales, in fiscal 2015, compared to $863 million, or 29.9 percent of sales, in fiscal 2014. Operating income as a percent of sales increased 0.3 percentage points compared to fiscal 2014. Airframe Products' continued to achieve strong operational drop-through as a result of focused integration of its most recent acquisitions, effective leverage of increased assets, and strategic deployment of production assets. Airframe Products is expecting a strong fiscal 2016 year, with sales up mid-single digits, reflecting higher aerospace build rates, share gains, and further contributions from recent acquisitions, partially offset by foreign currency headwinds. Demand to support current build rates is expected to drive sales in the fasteners operations in fiscal 2016. New business wins have secured market share for the aerostructures operations, and we anticipate that the contracts in place will lead to increased production in the second half of fiscal 2016. Build rate increases on platforms such as the Boeing 787 and Airbus A350 and narrow-body re-engining should provide further upside over the next 24 months. We expect the segment to deliver strong leverage on its growth, with incremental margins above the typical 35 to 40 percent level. Fiscal 2014 compared with fiscal 2013 Airframe Products segment sales were $2,882 million in fiscal 2014, a 24 percent increase from fiscal 2013 sales of $2,315 million. Results for fiscal 2013 include contributions from Centra for nearly ten months, Klune for eight months, Progressive for seven months, and Synchronous for three months, versus a full year in fiscal 2014. In addition, fiscal 2014 includes the results of Permaswage for five months. This segment experienced strong growth in aerospace sales of approximately $564 million, or 29 percent, due to solid contributions from new acquisitions coupled with organic sales expansion. The base aerostructures businesses grew year-over-year aerospace sales by approximately 14 percent, due to market growth and share gains, and shipped Boeing 787 content at approximately ten shipsets per month. Critical aerospace fasteners shipments improved 6 percent year over year, and continued to close the gap with commercial aircraft production schedules. General industrial and other sales decreased approximately $7 million, or 2 percent when compared to fiscal 2013 primarily due to a decrease in non-aerospace military sales, partially offset by an increase in the mining sector. Operating income for the Airframe Products segment was $863 million, or 29.9 percent of sales, in fiscal 2014, compared to $687 million, or 29.7 percent of sales, in fiscal 2013. Operating income as a percent of sales increased 0.2 percentage points compared to fiscal 2013 despite the inclusion of several lower-margin acquisitions due to continued achievement of strong incremental margins on base sales and organic growth. Airframe Products' operating income improved due to the leverage of increased throughput over an improving cost structure and variable cost improvements in the base businesses. Restructuring and asset impairment In the fourth quarter of fiscal 2015, we recognized a non-cash inventory and other asset impairment charge of $127 million, pre-tax, primarily in our oil & gas, pipe and associated raw material operations, reflecting the more challenging environment, declines in market value, and size or quality characteristics that impact marketability. In addition, to improve our cost structure and in response to the current market conditions, we implemented headcount reductions at impacted operations, which resulted in a pre-tax charge of $8 million in the fourth quarter of fiscal 2015. These restructuring plans provided for terminations of approximately 490 employees in the fourth quarter of fiscal 2015 and the first quarter of fiscal 2016. The restructuring and asset impairment charges recorded by segment are as follows: Interest and taxes Net interest expense during fiscal 2015 was $65 million, compared with $71 million during fiscal 2014. On September 30, 2013, we exercised the make-whole early prepayment option and redeemed all $200 million of the 5.60% Senior Notes then outstanding, and therefore incurred interest expense associated with that debt in the prior year. Interest income was $4 million for fiscal 2015 compared to $5 million in fiscal 2014. The decrease was a result of lower interest rates on cash balances invested outside the U.S. Net interest expense during fiscal 2014 was $71 million, compared with $31 million in fiscal 2013. The significant increase was due to debt associated with the acquisition of TIMET. Near the end of the third quarter of fiscal 2013, we issued $3.0 billion of debt to finance the acquisition of TIMET. In fiscal 2014, we incurred additional interest expense associated with that debt as it was outstanding for the full year. Interest income for fiscal 2014 was $5 million compared to $7 million in fiscal 2013. The decrease was a result of lower cash balances invested outside the U.S., which generally earn higher rates of return. The effective tax rate for both fiscal 2015 and 2014 was 32.1 percent. In fiscal 2015, we realized a tax benefit from remeasuring our domestic deferred tax assets and liabilities due to a reduction in our state effective tax rate This tax benefit was offset by reduced benefits in the current year from nonrecurring changes in tax assets and liabilities compared to fiscal 2014. The effective tax rate for fiscal 2014 was 32.1 percent, 0.6 percentage points lower than the 32.7 percent effective tax rate in fiscal 2013. The lower effective tax rate is primarily due to an increase in earnings taxed at rates lower than the U.S. statutory rate, the impact of the U.K. statutory rate reduction on deferred tax liabilities, and the settlement of a federal environmental penalty by TIMET that resulted in pre-tax income but not taxable income. Liquidity and capital resources Total assets of $19,428 million at March 29, 2015 represented an $842 million increase from the $18,586 million balance at March 30, 2014. The increase in total assets principally reflects cash generated from operations during fiscal 2015 totaling $1,702 million and tangible and intangible assets acquired with the purchase of ADI, which was funded by commercial paper borrowings, partially offset by the repurchase of common stock totaling $1,598 million. Total capitalization at March 29, 2015 was $15,516 million, consisting of $4,587 million of total debt and $10,929 million of PCC shareholders' equity. The debt-to-capitalization ratio increased to 29.6% at March 29, 2015 from 23.9% at the end of fiscal 2014, reflecting additional commercial paper borrowings to fund the acquisition of ADI and common stock repurchases, and lower cumulative translation adjustments, partially offset by the impact of increased equity from net income. Cash as of March 29, 2015 was $474 million, an increase of $113 million from the end of fiscal 2014, and total debt was $4,587 million, an increase of $1,015 million since the end of fiscal 2014. The net change in cash and debt primarily reflects stock repurchases of $1,598 million, cash paid to acquire businesses (net of cash acquired) of $637 million, and capital expenditures of $455 million, partially offset by cash generated from operations of $1,702 million and common stock issuances of $102 million. Capital spending of $455 million in fiscal 2015 principally provided for new buildings and facility expansions to increase capacity, and new equipment purchases and refurbishments, primarily in the Forged Products and Airframe Products segments. We expect capital expenditures for fiscal 2016 to increase to approximately $550 million based on our current forecasts. These expenditures will be targeted for facility expansions to increase capacity and reduce costs, equipment upgrades and press refurbishments, primarily in the Forged Products and Airframe Products segments. During fiscal 2015, we contributed $34 million to our defined benefit pension plans, of which $8 million was voluntary. In the first quarter of fiscal 2016, we made $31 million of voluntary contributions to our U.S. defined benefit pension plans. We expect to contribute approximately $20 million of required contributions in fiscal 2016, for total contributions to the defined benefit pension plans of approximately $51 million in fiscal 2016. In addition, we contributed $8 million to other postretirement benefit plans during fiscal 2015. We expect to contribute approximately $7 million to these other postretirement benefit plans during fiscal 2016. Our international operations hold cash that is denominated in foreign currencies. We manage our worldwide cash requirements by evaluating the available funds from our various subsidiaries and the cost effectiveness of accessing those funds. The repatriation of cash from our foreign subsidiaries could have an adverse effect on our effective tax rate. As discussed in Item 8. Financial Statements and Supplementary Data, Note 10-Income taxes, U.S. taxes have not been provided on the cumulative earnings of non-U.S. affiliates and associated companies. Our intention is to reinvest these earnings indefinitely. Historically, we have issued commercial paper as a method of raising short-term liquidity. We believe we will continue to have the ability to issue commercial paper and have issued commercial paper to fund acquisitions and short-term cash requirements in recent years. As of March 29, 2015, the amount of commercial paper borrowings outstanding was $1,587 million and the weighted average interest rate was 0.2%. As of March 30, 2014, the amount of commercial paper borrowings outstanding was $570 million and the weighted average interest rate was 0.2%. During fiscal 2015, the average amount of commercial paper borrowings outstanding was $1,315 million and the weighted average interest rate was 0.2%. During fiscal 2014, the average amount of commercial paper borrowings outstanding was $674 million and the weighted average interest rate was 0.2%. During fiscal 2015 and 2014, the largest daily balance of outstanding commercial paper borrowings was $1,737 million and $1,151 million, respectively. On December 15, 2014, we entered into a 364-day, $1.0 billion revolving credit facility maturing December 2015 (the “364-Day Credit Agreement”), unless converted into a one-year term loan at the option of the Company at the end of the revolving period. The 364-Day Credit Agreement replaces the prior 364-day credit agreement that expired in December 2014. The 364-Day Credit Agreement contains customary representations and warranties, events of default, and financial and other covenants. On December 16, 2013, we entered into a five-year, $1.0 billion revolving credit facility (the "New Credit Agreement") (with a $500 million increase option, subject to approval of the lenders) maturing December 2018, unless extended pursuant to two 364-day extension options. On the same day, we terminated the prior credit agreement maturing November 30, 2016. The New Credit Agreement contains customary representations and warranties, events of default, and financial and other covenants. The 364-Day and New Credit Agreements may be referred to collectively as the "Credit Agreements." We had not borrowed funds under the Credit Agreements as of March 29, 2015. We do not anticipate any changes in our ability to borrow under our current credit facilities, but changes in the financial condition of the participating financial institutions could negatively impact our ability to borrow funds in the future. Should that circumstance arise, we believe that we would be able to arrange any needed financing, although we are not able to predict what the terms of any such borrowings would be, or the source of the borrowed funds. On December 17, 2012, we issued $3.0 billion aggregate principal amount of notes (collectively, the “Notes”) as follows: $500 million of 0.70% Senior Notes due 2015 (the "2015 Notes"); $1.0 billion of 1.25% Senior Notes due 2018 (the "2018 Notes"); $1.0 billion of 2.50% Senior Notes due 2023 (the "2023 Notes"); and $500 million of 3.90% Senior Notes due 2043 (the "2043 Notes"). The Notes are unsecured senior obligations of the Company and rank equally with all of the other existing and future senior, unsecured and unsubordinated debt of the Company. The Company pays interest on the 2015 Notes on June 20 and December 20 of each year and pays interest on the 2018 Notes, the 2023 Notes and the 2043 Notes on January 15 and July 15 of each year. The maximum amount that can be borrowed under our Credit Agreements and commercial paper program is $2.0 billion. Our unused borrowing capacity as of March 29, 2015 was $413 million due to our outstanding commercial paper borrowings of $1,587 million. Our financial covenant requirement and actual ratio as of March 29, 2015 was as follows: _________________________ (1) Terms are defined in the Credit Agreements. As of March 29, 2015, we were in compliance with the financial covenant in the Credit Agreements. We believe we will be able to meet our short and longer-term liquidity needs for working capital, pension and other postretirement benefit obligations, capital spending, cash dividends, environmental remediation, scheduled repayment of debt and potential acquisitions with the cash generated from operations, borrowing from our Credit Agreements or new bank credit facilities, the issuance of public or privately placed debt securities, or the issuance of equity instruments. Off-balance sheet arrangements There are currently no off-balance sheet arrangements that are, or are reasonably likely to have, a current or future material effect on our financial condition. Contractual obligations and commercial commitments We are obligated to make future payments under various contracts such as debt agreements and lease agreements. The following table represents our contractual payment obligations as of March 29, 2015 and the estimated timing of future cash payments: _________________________ (1) Operating lease obligations attributable to operations held-for-sale were $8 million. (2) Interest on variable-rate debt is based on current prevailing interest rates. Our reserve for uncertain tax positions at March 29, 2015 was $16 million. Due to the uncertainties associated with settling these liabilities, we are unable to make reasonable estimates of the period of cash settlement. As a result, our reserve for unrecognized tax benefits is excluded from the table above. See Item 8. Financial Statements and Supplementary Data, Note 10-Income taxes for additional information regarding our reserve for uncertain tax positions. We also have benefit payments due under our non-qualified pension and other post-retirement benefit plans that are not required to be funded in advance, but are paid in the same period that benefits are provided. See Item 8. Financial Statements and Supplementary Data, Note 18-Pension and other postretirement benefit plans for additional information. As of March 29, 2015, we had accrued environmental liabilities of $448 million for future costs arising from environmental issues relating to our properties and operations. Only contractual payment obligations for environmental remediation are included in the table above. Our total future expenditures, however, relating to compliance and cleanup of environmental conditions at our properties cannot be conclusively determined and are excluded from the table above. See Item 8. Financial Statements and Supplementary Data, Note 13-Commitments and contingencies for additional information. Critical accounting policies We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations are discussed throughout Management’s Discussion and Analysis where such policies affect reported and expected financial results. For a detailed discussion on the application of these and other significant accounting policies, see the Notes to the Consolidated Financial Statements of this Annual Report. Note that the preparation of this Annual Report requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results may differ from those estimates. Revenue recognition We recognize revenue when the earnings process is complete. This occurs when products are delivered in accordance with the contract or purchase order, ownership and risk of loss have passed to the customer, collectability is reasonably assured, and pricing is fixed and determinable. In instances where title does not pass to the customer upon shipment, we recognize revenue upon delivery or customer acceptance, depending on terms of the sales agreement. Service sales, representing maintenance and engineering activities, are recognized as services are performed. Shipping and handling costs billed to customers are included in revenue. Valuation of inventories All inventories are stated at the lower of their cost or market value, with the market value being determined based on sales in the ordinary course of business. Cost for inventories at a significant number of our operations is determined on a last-in, first-out (“LIFO”) basis. The average inventory cost method is utilized for most other inventories. We regularly review inventory quantities on hand and record a provision for excess or obsolete inventory equal to the difference between the cost of the inventory and the estimated market value based on the age, historical usage or assumptions about future demand for the inventory. We also regularly review inventory balances on a LIFO basis to ensure the balances are stated at the lower of cost or market as of the balance sheet date. For those inventories valued using LIFO, their carrying value may be higher or lower than current replacement costs for such inventory, since the LIFO costing assumption matches current costs with current sales, not with current inventory values. When the LIFO cost is greater than the current cost, there is an increased likelihood that our inventories could be subject to write-downs to market value. As of March 29, 2015, the LIFO cost of our inventories exceeds the current cost by $679 million. If actual demand is significantly less than the future demand that we have projected, inventory write-downs may be required, which could have a material adverse effect on the value of our inventories and reported operating results. In the fourth quarter of fiscal 2015, we recognized a non-cash inventory impairment charge of $120 million, pre-tax, primarily in our oil & gas, pipe and associated raw material operations, reflecting the more challenging environment, declines in market value, and size or quality characteristics that impact marketability. The projections of future demand by management are based upon firm orders (including long-term agreements), forecasted demand from customers, and macro-economic industry data. The key drivers that are causing our LIFO inventory costs to exceed current costs are as follows: • Decreases in raw material prices in recent fiscal years, including nickel, titanium, cobalt, rutile, titanium sponge and revert • Reduced variable manufacturing costs as a result of operational efficiencies and improved labor productivity • Decreased fixed costs per unit of inventory due to cost controls and increasing production volumes • Inventory added through acquisitions that are valued at fair market value (typically higher than historical cost) that remains in the LIFO cost basis unless liquidated through quantity reductions As we acquire additional businesses, management first determines if the acquired business should account for inventory on a LIFO basis due to the nature of the business and materiality of the inventory balances. If LIFO treatment is deemed appropriate, management then determines whether to incorporate the acquired inventories into existing LIFO pools or create a new LIFO pool based on several factors. Those factors include, but are not limited to: • Similarity or dissimilarity of nature of operations, including raw materials used, product produced and cost structure, to existing businesses. The more similar businesses are, the more likely they will have common LIFO pools • Location of the business as LIFO pools do not typically include operations in more than one country for tax, functional currency and other reasons • The size of the acquisition in relation to the existing pool(s). Smaller businesses are often incorporated into existing LIFO pools Acquisition accounting We account for acquired businesses using the acquisition method of accounting. This requires that we make various assumptions and estimates regarding the fair value of assets, liabilities, and contractual and non-contractual contingencies at the date of acquisition. These assumptions can have a material impact on our balance sheet valuations and the related amount of depreciation and amortization expense that will be recognized in the future. Goodwill and acquired intangibles We regularly acquire businesses in purchase transactions that typically result in the recognition of goodwill and other intangible assets, which may affect the amount of future period amortization expense and possible impairment charges. The determination of the value of such intangible assets requires management to make estimates and assumptions that affect the consolidated financial statements. We recognize indefinite-lived intangible assets when circumstances are identified whereby there is no foreseeable limit on the period of time over which the asset is expected to contribute to the cash flows of the acquired entity. We evaluate many criteria and factors when determining whether an asset life is either indefinite or limited. Among the most significant factors are: the economic effects of competition, obsolescence and demand; the relative cost to the customer for terminating the relationship; the forecasted customer turnover rate and whether there are legal, regulatory, contractual, or other factors that limit the useful life of the asset. If no factors are identified that would limit the asset life then it is considered indefinite. Goodwill and indefinite-lived intangible assets related to our continuing operations are tested for impairment at a minimum each fiscal year at the end of the second month in the second quarter or when events or circumstances indicate that the carrying value of these assets are more likely than not to exceed their fair value. For fiscal 2015, our reporting units consisted of two reporting units within our Investment Cast Products reportable operating segment, three reporting units within our Forged Products reportable operating segment, as well as five reporting units in our Airframe Products reportable operating segment. In the fourth quarter of fiscal 2015, we recognized a goodwill impairment charge of $13 million, pre-tax, related to three of our discontinued operations held for sale as the fair value, as determined by expected net proceeds, did not exceed the carrying value. Testing for goodwill impairment involves the estimation of the fair value of the reporting units. Discounted cash flow and market-based valuation multiple models are typically used in these valuations. Such models require the use of significant estimates and assumptions primarily based on such factors as future cash flows, expected market growth rates, estimates of sales volumes, market valuation multiples, sales prices and related costs, and discount rates, which reflect the weighted average cost of capital. Management uses the best available information at the time fair values of the reporting units are estimated; however, estimates could be materially impacted by such factors as changes in growth trends and specific industry conditions, with the potential for a corresponding adverse effect on the consolidated financial statements which could potentially result in an impairment of goodwill. The discounted cash flow models used to determine fair value are sensitive to the expected future cash flows and the discount rate for each reporting unit. The discount rate used in the cash flow models for the fiscal 2015 goodwill impairment analysis ranged from 8% to 14% depending on the reporting unit. The annual growth rate for earnings before interest and taxes varied by reporting unit and ranged from 7% to 15% over the initial five-year forecast period. We used a terminal value growth rate of 3.5% and found that the reporting unit that would be most sensitive to worsening economic conditions has $1.6 billion of goodwill recorded as of March 29, 2015. We performed additional sensitivity analysis and determined that the forecast for future earnings before interest and taxes used in the cash flow model could decrease by more than 11% or the discount rate utilized could increase by approximately 1 percentage point, and the goodwill of our reporting units would not require additional impairment testing. The impairment test for indefinite-lived intangible assets encompasses calculating the fair value of an indefinite-lived intangible asset and comparing the fair value to its carrying value. The testing methodology utilizes a discounted cash flow model, consistent with goodwill impairment testing. Indefinite-lived intangible asset testing is performed at the same business unit or division level as the initial asset value determination. If the carrying value exceeds the estimated fair value, impairment is recorded. For fiscal 2015 and 2014, it was determined that the fair value of indefinite-lived intangible assets was greater than the carrying value. Environmental costs Total environmental liabilities accrued at March 29, 2015 and March 30, 2014 were $448 million and $525 million, respectively. The estimated future costs for known environmental remediation requirements are accrued on an undiscounted basis when it is probable that a liability has been incurred, and the amount of remediation costs can be reasonably estimated. When only a range of amounts is established, and no amount within the range is better than another, the minimum amount of the range is recorded. The estimated upper end of the range of reasonably possible environmental costs exceeded amounts accrued by approximately $360 million at March 29, 2015. Actual future losses may be lower or higher given the uncertainties regarding the status of laws, regulations, enforcement policies, the impact of potentially responsible parties, technology and information related to individual sites. Recoveries of environmental remediation costs from other parties are recorded as assets when collection is probable. Adjustments to our accruals may be necessary to reflect new information as investigation and remediation efforts proceed. The amounts of any such adjustments could have a material adverse effect on our results of operations in a given period. Due to the nature of its historical operations, TIMET has significant environmental liabilities at its titanium manufacturing plants. It has for many years, under the oversight of government agencies, conducted investigations of the soil and groundwater contamination at its plant sites. TIMET has initiated remedial actions at its properties, including the capping of former on-site landfills, removal of contaminated sediments from on-site surface impoundments, remediation of contaminated soils and the construction of a slurry wall and groundwater extraction system to treat contaminated groundwater as well as other remedial actions. Although it is anticipated that significant remediation will be completed within the next two to three years, it is expected that a substantial portion of the TIMET environmental accruals will be expended within an estimated 41 years. Expenditures related to these remedial actions and for resolving TIMET's other environmental liabilities will be applied against existing liabilities. As the remedial actions are implemented at these sites, the liabilities will be adjusted based on the progress made in determining the extent of contamination and the extent of required remediation. While the existing liability generally represents our current best estimate of the costs or range of costs of resolving the identified environmental liabilities, these costs may change substantially due to factors such as the nature and extent of contamination, changes in legal and remedial requirements, the allocation of costs among potentially responsible parties as well as other third parties, and technological changes, among others. Guidance on asset retirement and environmental obligations clarifies the term "conditional asset retirement obligation" and requires a liability to be recorded if the fair value of the obligation can be reasonably estimated. Asset retirement obligations covered by this guidance include those for which an entity has a significant obligation to perform an asset retirement activity; however, the timing or method of settling the obligation are conditional on a future event that may not be within the control of the entity. This guidance also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. In accordance with the asset retirement and environmental obligations guidance, we record all known asset retirement obligations for which the liability can be reasonably estimated. Currently, we have identified known asset retirement obligations associated with environmental contamination at several of our manufacturing facilities and have accrued approximately $5 million to satisfy these asset retirement obligations. However, we have not recognized a liability for an asset retirement obligations at two of our manufacturing facilities because the fair value retirement obligation at these sites cannot be reasonably estimated since the settlement date is unknown at this time. The settlement date is unknown because the retirement obligation (remediation of contamination) of these sites is not required until production ceases, and we have no current or future plans to cease production. These asset retirement obligations, when estimable, are not expected to have a material adverse effect on our consolidated financial position, results of operations, cash flows or business. Unconsolidated affiliates We have equity interests in various businesses, which we account for under the equity method as we do not exercise control of the major operating and financial policies. The carrying value of these investments as of March 29, 2015 and March 30, 2014 was $238 million and $416 million, respectively. We regularly assess the profitability and valuation of our investments for any potential impairment. At various times, we may be in discussions with the other owners of these businesses on a variety of topics, including status of the jointly owned entities. In the fourth quarter of fiscal 2015, we decided to sell our 50 percent ownership of Yangzhou Chengde Steel Tube Co. Ltd., a large-diameter pipe manufacturing joint venture in China. At that time, we concluded we no longer had the intent to retain our partial ownership and improve the operations of the facility and therefore, an impairment of the investment was warranted. Based on the estimated fair value of the investment, we recognized a non-cash impairment charge of $174 million, pre-tax, in the fourth quarter of fiscal 2015, which also includes a small impairment associated with an unrelated joint venture. Available for sale securities Available for sale securities consist of investments in shares of publicly traded companies, which we account for at fair value. The carrying value of our investments as of March 29, 2015 and March 30, 2014 was $32 million and $46 million, respectively. We regularly assess the valuation of our investments for potential impairment. While we consider the recent decline in the valuation to be temporary, persistent low valuations could cause us to reevaluate whether our investments are impaired. Income taxes Provisions for federal, state and foreign income taxes are calculated on reported pre-tax earnings based on current tax law and also include, in the current period, the cumulative effect of any changes in tax rates from those used previously in determining deferred tax assets and liabilities. Such provisions differ from the amounts currently receivable or payable, because certain items of income and expense are recognized in different time periods for financial reporting purposes than for income tax purposes. Significant judgment is required in determining income tax provisions and evaluating tax positions. Valuation allowances are recorded to reduce deferred tax assets when it is more likely than not that a tax benefit will not be realized. Tax benefits arising from uncertain tax positions are recognized when it is more likely than not that the position will be sustained upon examination by the relevant tax authorities. The amount recognized in the financial statements is the largest amount of tax benefit that is greater than 50 percent likely of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. We recognize interest and penalties, if any, related to uncertain tax positions in income tax expense. Pension and other postretirement benefit plans We sponsor many U.S. and non-U.S. defined benefit pension plans. Our pension and postretirement benefit plans are accounted for in accordance with defined benefit pension and other postretirement plans accounting guidance. Plan assets have been valued at fair value in accordance with this guidance. Pension and postretirement expense and liability amounts are derived from several significant assumptions, including the discount rate, expected return on plan assets and health care cost trend rate. For valuation of our pension liabilities, we derive a market-based discount rate from yields on high quality, liquid fixed income securities at the end of our fiscal year. We use only highly-rated bonds (AA/Aa or higher) to estimate the interest rate at which our pension benefits could be effectively settled. For our U.S. Plans, we used a discount rate assumption of 4.05% for the total benefit obligation of our pension plans at our March 29, 2015 measurement date. For our non-U.S. Plans, we used a discount rate assumption of 3.54% for the total benefit obligation of our pension plans at our March 29, 2015 measurement date. In developing the long-term rate of return on plan assets assumptions, we evaluate input from third-party investment consultants and actuaries, and review asset allocation and investment strategies, ranges of projected and historical returns, and inflation and economic assumptions. The expected return assumptions are derived from asset allocations within the Company's target asset allocation ranges consistent with our diversified investment approach. As the assumed rate of return on plan assets is a long-term assumption, it is not anticipated to be as volatile as the discount rate, which is a point-in-time measurement. For our U.S. Plans, we used a long-term rate of return assumption of 7.75% to calculate the 2015 net periodic pension cost. For our non-U.S. Plans, we used a long-term rate of return assumption of 7.25% to calculate the 2015 net periodic pension cost. For fiscal 2016, we will use a long-term rate of return assumption of 7.75% for our U.S. plans and 7.00% for our non-U.S. plans to calculate the net periodic pension cost. For fiscal 2015, our U.S. net periodic pension expense was $44 million and non-U.S. net periodic pension expense was $2 million. We estimate that for fiscal 2016, our U.S. net periodic pension expense will be approximately $46 million and non-U.S. net periodic pension expense will be approximately $2 million. Our U.S. net postretirement benefit cost was $6 million for fiscal 2015, and we estimate that for fiscal 2016, our U.S. net postretirement benefit cost will be $6 million. The table below quantifies the approximate impact, as of March 29, 2015, of a one-quarter percentage point decrease in our assumptions for discount rate and expected return on assets, holding other assumptions constant. The approximate impact, as of March 29, 2015, of a one percentage point increase in our assumption for the health care cost trend rate, holding other assumptions constant, on our total service and interest cost components and accumulated postretirement benefit obligation is not significant. Recently issued accounting standards In January 2015, the Financial Accounting Standards Board (“FASB”) issued guidance which eliminates the concept of an extraordinary item. As a result, entities will no longer segregate an extraordinary item from the results of ordinary operations; separately present an extraordinary item on its income statement, net of tax, after income from continuing operations; and disclose income taxes and earnings per share data applicable to an extraordinary item. The guidance is effective for the Company beginning the first quarter of fiscal 2017 with early adoption permitted. The adoption of this guidance is not expected to have a significant impact on our consolidated financial position, results of operations, or cash flows. In May 2014, the FASB issued guidance on revenue from contracts with customers. The guidance outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes the most current revenue recognition guidance. The guidance is effective for the Company beginning the first quarter of fiscal 2018. In April 2015, the FASB issued a proposal that would defer the effective date by one year. The Company is in the process of determining the impact of this guidance on our consolidated financial positions, results of operations, and cash flows. In April 2014, the FASB issued guidance that changes the criteria for reporting discontinued operations while enhancing disclosures in this area. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. The guidance is effective for the Company beginning the first quarter of fiscal 2016. The adoption of this guidance is not expected to have a significant impact on our consolidated financial position, results of operations, or cash flows. In July 2013, the FASB issued guidance on the presentation of unrecognized tax benefits when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The guidance requires entities to present an unrecognized tax benefit netted against certain deferred tax assets when specific requirements are met. The guidance was effective for the Company beginning the first quarter of fiscal 2015. The adoption of this guidance did not have a significant impact on our consolidated financial position, results of operations, or cash flows. In March 2013, the FASB issued guidance to address the accounting for the cumulative translation adjustment when a parent entity sells or transfers either a subsidiary or a group of assets within a foreign entity. The guidance was effective for the Company beginning the first quarter of fiscal 2015 and was applied prospectively. The adoption of this guidance did not have a significant impact on our consolidated financial position, results of operations, or cash flows.

<s>[INST] (in millions, except per share data) Business overview Fiscal 2015 presented Precision Castparts Corp. ("PCC") with a number of opportunities as well as challenges. We continued to be wellpositioned in the core commercial aerospace and industrial gas turbine ("IGT") markets, which provided us with sales and earnings growth throughout the fiscal year. However, beginning late in the third quarter, we experienced demand softness in our oil & gas and pipe markets, with customers deferring decisions on large projects and distribution demand falling almost to zero. Despite these dynamics, we believe the combination of our strong technical capabilities and improved cost structure places us in a solid position to serve our customers now and when increased demand returns. In the first quarter of fiscal 2015, we saw both solid operating results and a significant shift in customer order dynamics in our major end markets. Commercial aerospace activity was the biggest driver of growth as base aircraft production continued. We also saw an upward shift in orders from our customers in power markets. Continued expansion in interconnect pipe demand provided further upside. In the oil & gas market, we won sizeable new orders that leveraged our unique capabilities. We continued to grow total yearoveryear sales and earnings in the second quarter of fiscal 2015, demonstrating solid leverage of our strong market share position in primary end markets. Commercial aerospace sales continued a steady upward trajectory fueled by the segment's strong presence on all major aircraft/engine platforms, both in production and in development. IGT orders also steadily improved as a result of solid positions on upgrade programs, higher content on new production turbines and higher spares requirements. The third quarter of fiscal 2015 included some clear achievements, but we also faced some real challenges in several of our end markets. On the plus side, we made solid progress on our production and development aircraft and engine programs. In addition, our growth in IGT outpaced the market, given our higher content on new and upgrade platforms, and provided a steady supply of spares to the installed base. On the other hand, the third quarter also presented us with rapid declines in demand from our oil & gas customers and continued destocking from one of our large aerospace customers. We continued to face sizable challenges in our oil & gas and pipe markets in the fourth quarter of fiscal 2015, which had a negative impact on our financial results. In response, we took multiple actions to adjust our operations to the realities of the demand environment by rightsizing our operations, evaluating our inventory positions, and making decisions to exit underperforming investments. We recognized $127 million in pretax charges related to asset and inventory valuation adjustments and $8 million related to restructuring activities. In addition, we recognized $174 million, pretax, of impairment charges primarily associated with the company’s ownership interest in Yangzhou Chengde Steel Tube Co., Ltd. (Chengde). Our capital allocation framework supports a multipronged strategy that prioritizes internal investment and valuecreating acquisitions, with excess cash returned to shareholders in the form of share repurchases once the first two criteria are met. During fiscal 2015, we acquired two businesses for a total of approximately $637 million. The larger acquisition, Aerospace Dynamics International, broadens our large gantry capabilities and provides us with significant additional share on the Airbus A350 program. Subsequent to yearend, we acquired two small businesses, which expand our vertical integration capabilities. We continue to be very active on the acquisition front, with several potential opportunities in front of us. We delivered on our share repurchase program during fiscal 2015, returning $1.6 billion of cash to shareholders. During May 2015, the PCC Board of Directors added an additional $2.0 billion to our share repurchase authorization, which we expect to complete in the next 12 to 18 months, subject to market conditions, with the objective of lowering our share count over time. We remain committed to our valuecreating capital deployment strategy, focused on growing the business organically and through acquisitions and on returning excess cash to shareholders via share repurchases. _________________________ (1) Source: Bloomberg Fiscal 2015 compared with fiscal 2014 Total sales for fiscal 20 [/INST] Negative. </s>

EOG RESOURCES INC

2015-02-18

2014-12-31

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (non-integrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Canada, Trinidad, the United Kingdom and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a cost-effective basis, allowing EOG to deliver long-term production growth while maintaining a strong balance sheet. EOG implements its strategy by emphasizing the drilling of internally generated prospects in order to find and develop low-cost reserves. Maintaining the lowest possible operating cost structure that is consistent with prudent and safe operations is also an important goal in the implementation of EOG's strategy. Net income for 2014 totaled $2,915 million as compared to $2,197 million for 2013. At December 31, 2014, EOG's total estimated net proved reserves were 2,497 million barrels of oil equivalent (MMBoe), an increase of 378 MMBoe from December 31, 2013. During 2014, net proved crude oil and condensate and natural gas liquids (NGL) reserves increased by 329 million barrels (MMBbl), and net proved natural gas reserves increased by 298 billion cubic feet or 50 MMBoe. Operations Several important developments have occurred since January 1, 2014. United States and Canada. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquids-rich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquids-rich reservoirs. In 2014, EOG remained focused on developing its existing North American crude oil and liquids-rich acreage. In addition, increasing drilling and completion efficiencies and testing methods to improve the recovery factor of oil-in-place remained areas of emphasis in 2014. EOG continues to evaluate certain potential crude oil and liquids-rich natural gas exploration and development prospects. On a volumetric basis, as calculated using the ratio of 1.0 barrel of crude oil and condensate or NGL to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGL production accounted for approximately 69% of total North American production during 2014 compared to 63% in 2013. This liquids growth primarily reflects increased production from the South Texas Eagle Ford, the North Dakota Bakken and the Permian Basin. In 2014, EOG's net Eagle Ford production averaged 202.7 thousand barrels per day (MBbld) of crude oil and condensate and NGL as compared to 140.9 MBbld in 2013. EOG's major producing areas are in New Mexico, North Dakota, Texas, Utah and Wyoming. EOG continues to deliver its crude oil to various markets in the United States, including sales points on the Gulf Coast where sales are based upon the Light Louisiana Sweet crude oil index. EOG's crude-by-rail facilities provide EOG the flexibility to direct its crude oil shipments via rail car to the most favorable markets, including the Gulf Coast, Cushing, Oklahoma, and other markets. During the fourth quarter of 2014, EOG completed the divestiture of all its assets in Manitoba, Canada and the majority of its assets in Alberta, Canada in two separate transactions. Proceeds from the divestitures were approximately 400 million United States dollars, net of customary transaction adjustments. As a result of these transactions, approximately 150 million United States dollars of restricted cash related to future abandonment liabilities was released. The proceeds and cash were utilized for general corporate purposes. Production from the divested assets totaled approximately 7,050 barrels of crude oil per day, 580 barrels of NGL per day and 43.5 million cubic feet of natural gas per day. Net proved reserves divested are estimated to be 7.7 million barrels of oil, 0.8 million barrels of NGL and 78.7 billion cubic feet of natural gas. EOG divested 1.3 million gross acres (1.1 million net acres), 97 percent of which were in Alberta, and approximately 5,800 producing wells of which 5,155 were natural gas. EOG reclassified approximately $383 million of accumulated translation adjustments from Accumulated Other Comprehensive Income to Net Income as the divestitures represented a substantially complete liquidation of EOG's Canadian operations. See Note 17 to the Consolidated Financial Statements. International. In Trinidad, EOG continued to deliver natural gas under existing supply contracts. Several fields in the South East Coast Consortium (SECC) Block, Modified U(a) Block, Block 4(a) and Modified U(b) Block and the EMZ Area have been developed and are producing natural gas which is sold to the National Gas Company of Trinidad and Tobago and its subsidiary and crude oil and condensate which is sold to the Petroleum Company of Trinidad and Tobago Limited. In the fourth quarter of 2014, EOG initiated a three-net well drilling program in the SECC and Modified U(b) Blocks, completing one well in 2014. In 2015, EOG expects to drill and complete the remaining two net wells in this program. In the United Kingdom, EOG continues to make progress in the development of its 100% working interest East Irish Sea Conwy crude oil discovery. Modifications to the nearby third-party owned Douglas platform, which will be used to process Conwy production, began in 2013 and continued throughout 2014. First production from the Conwy field is anticipated in the third quarter of 2015. In the fourth quarter of 2014, EOG recognized a $351 million impairment of the Conwy project as a result of crude oil price declines. In the Sichuan Basin, Sichuan Province, China, in 2014, EOG drilled two wells and completed two wells, one of which was originally drilled in 2013. In 2015, EOG expects to complete the second well that was drilled in 2014 and drill and complete four additional wells. EOG's activity in Argentina is focused on the Vaca Muerta oil shale formation in the Neuquén Basin in Neuquén Province. In 2014, EOG completed a vertical well in the Cerro Avispa Block that was drilled in late 2013 and determined the well to be a dry hole. Also during 2014, EOG participated in the drilling of two wells in the Bajo del Toro Block, both of which were determined to be dry holes. In the fourth quarter of 2014, EOG recognized an impairment charge of $44 million for the balance of its investment in Argentina. Management is currently evaluating options for its investment. EOG continues to evaluate other select crude oil and natural gas opportunities outside the United States and Canada primarily by pursuing exploitation opportunities in countries where indigenous crude oil and natural gas reserves have been identified. Capital Structure One of management's key strategies is to maintain a strong balance sheet with a consistently below average debt-to-total capitalization ratio as compared to those in EOG's peer group. EOG's debt-to-total capitalization ratio was 25% at December 31, 2014 and 28% at December 31, 2013. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. At December 31, 2014, $500 million aggregate principal amount of its 2.95% Senior Notes due 2015 were reclassified as long-term debt based upon EOG's intent and ability to ultimately replace such amount with other long-term debt. On March 21, 2014, EOG closed its sale of the $500 million aggregate principal amount of its 2.45% Senior Notes due 2020 (Notes). Interest on the Notes is payable semi-annually in arrears on April 1 and October 1 of each year, beginning October 1, 2014. Net proceeds from the Notes offering of approximately $496 million were used for general corporate purposes. On March 17, 2014, EOG repaid upon maturity the $150 million aggregate principal amount of its 4.75% Subsidiary Debt due 2014 (Subsidiary Debt) and settled the foreign currency swap entered into contemporaneously with the issuance of the Subsidiary Debt for $32 million. On February 3, 2014, EOG repaid upon maturity the $350 million aggregate principal amount of its Floating Rate Senior Notes due 2014 (Floating Rate Notes). On the same date, EOG settled the interest rate swap entered into contemporaneously with the issuance of the Floating Rate Notes for $0.8 million. During 2014, EOG funded $8.4 billion in exploration and development and other property, plant and equipment expenditures (excluding asset retirement obligations), repaid at maturity $500 million aggregate principal amount of long-term debt, paid $280 million in dividends to common stockholders and purchased $127 million of treasury stock in connection with stock compensation plans, primarily by utilizing cash provided from its operating activities, net proceeds of $569 million from the sale of assets, net proceds from the sale of the Notes and $99 million of excess tax benefits from stock compensation. Total anticipated 2015 capital expenditures are estimated to range from approximately $4.9 billion to $5.1 billion, excluding acquisitions. The majority of 2015 expenditures will be focused on United States crude oil drilling activities. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program and other uncommitted credit facilities, bank borrowings, borrowings under its $2.0 billion senior unsecured Revolving Credit Agreement and equity and debt offerings. When it fits EOG's strategy, EOG will make acquisitions that bolster existing drilling programs or offer EOG incremental exploration and/or production opportunities. Management continues to believe EOG has one of the strongest prospect inventories in EOG's history. Results of Operations The following review of operations for each of the three years in the period ended December 31, 2014, should be read in conjunction with the consolidated financial statements of EOG and notes thereto beginning on page. Net Operating Revenues During 2014, net operating revenues increased $3,548 million, or 24%, to $18,035 million from $14,487 million in 2013. Total wellhead revenues, which are revenues generated from sales of EOG's production of crude oil and condensate, NGL and natural gas, increased $1,837 million, or 17%, to $12,593 million in 2014 from $10,756 million in 2013. Revenues from the sales of crude oil and condensate and NGL in 2014 were approximately 85% of total wellhead revenues compared to 84% in 2013. During 2014, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $834 million compared to net losses of $166 million in 2013. Gathering, processing and marketing revenues, which are revenues generated from sales of third-party crude oil and condensate, NGL and natural gas as well as gathering fees associated with gathering third-party natural gas, increased $402 million during 2014, to $4,046 million from $3,644 million in 2013. Gains on asset dispositions, net, totaled $508 million and $198 million in 2014 and 2013, respectively. Wellhead volume and price statistics for the years ended December 31, 2014, 2013 and 2012 were as follows: (1) Thousand barrels per day or million cubic feet per day, as applicable. (2) Other International includes EOG's United Kingdom, China and Argentina operations. (3) Dollars per barrel or per thousand cubic feet, as applicable. Excludes the impact of financial commodity derivative instruments (see Note 12 to Consolidated Financial Statements). (4) Thousand barrels of oil equivalent per day or million barrels of oil equivalent, as applicable; includes crude oil and condensate, NGL and natural gas. Crude oil equivalents are determined using the ratio of 1.0 barrel of crude oil and condensate or NGL to 6.0 thousand cubic feet of natural gas. MMBoe is calculated by multiplying the MBoed amount by the number of days in the period and then dividing that amount by one thousand. 2014 compared to 2013. Wellhead crude oil and condensate revenues in 2014 increased $1,441 million, or 17%, to $9,742 million from $8,301 million in 2013, due to an increase of 68.5 MBbld, or 31%, in wellhead crude oil and condensate deliveries ($2,558 million), partially offset by a lower composite average wellhead crude oil and condensate price ($1,117 million). The increase in deliveries primarily reflects increased production in the Eagle Ford, the North Dakota Bakken and the Permian Basin. EOG's composite wellhead crude oil and condensate price for 2014 decreased 10% to $92.58 per barrel compared to $103.20 per barrel in 2013. NGL revenues in 2014 increased $160 million, or 21%, to $934 million from $774 million in 2013, due to an increase of 15 MBbld, or 23%, in NGL deliveries ($179 million), partially offset by a lower composite average price ($19 million). The increase in deliveries primarily reflects increased volumes in the Eagle Ford and the Permian Basin. EOG's composite NGL price in 2014 decreased 2% to $31.91 per barrel compared to $32.55 per barrel in 2013. Wellhead natural gas revenues in 2014 increased $235 million, or 14%, to $1,916 million from $1,681 million in 2013, primarily due to a higher composite wellhead natural gas price. EOG's composite average wellhead natural gas price increased 13% to $3.88 per Mcf in 2014 compared to $3.42 per Mcf in 2013. Natural gas deliveries in 2014 increased less than 1% to 1,353 MMcfd as compared to 1,347 MMcfd in 2013. Increased production in the United States (12 MMcfd) and Trinidad (8 MMcfd) was offset by lower production in Canada (15 MMcfd). In the United States, increased production of associated natural gas in the Eagle Ford and Permian Basin areas was partially offset by lower production in the Upper Gulf Coast and Fort Worth Basin Barnett Shale areas. During 2014, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $834 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $34 million. During 2013, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $166 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $116 million. Gathering, processing and marketing revenues were primarily related to sales of third-party crude oil and natural gas. Purchases and sales of third-party crude oil and natural gas are utilized in order to balance firm transportation capacity with production in certain areas and to utilize excess capacity at EOG-owned facilities. Marketing costs represent the costs of purchasing third-party crude oil and natural gas and the associated transportation costs. Gathering, processing and marketing revenues less marketing costs in 2014 declined $75 million compared to 2013, primarily due to lower margins on crude oil marketing activities. 2013 compared to 2012. Wellhead crude oil and condensate revenues in 2013 increased $2,642 million, or 47%, to $8,301 million from $5,659 million in 2012, due to an increase of 63 MBbld, or 40%, in wellhead crude oil and condensate deliveries ($2,205 million) and a higher composite average wellhead crude oil and condensate price ($437 million). The increase in deliveries primarily reflects increased production in the Eagle Ford, the North Dakota Bakken and the Permian Basin. EOG's composite average wellhead crude oil and condensate price for 2013 increased 6% to $103.20 per barrel compared to $97.77 per barrel in 2012. NGL revenues in 2013 increased $47 million, or 6%, to $774 million from $727 million in 2012, due to an increase of 9 MBbld, or 17%, in NGL deliveries ($118 million), partially offset by a lower composite average price ($71 million). The increase in deliveries primarily reflects increased volumes in the Eagle Ford. EOG's composite average NGL price in 2013 decreased 8% to $32.55 per barrel compared to $35.54 per barrel in 2012. Wellhead natural gas revenues in 2013 increased $109 million, or 7%, to $1,681 million from $1,572 million in 2012. The increase was due to a higher composite average wellhead natural gas price ($288 million), partially offset by decreased natural gas deliveries ($179 million). EOG's composite average wellhead natural gas price increased 21% to $3.42 per Mcf in 2013 compared to $2.83 per Mcf in 2012. Natural gas deliveries in 2013 decreased 169 MMcfd, or 11%, primarily due to decreased production in the United States (126 MMcfd), Trinidad (23 MMcfd) and Canada (19 MMcfd). The decrease in the United States was attributable to asset sales and reduced natural gas drilling activity. The decrease in Trinidad was primarily attributable to higher contractual deliveries in 2012. During 2013, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $166 million, which included net cash received from settlements of commodity derivative contracts of $116 million. During 2012, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $394 million, which included net cash received from settlements of commodity derivative contracts of $711 million. During 2013, gathering, processing and marketing revenues and marketing costs increased, compared to 2012, primarily as a result of increased crude oil marketing activities. Gathering, processing and marketing revenues less marketing costs in 2013 decreased $66 million, compared to 2012, due primarily to lower margins on crude oil marketing activities. Operating and Other Expenses 2014 compared to 2013. During 2014, operating expenses of $12,794 million were $1,982 million higher than the $10,812 million incurred during 2013. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2014 and 2013: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2014 compared to 2013 are set forth below. See "Net Operating Revenues" above for a discussion of production volumes. Lease and well expenses include expenses for EOG-operated properties, as well as expenses billed to EOG from other operators where EOG is not the operator of a property. Lease and well expenses can be divided into the following categories: costs to operate and maintain crude oil and natural gas wells, the cost of workovers and lease and well administrative expenses. Operating and maintenance costs include, among other things, pumping services, salt water disposal, equipment repair and maintenance, compression expense, lease upkeep and fuel and power. Workovers are operations to restore or maintain production from existing wells. Each of these categories of costs individually fluctuates from time to time as EOG attempts to maintain and increase production while maintaining efficient, safe and environmentally responsible operations. EOG continues to increase its operating activities by drilling new wells in existing and new areas. Operating and maintenance costs within these existing and new areas, as well as the costs of services charged to EOG by vendors, fluctuate over time. Lease and well expenses of $1,416 million in 2014 increased $310 million from $1,106 million in 2013 primarily due to higher operating and maintenance costs ($209 million), increased workover expenditures ($69 million) and increased lease and well administrative expenses ($32 million), all in the United States. Transportation costs represent costs associated with the delivery of hydrocarbon products from the lease to a downstream point of sale. Transportation costs include transportation fees, costs associated with crude-by-rail operations, the cost of compression (the cost of compressing natural gas to meet pipeline pressure requirements), dehydration (the cost associated with removing water from natural gas to meet pipeline requirements), gathering fees and fuel costs. Transportation costs of $972 million in 2014 increased $119 million from $853 million in 2013 primarily due to increased transportation costs related to production from the Eagle Ford ($99 million) and the Rocky Mountain area ($15 million). DD&A of the cost of proved oil and gas properties is calculated using the unit-of-production method. EOG's DD&A rate and expense are the composite of numerous individual DD&A group calculations. There are several factors that can impact EOG's composite DD&A rate and expense, such as field production profiles, drilling or acquisition of new wells, disposition of existing wells and reserve revisions (upward or downward) primarily related to well performance, economic factors and impairments. Changes to these factors may cause EOG's composite DD&A rate and expense to fluctuate from period to period. DD&A of the cost of other property, plant and equipment is generally calculated using the straight-line depreciation method over the useful lives of the assets. DD&A expenses in 2014 increased $396 million to $3,997 million from $3,601 million in 2013. DD&A expenses associated with oil and gas properties in 2014 were $384 million higher than in 2013 primarily due to increased production in the United States ($630 million), partially offset by lower unit rates in the United States ($191 million) and Canada ($37 million) and a decrease in production in Canada ($31 million). Unit rates in the United States decreased primarily due to upward reserve revisions and reserves added at lower costs as a result of increased efficiencies. G&A expenses of $402 million in 2014 were $54 million higher than 2013 primarily due to higher costs associated with supporting expanding operations. Net interest expense of $201 million in 2014 was $34 million lower than 2013 primarily due to repayment of the $400 million aggregate principal amount of the 6.125% Senior Notes due 2013, the Subsidiary Debt and the Floating Rate Notes ($31 million), as well as an increase in capitalized interest across the company ($8 million). This was partially offset by interest expense on the Notes issued in March 2014 ($10 million). Gathering and processing costs represent operating and maintenance expenses and administrative expenses associated with operating EOG's gathering and processing assets. Gathering and processing costs increased $38 million to $146 million in 2014 compared to $108 million in 2013 primarily due to increased activities in the Eagle Ford. Exploration costs of $184 million in 2014 increased $23 million from $161 million in 2013 primarily due to increased geological and geophysical expenditures in the United States. Impairments include amortization of unproved oil and gas property costs; as well as impairments of proved oil and gas properties; other property, plant and equipment; and other assets. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. When circumstances indicate that a proved property may be impaired, EOG compares expected undiscounted future cash flows at a DD&A group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated by using the Income Approach described in the Fair Value Measurement Topic of the Financial Accounting Standards Board's Accounting Standards Codification (ASC). In certain instances, EOG utilizes accepted bids as the basis for determining fair value. Impairments of $744 million in 2014 increased $457 million from $287 million in 2013 primarily due to increased impairments of proved properties in the United Kingdom ($351 million), the United States ($145 million) and Argentina ($39 million); and increased amortization of unproved property costs in the United States ($54 million); partially offset by decreased impairments of proved properties in Canada ($67 million) and Trinidad ($14 million); and lower impairments of other assets in the United States ($46 million). EOG recorded impairments of proved properties; other property, plant and equipment; and other assets of $575 million and $172 million in 2014 and 2013, respectively. The 2014 and 2013 amounts include impairments of $503 million and $7 million, respectively, related to certain assets as a result of declining commodity prices and using accepted bids for determining fair value. Taxes other than income include severance/production taxes, ad valorem/property taxes, payroll taxes, franchise taxes and other miscellaneous taxes. Severance/production taxes are generally determined based on wellhead revenues, and ad valorem/property taxes are generally determined based on the valuation of the underlying assets. Taxes other than income in 2014 increased $134 million to $758 million (6.0% of wellhead revenues) from $624 million (5.8% of wellhead revenues) in 2013. The increase in taxes other than income was primarily due to increases in severance/production taxes ($112 million) primarily as a result of increased wellhead revenues and higher ad valorem/property taxes ($34 million) in the United States, partially offset by an increase in credits available to EOG in 2014 for Texas high-cost gas severance tax rate reductions ($11 million). Other expense, net, was $45 million in 2014 compared to $3 million in 2013. The increase of $42 million was primarily due to net foreign currency transaction losses. Income tax provision of $2,080 million in 2014 increased $840 million from $1,240 million in 2013 due primarily to higher pretax income. The net effective tax rate for 2014 increased to 42% from 36% in the prior year. The net effective tax rate for 2014 exceeded the United States statutory tax rate (35%) due primarily to valuation allowances in the United Kingdom and deferred tax in the United States related to EOG's undistributed foreign earnings. EOG no longer asserts that foreign earnings will remain permanently reinvested abroad and therefore recorded deferred tax of $250 million on the accumulated balance of such earnings in the fourth quarter of 2014. 2013 compared to 2012. During 2013, operating expenses of $10,812 million were $609 million higher than the $10,203 million incurred during 2012. The following table presents the costs per Boe for the years ended December 31, 2013 and 2012: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2013 compared to 2012 are set forth below. See "Net Operating Revenues" above for a discussion of production volumes. Lease and well expenses of $1,106 million in 2013 increased $106 million from $1,000 million in 2012 primarily due to higher operating and maintenance expenses in the United States ($48 million) and Canada ($13 million) and increased workover expenditures in the United States ($38 million). Transportation costs of $853 million in 2013 increased $252 million from $601 million in 2012 primarily due to increased transportation costs related to production from the Eagle Ford ($136 million), the Rocky Mountain area ($84 million) and the Fort Worth Basin Barnett Shale area ($27 million). DD&A expenses in 2013 increased $431 million to $3,601 million from $3,170 million in 2012. DD&A expenses associated with oil and gas properties in 2013 were $473 million higher than in 2012 primarily due to increased production in the United States ($347 million) and higher unit rates in the United States ($133 million) and Trinidad ($44 million), partially offset by a decrease in production in Canada ($29 million) and Trinidad ($10 million) and lower unit rates in Canada ($12 million). DD&A unit rates in the United States increased due primarily to downward revisions of natural gas reserves at December 31, 2012, and a proportional increase in production from higher cost properties. DD&A expenses associated with other property, plant and equipment were $42 million lower in 2013 than in 2012 primarily in the Fort Worth Basin Barnett Shale area ($32 million), the Eagle Ford ($7 million) and the Rocky Mountain area ($7 million). G&A expenses of $348 million in 2013 were $17 million higher than 2012 due primarily to higher costs associated with supporting expanding operations. Net interest expense of $235 million in 2013 was $22 million higher than 2012 due primarily to interest expense on the $1,250 million principal amount of 2.625% Senior Notes due 2023 issued in September 2012 ($23 million). This was partially offset by a reduction in interest expense on the 6.125% Senior Notes, which were repaid at maturity in October 2013 ($6 million). Gathering and processing costs increased $10 million to $108 million in 2013 compared to $98 million in 2012. The increase primarily reflects increased activities in the Eagle Ford ($22 million), partially offset by decreased costs in Canada ($9 million). Exploration costs of $161 million in 2013 decreased $25 million from $186 million in 2012 primarily due to decreased geological and geophysical expenditures in the United States. Impairments of $287 million in 2013 decreased $984 million from $1,271 million in 2012 primarily due to decreased impairments of proved and unproved properties in Canada ($881 million), decreased impairments of proved properties and other assets in the United States ($98 million) and decreased amortization of unproved property costs in the United States ($17 million). EOG recorded impairments of proved and unproved properties; other property, plant and equipment; and other assets of $172 million and $1,133 million in 2013 and 2012, respectively. The 2013 and 2012 amounts include impairments of $7 million and $1,022 million, respectively, related to certain North American assets as a result of declining commodity prices and using accepted bids for determining fair value. Taxes other than income in 2013 increased $129 million to $624 million (5.8% of wellhead revenues) from $495 million (6.2% of wellhead revenues) in 2012. The increase in taxes other than income was primarily due to increased severance/production taxes in the United States ($122 million) primarily as a result of increased wellhead revenues and higher ad valorem/property taxes in the United States ($15 million), partially offset by decreased severance/production taxes in Canada ($9 million). Other expense, net, was $3 million in 2013 compared to other income, net, of $14 million in 2012. The decrease of $17 million was primarily due to losses on warehouse stock sales and adjustments. Income tax provision of $1,240 million in 2013 increased $530 million from $710 million in 2012 primarily due to higher pretax income. The net effective tax rate for 2013 decreased to 36% from 55% in 2012 due primarily to the absence of certain 2012 Canadian losses (26% statutory tax rate). Capital Resources and Liquidity Cash Flow The primary sources of cash for EOG during the three-year period ended December 31, 2014, were funds generated from operations, proceeds from asset sales, net proceeds from issuances of long-term debt, excess tax benefits from stock-based compensation, net commercial paper borrowings and borrowings under other uncommitted credit facilities and revolving credit facilities. The primary uses of cash were funds used in operations; exploration and development expenditures; other property, plant and equipment expenditures; repayments of debt; dividend payments to stockholders; and purchases of treasury stock in connection with stock compensation plans. 2014 compared to 2013. Net cash provided by operating activities of $8,649 million in 2014 increased $1,320 million from $7,329 million in 2013 primarily reflecting an increase in wellhead revenues ($1,837 million), favorable changes in working capital and other assets and liabilities ($391 million) and a decrease in net cash paid for interest expense ($38 million), partially offset by an increase in cash operating expenses ($662 million), an unfavorable change in the net cash received from the settlement of financial commodity derivative contracts ($82 million) and an increase in net cash paid for income taxes ($48 million). Net cash used in investing activities of $7,514 million in 2014 increased by $1,199 million from $6,315 million in 2013 primarily due to an increase in additions to oil and gas properties ($823 million); an increase in additions to other property, plant and equipment ($364 million); and a decrease in proceeds from sales of assets ($191 million); partially offset by the release of restricted cash ($126 million) and favorable changes in working capital associated with investing activities ($52 million). Net cash used in financing activities of $328 million during 2014 included repayments of long-term debt ($500 million), cash dividend payments ($280 million), purchases of treasury stock in connection with stock compensation plans ($127 million) and the settlement of a foreign currency swap ($32 million). Cash provided by financing activities in 2014 included net proceeds from the issuance of the Notes ($496 million), excess tax benefits from stock-based compensation ($99 million) and proceeds from stock options exercised and employee stock purchase plan activity ($22 million). 2013 compared to 2012. Net cash provided by operating activities of $7,329 million in 2013 increased $2,092 million from $5,237 million in 2012 primarily reflecting an increase in wellhead revenues ($2,798 million), favorable changes in working capital and other assets and liabilities ($405 million) and a decrease in net cash paid for income taxes ($65 million), partially offset by an unfavorable change in the net cash received from the settlement of financial commodity derivative contracts ($595 million), an increase in cash operating expenses ($478 million) and an increase in net cash paid for interest expense ($39 million). Net cash used in investing activities of $6,315 million in 2013 increased by $196 million from $6,119 million for the same period of 2012 due primarily to a decrease in proceeds from sales of assets ($549 million); and an increase in restricted cash ($66 million); partially offset by a decrease in additions to other property, plant and equipment ($256 million); favorable changes in working capital associated with investing activities ($125 million); and a decrease in additions to oil and gas properties ($38 million). Net cash used in financing activities of $574 million during 2013 included the repayment of long-term debt ($400 million), cash dividend payments ($199 million) and treasury stock purchases in connection with stock compensation plans ($64 million). Cash provided by financing activities in 2013 included excess tax benefits from stock-based compensation ($56 million) and proceeds from stock options exercised and employee stock purchase plan activity ($39 million). Total Expenditures The table below sets out components of total expenditures for the years ended December 31, 2014, 2013 and 2012 (in millions): (1) Leasehold acquisitions included $5 million in both 2014 and 2013 and $20 million in 2012 related to non-cash property exchanges. (2) In 2012, other property, plant and equipment included non-cash additions of $66 million in connection with a capital lease transaction in the Eagle Ford. Exploration and development expenditures of $7,709 million for 2014 were $846 million higher than the prior year primarily due to increased drilling and facilities expenditures in the United States ($1,019 million) and China ($12 million); and increased property acquisitions ($19 million), increased exploration geological and geophysical expenditures ($18 million), and increased capitalized interest ($8 million), all in the United States. These increases were partially offset by decreased drilling and facilities expenditures in Canada ($82 million), Trinidad ($57 million), the United Kingdom ($40 million) and Argentina ($14 million); and decreased leasehold acquisition expenditures in the United States ($46 million). The 2014 exploration and development expenditures of $7,709 million included $6,804 million in development, $709 million in exploration, $139 million in property acquisitions and $57 million in capitalized interest. The 2013 exploration and development expenditures of $6,863 million included $5,952 million in development, $742 million in exploration, $120 million in property acquisitions and $49 million in capitalized interest. The 2012 exploration and development expenditures of $6,941 million included $5,989 million in development, $901 million in exploration and $50 million in capitalized interest. The level of exploration and development expenditures, including acquisitions, will vary in future periods depending on energy market conditions and other related economic factors. EOG has significant flexibility with respect to financing alternatives and the ability to adjust its exploration and development expenditure budget as circumstances warrant. While EOG has certain continuing commitments associated with expenditure plans related to its operations, such commitments are not expected to be material when considered in relation to the total financial capacity of EOG. Derivative Transactions Commodity Derivative Contracts. The total fair value of EOG's crude oil and natural gas derivative contracts is reflected on the Consolidated Balance Sheets at December 31, 2014, as a net asset of $465 million. Presented below is a comprehensive summary of EOG's crude oil derivative contracts at February 16, 2015, with notional volumes expressed in barrels per day (Bbld) and prices expressed in dollars per barrel ($/Bbl). (1) EOG has entered into crude oil derivative contracts which give counterparties the option to extend certain current derivative contracts for additional six-month periods. Options covering a notional volume of 37,000 Bbld are exercisable on June 30, 2015. If the counterparties exercise all such options, the notional volume of EOG's existing crude oil derivative contracts will increase by 37,000 Bbld at an average price of $91.56 per barrel for each month during the period July 1, 2015 through December 31, 2015. Presented below is a comprehensive summary of EOG's natural gas derivative contracts at February 16, 2015, with notional volumes expressed in million British thermal units (MMBtu) per day (MMBtud) and prices expressed in dollars per MMBtu ($/MMBtu). (1) EOG has entered into natural gas derivative contracts which give counterparties the option of entering into derivative contracts at future dates. All such options are exercisable monthly up until the settlement date of each monthly contract. If the counterparties exercise all such options, the notional volume of EOG's existing natural gas derivative contracts will increase by 175,000 MMBtud at an average price of $4.51 per MMBtu for each month during the period March 1, 2015 through December 31, 2015. Financing EOG's debt-to-total capitalization ratio was 25% at December 31, 2014, compared to 28% at December 31, 2013. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. The principal amount of debt outstanding totaled $5,890 million at both December 31, 2014 and 2013. The estimated fair value of EOG's debt at December 31, 2014 and 2013 was $6,242 million and $6,222 million, respectively. The estimated fair value of debt was based upon quoted market prices and, where such prices were not available, other observable inputs regarding interest rates available to EOG at year-end. EOG's debt is at fixed interest rates. While changes in interest rates affect the fair value of EOG's debt, such changes do not expose EOG to material fluctuations in earnings or cash flow. During 2014, EOG funded its capital program primarily by utilizing cash provided by operating activities, proceeds from asset sales and cash provided by borrowings from its commercial paper program. While EOG maintains a $2.0 billion commercial paper program, the maximum outstanding at any time during 2014 was $345 million, and the amount outstanding at year-end was zero. The maximum amount outstanding under uncommitted credit facilities during 2014 was $31 million with zero outstanding at year-end. The average borrowings outstanding under the commercial paper program and the uncommitted credit facilities were $12 million and $0.1 million, respectively, during the year 2014. EOG considers this excess availability, which is backed by its $2.0 billion senior unsecured Revolving Credit Agreement (Credit Agreement) described in Note 2 to Consolidated Financial Statements, to be ample to meet its ongoing operating needs. Contractual Obligations The following table summarizes EOG's contractual obligations at December 31, 2014, (in thousands): (1) This table does not include the liability for unrecognized tax benefits, EOG's pension or postretirement benefit obligations or liability for dismantlement, abandonment and asset retirement obligations (see Notes 6, 7 and 15, respectively, to Consolidated Financial Statements). (2) Amounts shown are based on current transportation and storage rates and the foreign currency exchange rates used to convert Canadian dollars and British pounds into United States dollars at December 31, 2014. Management does not believe that any future changes in these rates before the expiration dates of these commitments will have a material adverse effect on the financial condition or results of operations of EOG. (3) Amounts shown represent minimum future expenditures for drilling rig services. EOG's expenditures for drilling rig services will exceed such minimum amounts to the extent EOG utilizes the drilling rigs subject to a particular contractual commitment for a period greater than the period set forth in the governing contract or if EOG utilizes drilling rigs in addition to the drilling rigs subject to the particular contractual commitment (for example, pursuant to the exercise of an option to utilize additional drilling rigs provided for in the governing contract). Off-Balance Sheet Arrangements EOG does not participate in financial transactions that generate relationships with unconsolidated entities or financial partnerships. Such entities or partnerships, often referred to as variable interest entities (VIE) or special purpose entities (SPE), are generally established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. EOG was not involved in any unconsolidated VIE or SPE financial transactions or any other "off-balance sheet arrangement" (as defined in Item 303(a)(4)(ii) of Regulation S-K) during any of the periods covered by this report and currently has no intention of participating in any such transaction or arrangement in the foreseeable future. Foreign Currency Exchange Rate Risk During 2014, EOG was exposed to foreign currency exchange rate risk inherent in its operations in foreign countries, including Canada, Trinidad, the United Kingdom, China and Argentina. The foreign currency most significant to EOG's operations during 2014 was the Canadian dollar. The fluctuation of the Canadian dollar in 2014 impacted both the revenues and expenses of EOG's Canadian subsidiaries. However, since Canadian commodity prices are largely correlated to United States prices, the changes in the Canadian currency exchange rate have less of an impact on the Canadian revenues than the Canadian expenses. As previously discussed, during the fourth quarter of 2014, EOG sold substantially all of its Canadian assets. EOG continues to monitor the foreign currency exchange rates of countries in which it is currently conducting business and may implement measures to protect against foreign currency exchange rate risk. EOG was party to a foreign currency aggregate swap with multiple banks to eliminate any exchange rate impacts that may have resulted from the Subsidiary Debt. The foreign currency swap expired and was settled contemporaneously with the repayment upon maturity of the Subsidiary Debt on March 17, 2014 (see Note 2 to the Consolidated Financial Statements). Outlook Pricing. Crude oil and natural gas prices have been volatile, and this volatility is expected to continue. As a result of the many uncertainties associated with the world political environment, worldwide supplies of crude oil and condensate, NGL and natural gas, the availabilities of other worldwide energy supplies and the relative competitive relationships of the various energy sources in the view of consumers, EOG is unable to predict what changes may occur in crude oil and condensate, NGL, natural gas, ammonia and methanol prices in the future. The market price of crude oil and condensate, NGL and natural gas in 2015 will impact the amount of cash generated from operating activities, which will in turn impact EOG's financial position. As of January 30, 2015, the average 2015 U.S. New York Mercantile Exchange (NYMEX) crude oil and natural gas price was $51.86 and $2.85, respectively, representing declines of 44% and 35%, respectively, from the average NYMEX prices in 2014. See ITEM 1A. Risk Factors. Including the impact of EOG's 2015 crude oil derivative contracts (exclusive of options) and based on EOG's tax position, EOG's price sensitivity in 2015 for each $1.00 per barrel increase or decrease in wellhead crude oil and condensate price, combined with the estimated change in NGL price, is approximately $63 million for net income and $93 million for cash flows from operating activities. Including the impact of EOG's 2015 natural gas derivative contracts (exclusive of options) and based on EOG's tax position and the portion of EOG's anticipated natural gas volumes for 2015 for which prices have not been determined under long-term marketing contracts, EOG's price sensitivity for each $0.10 per Mcf increase or decrease in wellhead natural gas price is approximately $15 million for net income and $22 million for cash flows from operating activities. For information regarding EOG's crude oil and natural gas financial commodity derivative contracts at February 16, 2015, see "Derivative Transactions" above. Capital. EOG plans to continue to focus a substantial portion of its exploration and development expenditures in its major producing areas in the United States. In particular, EOG will be focused on United States crude oil drilling activity in its Eagle Ford, Delaware Basin and Bakken plays. The total anticipated 2015 capital expenditures of $4.9 to $5.1 billion, excluding acquisitions, is structured to maintain EOG's strategy of capital discipline by funding its exploration, development and exploitation activities primarily from available internally generated cash flows and cash on hand. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program and other uncommitted credit facilities, bank borrowings, borrowings under its Credit Agreement and equity and debt offerings. Operations. In 2015, EOG does not plan to increase crude oil production in the current low commodity price environment. Overall production in 2015 is expected to decline modestly from 2014 levels, and total crude oil production is expected to be flat as compared to the prior year. In 2015, EOG expects to allocate capital primarily to its highest rate-of-return crude oil assets, focus on cost reductions and seek out opportunities to acquire high-quality acreage at low costs. Summary of Critical Accounting Policies EOG prepares its financial statements and the accompanying notes in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions about future events that affect the reported amounts in the financial statements and the accompanying notes. EOG identifies certain accounting policies as critical based on, among other things, their impact on the portrayal of EOG's financial condition, results of operations or liquidity, and the degree of difficulty, subjectivity and complexity in their application. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. Management routinely discusses the development, selection and disclosure of each of the critical accounting policies. Following is a discussion of EOG's most critical accounting policies: Proved Oil and Gas Reserves EOG's engineers estimate proved oil and gas reserves in accordance with United States Securities and Exchange Commission regulations, which directly impact financial accounting estimates, including depreciation, depletion and amortization and impairments of proved properties. Proved reserves represent estimated quantities of crude oil and condensate, NGL and natural gas that geological and engineering data demonstrate, with reasonable certainty, to be recoverable in future years from known reservoirs under economic and operating conditions existing at the time the estimates were made. The process of estimating quantities of proved oil and gas reserves is complex, requiring significant subjective decisions in the evaluation of all available geological, engineering and economic data for each reservoir. The data for a given reservoir may also change substantially over time as a result of numerous factors including, but not limited to, additional development activity, evolving production history and continual reassessment of the viability of production under varying economic conditions. Consequently, material revisions (upward or downward) to existing reserve estimates may occur from time to time. For related discussion, see ITEM 1A. Risk Factors and "Supplemental Information to Consolidated Financial Statements." Oil and Gas Exploration Costs EOG accounts for its crude oil and natural gas exploration and production activities under the successful efforts method of accounting. Oil and gas exploration costs, other than the costs of drilling exploratory wells, are charged to expense as incurred. The costs of drilling exploratory wells are capitalized pending determination of whether EOG has discovered proved commercial reserves. Exploratory drilling costs are capitalized when drilling is complete if it is determined that there is economic producibility supported by either actual production, a conclusive formation test or certain technical data if the discovery is located offshore. If proved commercial reserves are not discovered, such drilling costs are expensed. In some circumstances, it may be uncertain whether proved commercial reserves have been discovered when drilling has been completed. Such exploratory well drilling costs may continue to be capitalized if the reserve quantity is sufficient to justify its completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made. As of December 31, 2012, EOG had exploratory drilling costs related to a project in the United Kingdom that had been deferred for more than one year (see Note 16 to Consolidated Financial Statements). These costs met the accounting requirements outlined above for continued capitalization. Costs to develop proved reserves, including the costs of all development wells and related equipment used in the production of crude oil and natural gas, are capitalized. Depreciation, Depletion and Amortization for Oil and Gas Properties The quantities of estimated proved oil and gas reserves are a significant component of EOG's calculation of depreciation, depletion and amortization expense, and revisions in such estimates may alter the rate of future expense. Holding all other factors constant, if reserves were revised upward or downward, earnings would increase or decrease, respectively. Depreciation, depletion and amortization of the cost of proved oil and gas properties is calculated using the unit-of-production method. The reserve base used to calculate depreciation, depletion and amortization for leasehold acquisition costs and the cost to acquire proved properties is the sum of proved developed reserves and proved undeveloped reserves. With respect to lease and well equipment costs, which include development costs and successful exploration drilling costs, the reserve base includes only proved developed reserves. Estimated future dismantlement, restoration and abandonment costs, net of salvage values, are taken into account. Oil and gas properties are grouped in accordance with the provisions of the Extractive Industries - Oil and Gas Topic of the ASC. The basis for grouping is a reasonable aggregation of properties with a common geological structural feature or stratigraphic condition, such as a reservoir or field. Amortization rates are updated quarterly to reflect the addition of capital costs, reserve revisions (upwards or downwards) and additions, property acquisitions and/or property dispositions and impairments. Depreciation and amortization of other property, plant and equipment is calculated on a straight-line basis over the estimated useful life of the asset. Impairments Oil and gas lease acquisition costs are capitalized when incurred. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. If the unproved properties are determined to be productive, the appropriate related costs are transferred to proved oil and gas properties. Lease rentals are expensed as incurred. When circumstances indicate that proved oil and gas properties may be impaired, EOG compares expected undiscounted future cash flows at a depreciation, depletion and amortization group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows, based on EOG's estimate of future crude oil and natural gas prices, operating costs, anticipated production from proved reserves and other relevant data, are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated using the Income Approach described in the Fair Value Measurement Topic of the ASC. In certain instances, EOG utilizes accepted bids as the basis for determining fair value. Estimates of undiscounted future cash flows require significant judgment. Crude oil and natural gas prices have exhibited significant volatility in the past, and EOG expects that volatility to continue in the future. During the past five years, West Texas Intermediate crude oil spot prices have fluctuated from approximately $53.45 per barrel to $113.39 per barrel, and Henry Hub natural gas spot prices have ranged from approximately $1.82 per MMBtu to $8.15 per MMBtu. EOG's proved reserves estimates, including the timing of future production, are also subject to significant assumptions and judgment, and are frequently revised (upwards and downwards) as more information becomes available. In the future, if actual crude oil and/or natural gas prices and/or actual production diverge negatively from EOG's current estimates, impairment charges may be necessary. Income Taxes Income taxes are accounted for using the asset and liability approach. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax basis. EOG assesses the realizability of deferred tax assets and recognizes valuation allowances as appropriate. Significant assumptions used in estimating future taxable income include future oil and gas prices and changes in tax rates. Changes in such assumptions could materially affect the recognized amounts of valuation allowances. Stock-Based Compensation In accounting for stock-based compensation, judgments and estimates are made regarding, among other things, the appropriate valuation methodology to follow in valuing stock compensation awards and the related inputs required by those valuation methodologies. Assumptions regarding expected volatility of EOG's common stock, the level of risk-free interest rates, expected dividend yields on EOG's common stock, the expected term of the awards, expected volatility of the price of shares of EOG's peer companies and other valuation inputs are subject to change. Any such changes could result in different valuations and thus impact the amount of stock-based compensation expense recognized on the Consolidated Statements of Income and Comprehensive Income. Information Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical facts, including, among others, statements and projections regarding EOG's future financial position, operations, performance, business strategy, returns, budgets, reserves, levels of production and costs, statements regarding future commodity prices and statements regarding the plans and objectives of EOG's management for future operations, are forward-looking statements. EOG typically uses words such as "expect," "anticipate," "estimate," "project," "strategy," "intend," "plan," "target," "goal," "may," "will," "should" and "believe" or the negative of those terms or other variations or comparable terminology to identify its forward-looking statements. In particular, statements, express or implied, concerning EOG's future operating results and returns or EOG's ability to replace or increase reserves, increase production, generate income or cash flows or pay dividends are forward-looking statements. Forward-looking statements are not guarantees of performance. Although EOG believes the expectations reflected in its forward-looking statements are reasonable and are based on reasonable assumptions, no assurance can be given that these assumptions are accurate or that any of these expectations will be achieved (in full or at all) or will prove to have been correct. Moreover, EOG's forward-looking statements may be affected by known, unknown or currently unforeseen risks, events or circumstances that may be outside EOG's control. Important factors that could cause EOG's actual results to differ materially from the expectations reflected in EOG's forward-looking statements include, among others: • the timing, extent and duration of changes in prices for, and demand for, crude oil and condensate, NGL, natural gas and related commodities; • the extent to which EOG is successful in its efforts to acquire or discover additional reserves; • the extent to which EOG is successful in its efforts to economically develop its acreage in, produce reserves and achieve anticipated production levels from, and optimize reserve recovery from, its existing and future crude oil and natural gas exploration and development projects; • the extent to which EOG is successful in its efforts to market its crude oil, natural gas and related commodity production; • the availability, proximity and capacity of, and costs associated with, appropriate gathering, processing, compression, transportation and refining facilities; • the availability, cost, terms and timing of issuance or execution of, and competition for, mineral licenses and leases and governmental and other permits and rights-of-way, and EOG's ability to retain mineral licenses and leases; • the impact of, and changes in, government policies, laws and regulations, including tax laws and regulations; environmental, health and safety laws and regulations relating to air emissions, disposal of produced water, drilling fluids and other wastes, hydraulic fracturing and access to and use of water; laws and regulations imposing conditions or restrictions on drilling and completion operations and on the transportation of crude oil and natural gas; laws and regulations with respect to derivatives and hedging activities; and laws and regulations with respect to the import and export of crude oil, natural gas and related commodities; • EOG's ability to effectively integrate acquired crude oil and natural gas properties into its operations, fully identify existing and potential problems with respect to such properties and accurately estimate reserves, production and costs with respect to such properties; • the extent to which EOG's third-party-operated crude oil and natural gas properties are operated successfully and economically; • competition in the oil and gas exploration and production industry for employees and other personnel, facilities, equipment, materials and services; • the availability and cost of employees and other personnel, facilities, equipment, materials (such as water) and services; • the accuracy of reserve estimates, which by their nature involve the exercise of professional judgment and may therefore be imprecise; • weather, including its impact on crude oil and natural gas demand, and weather-related delays in drilling and in the installation and operation (by EOG or third parties) of production, gathering, processing, refining, compression and transportation facilities; • the ability of EOG's customers and other contractual counterparties to satisfy their obligations to EOG and, related thereto, to access the credit and capital markets to obtain financing needed to satisfy their obligations to EOG; • EOG's ability to access the commercial paper market and other credit and capital markets to obtain financing on terms it deems acceptable, if at all, and to otherwise satisfy its capital expenditure requirements; • the extent and effect of any hedging activities engaged in by EOG; • the timing and extent of changes in foreign currency exchange rates, interest rates, inflation rates, global and domestic financial market conditions and global and domestic general economic conditions; • political conditions and developments around the world (such as political instability and armed conflict), including in the areas in which EOG operates; • the use of competing energy sources and the development of alternative energy sources; • the extent to which EOG incurs uninsured losses and liabilities or losses and liabilities in excess of its insurance coverage; • acts of war and terrorism and responses to these acts; • physical, electronic and cyber security breaches; and • the other factors described under ITEM 1A, Risk Factors, on pages 13 through 20 of this Annual Report on Form 10-K and any updates to those factors set forth in EOG's subsequent Quarterly Reports on Form 10-Q or Current Reports on Form 8-K. In light of these risks, uncertainties and assumptions, the events anticipated by EOG's forward-looking statements may not occur, and, if any of such events do, we may not have anticipated the timing of their occurrence or the extent of their impact on our actual results. Accordingly, you should not place any undue reliance on any of EOG's forward-looking statements. EOG's forward-looking statements speak only as of the date made, and EOG undertakes no obligation, other than as required by applicable law, to update or revise its forward-looking statements, whether as a result of new information, subsequent events, anticipated or unanticipated circumstances or otherwise.

<s>[INST] EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (nonintegrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Canada, Trinidad, the United Kingdom and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a costeffective basis, allowing EOG to deliver longterm production growth while maintaining a strong balance sheet. EOG implements its strategy by emphasizing the drilling of internally generated prospects in order to find and develop lowcost reserves. Maintaining the lowest possible operating cost structure that is consistent with prudent and safe operations is also an important goal in the implementation of EOG's strategy. Net income for 2014 totaled $2,915 million as compared to $2,197 million for 2013. At December 31, 2014, EOG's total estimated net proved reserves were 2,497 million barrels of oil equivalent (MMBoe), an increase of 378 MMBoe from December 31, 2013. During 2014, net proved crude oil and condensate and natural gas liquids (NGL) reserves increased by 329 million barrels (MMBbl), and net proved natural gas reserves increased by 298 billion cubic feet or 50 MMBoe. Operations Several important developments have occurred since January 1, 2014. United States and Canada. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquidsrich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquidsrich reservoirs. In 2014, EOG remained focused on developing its existing North American crude oil and liquidsrich acreage. In addition, increasing drilling and completion efficiencies and testing methods to improve the recovery factor of oilinplace remained areas of emphasis in 2014. EOG continues to evaluate certain potential crude oil and liquidsrich natural gas exploration and development prospects. On a volumetric basis, as calculated using the ratio of 1.0 barrel of crude oil and condensate or NGL to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGL production accounted for approximately 69% of total North American production during 2014 compared to 63% in 2013. This liquids growth primarily reflects increased production from the South Texas Eagle Ford, the North Dakota Bakken and the Permian Basin. In 2014, EOG's net Eagle Ford production averaged 202.7 thousand barrels per day (MBbld) of crude oil and condensate and NGL as compared to 140.9 MBbld in 2013. EOG's major producing areas are in New Mexico, North Dakota, Texas, Utah and Wyoming. EOG continues to deliver its crude oil to various markets in the United States, including sales points on the Gulf Coast where sales are based upon the Light Louisiana Sweet crude oil index. EOG's crudebyrail facilities provide EOG the flexibility to direct its crude oil shipments via rail car to the most favorable markets, including the Gulf Coast, Cushing, Oklahoma, and other markets. During the fourth quarter of 2014, EOG completed the divestiture of all its assets in Manitoba, Canada and the majority of its assets in Alberta, Canada in two separate transactions. Proceeds from the divestitures were approximately 400 million United States dollars, net of customary transaction adjustments. As a result of these transactions, approximately 150 million United States dollars of restricted cash related [/INST] Negative. </s>

EOG RESOURCES INC

2016-02-25

2015-12-31

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (non-integrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad, the United Kingdom and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a cost-effective basis, allowing EOG to deliver long-term production growth while maintaining a strong balance sheet. EOG implements its strategy by emphasizing the drilling of internally generated prospects in order to find and develop low-cost reserves. Maintaining the lowest possible operating cost structure that is consistent with prudent and safe operations is also an important goal in the implementation of EOG's strategy. EOG realized a net loss of $4,525 million during 2015 as compared to net income of $2,915 million for 2014. During 2015, impairments of proved oil and gas properties and other assets totaling $6,326 million, $4,141 million net of tax, were recognized primarily due to the decline in commodity prices. At December 31, 2015, EOG's total estimated net proved reserves were 2,118 million barrels of oil equivalent (MMBoe), a decrease of 379 MMBoe from December 31, 2014. During 2015, net proved crude oil and condensate and natural gas liquids (NGLs) reserves decreased by 126 million barrels (MMBbl), and net proved natural gas reserves decreased by 1,517 billion cubic feet or 253 MMBoe. Operations Several important developments have occurred since January 1, 2015. United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquids-rich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquids-rich reservoirs. During 2015, EOG focused on increasing drilling and completion efficiencies, testing methods to improve the recovery factor of oil-in-place and reducing operating costs through efficiency improvements and service cost reductions. These efficiency gains along with realized lower service costs resulted in lower drilling and completion costs and decreased operating expenses. EOG continues to evaluate certain potential crude oil and liquids-rich natural gas exploration and development prospects. On a volumetric basis, as calculated using the ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGL production accounted for approximately 71% of United States production during 2015, consistent with 2014. During 2015, drilling occurred primarily in the Eagle Ford, Delaware Basin and North Dakota Bakken plays, where EOG has built an inventory of uncompleted wells. In addition, EOG continues to look for opportunities to add drilling inventory through leasehold acquisitions, farm-ins or tactical acquisitions and to evaluate certain potential crude oil and liquids-rich natural gas exploration and development prospects. In 2015, EOG completed four transactions to acquire certain proved crude oil properties and related assets in the Delaware Basin. The aggregate purchase price of the transactions totaled approximately $400 million. EOG's major producing areas in the United States are in New Mexico, North Dakota, Texas, Utah and Wyoming. During 2015, due to the decline in commodity prices, proved oil and gas properties and related assets in the United States were written down to their fair value resulting in pretax impairment charges of $6,130 million, $3,945 million net of tax. Impairments were related to legacy natural gas assets and marginal liquids plays. Trinidad. In Trinidad, EOG continued to deliver natural gas under existing supply contracts. Several fields in the South East Coast Consortium (SECC) Block, Modified U(a) Block, Block 4(a) and Modified U(b) Block and the Sercan Area (formerly known as the EMZ area) have been developed and are producing natural gas which is sold to the National Gas Company of Trinidad and Tobago Limited and its subsidiary and crude oil and condensate which is sold to the Petroleum Company of Trinidad and Tobago Limited. EOG completed three net wells in 2015, finishing its SECC Block and Modified U(b) Block drilling program that was initiated in 2014. In 2016, EOG expects to complete one net well and install infrastructure in the Sercan Area. Other International. As previously reported, during the fourth quarter of 2014, EOG completed the divestiture of substantially all its assets in Canada (see Note 17 to the Consolidated Financial Statements). At the time of the sales, production from the divested assets totaled approximately 7,050 barrels of crude oil per day, 580 barrels of NGLs per day and 43.5 million cubic feet of natural gas per day. Information related to EOG's remaining Canadian operations is presented in the "Other International" segment. In the United Kingdom, EOG continues to make progress in the development of its 100% working interest East Irish Sea Conwy crude oil discovery. Modifications to the nearby third-party owned Douglas platform, which will be used to process Conwy production, began in 2013 and continued throughout 2014 and 2015. First production from the Conwy field is anticipated in March 2016. During 2015, EOG recognized a pretax impairment charge of $186 million for the Conwy project as a result of crude oil price declines. In 2015, EOG drilled four wells and completed three wells, one of which was drilled in 2014, in the Sichuan Basin, Sichuan Province, China. The successful completions extended the Shaximiao development in the Chuan Zhong Block and provides additional opportunities in the future. EOG's activity in Argentina is focused on the Vaca Muerta oil shale formation in the Neuquén Province. Management is currently evaluating options for its investment. EOG continues to evaluate other select crude oil and natural gas opportunities outside the United States, primarily by pursuing exploitation opportunities in countries where indigenous crude oil and natural gas reserves have been identified. Capital Structure One of management's key strategies is to maintain a strong balance sheet with a consistently below average debt-to-total capitalization ratio as compared to those in EOG's peer group. EOG's debt-to-total capitalization ratio was 34% at December 31, 2015 and 25% at December 31, 2014. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. At December 31, 2015, $400 million aggregate principal amount of its 2.500% Senior Notes due 2016 (the 2016 Notes) and $260 million principal amount of commercial paper borrowings were reclassified as long-term debt based upon EOG's intent and ability to ultimately replace such amount with other long-term debt. On January 14, 2016, EOG closed its sale of $750 million aggregate principal amount of its 4.15% Senior Notes due 2026 and $250 million aggregate principal amount of its 5.10% Senior Notes due 2036 (collectively, the New Notes). Interest on the New Notes is payable semi-annually in arrears on January 15 and July 15 of each year, beginning July 15, 2016. Proceeds from the issuance of the New Notes totaled approximately $991 million and were used to repay the $400 million aggregate principal amount of the 2016 Notes when such notes came due on February 1, 2016 and for general corporate purposes, including the repayment of outstanding commercial paper borrowings and funding of future capital expenditures. On July 21, 2015, EOG entered into a new $2.0 billion senior unsecured Revolving Credit Agreement (2015 Agreement) with domestic and foreign lenders (Banks). The 2015 Agreement replaced EOG's $2.0 billion senior unsecured revolving credit agreement which was canceled by EOG upon the closing of the 2015 Agreement. The 2015 Agreement has a scheduled maturity date of July 21, 2020, and includes an option for EOG to extend, on up to two occasions, the term for successive one-year periods, subject to certain terms and conditions. The 2015 Agreement commits the Banks to provide advances up to an aggregate principal amount of $2.0 billion at any one time outstanding, with an option for EOG to request increases in the aggregate commitments to an amount not to exceed $3.0 billion, subject to certain terms and conditions. On June 1, 2015, EOG repaid upon maturity the $500 million aggregate principal amount of its 2.95% Senior Notes due 2015. On March 17, 2015, EOG closed its sale of $500 million aggregate principal amount of its 3.15% Senior Notes due 2025 and $500 million aggregate principal amount of its 3.90% Senior Notes due 2035 (together, the Notes). Interest on the Notes is payable semi-annually in arrears on April 1 and October 1 of each year, beginning on October 1, 2015. Net proceeds from the Notes offering of approximately $990 million were used for general corporate purposes. During 2015, EOG funded $5.2 billion in exploration and development and other property, plant and equipment expenditures (excluding asset retirement obligations), repaid at maturity $500 million aggregate principal amount of long-term debt, paid $367 million in dividends to common stockholders and purchased $49 million of treasury stock in connection with stock compensation plans, primarily by utilizing net cash provided from its operating activities, net proceeds from the sale of the Notes, commercial paper borrowings, net proceeds of $193 million from the sale of assets and $26 million of excess tax benefits from stock compensation. Total anticipated 2016 capital expenditures are estimated to range from approximately $2.4 billion to $2.6 billion, excluding acquisitions. The majority of 2016 expenditures will be focused on United States crude oil drilling activities. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program and other uncommitted credit facilities, bank borrowings, borrowings under the 2015 Agreement and equity and debt offerings. When it fits EOG's strategy, EOG will make acquisitions that bolster existing drilling programs or offer incremental exploration and/or production opportunities. Management continues to believe EOG has one of the strongest prospect inventories in EOG's history. Results of Operations The following review of operations for each of the three years in the period ended December 31, 2015, should be read in conjunction with the consolidated financial statements of EOG and notes thereto beginning on page. Net Operating Revenues During 2015, net operating revenues decreased $9,278 million, or 51%, to $8,757 million from $18,035 million in 2014. Total wellhead revenues, which are revenues generated from sales of EOG's production of crude oil and condensate, NGLs and natural gas, decreased $6,188 million, or 49%, to $6,404 million in 2015 from $12,592 million in 2014. Revenues from the sales of crude oil and condensate and NGLs in 2015 were approximately 83% of total wellhead revenues compared to 85% in 2014. During 2015, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $62 million compared to net gains of $834 million in 2014. Gathering, processing and marketing revenues decreased $1,793 million during 2015, to $2,253 million from $4,046 million in 2014. Net losses on asset dispositions totaled $9 million in 2015 compared to net gains on asset dispositions of $508 million in 2014. Wellhead volume and price statistics for the years ended December 31, 2015, 2014 and 2013 were as follows: (1) Thousand barrels per day or million cubic feet per day, as applicable. (2) Other International includes EOG's United Kingdom, China, Canada and Argentina operations. (3) Dollars per barrel or per thousand cubic feet, as applicable. Excludes the impact of financial commodity derivative instruments (see Note 12 to Consolidated Financial Statements). (4) Thousand barrels of oil equivalent per day or million barrels of oil equivalent, as applicable; includes crude oil and condensate, NGLs and natural gas. Crude oil equivalent volumes are determined using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas. MMBoe is calculated by multiplying the MBoed amount by the number of days in the period and then dividing that amount by one thousand. 2015 compared to 2014. Wellhead crude oil and condensate revenues in 2015 decreased $4,807 million, or 49%, to $4,935 million from $9,742 million in 2014, due to a lower composite average wellhead crude oil and condensate price ($4,677 million) and a decrease of 5 MBbld, or 2%, in wellhead crude oil and condensate deliveries ($131 million). The decrease in deliveries primarily reflects decreased production in the North Dakota Bakken, the Fort Worth Barnett Shale area and Other International, partially offset by increased production in the Permian Basin and Eagle Ford. The decrease in Other International is due to the sale of the Canadian assets. EOG's composite wellhead crude oil and condensate price for 2015 decreased 49% to $47.53 per barrel compared to $92.58 per barrel in 2014. NGL revenues in 2015 decreased $526 million, or 56%, to $408 million from $934 million in 2014, due to a lower composite average price ($490 million) and a decrease of 3 MBbld, or 4%, in NGL deliveries ($36 million). EOG's composite NGL price in 2015 decreased 55% to $14.49 per barrel compared to $31.91 per barrel in 2014. Wellhead natural gas revenues in 2015 decreased $855 million, or 45%, to $1,061 million from $1,916 million in 2014, primarily due to a lower composite wellhead natural gas price ($730 million) and a decrease in wellhead natural gas deliveries ($125 million). EOG's composite average wellhead natural gas price decreased 41% to $2.30 per Mcf in 2015 compared to $3.88 per Mcf in 2014. Natural gas deliveries in 2015 decreased 7% to 1,265 MMcfd as compared to 1,353 MMcfd in 2014. The decrease in production was due to decreased production in Other International (40 MMcfd), the United States (34 MMcfd) and Trinidad (14 MMcfd). In the United States, decreased production was due primarily to lower production in the Upper Gulf Coast, Fort Worth Barnett Shale and South Texas areas, partially offset by increased production of associated gas in the Eagle Ford and Permian Basin. The decline in Other International primarily reflects the sale of the Canadian assets. During 2015, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $62 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $730 million. During 2014, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $834 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $34 million. Gathering, processing and marketing revenues are revenues generated from sales of third-party crude oil, NGLs, and natural gas as well as gathering fees associated with gathering third-party natural gas and revenues from sales of EOG-owned sand. Purchases and sales of third-party crude oil and natural gas are utilized in order to balance firm transportation capacity with production in certain areas and to utilize excess capacity at EOG-owned facilities. Marketing costs represent the costs of purchasing third-party crude oil and natural gas and the associated transportation costs as well as costs associated with EOG-owned sand sold to third parties. Gathering, processing and marketing revenues less marketing costs in 2015 declined $53 million compared to 2014, primarily due to lower margins on crude oil and natural gas marketing activities and losses on sand sales. 2014 compared to 2013. Wellhead crude oil and condensate revenues in 2014 increased $1,441 million, or 17%, to $9,742 million from $8,301 million in 2013, due to an increase of 68.5 MBbld, or 31%, in wellhead crude oil and condensate deliveries ($2,558 million), partially offset by a lower composite average wellhead crude oil and condensate price ($1,117 million). The increase in deliveries primarily reflects increased production in the Eagle Ford, the North Dakota Bakken and the Permian Basin. EOG's composite wellhead crude oil and condensate price for 2014 decreased 10% to $92.58 per barrel compared to $103.20 per barrel in 2013. NGL revenues in 2014 increased $160 million, or 21%, to $934 million from $774 million in 2013, due to an increase of 15 MBbld, or 23%, in NGL deliveries ($179 million), partially offset by a lower composite average price ($19 million). The increase in deliveries primarily reflects increased volumes in the Eagle Ford and the Permian Basin. EOG's composite NGL price in 2014 decreased 2% to $31.91 per barrel compared to $32.55 per barrel in 2013. Wellhead natural gas revenues in 2014 increased $235 million, or 14%, to $1,916 million from $1,681 million in 2013, primarily due to a higher composite wellhead natural gas price. EOG's composite average wellhead natural gas price increased 13% to $3.88 per Mcf in 2014 compared to $3.42 per Mcf in 2013. Natural gas deliveries in 2014 increased less than 1% to 1,353 MMcfd as compared to 1,347 MMcfd in 2013. Increased production in the United States (12 MMcfd) and Trinidad (8 MMcfd) was offset by lower production in Canada (15 MMcfd). In the United States, increased production of associated natural gas in the Eagle Ford and Permian Basin areas was partially offset by lower production in the Upper Gulf Coast and Fort Worth Basin Barnett Shale areas. During 2014, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $834 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $34 million. During 2013, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $166 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $116 million. Gathering, processing and marketing revenues less marketing costs in 2014 declined $75 million compared to 2013, primarily due to lower margins on crude oil marketing activities. Operating and Other Expenses 2015 compared to 2014. During 2015, operating expenses of $15,444 million were $2,650 million higher than the $12,794 million incurred during 2014. Operating expenses for 2015 included impairments of proved properties, other property, plant and equipment and other assets of $6,326 million primarily due to commodity price declines. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2015 and 2014: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2015 compared to 2014 are set forth below. See "Net Operating Revenues" above for a discussion of production volumes. Lease and well expenses include expenses for EOG-operated properties, as well as expenses billed to EOG from other operators where EOG is not the operator of a property. Lease and well expenses can be divided into the following categories: costs to operate and maintain crude oil and natural gas wells, the cost of workovers and lease and well administrative expenses. Operating and maintenance costs include, among other things, pumping services, salt water disposal, equipment repair and maintenance, compression expense, lease upkeep and fuel and power. Workovers are operations to restore or maintain production from existing wells. Each of these categories of costs individually fluctuates from time to time as EOG attempts to maintain and increase production while maintaining efficient, safe and environmentally responsible operations. EOG continues to increase its operating activities by drilling new wells in existing and new areas. Operating and maintenance costs within these existing and new areas, as well as the costs of services charged to EOG by vendors, fluctuate over time. Lease and well expenses of $1,182 million in 2015 decreased $234 million from $1,416 million in 2014 primarily due to lower operating and maintenance costs in the United States ($125 million), lower lease and well expenses in Other International ($99 million) primarily due to the sale of the Canadian assets and lower workover expenditures in the United States ($21 million), partially offset by increased lease and well administrative expenses in the United States ($12 million). Transportation costs represent costs associated with the delivery of hydrocarbon products from the lease to a downstream point of sale. Transportation costs include transportation fees, costs associated with crude-by-rail operations, the cost of compression (the cost of compressing natural gas to meet pipeline pressure requirements), dehydration (the cost associated with removing water from natural gas to meet pipeline requirements), gathering fees and fuel costs. Transportation costs of $849 million in 2015 decreased $123 million from $972 million in 2014 primarily due to decreased transportation costs in the Rocky Mountain area ($81 million) and the Eagle Ford ($48 million) primarily due to an increase in the use of pipelines to transport crude oil production, partially offset by increased transportation costs related to higher production from the Permian Basin ($19 million). DD&A of the cost of proved oil and gas properties is calculated using the unit-of-production method. EOG's DD&A rate and expense are the composite of numerous individual DD&A group calculations. There are several factors that can impact EOG's composite DD&A rate and expense, such as field production profiles, drilling or acquisition of new wells, disposition of existing wells and reserve revisions (upward or downward) primarily related to well performance, economic factors and impairments. Changes to these factors may cause EOG's composite DD&A rate and expense to fluctuate from period to period. DD&A of the cost of other property, plant and equipment is generally calculated using the straight-line depreciation method over the useful lives of the assets. DD&A expenses in 2015 decreased $683 million to $3,314 million from $3,997 million in 2014. DD&A expenses associated with oil and gas properties in 2015 were $691 million lower than in 2014 primarily due to lower unit rates in the United States ($513 million) and Trinidad ($28 million), a decrease in production in the United States ($44 million) and lower DD&A expense in Other International ($104 million) primarily due to the sale of the Canadian assets. Unit rates in the United States decreased primarily due to impairments of proved oil and gas properties (see Note 14 to the Consolidated Financial Statements), upward reserve revisions and reserves added at lower costs as a result of increased efficiencies. G&A expenses of $367 million in 2015 were $35 million lower than 2014 primarily due to lower employee-related expenses. Net interest expense of $237 million in 2015 was $36 million higher than 2014 primarily due to interest incurred on the Notes issued in March 2015 ($28 million), as well as a decrease in capitalized interest ($15 million). This was partially offset by the reduction of interest on debt repaid in June 2015 and during 2014 ($11 million). Exploration costs of $149 million in 2015 decreased $35 million from $184 million in 2014 primarily due to decreased geological and geophysical expenditures in the United States ($19 million) and lower exploration administrative expenses in Other International ($10 million) primarily due to the sale of the Canadian assets. Impairments include amortization of unproved oil and gas property costs; as well as impairments of proved oil and gas properties; other property, plant and equipment; and other assets. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. When circumstances indicate that a proved property may be impaired, EOG compares expected undiscounted future cash flows at a DD&A group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated by using the Income Approach described in the Fair Value Measurement Topic of the Financial Accounting Standards Board's Accounting Standards Codification (ASC). In certain instances, EOG utilizes accepted bids as the basis for determining fair value. Impairments of $6,614 million in 2015 increased $5,870 million from $744 million in 2014 primarily due to increased impairments of proved properties and other assets in the United States ($5,959 million), primarily due to commodity price declines; and increased amortization of unproved property costs in the United States ($112 million), which was caused by higher amortization rates being applied to undeveloped leasehold costs in response to the significant decrease in commodity prices and an increase in EOG's estimates of undeveloped properties not expected to be developed before lease expiration; partially offset by decreased impairments of proved properties in the United Kingdom ($156 million) and Argentina ($43 million). Proved property and other asset impairments in the United States were primarily related to legacy natural gas assets and marginal liquids plays. EOG recorded impairments of proved properties; other property, plant and equipment; and other assets of $6,326 million and $575 million in 2015 and 2014, respectively. Taxes other than income include severance/production taxes, ad valorem/property taxes, payroll taxes, franchise taxes and other miscellaneous taxes. Severance/production taxes are generally determined based on wellhead revenues, and ad valorem/property taxes are generally determined based on the valuation of the underlying assets. Taxes other than income in 2015 decreased $336 million to $422 million (6.6% of wellhead revenues) from $758 million (6.0% of wellhead revenues) in 2014. The decrease in taxes other than income was primarily due to decreases in severance/production taxes ($307 million), primarily as a result of decreased wellhead revenues and lower ad valorem/property taxes ($17 million), both in the United States. Other income, net, was $2 million in 2015 compared to other expense, net, of $45 million in 2014. The increase of $47 million was primarily due to a decrease in net foreign currency transaction losses and decreased deferred compensation expense. EOG recognized an income tax benefit of $2,397 million in 2015 compared to an income tax expense of $2,080 million in 2014 primarily due to impairments recognized in the United States in 2015. The net effective tax rate for 2015 decreased to 35% from 42% in the prior year primarily due to the effects of recording valuation allowances in the United Kingdom and deferred tax in the United States related to undistributed foreign earnings in 2014. 2014 compared to 2013. During 2014, operating expenses of $12,794 million were $1,982 million higher than the $10,812 million incurred during 2013. The following table presents the costs per Boe for the years ended December 31, 2014 and 2013: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2014 compared to 2013 are set forth below. See "Net Operating Revenues" above for a discussion of production volumes. Lease and well expenses of $1,416 million in 2014 increased $310 million from $1,106 million in 2013 primarily due to higher operating and maintenance costs ($209 million), increased workover expenditures ($69 million) and increased lease and well administrative expenses ($32 million), all in the United States. Transportation costs of $972 million in 2014 increased $119 million from $853 million in 2013 primarily due to increased transportation costs related to production from the Eagle Ford ($99 million) and the Rocky Mountain area ($15 million). DD&A expenses in 2014 increased $396 million to $3,997 million from $3,601 million in 2013. DD&A expenses associated with oil and gas properties in 2014 were $384 million higher than in 2013 primarily due to increased production in the United States ($630 million), partially offset by lower unit rates in the United States ($191 million) and Canada ($37 million) and a decrease in production in Canada ($31 million). Unit rates in the United States decreased primarily due to upward reserve revisions and reserves added at lower costs as a result of increased efficiencies. G&A expenses of $402 million in 2014 were $54 million higher than 2013 primarily due to higher costs associated with supporting expanding operations. Net interest expense of $201 million in 2014 was $34 million lower than 2013 primarily due to repayment of the $400 million aggregate principal amount of the 6.125% Senior Notes due 2013, the Subsidiary Debt and the Floating Rate Notes ($31 million), as well as an increase in capitalized interest across the company ($8 million). This was partially offset by interest expense on the Notes issued in March 2014 ($10 million). Gathering and processing costs increased $38 million to $146 million in 2014 compared to $108 million in 2013 primarily due to increased activities in the Eagle Ford. Exploration costs of $184 million in 2014 increased $23 million from $161 million in 2013 primarily due to increased geological and geophysical expenditures in the United States. Impairments of $744 million in 2014 increased $457 million from $287 million in 2013 primarily due to increased impairments of proved properties in the United Kingdom ($351 million), the United States ($145 million) and Argentina ($39 million); and increased amortization of unproved property costs in the United States ($54 million); partially offset by decreased impairments of proved properties in Canada ($67 million) and Trinidad ($14 million); and lower impairments of other assets in the United States ($46 million). EOG recorded impairments of proved properties; other property, plant and equipment; and other assets of $575 million and $172 million in 2014 and 2013, respectively. The 2014 and 2013 amounts include impairments of $503 million and $7 million, respectively, related to certain assets as a result of declining commodity prices and using accepted bids for determining fair value. Taxes other than income in 2014 increased $134 million to $758 million (6.0% of wellhead revenues) from $624 million (5.8% of wellhead revenues) in 2013. The increase in taxes other than income was primarily due to increases in severance/production taxes ($112 million) primarily as a result of increased wellhead revenues and higher ad valorem/property taxes ($34 million) in the United States, partially offset by an increase in credits available to EOG in 2014 for Texas high-cost gas severance tax rate reductions ($11 million). Other expense, net, was $45 million in 2014 compared to $3 million in 2013. The increase of $42 million was primarily due to net foreign currency transaction losses. Income tax provision of $2,080 million in 2014 increased $840 million from $1,240 million in 2013 due primarily to higher pretax income. The net effective tax rate for 2014 increased to 42% from 36% in the prior year. The net effective tax rate for 2014 exceeded the United States statutory tax rate (35%) due primarily to valuation allowances in the United Kingdom and deferred tax in the United States related to EOG's undistributed foreign earnings. EOG no longer asserts that foreign earnings will remain permanently reinvested abroad and therefore recorded deferred tax of $250 million on the accumulated balance of such earnings in the fourth quarter of 2014. Capital Resources and Liquidity Cash Flow The primary sources of cash for EOG during the three-year period ended December 31, 2015, were funds generated from operations, net proceeds from issuances of long-term debt, proceeds from asset sales, excess tax benefits from stock-based compensation and net commercial paper borrowings and borrowings under other uncommitted credit facilities. The primary uses of cash were funds used in operations; exploration and development expenditures; other property, plant and equipment expenditures; repayments of debt; dividend payments to stockholders; and purchases of treasury stock in connection with stock compensation plans. 2015 compared to 2014. Net cash provided by operating activities of $3,595 million in 2015 decreased $5,054 million from $8,649 million in 2014 primarily reflecting a decrease in wellhead revenues ($6,188 million), unfavorable changes in working capital and other assets and liabilities ($591 million) and an increase in net cash paid for interest expense ($25 million), partially offset by a decrease in cash operating expenses ($741 million), a favorable change in the net cash received from the settlement of financial commodity derivative contracts ($696 million) and a decrease in net cash paid for income taxes ($302 million). Net cash used in investing activities of $5,320 million in 2015 decreased by $2,194 million from $7,514 million in 2014 primarily due to a decrease in additions to oil and gas properties ($2,795 million); and a decrease in additions to other property, plant and equipment ($439 million); partially offset by unfavorable changes in working capital associated with investing activities ($603 million); a decrease in proceeds from sales of assets ($377 million) and the release of restricted cash in 2014 ($60 million). Net cash provided by financing activities of $371 million in 2015 included net proceeds from the issuance of the Notes ($990 million), net commercial paper borrowings ($260 million), excess tax benefits from stock-based compensation ($26 million) and proceeds from stock options exercised and employee stock purchase plan activity ($23 million). Cash used in financing activities in 2015 included repayments of long-term debt ($500 million), cash dividend payments ($367 million) and purchases of treasury stock in connection with stock compensation plans ($49 million). 2014 compared to 2013. Net cash provided by operating activities of $8,649 million in 2014 increased $1,320 million from $7,329 million in 2013 primarily reflecting an increase in wellhead revenues ($1,837 million), favorable changes in working capital and other assets and liabilities ($391 million) and a decrease in net cash paid for interest expense ($38 million), partially offset by an increase in cash operating expenses ($662 million), an unfavorable change in the net cash received from the settlement of financial commodity derivative contracts ($82 million) and an increase in net cash paid for income taxes ($48 million). Net cash used in investing activities of $7,514 million in 2014 increased by $1,199 million from $6,315 million in 2013 primarily due to an increase in additions to oil and gas properties ($823 million); an increase in additions to other property, plant and equipment ($364 million); and a decrease in proceeds from sales of assets ($191 million); partially offset by the release of restricted cash ($126 million) and favorable changes in working capital associated with investing activities ($52 million). Net cash used in financing activities of $328 million during 2014 included repayments of long-term debt ($500 million), cash dividend payments ($280 million), purchases of treasury stock in connection with stock compensation plans ($127 million) and the settlement of a foreign currency swap ($32 million). Cash provided by financing activities in 2014 included net proceeds from the issuances of long-term debt ($496 million), excess tax benefits from stock-based compensation ($99 million) and proceeds from stock options exercised and employee stock purchase plan activity ($22 million). Total Expenditures The table below sets out components of total expenditures for the years ended December 31, 2015, 2014 and 2013 (in millions): (1) Leasehold acquisitions included $5 million in both 2014 and 2013 related to non-cash property exchanges. Exploration and development expenditures of $4,875 million for 2015 were $2,834 million lower than the prior year primarily due to decreased exploration and development drilling expenditures in the United States ($2,189 million) and Other International ($74 million); decreased facilities expenditures ($553 million), decreased leasehold acquisitions ($232 million), decreased exploration geological and geophysical expenditures ($19 million), and decreased capitalized interest ($11 million), all in the United States. These decreases were partially offset by increased property acquisitions ($342 million) in the United States. The 2015 exploration and development expenditures of $4,875 million included $4,007 million in development drilling and facilities, $481 million in property acquisitions, $345 million in exploration and $42 million in capitalized interest. The 2014 exploration and development expenditures of $7,709 million included $6,804 million in development drilling and facilities, $709 million in exploration, $139 million in property acquisitions and $57 million in capitalized interest. The 2013 exploration and development expenditures of $6,863 million included $5,952 million in development drilling and facilities, $742 million in exploration, $120 million in property acquisitions and $49 million in capitalized interest. The level of exploration and development expenditures, including acquisitions, will vary in future periods depending on energy market conditions and other related economic factors. EOG has significant flexibility with respect to financing alternatives and the ability to adjust its exploration and development expenditure budget as circumstances warrant. While EOG has certain continuing commitments associated with expenditure plans related to its operations, such commitments are not expected to be material when considered in relation to the total financial capacity of EOG. Derivative Transactions Commodity Derivative Contracts. Presented below is a comprehensive summary of EOG's natural gas derivative contracts at February 25, 2016, with notional volumes expressed in million British thermal units (MMBtu) per day (MMBtud) and prices expressed in dollars per MMBtu ($/MMBtu). Financing EOG's debt-to-total capitalization ratio was 34% at December 31, 2015, compared to 25% at December 31, 2014. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. At December 31, 2015 and 2014, respectively, EOG had outstanding $6,390 million and $5,890 million aggregate principal amount of senior notes which had estimated fair values of $6,524 million and $6,242 million, respectively. The estimated fair value was based upon quoted market prices and, where such prices were not available, other observable inputs regarding interest rates available to EOG at year-end. EOG's debt is at fixed interest rates. While changes in interest rates affect the fair value of EOG's senior notes, such changes do not expose EOG to material fluctuations in earnings or cash flow. During 2015, EOG funded its capital program primarily by utilizing cash provided by operating activities, proceeds from the issuance of the Notes, cash provided by borrowings from its commercial paper program and proceeds from asset sales. While EOG maintains a $2.0 billion commercial paper program, the maximum outstanding at any time during 2015 was $641 million, and the amount outstanding at year-end was $260 million. There were no amounts outstanding under uncommitted credit facilities during 2015. The average borrowings outstanding under the commercial paper program and the uncommitted credit facilities were $81 million and zero, respectively, during the year 2015. EOG considers this excess availability, which is backed by its 2015 Agreement described in Note 2 to Consolidated Financial Statements, to be sufficient to meet its ongoing operating needs. Contractual Obligations The following table summarizes EOG's contractual obligations at December 31, 2015, (in thousands): (1) This table does not include the liability for unrecognized tax benefits, EOG's pension or postretirement benefit obligations or liability for dismantlement, abandonment and asset retirement obligations (see Notes 6, 7 and 15, respectively, to Consolidated Financial Statements). (2) Amounts shown are based on current transportation and storage rates and the foreign currency exchange rates used to convert Canadian dollars and British pounds into United States dollars at December 31, 2015. Management does not believe that any future changes in these rates before the expiration dates of these commitments will have a material adverse effect on the financial condition or results of operations of EOG. (3) Amounts shown represent minimum future expenditures for drilling rig services. EOG's expenditures for drilling rig services will exceed such minimum amounts to the extent EOG utilizes the drilling rigs subject to a particular contractual commitment for a period greater than the period set forth in the governing contract or if EOG utilizes drilling rigs in addition to the drilling rigs subject to the particular contractual commitment (for example, pursuant to the exercise of an option to utilize additional drilling rigs provided for in the governing contract). Off-Balance Sheet Arrangements EOG does not participate in financial transactions that generate relationships with unconsolidated entities or financial partnerships. Such entities or partnerships, often referred to as variable interest entities (VIE) or special purpose entities (SPE), are generally established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. EOG was not involved in any unconsolidated VIE or SPE financial transactions or any other "off-balance sheet arrangement" (as defined in Item 303(a)(4)(ii) of Regulation S-K) during any of the periods covered by this report and currently has no intention of participating in any such transaction or arrangement in the foreseeable future. Foreign Currency Exchange Rate Risk During 2015, EOG was exposed to foreign currency exchange rate risk inherent in its operations in foreign countries, including Trinidad, the United Kingdom, China, Canada and Argentina. The foreign currency most significant to EOG's operations during 2015 was the British pound. EOG continues to monitor the foreign currency exchange rates of countries in which it is currently conducting business and may implement measures to protect against foreign currency exchange rate risk. Outlook Pricing. Crude oil and natural gas prices have been volatile, and this volatility is expected to continue. As a result of the many uncertainties associated with the world political environment, worldwide supplies of, and demand for, crude oil and condensate, NGL and natural gas, the availabilities of other worldwide energy supplies and the relative competitive relationships of the various energy sources in the view of consumers, EOG is unable to predict what changes may occur in crude oil and condensate, NGLs, natural gas, ammonia and methanol prices in the future. The market price of crude oil and condensate, NGLs and natural gas in 2016 will impact the amount of cash generated from operating activities, which will in turn impact EOG's financial position. As of February 12, 2016, the average 2016 U.S. New York Mercantile Exchange (NYMEX) crude oil and natural gas prices were $34.97 per barrel and $2.23 per MMBtu, respectively, representing declines of 28% and 17%, respectively, from the average NYMEX prices in 2015. See ITEM 1A, Risk Factors. Based on EOG's tax position, EOG's price sensitivity in 2016 for each $1.00 per barrel increase or decrease in wellhead crude oil and condensate price, combined with the estimated change in NGL price, is approximately $65 million for net income and $81 million for cash flows from operating activities. Including the impact of EOG's 2016 natural gas derivative contracts (exclusive of options) and based on EOG's tax position and the portion of EOG's anticipated natural gas volumes for 2016 for which prices have not been determined under long-term marketing contracts, EOG's price sensitivity for each $0.10 per Mcf increase or decrease in wellhead natural gas price is approximately $15 million for net income and $18 million for cash flows from operating activities. For information regarding EOG's crude oil and natural gas financial commodity derivative contracts at February 25, 2016, see "Derivative Transactions" above. Capital. EOG plans to continue to focus a substantial portion of its exploration and development expenditures in its major producing areas in the United States. In particular, EOG will be focused on United States crude oil drilling activity in its Eagle Ford, Delaware Basin and Bakken plays where it generates its highest rates-of-return. To further enhance the economics of these plays, EOG expects to continue to improve well performance and lower drilling and completion costs through efficiency gains and lower service costs. The total anticipated 2016 capital expenditures of approximately $2.4 billion to $2.6 billion, excluding acquisitions, is structured to maintain EOG's strategy of capital discipline by funding its exploration, development and exploitation activities primarily from available internally generated cash flows, net proceeds from the New Notes and cash on hand. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program and other uncommitted credit facilities, bank borrowings, borrowings under its 2015 Agreement and equity and debt offerings. Operations. In 2016, both total production and total crude oil production are expected to decline slightly from 2015 levels. In 2016, EOG expects to continue to focus on reducing operating costs through efficiency improvements and lower service costs. Summary of Critical Accounting Policies EOG prepares its financial statements and the accompanying notes in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions about future events that affect the reported amounts in the financial statements and the accompanying notes. EOG identifies certain accounting policies as critical based on, among other things, their impact on the portrayal of EOG's financial condition, results of operations or liquidity, and the degree of difficulty, subjectivity and complexity in their application. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. Management routinely discusses the development, selection and disclosure of each of the critical accounting policies. Following is a discussion of EOG's most critical accounting policies: Proved Oil and Gas Reserves EOG's engineers estimate proved oil and gas reserves in accordance with United States Securities and Exchange Commission regulations, which directly impact financial accounting estimates, including depreciation, depletion and amortization and impairments of proved properties and related assets. Proved reserves represent estimated quantities of crude oil and condensate, NGLs and natural gas that geological and engineering data demonstrate, with reasonable certainty, to be recoverable in future years from known reservoirs under economic and operating conditions existing at the time the estimates were made. The process of estimating quantities of proved oil and gas reserves is complex, requiring significant subjective decisions in the evaluation of all available geological, engineering and economic data for each reservoir. The data for a given reservoir may also change substantially over time as a result of numerous factors including, but not limited to, additional development activity, evolving production history and continual reassessment of the viability of production under varying economic conditions. Consequently, material revisions (upward or downward) to existing reserve estimates may occur from time to time. For related discussion, see ITEM 1A, Risk Factors, and "Supplemental Information to Consolidated Financial Statements." Oil and Gas Exploration Costs EOG accounts for its crude oil and natural gas exploration and production activities under the successful efforts method of accounting. Oil and gas exploration costs, other than the costs of drilling exploratory wells, are charged to expense as incurred. The costs of drilling exploratory wells are capitalized pending determination of whether EOG has discovered proved commercial reserves. If proved commercial reserves are not discovered, such drilling costs are expensed. In some circumstances, it may be uncertain whether proved commercial reserves have been discovered when drilling has been completed. Such exploratory well drilling costs may continue to be capitalized if the reserve quantity is sufficient to justify its completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made. Costs to develop proved reserves, including the costs of all development wells and related equipment used in the production of crude oil and natural gas, are capitalized. Depreciation, Depletion and Amortization for Oil and Gas Properties The quantities of estimated proved oil and gas reserves are a significant component of EOG's calculation of depreciation, depletion and amortization expense, and revisions in such estimates may alter the rate of future expense. Holding all other factors constant, if reserves were revised upward or downward, earnings would increase or decrease, respectively. Depreciation, depletion and amortization of the cost of proved oil and gas properties is calculated using the unit-of-production method. The reserve base used to calculate depreciation, depletion and amortization for leasehold acquisition costs and the cost to acquire proved properties is the sum of proved developed reserves and proved undeveloped reserves. With respect to lease and well equipment costs, which include development costs and successful exploration drilling costs, the reserve base includes only proved developed reserves. Estimated future dismantlement, restoration and abandonment costs, net of salvage values, are taken into account. Oil and gas properties are grouped in accordance with the provisions of the Extractive Industries - Oil and Gas Topic of the ASC. The basis for grouping is a reasonable aggregation of properties with a common geological structural feature or stratigraphic condition, such as a reservoir or field. Depreciation, depletion and amortization rates are updated quarterly to reflect the addition of capital costs, reserve revisions (upwards or downwards) and additions, property acquisitions and/or property dispositions and impairments. Depreciation and amortization of other property, plant and equipment is calculated on a straight-line basis over the estimated useful life of the asset. Impairments Oil and gas lease acquisition costs are capitalized when incurred. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. If the unproved properties are determined to be productive, the appropriate related costs are transferred to proved oil and gas properties. Lease rentals are expensed as incurred. When circumstances indicate that proved oil and gas properties may be impaired, EOG compares expected undiscounted future cash flows at a depreciation, depletion and amortization group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows, based on EOG's estimate of future crude oil and natural gas prices, operating costs, anticipated production from proved reserves and other relevant data, are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated using the Income Approach described in the Fair Value Measurement Topic of the ASC. In certain instances, EOG utilizes accepted bids as the basis for determining fair value. Estimates of undiscounted future cash flows require significant judgment. Crude oil and natural gas prices have exhibited significant volatility in the past, and EOG expects that volatility to continue in the future. During the five years ended December 31, 2015, West Texas Intermediate crude oil spot prices have fluctuated from approximately $34.55 per barrel to $113.39 per barrel, and Henry Hub natural gas spot prices have ranged from approximately $1.63 per MMBtu to $8.15 per MMBtu. EOG's proved reserves estimates, including the timing of future production, are also subject to significant assumptions and judgment, and are frequently revised (upwards and downwards) as more information becomes available. In the future, if actual crude oil and/or natural gas prices and/or actual production diverge negatively from EOG's current estimates, impairment charges may be necessary. Income Taxes Income taxes are accounted for using the asset and liability approach. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax basis. EOG assesses the realizability of deferred tax assets and recognizes valuation allowances as appropriate. Significant assumptions used in estimating future taxable income include future oil and gas prices and changes in tax rates. Changes in such assumptions could materially affect the recognized amounts of valuation allowances. Stock-Based Compensation In accounting for stock-based compensation, judgments and estimates are made regarding, among other things, the appropriate valuation methodology to follow in valuing stock compensation awards and the related inputs required by those valuation methodologies. Assumptions regarding expected volatility of EOG's common stock, the level of risk-free interest rates, expected dividend yields on EOG's common stock, the expected term of the awards, expected volatility of the price of shares of EOG's peer companies and other valuation inputs are subject to change. Any such changes could result in different valuations and thus impact the amount of stock-based compensation expense recognized on the Consolidated Statements of Income and Comprehensive Income. Information Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical facts, including, among others, statements and projections regarding EOG's future financial position, operations, performance, business strategy, returns, budgets, reserves, levels of production and costs, statements regarding future commodity prices and statements regarding the plans and objectives of EOG's management for future operations, are forward-looking statements. EOG typically uses words such as "expect," "anticipate," "estimate," "project," "strategy," "intend," "plan," "target," "goal," "may," "will," "should" and "believe" or the negative of those terms or other variations or comparable terminology to identify its forward-looking statements. In particular, statements, express or implied, concerning EOG's future operating results and returns or EOG's ability to replace or increase reserves, increase production, reduce or otherwise control operating and capital costs, generate income or cash flows or pay dividends are forward-looking statements. Forward-looking statements are not guarantees of performance. Although EOG believes the expectations reflected in its forward-looking statements are reasonable and are based on reasonable assumptions, no assurance can be given that these assumptions are accurate or that any of these expectations will be achieved (in full or at all) or will prove to have been correct. Moreover, EOG's forward-looking statements may be affected by known, unknown or currently unforeseen risks, events or circumstances that may be outside EOG's control. Important factors that could cause EOG's actual results to differ materially from the expectations reflected in EOG's forward-looking statements include, among others: • the timing, extent and duration of changes in prices for, supplies of, and demand for, crude oil and condensate, natural gas liquids, natural gas and related commodities; • the extent to which EOG is successful in its efforts to acquire or discover additional reserves; • the extent to which EOG is successful in its efforts to economically develop its acreage in, produce reserves and achieve anticipated production levels from, and maximize reserve recovery from, its existing and future crude oil and natural gas exploration and development projects; • the extent to which EOG is successful in its efforts to market its crude oil and condensate, natural gas liquids, natural gas and related commodity production; • the availability, proximity and capacity of, and costs associated with, appropriate gathering, processing, compression, transportation and refining facilities; • the availability, cost, terms and timing of issuance or execution of, and competition for, mineral licenses and leases and governmental and other permits and rights-of-way, and EOG’s ability to retain mineral licenses and leases; • the impact of, and changes in, government policies, laws and regulations, including tax laws and regulations; environmental, health and safety laws and regulations relating to air emissions, disposal of produced water, drilling fluids and other wastes, hydraulic fracturing and access to and use of water; laws and regulations imposing conditions or restrictions on drilling and completion operations and on the transportation of crude oil and natural gas; laws and regulations with respect to derivatives and hedging activities; and laws and regulations with respect to the import and export of crude oil, natural gas and related commodities; • EOG's ability to effectively integrate acquired crude oil and natural gas properties into its operations, fully identify existing and potential problems with respect to such properties and accurately estimate reserves, production and costs with respect to such properties; • the extent to which EOG's third-party-operated crude oil and natural gas properties are operated successfully and economically; • competition in the oil and gas exploration and production industry for the acquisition of licenses, leases and properties, employees and other personnel, facilities, equipment, materials and services; • the availability and cost of employees and other personnel, facilities, equipment, materials (such as water) and services; • the accuracy of reserve estimates, which by their nature involve the exercise of professional judgment and may therefore be imprecise; • weather, including its impact on crude oil and natural gas demand, and weather-related delays in drilling and in the installation and operation (by EOG or third parties) of production, gathering, processing, refining, compression and transportation facilities; • the ability of EOG's customers and other contractual counterparties to satisfy their obligations to EOG and, related thereto, to access the credit and capital markets to obtain financing needed to satisfy their obligations to EOG; • EOG's ability to access the commercial paper market and other credit and capital markets to obtain financing on terms it deems acceptable, if at all, and to otherwise satisfy its capital expenditure requirements; • the extent and effect of any hedging activities engaged in by EOG; • the timing and extent of changes in foreign currency exchange rates, interest rates, inflation rates, global and domestic financial market conditions and global and domestic general economic conditions; • political conditions and developments around the world (such as political instability and armed conflict), including in the areas in which EOG operates; • the use of competing energy sources and the development of alternative energy sources; • the extent to which EOG incurs uninsured losses and liabilities or losses and liabilities in excess of its insurance coverage; • acts of war and terrorism and responses to these acts; • physical, electronic and cyber security breaches; and • the other factors described under ITEM 1A, Risk Factors, on pages 13 through 21 of this Annual Report on Form 10-K and any updates to those factors set forth in EOG's subsequent Quarterly Reports on Form 10-Q or Current Reports on Form 8-K. In light of these risks, uncertainties and assumptions, the events anticipated by EOG's forward-looking statements may not occur, and, if any of such events do, we may not have anticipated the timing of their occurrence or the duration and extent of their impact on our actual results. Accordingly, you should not place any undue reliance on any of EOG's forward-looking statements. EOG's forward-looking statements speak only as of the date made, and EOG undertakes no obligation, other than as required by applicable law, to update or revise its forward-looking statements, whether as a result of new information, subsequent events, anticipated or unanticipated circumstances or otherwise.

<s>[INST] EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (nonintegrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad, the United Kingdom and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a costeffective basis, allowing EOG to deliver longterm production growth while maintaining a strong balance sheet. EOG implements its strategy by emphasizing the drilling of internally generated prospects in order to find and develop lowcost reserves. Maintaining the lowest possible operating cost structure that is consistent with prudent and safe operations is also an important goal in the implementation of EOG's strategy. EOG realized a net loss of $4,525 million during 2015 as compared to net income of $2,915 million for 2014. During 2015, impairments of proved oil and gas properties and other assets totaling $6,326 million, $4,141 million net of tax, were recognized primarily due to the decline in commodity prices. At December 31, 2015, EOG's total estimated net proved reserves were 2,118 million barrels of oil equivalent (MMBoe), a decrease of 379 MMBoe from December 31, 2014. During 2015, net proved crude oil and condensate and natural gas liquids (NGLs) reserves decreased by 126 million barrels (MMBbl), and net proved natural gas reserves decreased by 1,517 billion cubic feet or 253 MMBoe. Operations Several important developments have occurred since January 1, 2015. United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquidsrich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquidsrich reservoirs. During 2015, EOG focused on increasing drilling and completion efficiencies, testing methods to improve the recovery factor of oilinplace and reducing operating costs through efficiency improvements and service cost reductions. These efficiency gains along with realized lower service costs resulted in lower drilling and completion costs and decreased operating expenses. EOG continues to evaluate certain potential crude oil and liquidsrich natural gas exploration and development prospects. On a volumetric basis, as calculated using the ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGL production accounted for approximately 71% of United States production during 2015, consistent with 2014. During 2015, drilling occurred primarily in the Eagle Ford, Delaware Basin and North Dakota Bakken plays, where EOG has built an inventory of uncompleted wells. In addition, EOG continues to look for opportunities to add drilling inventory through leasehold acquisitions, farmins or tactical acquisitions and to evaluate certain potential crude oil and liquidsrich natural gas exploration and development prospects. In 2015, EOG completed four transactions to acquire certain proved crude oil properties and related assets in the Delaware Basin. The aggregate purchase price of the transactions totaled approximately $400 million. EOG's major producing areas in the United States are in New Mexico, North Dakota, Texas, Utah and Wyoming. During 2015, due to the decline in commodity prices, proved oil and gas properties and related assets in the United States were written down to their fair value resulting in pretax impairment charges of $6,130 million, $3,945 million net of tax. Impairments were [/INST] Negative. </s>

EOG RESOURCES INC

2017-02-27

2016-12-31

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (non-integrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad, the United Kingdom and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. Each prospective drilling location is evaluated by its estimated rate of return. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a cost-effective basis, allowing EOG to deliver long-term production growth while maintaining a strong balance sheet. EOG implements its strategy by emphasizing the drilling of internally generated prospects in order to find and develop low-cost reserves. Maintaining the lowest possible operating cost structure that is consistent with prudent and safe operations is also an important goal in the implementation of EOG's strategy. EOG realized a net loss of $1,097 million during 2016 as compared to a net loss of $4,525 million for 2015. At December 31, 2016, EOG's total estimated net proved reserves were 2,147 million barrels of oil equivalent (MMBoe), an increase of 29 MMBoe from December 31, 2015. During 2016, net proved crude oil and condensate and natural gas liquids (NGLs) reserves increased by 113 million barrels (MMBbl), and net proved natural gas reserves decreased by 508 billion cubic feet or 84 MMBoe. Operations Several important developments have occurred since January 1, 2016. United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquids-rich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquids-rich reservoirs. During 2016, EOG continued to focus on increasing drilling and completion efficiencies using precision lateral targeting and advanced completion methods and reducing operating and capital costs through efficiency improvements and service cost reductions. These efficiency gains along with realized lower service costs resulted in lower drilling and completion costs and decreased operating expenses during 2016. EOG continues to look for opportunities to add drilling inventory through leasehold acquisitions, farm-ins or tactical acquisitions and to evaluate certain potential crude oil and liquids-rich natural gas exploration and development prospects. On a volumetric basis, as calculated using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGL production accounted for approximately 73% of United States production during 2016 as compared to 71% for 2015. During 2016, drilling and completion activities occurred primarily in the Eagle Ford play, Delaware Basin play and Rocky Mountain area. EOG's major producing areas in the United States are in New Mexico, North Dakota, Texas, Utah and Wyoming. On October 4, 2016, EOG completed its previously announced mergers and related asset purchase transactions with Yates Petroleum Corporation (YPC), Abo Petroleum Corporation (ABO), MYCO Industries, Inc. (MYCO) and certain affiliated entities (collectively with YPC, ABO and MYCO, the Yates Entities). The Yates Entities had recent net production of approximately 28,600 barrels of oil equivalent per day, with 48% crude oil. The assets of the Yates Entities include 1.6 million total net acres, with approximately 180,000 net acres in the Delaware Basin Core, approximately 200,000 net acres in the Powder River Basin and approximately 130,000 net acres in the Permian Basin Northwest Shelf. The financial results of YPC, ABO and MYCO were included in EOG's consolidated financial statements beginning October 4, 2016. Trinidad. In Trinidad, EOG continued to deliver natural gas under existing supply contracts. Several fields in the South East Coast Consortium (SECC) Block, Modified U(a) Block, Block 4(a) and Modified U(b) Block and the Sercan Area (formerly known as the EMZ Area) have been developed and are producing natural gas which is sold to the National Gas Company of Trinidad and Tobago Limited and its subsidiary and crude oil and condensate which is sold to the Petroleum Company of Trinidad and Tobago Limited. In the third quarter of 2016, EOG installed a platform and pipeline in the Sercan Area in preparation for its three net well drilling program. In the fourth quarter of 2016, EOG drilled and completed one net well and began drilling a second well. EOG expects to bring the remaining two net wells of the Sercan program on-line in early 2017 and to drill three additional net wells in the second half of 2017. Other International. In the United Kingdom, EOG began production from its 100% working interest East Irish Sea Conwy crude oil project in March 2016, selling its first crude oil cargo at the end of the first quarter. Modifications to the nearby third-party-owned Douglas platform, which is used to process Conwy production, were completed in the first quarter of 2016 and acceptance and performance testing is ongoing. In the Sichuan Basin, Sichuan Province, China, EOG plans to drill and complete four wells in 2017. During the third quarter of 2016, EOG successfully completed the sale of all its Argentina assets. EOG continues to evaluate other select crude oil and natural gas opportunities outside the United States, primarily by pursuing exploitation opportunities in countries where indigenous crude oil and natural gas reserves have been identified. Capital Structure One of management's key strategies is to maintain a strong balance sheet with a consistently below average debt-to-total capitalization ratio as compared to those in EOG's peer group. EOG's debt-to-total capitalization ratio was 33% at December 31, 2016 and 34% at December 31, 2015. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. On October 4, 2016, in connection with the mergers and related asset purchase transactions with the Yates Entities, EOG issued an aggregate of approximately 25 million shares of EOG common stock, subject to the terms of the agreements, and paid to certain of the sellers under the asset purchase transactions an aggregate of approximately $16 million in cash for total consideration transferred of approximately $2.4 billion. In addition, under the terms of the agreements, EOG assumed and repaid approximately $164 million of debt owed by the Yates Entities, which was offset by approximately $70 million of cash of the Yates Entities. At December 31, 2016, the $600 million aggregate principal amount of EOG's 5.875% Senior Notes due 2017 were reclassified as long-term debt based upon its intent and ability to ultimately replace such amount with other long-term debt. On February 1, 2016, EOG repaid upon maturity the $400 million aggregate principal amount of its 2.500% Senior Notes due 2016 (2016 Notes). On January 14, 2016, EOG closed its sale of $750 million aggregate principal amount of its 4.15% Senior Notes due 2026 and $250 million aggregate principal amount of its 5.10% Senior Notes due 2036 (collectively, the Notes). Interest on the Notes is payable semi-annually in arrears on January 15 and July 15 of each year, beginning on July 15, 2016. Net proceeds from the Notes offering totaled approximately $991 million and were used to repay the 2016 Notes when they matured on February 1, 2016, and for general corporate purposes, including repayment of outstanding commercial paper borrowings and funding of capital expenditures. During 2016, EOG funded $6.6 billion ($3.9 billion of which was related to the aforementioned Yates transaction) in exploration and development and other property, plant and equipment expenditures (excluding asset retirement obligations), repaid $564 million aggregate principal amount of long-term debt, paid $373 million in dividends to common stockholders, repaid $260 million of outstanding commercial paper borrowings and purchased $82 million of treasury stock in connection with stock compensation plans, primarily by utilizing net cash provided from its operating activities, net proceeds of $1,119 million from the sale of assets, net proceeds from the sale of the Notes and $29 million of excess tax benefits from stock compensation. Total anticipated 2017 capital expenditures are estimated to range from approximately $3.7 billion to $4.1 billion, excluding acquisitions. The majority of 2017 expenditures will be focused on United States crude oil drilling activities. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program and other uncommitted credit facilities, bank borrowings, borrowings under its $2.0 billion senior unsecured revolving credit facility and equity and debt offerings. When it fits EOG's strategy, EOG will make acquisitions that bolster existing drilling programs or offer incremental exploration and/or production opportunities. Management continues to believe EOG has one of the strongest prospect inventories in EOG's history. Results of Operations The following review of operations for each of the three years in the period ended December 31, 2016, should be read in conjunction with the consolidated financial statements of EOG and notes thereto beginning on page. Net Operating Revenues During 2016, net operating revenues decreased $1,106 million, or 13%, to $7,651 million from $8,757 million in 2015. Total wellhead revenues, which are revenues generated from sales of EOG's production of crude oil and condensate, NGLs and natural gas, decreased $907 million, or 14%, to $5,497 million in 2016 from $6,404 million in 2015. Revenues from the sales of crude oil and condensate and NGLs in 2016 were approximately 86% of total wellhead revenues compared to 83% in 2015. During 2016, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $100 million compared to net gains of $62 million in 2015. Gathering, processing and marketing revenues decreased $287 million during 2016, to $1,966 million from $2,253 million in 2015. Net gains on asset dispositions of $206 million in 2016 were primarily as a result of sales of producing properties and acreage in Texas, Louisiana, the Rocky Mountain area and Oklahoma compared to net losses on asset dispositions of $9 million in 2015. Wellhead volume and price statistics for the years ended December 31, 2016, 2015 and 2014 were as follows: (1) Thousand barrels per day or million cubic feet per day, as applicable. (2) Other International includes EOG's United Kingdom, China, Canada and Argentina operations. The Argentina operations were sold in the third quarter of 2016. (3) Dollars per barrel or per thousand cubic feet, as applicable. Excludes the impact of financial commodity derivative instruments (see Note 12 to Consolidated Financial Statements). (4) Thousand barrels of oil equivalent per day or million barrels of oil equivalent, as applicable; includes crude oil and condensate, NGLs and natural gas. Crude oil equivalent volumes are determined using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas. MMBoe is calculated by multiplying the MBoed amount by the number of days in the period and then dividing that amount by one thousand. 2016 compared to 2015. Wellhead crude oil and condensate revenues in 2016 decreased $618 million, or 13%, to $4,317 million from $4,935 million in 2015, due primarily to a lower composite average wellhead crude oil and condensate price. EOG's composite wellhead crude oil and condensate price for 2016 decreased 12% to $41.76 per barrel compared to $47.53 per barrel in 2015. Wellhead crude oil and condensate deliveries in 2016 decreased 1% to 283 MBbld as compared to 284 MBbld in 2015. The decreased production was primarily due to lower production in the Eagle Ford and the Rocky Mountain area, largely offset by increased production in the Permian Basin. NGL revenues in 2016 increased $29 million, or 7%, to $437 million from $408 million in 2015, due to an increase of 5 MBbld, or 6%, in NGL deliveries primarily as a result of increased production in the Permian Basin. Wellhead natural gas revenues in 2016 decreased $319 million, or 30%, to $742 million from $1,061 million in 2015, primarily due to a lower composite wellhead natural gas price ($246 million) and a decrease in wellhead natural gas deliveries ($73 million). EOG's composite average wellhead natural gas price decreased 25% to $1.73 per Mcf in 2016 compared to $2.30 per Mcf in 2015. Natural gas deliveries in 2016 decreased 7% to 1,175 MMcfd as compared to 1,265 MMcfd in 2015. The decrease in production was primarily due to decreased production in the United States (76 MMcfd). The decreased production was due primarily to lower volumes in the Fort Worth Barnett Shale, Upper Gulf Coast and South Texas areas, largely resulting from asset sales in these regions during the year, partially offset by increased production of associated gas in the Permian Basin and the acquisition of the Yates Entities. During 2016, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $100 million, which included net cash paid for settlements of crude oil and natural gas financial derivative contracts of $22 million. During 2015, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $62 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $730 million. Gathering, processing and marketing revenues are revenues generated from sales of third-party crude oil, NGLs, and natural gas as well as gathering fees associated with gathering third-party natural gas and revenues from sales of EOG-owned sand. Purchases and sales of third-party crude oil and natural gas are utilized in order to balance firm transportation capacity with production in certain areas and to utilize excess capacity at EOG-owned facilities. Marketing costs represent the costs of purchasing third-party crude oil and natural gas and the associated transportation costs as well as costs associated with EOG-owned sand sold to third parties. Gathering, processing and marketing revenues less marketing costs in 2016 increased $91 million compared to 2015, primarily due to higher margins on crude oil marketing activities and on sand sales. 2015 compared to 2014. Wellhead crude oil and condensate revenues in 2015 decreased $4,807 million, or 49%, to $4,935 million from $9,742 million in 2014, due to a lower composite average wellhead crude oil and condensate price ($4,677 million) and a decrease of 5 MBbld, or 2%, in wellhead crude oil and condensate deliveries ($131 million). The decrease in deliveries primarily reflects decreased production in the North Dakota Bakken, the Fort Worth Barnett Shale area and Other International, partially offset by increased production in the Permian Basin and Eagle Ford. The decrease in Other International is due to the sale of the Canadian assets. EOG's composite wellhead crude oil and condensate price for 2015 decreased 49% to $47.53 per barrel compared to $92.58 per barrel in 2014. NGL revenues in 2015 decreased $526 million, or 56%, to $408 million from $934 million in 2014, due to a lower composite average price ($490 million) and a decrease of 3 MBbld, or 4%, in NGL deliveries ($36 million). EOG's composite NGL price in 2015 decreased 55% to $14.49 per barrel compared to $31.91 per barrel in 2014. Wellhead natural gas revenues in 2015 decreased $855 million, or 45%, to $1,061 million from $1,916 million in 2014, primarily due to a lower composite wellhead natural gas price ($730 million) and a decrease in wellhead natural gas deliveries ($125 million). EOG's composite average wellhead natural gas price decreased 41% to $2.30 per Mcf in 2015 compared to $3.88 per Mcf in 2014. Natural gas deliveries in 2015 decreased 7% to 1,265 MMcfd as compared to 1,353 MMcfd in 2014. The decrease in production was due to decreased production in Other International (40 MMcfd), the United States (34 MMcfd) and Trinidad (14 MMcfd). In the United States, decreased production was due primarily to lower production in the Upper Gulf Coast, Fort Worth Barnett Shale and South Texas areas, partially offset by increased production of associated gas in the Eagle Ford and Permian Basin. The decline in Other International primarily reflects the sale of the Canadian assets. During 2015, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $62 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $730 million. During 2014, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $834 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $34 million. Gathering, processing and marketing revenues less marketing costs in 2015 declined $53 million compared to 2014, primarily due to lower margins on crude oil and natural gas marketing activities and losses on sand sales. Operating and Other Expenses 2016 compared to 2015. During 2016, operating expenses of $8,876 million were $6,568 million lower than the $15,444 million incurred during 2015. Operating expenses for 2015 included impairments of proved properties; other property, plant and equipment; and other assets of $6,326 million primarily due to commodity price declines. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2016 and 2015: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2016 compared to 2015 are set forth below. See "Net Operating Revenues" above for a discussion of production volumes. Lease and well expenses include expenses for EOG-operated properties, as well as expenses billed to EOG from other operators where EOG is not the operator of a property. Lease and well expenses can be divided into the following categories: costs to operate and maintain crude oil and natural gas wells, the cost of workovers and lease and well administrative expenses. Operating and maintenance costs include, among other things, pumping services, salt water disposal, equipment repair and maintenance, compression expense, lease upkeep and fuel and power. Workovers are operations to restore or maintain production from existing wells. Each of these categories of costs individually fluctuates from time to time as EOG attempts to maintain and increase production while maintaining efficient, safe and environmentally responsible operations. EOG continues to increase its operating activities by drilling new wells in existing and new areas. Operating and maintenance costs within these existing and new areas, as well as the costs of services charged to EOG by vendors, fluctuate over time. Lease and well expenses of $927 million in 2016 decreased $255 million from $1,182 million in 2015 primarily due to lower operating and maintenance costs ($218 million) and lower lease and well administrative expenses ($35 million), both in the United States. Transportation costs represent costs associated with the delivery of hydrocarbon products from the lease to a downstream point of sale. Transportation costs include transportation fees, costs associated with crude-by-rail operations, the cost of compression (the cost of compressing natural gas to meet pipeline pressure requirements), dehydration (the cost associated with removing water from natural gas to meet pipeline requirements), gathering fees and fuel costs. Transportation costs of $764 million in 2016 decreased $85 million from $849 million in 2015 primarily due to decreased transportation costs in the Rocky Mountain area ($55 million), the Barnett Shale ($21 million), the Eagle Ford ($19 million) and the Upper Gulf Coast region ($10 million) primarily due to lower production and service cost reductions in these regions, partially offset by increased transportation costs related to higher production from the Permian Basin ($18 million). DD&A of the cost of proved oil and gas properties is calculated using the unit-of-production method. EOG's DD&A rate and expense are the composite of numerous individual DD&A group calculations. There are several factors that can impact EOG's composite DD&A rate and expense, such as field production profiles, drilling or acquisition of new wells, disposition of existing wells and reserve revisions (upward or downward) primarily related to well performance, economic factors and impairments. Changes to these factors may cause EOG's composite DD&A rate and expense to fluctuate from period to period. DD&A of the cost of other property, plant and equipment is generally calculated using the straight-line depreciation method over the useful lives of the assets. DD&A expenses in 2016 increased $239 million to $3,553 million from $3,314 million in 2015. DD&A expenses associated with oil and gas properties in 2016 were $247 million higher than in 2015 primarily due to higher unit rates in the United States ($300 million) and China ($3 million) and commencement of crude oil production from the Conwy field in the United Kingdom ($22 million), partially offset by a decrease in production in the United States ($68 million) and Trinidad ($4 million) and lower unit rates in Trinidad ($6 million). Unit rates in the United States increased primarily due to downward reserve revisions at December 31, 2015, as a result of lower commodity prices. G&A expenses of $395 million in 2016 increased $28 million from $367 million in 2015 primarily due to employee-related expenses in connection with certain voluntary retirements and costs related to the Yates transaction. Net interest expense of $282 million in 2016 was $45 million higher than 2015 primarily due to interest incurred on the Notes issued in January 2016 ($43 million), as well as a decrease in capitalized interest ($10 million). This was partially offset by the reduction of interest expense related to the debt repaid in February 2016 and June 2015 ($16 million). Gathering and processing costs represent operating and maintenance expenses and administrative expenses associated with operating EOG's gathering and processing assets. Gathering and processing costs decreased $23 million to $123 million in 2016 compared to $146 million in 2015 due to decreased activities in the Eagle Ford ($16 million) and the Barnett Shale ($7 million). Exploration costs of $125 million in 2016 decreased $24 million from $149 million in 2015 primarily due to decreased geological and geophysical expenditures ($15 million) and lower exploration administrative expenses ($14 million), partially offset by higher delay rentals ($5 million), all in the United States. Impairments include amortization of unproved oil and gas property costs as well as impairments of proved oil and gas properties; other property, plant and equipment; and other assets. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. When circumstances indicate that a proved property may be impaired, EOG compares expected undiscounted future cash flows at a DD&A group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated by using the Income Approach described in the Fair Value Measurement Topic of the Financial Accounting Standards Board's Accounting Standards Codification (ASC). In certain instances, EOG utilizes accepted offers from third-party purchasers as the basis for determining fair value. The following table represents impairments of $620 million and $6,614 million for the years ended December 31, 2016 and 2015 (in millions): Impairments of proved properties were primarily due to the write-down to fair value of divested legacy natural gas assets in 2016 and primarily due to commodity price declines in 2015. Impairments of unproved properties were primarily due to higher amortization rates being applied to undeveloped leasehold costs in response to the significant decrease in commodity prices and an increase in EOG's estimates of undeveloped properties not expected to be developed before lease expiration in 2016 and 2015. EOG recognized additional impairment charges in 2016 of $61 million related to obsolete inventory and $138 million related to firm commitment contracts related to divested Haynesville natural gas assets. Taxes other than income include severance/production taxes, ad valorem/property taxes, payroll taxes, franchise taxes and other miscellaneous taxes. Severance/production taxes are generally determined based on wellhead revenues, and ad valorem/property taxes are generally determined based on the valuation of the underlying assets. Taxes other than income in 2016 decreased $72 million to $350 million (6.4% of wellhead revenues) from $422 million (6.6% of wellhead revenues) in 2015. The decrease in taxes other than income was primarily due to decreases in ad valorem/property taxes ($49 million) and in severance/production taxes ($34 million), primarily as a result of decreased wellhead revenues, both in the United States. These decreases were partially offset by a decrease in credits available to EOG in 2016 for Texas high-cost gas severance tax rate reductions ($12 million). Other expense, net, was $51 million in 2016 compared to other income, net, of $2 million in 2015. The increase of $53 million was primarily due to an increase in foreign currency transaction losses and increased deferred compensation expense. EOG recognized an income tax benefit of $461 million in 2016 compared to an income tax benefit of $2,397 million in 2015, primarily due to a decrease in pretax loss resulting from the absence of certain 2015 impairments. The net effective tax rate for 2016 decreased to 30% from 35% in the prior year primarily due to additional Trinidad taxes resulting from a tax settlement reached in the second quarter of 2016 ($43 million). 2015 compared to 2014. During 2015, operating expenses of $15,444 million were $2,650 million higher than the $12,794 million incurred during 2014. Operating expenses for 2015 included impairments of proved properties, other property, plant and equipment and other assets of $6,326 million primarily due to commodity price declines. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2015 and 2014: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2015 compared to 2014 are set forth below. See "Net Operating Revenues" above for a discussion of production volumes. Lease and well expenses of $1,182 million in 2015 decreased $234 million from $1,416 million in 2014 primarily due to lower operating and maintenance costs in the United States ($125 million), lower lease and well expenses in Other International ($99 million) primarily due to the sale of the Canadian assets and lower workover expenditures in the United States ($21 million), partially offset by increased lease and well administrative expenses in the United States ($12 million). Transportation costs of $849 million in 2015 decreased $123 million from $972 million in 2014 primarily due to decreased transportation costs in the Rocky Mountain area ($81 million) and the Eagle Ford ($48 million) primarily due to an increase in the use of pipelines to transport crude oil production, partially offset by increased transportation costs related to higher production from the Permian Basin ($19 million). DD&A expenses in 2015 decreased $683 million to $3,314 million from $3,997 million in 2014. DD&A expenses associated with oil and gas properties in 2015 were $691 million lower than in 2014 primarily due to lower unit rates in the United States ($513 million) and Trinidad ($28 million), a decrease in production in the United States ($44 million) and lower DD&A expense in Other International ($104 million) primarily due to the sale of the Canadian assets. Unit rates in the United States decreased primarily due to impairments of proved oil and gas properties (see Note 14 to the Consolidated Financial Statements), upward reserve revisions and reserves added at lower costs as a result of increased efficiencies. G&A expenses of $367 million in 2015 were $35 million lower than 2014 primarily due to lower employee-related expenses. Net interest expense of $237 million in 2015 was $36 million higher than 2014 primarily due to interest incurred on the Notes issued in March 2015 ($28 million), as well as a decrease in capitalized interest ($15 million). This was partially offset by the reduction of interest on debt repaid in June 2015 and during 2014 ($11 million). Exploration costs of $149 million in 2015 decreased $35 million from $184 million in 2014 primarily due to decreased geological and geophysical expenditures in the United States ($19 million) and lower exploration administrative expenses in Other International ($10 million) primarily due to the sale of the Canadian assets. Impairments of $6,614 million in 2015 increased $5,870 million from $744 million in 2014 primarily due to increased impairments of proved properties and other assets in the United States ($5,959 million), primarily due to commodity price declines; and increased amortization of unproved property costs in the United States ($112 million), which was caused by higher amortization rates being applied to undeveloped leasehold costs in response to the significant decrease in commodity prices and an increase in EOG's estimates of undeveloped properties not expected to be developed before lease expiration; partially offset by decreased impairments of proved properties in the United Kingdom ($156 million) and Argentina ($43 million). Proved property and other asset impairments in the United States were primarily related to legacy natural gas assets and marginal liquids plays. EOG recorded impairments of proved properties; other property, plant and equipment; and other assets of $6,326 million and $575 million in 2015 and 2014, respectively. Taxes other than income in 2015 decreased $336 million to $422 million (6.6% of wellhead revenues) from $758 million (6.0% of wellhead revenues) in 2014. The decrease in taxes other than income was primarily due to decreases in severance/production taxes ($307 million), primarily as a result of decreased wellhead revenues and lower ad valorem/property taxes ($17 million), both in the United States. Other income, net, was $2 million in 2015 compared to other expense, net, of $45 million in 2014. The increase of $47 million was primarily due to a decrease in net foreign currency transaction losses and decreased deferred compensation expense. EOG recognized an income tax benefit of $2,397 million in 2015 compared to an income tax expense of $2,080 million in 2014 primarily due to impairments recognized in the United States in 2015. The net effective tax rate for 2015 decreased to 35% from 42% in the prior year primarily due to the effects of recording valuation allowances in the United Kingdom and deferred tax in the United States related to undistributed foreign earnings in 2014. Capital Resources and Liquidity Cash Flow The primary sources of cash for EOG during the three-year period ended December 31, 2016, were funds generated from operations, net proceeds from issuances of long-term debt, proceeds from asset sales, excess tax benefits from stock-based compensation and net commercial paper borrowings and borrowings under other uncommitted credit facilities. The primary uses of cash were funds used in operations; exploration and development expenditures; other property, plant and equipment expenditures; repayments of debt; dividend payments to stockholders; and purchases of treasury stock in connection with stock compensation plans. 2016 compared to 2015. Net cash provided by operating activities of $2,359 million in 2016 decreased $1,236 million from $3,595 million in 2015 primarily reflecting a decrease in wellhead revenues ($907 million), an unfavorable change in the net cash received from the settlement of financial commodity derivative contracts ($752 million), unfavorable changes in working capital and other assets and liabilities ($197 million) and an increase in net cash paid for interest expense ($30 million), partially offset by a decrease in cash operating expenses ($442 million) and a decrease in net cash paid for income taxes ($80 million). Net cash used in investing activities of $1,253 million in 2016 decreased by $4,067 million from $5,320 million in 2015 primarily due to a decrease in additions to oil and gas properties ($2,235 million); an increase in proceeds from asset sales ($926 million); favorable changes in working capital associated with investing activities ($656 million); a decrease in additions to other property, plant and equipment ($195 million); and net cash received from the Yates transaction ($55 million). Net cash used for financing activities of $243 million in 2016 included repayments of long-term debt ($564 million), cash dividend payments ($373 million), net commercial paper repayments ($260 million) and purchases of treasury stock in connection with stock compensation plans ($82 million). Cash provided by financing activities in 2016 included net proceeds from the issuance of the Notes ($991 million), excess tax benefits from stock-based compensation ($29 million) and proceeds from stock options exercised and employee stock purchase plan activity ($23 million). 2015 compared to 2014. Net cash provided by operating activities of $3,595 million in 2015 decreased $5,054 million from $8,649 million in 2014 primarily reflecting a decrease in wellhead revenues ($6,188 million), unfavorable changes in working capital and other assets and liabilities ($591 million) and an increase in net cash paid for interest expense ($25 million), partially offset by a decrease in cash operating expenses ($741 million), a favorable change in the net cash received from the settlement of financial commodity derivative contracts ($696 million) and a decrease in net cash paid for income taxes ($302 million). Net cash used in investing activities of $5,320 million in 2015 decreased by $2,194 million from $7,514 million in 2014 primarily due to a decrease in additions to oil and gas properties ($2,795 million); and a decrease in additions to other property, plant and equipment ($439 million); partially offset by unfavorable changes in working capital associated with investing activities ($603 million); a decrease in proceeds from sales of assets ($377 million) and the release of restricted cash in 2014 ($60 million). Net cash provided by financing activities of $371 million in 2015 included net proceeds from the issuance of the Notes ($990 million), net commercial paper borrowings ($260 million), excess tax benefits from stock-based compensation ($26 million) and proceeds from stock options exercised and employee stock purchase plan activity ($23 million). Cash used in financing activities in 2015 included repayments of long-term debt ($500 million), cash dividend payments ($367 million) and purchases of treasury stock in connection with stock compensation plans ($49 million). Total Expenditures The table below sets out components of total expenditures for the years ended December 31, 2016, 2015 and 2014 (in millions): (1) Leasehold acquisitions included $3,115 million in 2016 related to the Yates transaction and $5 million in 2014 related to non-cash property exchanges. (2) Property acquisitions included $735 million in 2016 related to the Yates transaction. (3) Other property, plant and equipment included $17 million in 2016 related to the Yates transaction. Exploration and development expenditures of $6,465 million for 2016 were $1,590 million higher than the prior year. The increase was primarily due to increased leasehold acquisitions ($3,083 million) and increased property acquisitions ($268 million), partially offset by decreased exploration and development drilling expenditures in the United States ($1,280 million), Trinidad ($46 million) and Other International ($6 million); decreased facilities expenditures ($390 million); decreased geological and geophysical expenditures ($15 million); and decreased capitalized interest ($11 million). The 2016 exploration and development expenditures of $6,465 million included $3,351 million in exploration, $2,334 million in development drilling and facilities, $749 million in property acquisitions and $31 million in capitalized interest. The 2015 exploration and development expenditures of $4,875 million included $4,007 million in development drilling and facilities, $481 million in property acquisitions, $345 million in exploration and $42 million in capitalized interest. The 2014 exploration and development expenditures of $7,709 million included $6,804 million in development drilling and facilities, $709 million in exploration, $139 million in property acquisitions and $57 million in capitalized interest. The level of exploration and development expenditures, including acquisitions, will vary in future periods depending on energy market conditions and other related economic factors. EOG has significant flexibility with respect to financing alternatives and the ability to adjust its exploration and development expenditure budget as circumstances warrant. While EOG has certain continuing commitments associated with expenditure plans related to its operations, such commitments are not expected to be material when considered in relation to the total financial capacity of EOG. Derivative Transactions Commodity Derivative Contracts. Presented below is a comprehensive summary of EOG's crude oil price swap contracts through February 20, 2017, with notional volumes expressed in barrels per day (Bbld) and prices expressed in dollars per barrel ($/Bbl). EOG has entered into crude oil collar contracts, which establish ceiling and floor prices for the sale of notional volumes of crude oil as specified in the collar contracts. The collars require that EOG pay the difference between the ceiling price and the average U.S. New York Mercantile Exchange (NYMEX) West Texas Intermediate crude oil price for the contract month (Index Price) in the event the Index Price is above the ceiling price. The collars grant EOG the right to receive the difference between the floor price and the Index Price in the event the Index Price is below the floor price. Presented below is a comprehensive summary of EOG's crude oil collar contracts through February 20, 2017, with notional volumes expressed in Bbld and prices expressed in $/Bbl. Presented below is a comprehensive summary of EOG's natural gas price swap contracts through February 20, 2017, with notional volumes expressed in million British thermal units (MMBtu) per day (MMBtud) and prices expressed in dollars per MMBtu ($/MMBtu). EOG has sold call options which establish a ceiling price for the sale of notional volumes of natural gas as specified in the call option contracts. The call options require that EOG pay the difference between the call option strike price and either the average or last business day NYMEX Henry Hub natural gas price for the contract month (Henry Hub Index Price) in the event the Henry Hub Index Price is above the call option strike price. In addition, EOG has purchased put options which establish a floor price for the sale of notional volumes of natural gas as specified in the put option contracts. The put options grant EOG the right to receive the difference between the put option strike price and the Henry Hub Index Price in the event the Henry Hub Index Price is below the put option strike price. Presented below is a comprehensive summary of EOG's natural gas call and put option contracts through February 20, 2017, with notional volumes expressed in MMBtud and prices expressed in $/MMBtu. EOG has also entered into natural gas collar contracts, which establish ceiling and floor prices for the sale of notional volumes of natural gas as specified in the collar contracts. The collars require that EOG pay the difference between the ceiling price and the Henry Hub Index Price in the event the Henry Hub Index Price is above the ceiling price. The collars grant EOG the right to receive the difference between the floor price and the Henry Hub Index Price in the event the Henry Hub Index Price is below the floor price. Presented below is a comprehensive summary of EOG's natural gas collar contracts through February 20, 2017, with notional volumes expressed in MMBtud and prices expressed in $/MMbtu. Financing EOG's debt-to-total capitalization ratio was 33% at December 31, 2016, compared to 34% at December 31, 2015. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. At December 31, 2016 and 2015, respectively, EOG had outstanding $6,990 million and $6,390 million aggregate principal amount of senior notes which had estimated fair values of $7,190 million and $6,524 million, respectively. The estimated fair value was based upon quoted market prices and, where such prices were not available, other observable inputs regarding interest rates available to EOG at year-end. EOG's debt is at fixed interest rates. While changes in interest rates affect the fair value of EOG's senior notes, such changes do not expose EOG to material fluctuations in earnings or cash flow. During 2016, EOG funded its capital program primarily by utilizing cash provided by operating activities, proceeds from the issuance of the Notes, proceeds from asset sales and cash provided by borrowings from its commercial paper program. While EOG maintains a $2.0 billion commercial paper program, the maximum outstanding at any time during 2016 was $604 million, and the amount outstanding at year-end was zero. There were no amounts outstanding under uncommitted credit facilities during 2016. The average borrowings outstanding under the commercial paper program and the uncommitted credit facilities were $130 million and zero, respectively, during the year 2016. EOG considers this excess availability, which is backed by its $2.0 billion senior unsecured revolving credit facility described in Note 2 to Consolidated Financial Statements, to be sufficient to meet its ongoing operating needs. Contractual Obligations The following table summarizes EOG's contractual obligations at December 31, 2016, (in thousands): (1) This table does not include the liability for unrecognized tax benefits, EOG's pension or postretirement benefit obligations or liability for dismantlement, abandonment and asset retirement obligations (see Notes 6, 7 and 15, respectively, to Consolidated Financial Statements). (2) Amounts shown are based on current transportation and storage rates and the foreign currency exchange rates used to convert Canadian dollars and British pounds into United States dollars at December 31, 2016. Management does not believe that any future changes in these rates before the expiration dates of these commitments will have a material adverse effect on the financial condition or results of operations of EOG. (3) Amounts shown represent minimum future expenditures for drilling rig services. EOG's expenditures for drilling rig services will exceed such minimum amounts to the extent EOG utilizes the drilling rigs subject to a particular contractual commitment for a period greater than the period set forth in the governing contract or if EOG utilizes drilling rigs in addition to the drilling rigs subject to the particular contractual commitment (for example, pursuant to the exercise of an option to utilize additional drilling rigs provided for in the governing contract). Off-Balance Sheet Arrangements EOG does not participate in financial transactions that generate relationships with unconsolidated entities or financial partnerships. Such entities or partnerships, often referred to as variable interest entities (VIE) or special purpose entities (SPE), are generally established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. EOG was not involved in any unconsolidated VIE or SPE financial transactions or any other "off-balance sheet arrangement" (as defined in Item 303(a)(4)(ii) of Regulation S-K) during any of the periods covered by this report and currently has no intention of participating in any such transaction or arrangement in the foreseeable future. Foreign Currency Exchange Rate Risk During 2016, EOG was exposed to foreign currency exchange rate risk inherent in its operations in foreign countries, including Trinidad, the United Kingdom, China, Canada and Argentina. The foreign currency most significant to EOG's operations during 2016 was the British pound. EOG continues to monitor the foreign currency exchange rates of countries in which it is currently conducting business and may implement measures to protect against foreign currency exchange rate risk. Outlook Pricing. Crude oil and natural gas prices have been volatile, and this volatility is expected to continue. As a result of the many uncertainties associated with the world political environment, worldwide supplies of, and demand for, crude oil and condensate, NGL and natural gas, the availabilities of other worldwide energy supplies and the relative competitive relationships of the various energy sources in the view of consumers, EOG is unable to predict what changes may occur in crude oil and condensate, NGLs, natural gas, ammonia and methanol prices in the future. The market price of crude oil and condensate, NGLs and natural gas in 2017 will impact the amount of cash generated from EOG's operating activities, which will in turn impact EOG's financial position. As of February 17, 2017, the average 2017 NYMEX crude oil and natural gas prices were $54.16 per barrel and $3.19 per MMBtu, respectively, representing increases of 25% and 31%, respectively, from the average NYMEX prices in 2016. See ITEM 1A, Risk Factors. Including the impact of EOG's 2017 crude oil derivative contracts (exclusive of options) and based on EOG's tax position, EOG's price sensitivity in 2017 for each $1.00 per barrel increase or decrease in wellhead crude oil and condensate price, combined with the estimated change in NGL price, is approximately $77 million for net income and $96 million for cash flows from operating activities. Including the impact of EOG's 2017 natural gas derivative contracts (exclusive of options) and based on EOG's tax position and the portion of EOG's anticipated natural gas volumes for 2017 for which prices have not been determined under long-term marketing contracts, EOG's price sensitivity for each $0.10 per Mcf increase or decrease in wellhead natural gas price is approximately $12 million for net income and $15 million for cash flows from operating activities. For information regarding EOG's crude oil and natural gas financial commodity derivative contracts through February 20, 2017, see "Derivative Transactions" above. Capital. EOG plans to continue to focus a substantial portion of its exploration and development expenditures in its major producing areas in the United States. In particular, EOG will be focused on United States crude oil drilling activity in its Eagle Ford, Delaware Basin and Rocky Mountain area where it generates its highest rates-of-return. To further enhance the economics of these plays, EOG expects to continue to improve well performance and lower drilling and completion costs through efficiency gains and lower service costs. The total anticipated 2017 capital expenditures of approximately $3.7 billion to $4.1 billion, excluding acquisitions, is structured to maintain EOG's strategy of capital discipline by funding its exploration, development and exploitation activities primarily from available internally generated cash flows and cash on hand. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program and other uncommitted credit facilities, bank borrowings, borrowings under its $2.0 billion senior unsecured revolving credit facility and equity and debt offerings. Operations. In 2017, both total production and total crude oil production are expected to increase from 2016 levels. In 2017, EOG expects to continue to focus on reducing operating costs through efficiency improvements. Summary of Critical Accounting Policies EOG prepares its financial statements and the accompanying notes in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions about future events that affect the reported amounts in the financial statements and the accompanying notes. EOG identifies certain accounting policies as critical based on, among other things, their impact on the portrayal of EOG's financial condition, results of operations or liquidity, and the degree of difficulty, subjectivity and complexity in their application. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. Management routinely discusses the development, selection and disclosure of each of the critical accounting policies. Following is a discussion of EOG's most critical accounting policies: Proved Oil and Gas Reserves EOG's engineers estimate proved oil and gas reserves in accordance with United States Securities and Exchange Commission (SEC) regulations, which directly impact financial accounting estimates, including depreciation, depletion and amortization and impairments of proved properties and related assets. Proved reserves represent estimated quantities of crude oil and condensate, NGLs and natural gas that geological and engineering data demonstrate, with reasonable certainty, to be recoverable in future years from known reservoirs under economic and operating conditions existing at the time the estimates were made. The process of estimating quantities of proved oil and gas reserves is complex, requiring significant subjective decisions in the evaluation of all available geological, engineering and economic data for each reservoir. The data for a given reservoir may also change substantially over time as a result of numerous factors including, but not limited to, additional development activity, evolving production history and continual reassessment of the viability of production under varying economic conditions. Consequently, material revisions (upward or downward) to existing reserve estimates may occur from time to time. For related discussion, see ITEM 1A, Risk Factors, and "Supplemental Information to Consolidated Financial Statements." Oil and Gas Exploration Costs EOG accounts for its crude oil and natural gas exploration and production activities under the successful efforts method of accounting. Oil and gas exploration costs, other than the costs of drilling exploratory wells, are charged to expense as incurred. The costs of drilling exploratory wells are capitalized pending determination of whether EOG has discovered proved commercial reserves. If proved commercial reserves are not discovered, such drilling costs are expensed. In some circumstances, it may be uncertain whether proved commercial reserves have been discovered when drilling has been completed. Such exploratory well drilling costs may continue to be capitalized if the reserve quantity is sufficient to justify its completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made. Costs to develop proved reserves, including the costs of all development wells and related equipment used in the production of crude oil and natural gas, are capitalized. Depreciation, Depletion and Amortization for Oil and Gas Properties The quantities of estimated proved oil and gas reserves are a significant component of EOG's calculation of depreciation, depletion and amortization expense, and revisions in such estimates may alter the rate of future expense. Holding all other factors constant, if reserves were revised upward or downward, earnings would increase or decrease, respectively. Depreciation, depletion and amortization of the cost of proved oil and gas properties is calculated using the unit-of-production method. The reserve base used to calculate depreciation, depletion and amortization for leasehold acquisition costs and the cost to acquire proved properties is the sum of proved developed reserves and proved undeveloped reserves. With respect to lease and well equipment costs, which include development costs and successful exploration drilling costs, the reserve base includes only proved developed reserves. Estimated future dismantlement, restoration and abandonment costs, net of salvage values, are taken into account. Oil and gas properties are grouped in accordance with the provisions of the Extractive Industries - Oil and Gas Topic of the ASC. The basis for grouping is a reasonable aggregation of properties with a common geological structural feature or stratigraphic condition, such as a reservoir or field. Depreciation, depletion and amortization rates are updated quarterly to reflect the addition of capital costs, reserve revisions (upwards or downwards) and additions, property acquisitions and/or property dispositions and impairments. Depreciation and amortization of other property, plant and equipment is calculated on a straight-line basis over the estimated useful life of the asset. Impairments Oil and gas lease acquisition costs are capitalized when incurred. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. If the unproved properties are determined to be productive, the appropriate related costs are transferred to proved oil and gas properties. Lease rentals are expensed as incurred. When circumstances indicate that proved oil and gas properties may be impaired, EOG compares expected undiscounted future cash flows at a depreciation, depletion and amortization group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows, based on EOG's estimates of (and assumptions regarding) future crude oil and natural gas prices, operating costs, development expenditures, anticipated production from proved reserves and other relevant data, are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated using the Income Approach described in the Fair Value Measurement Topic of the ASC. In certain instances, EOG utilizes accepted offers from third-party purchasers as the basis for determining fair value. Estimates of undiscounted future cash flows require significant judgment, and the assumptions used in preparing such estimates are inherently uncertain. In addition, such assumptions and estimates are reasonably likely to change in the future. Crude oil and natural gas prices have exhibited significant volatility in the past, and EOG expects that volatility to continue in the future. During the five years ended December 31, 2016, West Texas Intermediate crude oil spot prices have fluctuated from approximately $26.19 per barrel to $110.62 per barrel, and Henry Hub natural gas spot prices have ranged from approximately $1.49 per MMBtu to $8.15 per MMBtu. EOG uses the five-year NYMEX futures strip for West Texas Intermediate crude oil and Henry Hub natural gas (in each case as of the applicable balance sheet date) as a basis to estimate future crude oil and natural gas prices. EOG's proved reserves estimates, including the timing of future production, are also subject to significant assumptions and judgment, and are frequently revised (upwards and downwards) as more information becomes available. Proved reserves are estimated using a trailing 12-month average price, in accordance with SEC rules. In the future, if any combination of crude oil, natural gas prices, actual production or operating costs diverge negatively from EOG's current estimates, impairment charges and downward adjustments to our proved reserves may be necessary. Income Taxes Income taxes are accounted for using the asset and liability approach. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax basis. EOG assesses the realizability of deferred tax assets and recognizes valuation allowances as appropriate. Significant assumptions used in estimating future taxable income include future oil and gas prices and changes in tax rates. Changes in such assumptions could materially affect the recognized amounts of valuation allowances. Stock-Based Compensation In accounting for stock-based compensation, judgments and estimates are made regarding, among other things, the appropriate valuation methodology to follow in valuing stock compensation awards and the related inputs required by those valuation methodologies. Assumptions regarding expected volatility of EOG's common stock, the level of risk-free interest rates, expected dividend yields on EOG's common stock, the expected term of the awards, expected volatility of the price of shares of EOG's peer companies and other valuation inputs are subject to change. Any such changes could result in different valuations and thus impact the amount of stock-based compensation expense recognized on the Consolidated Statements of Income and Comprehensive Income. Information Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical facts, including, among others, statements and projections regarding EOG's future financial position, operations, performance, business strategy, returns, budgets, reserves, levels of production, costs and asset sales, statements regarding future commodity prices and statements regarding the plans and objectives of EOG's management for future operations, are forward-looking statements. EOG typically uses words such as "expect," "anticipate," "estimate," "project," "strategy," "intend," "plan," "target," "goal," "may," "will," "should" and "believe" or the negative of those terms or other variations or comparable terminology to identify its forward-looking statements. In particular, statements, express or implied, concerning EOG's future operating results and returns or EOG's ability to replace or increase reserves, increase production, reduce or otherwise control operating and capital costs, generate income or cash flows or pay dividends are forward-looking statements. Forward-looking statements are not guarantees of performance. Although EOG believes the expectations reflected in its forward-looking statements are reasonable and are based on reasonable assumptions, no assurance can be given that these assumptions are accurate or that any of these expectations will be achieved (in full or at all) or will prove to have been correct. Moreover, EOG's forward-looking statements may be affected by known, unknown or currently unforeseen risks, events or circumstances that may be outside EOG's control. Important factors that could cause EOG's actual results to differ materially from the expectations reflected in EOG's forward-looking statements include, among others: • the timing, extent and duration of changes in prices for, supplies of, and demand for, crude oil and condensate, natural gas liquids, natural gas and related commodities; • the extent to which EOG is successful in its efforts to acquire or discover additional reserves; • the extent to which EOG is successful in its efforts to economically develop its acreage in, produce reserves and achieve anticipated production levels from, and maximize reserve recovery from, its existing and future crude oil and natural gas exploration and development projects; • the extent to which EOG is successful in its efforts to market its crude oil and condensate, natural gas liquids, natural gas and related commodity production; • the availability, proximity and capacity of, and costs associated with, appropriate gathering, processing, compression, transportation and refining facilities; • the availability, cost, terms and timing of issuance or execution of, and competition for, mineral licenses and leases and governmental and other permits and rights-of-way, and EOG’s ability to retain mineral licenses and leases; • the impact of, and changes in, government policies, laws and regulations, including tax laws and regulations; environmental, health and safety laws and regulations relating to air emissions, disposal of produced water, drilling fluids and other wastes, hydraulic fracturing and access to and use of water; laws and regulations imposing conditions or restrictions on drilling and completion operations and on the transportation of crude oil and natural gas; laws and regulations with respect to derivatives and hedging activities; and laws and regulations with respect to the import and export of crude oil, natural gas and related commodities; • EOG's ability to effectively integrate acquired crude oil and natural gas properties into its operations, fully identify existing and potential problems with respect to such properties and accurately estimate reserves, production and costs with respect to such properties; • the extent to which EOG's third-party-operated crude oil and natural gas properties are operated successfully and economically; • competition in the oil and gas exploration and production industry for the acquisition of licenses, leases and properties, employees and other personnel, facilities, equipment, materials and services; • the availability and cost of employees and other personnel, facilities, equipment, materials (such as water) and services; • the accuracy of reserve estimates, which by their nature involve the exercise of professional judgment and may therefore be imprecise; • weather, including its impact on crude oil and natural gas demand, and weather-related delays in drilling and in the installation and operation (by EOG or third parties) of production, gathering, processing, refining, compression and transportation facilities; • the ability of EOG's customers and other contractual counterparties to satisfy their obligations to EOG and, related thereto, to access the credit and capital markets to obtain financing needed to satisfy their obligations to EOG; • EOG's ability to access the commercial paper market and other credit and capital markets to obtain financing on terms it deems acceptable, if at all, and to otherwise satisfy its capital expenditure requirements; • the extent to which EOG is successful in its completion of planned asset dispositions; • the extent and effect of any hedging activities engaged in by EOG; • the timing and extent of changes in foreign currency exchange rates, interest rates, inflation rates, global and domestic financial market conditions and global and domestic general economic conditions; • political conditions and developments around the world (such as political instability and armed conflict), including in the areas in which EOG operates; • the use of competing energy sources and the development of alternative energy sources; • the extent to which EOG incurs uninsured losses and liabilities or losses and liabilities in excess of its insurance coverage; • acts of war and terrorism and responses to these acts; • physical, electronic and cyber security breaches; and • the other factors described under ITEM 1A, Risk Factors, on pages 13 through 22 of this Annual Report on Form 10-K and any updates to those factors set forth in EOG's subsequent Quarterly Reports on Form 10-Q or Current Reports on Form 8-K. In light of these risks, uncertainties and assumptions, the events anticipated by EOG's forward-looking statements may not occur, and, if any of such events do, we may not have anticipated the timing of their occurrence or the duration and extent of their impact on our actual results. Accordingly, you should not place any undue reliance on any of EOG's forward-looking statements. EOG's forward-looking statements speak only as of the date made, and EOG undertakes no obligation, other than as required by applicable law, to update or revise its forward-looking statements, whether as a result of new information, subsequent events, anticipated or unanticipated circumstances or otherwise.

<s>[INST] EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (nonintegrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad, the United Kingdom and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. Each prospective drilling location is evaluated by its estimated rate of return. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a costeffective basis, allowing EOG to deliver longterm production growth while maintaining a strong balance sheet. EOG implements its strategy by emphasizing the drilling of internally generated prospects in order to find and develop lowcost reserves. Maintaining the lowest possible operating cost structure that is consistent with prudent and safe operations is also an important goal in the implementation of EOG's strategy. EOG realized a net loss of $1,097 million during 2016 as compared to a net loss of $4,525 million for 2015. At December 31, 2016, EOG's total estimated net proved reserves were 2,147 million barrels of oil equivalent (MMBoe), an increase of 29 MMBoe from December 31, 2015. During 2016, net proved crude oil and condensate and natural gas liquids (NGLs) reserves increased by 113 million barrels (MMBbl), and net proved natural gas reserves decreased by 508 billion cubic feet or 84 MMBoe. Operations Several important developments have occurred since January 1, 2016. United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquidsrich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquidsrich reservoirs. During 2016, EOG continued to focus on increasing drilling and completion efficiencies using precision lateral targeting and advanced completion methods and reducing operating and capital costs through efficiency improvements and service cost reductions. These efficiency gains along with realized lower service costs resulted in lower drilling and completion costs and decreased operating expenses during 2016. EOG continues to look for opportunities to add drilling inventory through leasehold acquisitions, farmins or tactical acquisitions and to evaluate certain potential crude oil and liquidsrich natural gas exploration and development prospects. On a volumetric basis, as calculated using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGL production accounted for approximately 73% of United States production during 2016 as compared to 71% for 2015. During 2016, drilling and completion activities occurred primarily in the Eagle Ford play, Delaware Basin play and Rocky Mountain area. EOG's major producing areas in the United States are in New Mexico, North Dakota, Texas, Utah and Wyoming. On October 4, 2016, EOG completed its previously announced mergers and related asset purchase transactions with Yates Petroleum Corporation (YPC), Abo Petroleum Corporation (ABO), MYCO Industries, Inc. (MYCO) and certain affiliated entities (collectively with YPC, ABO and MYCO, the Yates Entities). The Yates Entities had recent net production of approximately 28,600 barrels of oil equivalent per day, with 48% crude oil. The assets of the Yates Entities include 1.6 million total net acres, with approximately 180,000 net acres in the Delaware Basin Core, approximately 200,000 net acres in the Powder River Basin and approximately 130,000 net acres in [/INST] Positive. </s>

EOG RESOURCES INC

2018-02-27

2017-12-31

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (non-integrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad, the United Kingdom and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. Each prospective drilling location is evaluated by its estimated rate of return. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a cost-effective basis, allowing EOG to deliver long-term production growth while maintaining a strong balance sheet. EOG implements its strategy by emphasizing the drilling of internally generated prospects in order to find and develop low-cost reserves. Maintaining the lowest possible operating cost structure that is consistent with prudent and safe operations is also an important goal in the implementation of EOG's strategy. EOG realized net income of $2,583 million during 2017 as compared to a net loss of $1,097 million for 2016. At December 31, 2017, EOG's total estimated net proved reserves were 2,527 million barrels of oil equivalent (MMBoe), an increase of 380 MMBoe from December 31, 2016. During 2017, net proved crude oil and condensate and natural gas liquids (NGLs) reserves increased by 223 million barrels (MMBbl), and net proved natural gas reserves increased by 945 billion cubic feet or 158 MMBoe, in each case from December 31, 2016. Operations Several important developments have occurred since January 1, 2017. United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquids-rich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquids-rich reservoirs. During 2017, EOG continued to focus on increasing drilling, completion and operating efficiencies using precision lateral targeting and advanced completion methods and reducing operating and capital costs through efficiency improvements and service cost reductions. These efficiency gains along with certain realized lower service costs resulted in lower drilling and completion costs and decreased operating expenses during 2017. EOG continues to look for opportunities to add drilling inventory through leasehold acquisitions, farm-ins, exchanges or tactical acquisitions and to evaluate certain potential crude oil and liquids-rich natural gas exploration and development prospects. On a volumetric basis, as calculated using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGL production accounted for approximately 77% of United States production during 2017 as compared to 73% for 2016. During 2017, drilling and completion activities occurred primarily in the Eagle Ford play, Delaware Basin play and Rocky Mountain area. EOG's major producing areas in the United States are in New Mexico, North Dakota, Texas, Utah and Wyoming. Trinidad. In Trinidad, EOG continued to deliver natural gas under existing supply contracts. Several fields in the South East Coast Consortium (SECC) Block, Modified U(a) Block, Block 4(a), Modified U(b) Block, the Banyan Field and the Sercan Area have been developed and are producing natural gas which is sold to the National Gas Company of Trinidad and Tobago Limited and its subsidiary and crude oil and condensate which is sold to the Petroleum Company of Trinidad and Tobago Limited. In 2017, EOG completed and brought on-line two net wells finishing its program in the Sercan Area and drilled and completed five additional net wells in the Banyan and Osprey fields. EOG conducted a seismic survey in the U(a) Block, participated in a seismic survey program with a joint venture partner in the Ska, Mento and Reggae area and signed a new multi-year contract under which EOG will supply future natural gas volumes to NGC beginning in 2019. Other International. In the United Kingdom, EOG produces crude oil from its 100% working interest East Irish Sea Conwy project. Beginning in the second quarter of 2017, production in the Conwy was off-line due to facility improvements and operational issues. EOG resumed production in the first quarter of 2018. In the Sichuan Basin, Sichuan Province, China, EOG drilled five natural gas wells and completed four of those wells in 2017 as part of the continuing development of the Bajiaochang Field, which natural gas is sold under a long-term contract to PetroChina. EOG continues to evaluate other select crude oil and natural gas opportunities outside the United States, primarily by pursuing exploitation opportunities in countries where indigenous crude oil and natural gas reserves have been identified. Tax Cuts and Jobs Act In December 2017, the United States enacted the Tax Cuts and Jobs Act (TCJA), which made significant changes to United States federal income tax law. Under the Income Taxes Topic of the Accounting Standards Codification, the effects of new legislation are recognized upon enactment. Accordingly, recognition of the tax effects of the TCJA is required in the consolidated financial statements for the fiscal year ended December 31, 2017. As more fully described in the Notes to Consolidated Financial Statements, the TCJA made several changes to United States corporate income tax laws, some of which will have a material impact on EOG's tax provision for 2017 and subsequent periods, including the reduction in the statutory tax rate from 35 percent to 21 percent, a one-time tax on the deemed repatriation of foreign earnings and the conversion to the territorial system of taxation of foreign earnings. The TCJA is expected to reduce EOG's effective tax rate in 2018 and subsequent years, though the ultimate impact on its worldwide effective tax rate will depend on the percentage of pretax income generated by EOG in the United States as compared to its other jurisdictions. Capital Structure One of management's key strategies is to maintain a strong balance sheet with a consistently below average debt-to-total capitalization ratio as compared to those in EOG's peer group. EOG's debt-to-total capitalization ratio was 28% at December 31, 2017 and 33% at December 31, 2016. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. On September 15, 2017, EOG repaid upon maturity the $600 million aggregate principal amount of its 5.875% Senior Notes due 2017. On February 15, 2017, the Board of Directors approved an amendment to EOG's Restated Certificate of Incorporation to increase the number of EOG's authorized shares of common stock from 640 million to 1,280 million. EOG's stockholders approved the increase at the Annual Meeting of Stockholders on April 27, 2017, and the amendment was filed with the Delaware Secretary of State on April 28, 2017. During 2017, EOG funded $4.6 billion ($282 million of which was non-cash property exchanges) in exploration and development and other property, plant and equipment expenditures (excluding asset retirement obligations), repaid $600 million aggregate principal amount of long-term debt, paid $387 million in dividends to common stockholders and purchased $63 million of treasury stock in connection with stock compensation plans, primarily by utilizing net cash provided from its operating activities and net proceeds of $227 million from the sale of assets. Total anticipated 2018 capital expenditures are estimated to range from approximately $5.4 billion to $5.8 billion, excluding acquisitions. The majority of 2018 expenditures will be focused on United States crude oil drilling activities. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program and other uncommitted credit facilities, bank borrowings, borrowings under its $2.0 billion senior unsecured revolving credit facility, joint development agreements and similar agreements and equity and debt offerings. When it fits EOG's strategy, EOG will make acquisitions that bolster existing drilling programs or offer incremental exploration and/or production opportunities. Management continues to believe EOG has one of the strongest prospect inventories in EOG's history. Results of Operations The following review of operations for each of the three years in the period ended December 31, 2017, should be read in conjunction with the consolidated financial statements of EOG and notes thereto beginning on page. Net Operating Revenues and Other During 2017, net operating revenues increased $3,557 million, or 47%, to $11,208 million from $7,651 million in 2016. Total wellhead revenues, which are revenues generated from sales of EOG's production of crude oil and condensate, NGLs and natural gas, increased $2,411 million, or 44%, to $7,908 million in 2017 from $5,497 million in 2016. Revenues from the sales of crude oil and condensate and NGLs in 2017 were approximately 88% of total wellhead revenues compared to 86% in 2016. During 2017, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $20 million compared to net losses of $100 million in 2016. Gathering, processing and marketing revenues increased $1,332 million during 2017, to $3,298 million from $1,966 million in 2016. Net losses on asset dispositions of $99 million in 2017 were primarily as a result of sales of producing properties and acreage in Texas and the Rocky Mountain area compared to net gains on asset dispositions of $206 million in 2016. Wellhead volume and price statistics for the years ended December 31, 2017, 2016 and 2015 were as follows: (1) Thousand barrels per day or million cubic feet per day, as applicable. (2) Other International includes EOG's United Kingdom, China, Canada and Argentina operations. The Argentina operations were sold in the third quarter of 2016. (3) Dollars per barrel or per thousand cubic feet, as applicable. Excludes the impact of financial commodity derivative instruments (see Note 12 to Consolidated Financial Statements). (4) Thousand barrels of oil equivalent per day or million barrels of oil equivalent, as applicable; includes crude oil and condensate, NGLs and natural gas. Crude oil equivalent volumes are determined using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas. MMBoe is calculated by multiplying the MBoed amount by the number of days in the period and then dividing that amount by one thousand. 2017 compared to 2016. Wellhead crude oil and condensate revenues in 2017 increased $1,939 million, or 45%, to $6,256 million from $4,317 million in 2016, due primarily to a higher composite average wellhead crude oil and condensate price ($1,124 million) and an increase in production ($815 million). EOG's composite wellhead crude oil and condensate price for 2017 increased 22% to $50.91 per barrel compared to $41.76 per barrel in 2016. Wellhead crude oil and condensate deliveries in 2017 increased 19% to 337 MBbld as compared to 283 MBbld in 2016. The increased production was primarily due to higher production in the Permian Basin and Rocky Mountain area. NGL revenues in 2017 increased $292 million, or 67%, to $729 million from $437 million in 2016 primarily due to a higher composite wellhead NGL price ($257 million) and an increase in production ($35 million). EOG's composite average wellhead NGL price increased 55% to $22.61 per barrel in 2017 compared to $14.63 per barrel in 2016. The increased production was primarily due to higher production in the Permian Basin and Rocky Mountain area, partially offset by decreased production in the Fort Worth Barnett Shale, largely resulting from 2016 asset sales in this region. Wellhead natural gas revenues in 2017 increased $180 million, or 24%, to $922 million from $742 million in 2016, primarily due to a higher composite wellhead natural gas price ($227 million), partially offset by a decrease in wellhead natural gas deliveries ($47 million). EOG's composite average wellhead natural gas price increased 32% to $2.29 per Mcf in 2017 compared to $1.73 per Mcf in 2016. Natural gas deliveries in 2017 decreased 6% to 1,103 MMcfd as compared to 1,175 MMcfd in 2016. The decrease in production was primarily due to decreased production in the United States (45 MMcfd) and Trinidad (27 MMcfd). The decreased production in the United States was due primarily to lower volumes in the Fort Worth Barnett Shale, Upper Gulf Coast and South Texas areas, largely resulting from 2016 asset sales in these regions, partially offset by increased production of associated gas in the Permian Basin and Rocky Mountain area and from the 2016 mergers and related asset purchase transactions with Yates Petroleum Corporation and other affiliated entities (collectively, the Yates Entities). The decrease in Trinidad was primarily attributable to higher contractual deliveries in 2016. During 2017, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $20 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $7 million. During 2016, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $100 million, which included net cash paid for settlements of crude oil and natural gas financial derivative contracts of $22 million. Gathering, processing and marketing revenues are revenues generated from sales of third-party crude oil, NGLs and natural gas as well as gathering fees associated with gathering third-party natural gas and revenues from sales of EOG-owned sand. Purchases and sales of third-party crude oil and natural gas are utilized in order to balance firm transportation capacity with production in certain areas and to utilize excess capacity at EOG-owned facilities. EOG sells sand in order to balance the timing of firm purchase agreements with completion operations and to utilize excess capacity at EOG-owned facilities. Marketing costs represent the costs to purchase third-party crude oil, natural gas and sand and the associated transportation costs as well as costs associated with EOG-owned sand sold to third parties. Gathering, processing and marketing revenues less marketing costs in 2017 increased $9 million compared to 2016, primarily due to higher margins on natural gas and NGL marketing activities ($16 million), partially offset by lower margins on sand sales ($9 million). 2016 compared to 2015. Wellhead crude oil and condensate revenues in 2016 decreased $618 million, or 13%, to $4,317 million from $4,935 million in 2015, due primarily to a lower composite average wellhead crude oil and condensate price. EOG's composite wellhead crude oil and condensate price for 2016 decreased 12% to $41.76 per barrel compared to $47.53 per barrel in 2015. Wellhead crude oil and condensate deliveries in 2016 decreased 1% to 283 MBbld as compared to 284 MBbld in 2015. The decreased production was primarily due to lower production in the Eagle Ford and the Rocky Mountain area, largely offset by increased production in the Permian Basin. NGL revenues in 2016 increased $29 million, or 7%, to $437 million from $408 million in 2015, due to an increase of 5 MBbld, or 6%, in NGL deliveries primarily as a result of increased production in the Permian Basin. Wellhead natural gas revenues in 2016 decreased $319 million, or 30%, to $742 million from $1,061 million in 2015, primarily due to a lower composite wellhead natural gas price ($246 million) and a decrease in wellhead natural gas deliveries ($73 million). EOG's composite average wellhead natural gas price decreased 25% to $1.73 per Mcf in 2016 compared to $2.30 per Mcf in 2015. Natural gas deliveries in 2016 decreased 7% to 1,175 MMcfd as compared to 1,265 MMcfd in 2015. The decrease in production was primarily due to decreased production in the United States (76 MMcfd). The decreased production was due primarily to lower volumes in the Fort Worth Barnett Shale, Upper Gulf Coast and South Texas areas, largely resulting from asset sales in these regions during the year, partially offset by increased production of associated gas in the Permian Basin and the acquisition of the Yates Entities. During 2016, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $100 million, which included net cash paid for settlements of crude oil and natural gas financial derivative contracts of $22 million. During 2015, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $62 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $730 million. Gathering, processing and marketing revenues less marketing costs in 2016 increased $91 million compared to 2015, primarily due to higher margins on crude oil marketing activities and on sand sales. Operating and Other Expenses 2017 compared to 2016. During 2017, operating expenses of $10,282 million were $1,406 million higher than the $8,876 million incurred during 2016. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2017 and 2016: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2017 compared to 2016 are set forth below. See "Net Operating Revenues and Other" above for a discussion of production volumes. Lease and well expenses include expenses for EOG-operated properties, as well as expenses billed to EOG from other operators where EOG is not the operator of a property. Lease and well expenses can be divided into the following categories: costs to operate and maintain crude oil and natural gas wells, the cost of workovers and lease and well administrative expenses. Operating and maintenance costs include, among other things, pumping services, salt water disposal, equipment repair and maintenance, compression expense, lease upkeep and fuel and power. Workovers are operations to restore or maintain production from existing wells. Each of these categories of costs individually fluctuates from time to time as EOG attempts to maintain and increase production while maintaining efficient, safe and environmentally responsible operations. EOG continues to increase its operating activities by drilling new wells in existing and new areas. Operating and maintenance costs within these existing and new areas, as well as the costs of services charged to EOG by vendors, fluctuate over time. Lease and well expenses of $1,045 million in 2017 increased $118 million from $927 million in 2016 primarily due to higher operating and maintenance costs in the United States ($71 million) and the United Kingdom ($30 million) and higher workover expenditures in the United States ($21 million). Lease and well expenses increased in the United States primarily due to increased operating activities resulting in increased production. Transportation costs represent costs associated with the delivery of hydrocarbon products from the lease to a downstream point of sale. Transportation costs include transportation fees, the cost of compression (the cost of compressing natural gas to meet pipeline pressure requirements), dehydration (the cost associated with removing water from natural gas to meet pipeline requirements), gathering fees and fuel costs. Transportation costs of $740 million in 2017 decreased $24 million from $764 million in 2016 primarily due to divestitures in the Barnett Shale and Upper Gulf Coast ($85 million) and decreased transportation costs in the Eagle Ford ($8 million) and the United Kingdom ($8 million), partially offset by increased transportation costs related to higher production in the Permian Basin ($47 million) and the Rocky Mountain area ($20 million) and from the 2016 transactions with the Yates Entities ($13 million). DD&A of the cost of proved oil and gas properties is calculated using the unit-of-production method. EOG's DD&A rate and expense are the composite of numerous individual DD&A group calculations. There are several factors that can impact EOG's composite DD&A rate and expense, such as field production profiles, drilling or acquisition of new wells, disposition of existing wells and reserve revisions (upward or downward) primarily related to well performance, economic factors and impairments. Changes to these factors may cause EOG's composite DD&A rate and expense to fluctuate from period to period. DD&A of the cost of other property, plant and equipment is generally calculated using the straight-line depreciation method over the useful lives of the assets. DD&A expenses in 2017 decreased $144 million to $3,409 million from $3,553 million in 2016. DD&A expenses associated with oil and gas properties in 2017 were $141 million lower than in 2016 primarily due to lower unit rates in the United States ($449 million) and Trinidad ($19 million) and a decrease in production in the United Kingdom ($16 million) and Trinidad ($11 million), partially offset by an increase in production in the United States ($354 million). Unit rates in the United States decreased primarily due to upward reserve revisions and reserves added at lower costs as a result of increased efficiencies. G&A expenses of $434 million in 2017 increased $39 million from $395 million in 2016 primarily due to increased employee-related expenses resulting from expanded operations and from the 2016 transactions with the Yates Entities ($45 million) and increased professional, legal and other services ($30 million), partially offset by 2016 employee related expenses in connection with certain voluntary retirements ($42 million). Net interest expense of $274 million in 2017 was $8 million lower than 2016 primarily due to repayment of the $600 million aggregate principal amount of 5.875% Senior Notes due 2017 in September 2017 ($11 million), partially offset by a decrease in capitalized interest ($4 million). Gathering and processing costs represent operating and maintenance expenses and administrative expenses associated with operating EOG's gathering and processing assets and certain charges from third-party processors. Gathering and processing costs increased $26 million to $149 million in 2017 compared to $123 million in 2016 due to increased activities in the Permian Basin ($12 million) and the Rocky Mountain area ($8 million). Exploration costs of $145 million in 2017 increased $20 million from $125 million in 2016 primarily due to increased geological and geophysical expenditures in Trinidad. Impairments include amortization of unproved oil and gas property costs as well as impairments of proved oil and gas properties; other property, plant and equipment; and other assets. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. Unproved properties with individually significant acquisition costs are reviewed individually for impairment. When circumstances indicate that a proved property may be impaired, EOG compares expected undiscounted future cash flows at a DD&A group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated by using the Income Approach described in the Fair Value Measurement Topic of the Financial Accounting Standards Board's Accounting Standards Codification (ASC). In certain instances, EOG utilizes accepted offers from third-party purchasers as the basis for determining fair value. The following table represents impairments for the years ended December 31, 2017 and 2016 (in millions): Impairments of proved properties were primarily due to the write-down to fair value of divested legacy natural gas assets in 2017 and 2016. EOG recognized additional impairment charges in 2016 of $61 million related to obsolete inventory and $138 million related to firm commitment contracts related to divested Haynesville natural gas assets. Taxes other than income include severance/production taxes, ad valorem/property taxes, payroll taxes, franchise taxes and other miscellaneous taxes. Severance/production taxes are generally determined based on wellhead revenues, and ad valorem/property taxes are generally determined based on the valuation of the underlying assets. Taxes other than income in 2017 increased $195 million to $545 million (6.9% of wellhead revenues) from $350 million (6.4% of wellhead revenues) in 2016. The increase in taxes other than income was primarily due to increases in severance/production taxes ($171 million) and in ad valorem property taxes ($18 million), both primarily as a result of increased wellhead revenues in the United States. Other income, net, was $9 million in 2017 compared to other expense, net, of $51 million in 2016. The increase of $60 million was primarily due to an increase in foreign currency transaction gains in 2017 ($49 million) and interest income ($5 million). EOG recognized an income tax benefit of $1,921 million in 2017 compared to an income tax benefit of $461 million in 2016, primarily due to the enactment of the TCJA in December 2017. The most significant impact of the TCJA on EOG was the reduction in the statutory income tax rate from 35% to 21%, which required the existing net United States federal deferred income tax liability to be remeasured, resulting in the recognition of an income tax benefit of approximately $2.2 billion. Due largely to this tax rate reduction, the net effective tax rate for 2017 decreased to (291)% from 30% in the prior year. See Note 6 to Consolidated Financial Statements for a further description of the income tax changes enacted by TCJA affecting EOG. 2016 compared to 2015. During 2016, operating expenses of $8,876 million were $6,568 million lower than the $15,444 million incurred during 2015. Operating expenses for 2015 included impairments of proved properties; other property, plant and equipment; and other assets of $6,326 million primarily due to commodity price declines. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2016 and 2015: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2016 compared to 2015 are set forth below. See "Net Operating Revenues and Other" above for a discussion of production volumes. Lease and well expenses of $927 million in 2016 decreased $255 million from $1,182 million in 2015 primarily due to lower operating and maintenance costs ($218 million) and lower lease and well administrative expenses ($35 million), both in the United States. Transportation costs of $764 million in 2016 decreased $85 million from $849 million in 2015 primarily due to decreased transportation costs in the Rocky Mountain area ($55 million), the Barnett Shale ($21 million), the Eagle Ford ($19 million) and the Upper Gulf Coast region ($10 million) primarily due to lower production and service cost reductions in these regions, partially offset by increased transportation costs related to higher production from the Permian Basin ($18 million). DD&A expenses in 2016 increased $239 million to $3,553 million from $3,314 million in 2015. DD&A expenses associated with oil and gas properties in 2016 were $247 million higher than in 2015 primarily due to higher unit rates in the United States ($300 million) and China ($3 million) and commencement of crude oil production from the Conwy field in the United Kingdom ($22 million), partially offset by a decrease in production in the United States ($68 million) and Trinidad ($4 million) and lower unit rates in Trinidad ($6 million). Unit rates in the United States increased primarily due to downward reserve revisions at December 31, 2015, as a result of lower commodity prices. G&A expenses of $395 million in 2016 increased $28 million from $367 million in 2015 primarily due to employee-related expenses in connection with certain voluntary retirements and costs related to the Yates transaction. Net interest expense of $282 million in 2016 was $45 million higher than 2015 primarily due to interest incurred on the notes issued in January 2016 ($43 million), as well as a decrease in capitalized interest ($10 million). This was partially offset by the reduction of interest expense related to the debt repaid in February 2016 and June 2015 ($16 million). Gathering and processing costs decreased $23 million to $123 million in 2016 compared to $146 million in 2015 due to decreased activities in the Eagle Ford ($16 million) and the Barnett Shale ($7 million). Exploration costs of $125 million in 2016 decreased $24 million from $149 million in 2015 primarily due to decreased geological and geophysical expenditures ($15 million) and lower exploration administrative expenses ($14 million), partially offset by higher delay rentals ($5 million), all in the United States. The following table represents impairments for the years ended December 31, 2016 and 2015 (in millions): Impairments of proved properties were primarily due to the write-down to fair value of divested legacy natural gas assets in 2016 and primarily due to commodity price declines in 2015. Impairments of unproved properties were primarily due to higher amortization rates being applied to undeveloped leasehold costs in response to the significant decrease in commodity prices and an increase in EOG's estimates of undeveloped properties not expected to be developed before lease expiration in 2016 and 2015. EOG recognized additional impairment charges in 2016 of $61 million related to obsolete inventory and $138 million related to firm commitment contracts related to divested Haynesville natural gas assets. Taxes other than income in 2016 decreased $72 million to $350 million (6.4% of wellhead revenues) from $422 million (6.6% of wellhead revenues) in 2015. The decrease in taxes other than income was primarily due to decreases in ad valorem/property taxes ($49 million) and in severance/production taxes ($34 million), primarily as a result of decreased wellhead revenues, both in the United States. These decreases were partially offset by a decrease in credits available to EOG in 2016 for Texas high-cost gas severance tax rate reductions ($12 million). Other expense, net, was $51 million in 2016 compared to other income, net, of $2 million in 2015. The increase of $53 million was primarily due to an increase in foreign currency transaction losses and increased deferred compensation expense. EOG recognized an income tax benefit of $461 million in 2016 compared to an income tax benefit of $2,397 million in 2015, primarily due to a decrease in pretax loss resulting from the absence of certain 2015 impairments. The net effective tax rate for 2016 decreased to 30% from 35% in the prior year primarily due to additional Trinidad taxes resulting from a tax settlement reached in the second quarter of 2016 ($43 million). Capital Resources and Liquidity Cash Flow The primary sources of cash for EOG during the three-year period ended December 31, 2017, were funds generated from operations and proceeds from asset sales. The primary uses of cash were funds used in operations; exploration and development expenditures; other property, plant and equipment expenditures; repayments of debt; dividend payments to stockholders; and purchases of treasury stock in connection with stock compensation plans. 2017 compared to 2016. Net cash provided by operating activities of $4,265 million in 2017 increased $1,906 million from $2,359 million in 2016 primarily reflecting an increase in wellhead revenues ($2,411 million) and a favorable change in the net cash received from the settlement of financial commodity derivative contracts ($30 million), partially offset by an increase in cash operating expenses ($362 million), an increase in net cash paid for income taxes ($228 million), an increase in net cash paid for interest expense ($23 million) and unfavorable changes in working capital and other assets and liabilities ($10 million). Net cash used in investing activities of $3,987 million in 2017 increased by $2,734 million from $1,253 million in 2016 primarily due to an increase in additions to oil and gas properties ($1,461 million); a decrease in proceeds from asset sales ($892 million); unfavorable changes in working capital associated with investing activities ($246 million); and an increase in additions to other property, plant and equipment ($80 million). Net cash used in financing activities of $1,036 million in 2017 included repayments of long-term debt ($600 million), cash dividend payments ($387 million) and purchases of treasury stock in connection with stock compensation plans ($63 million). Cash provided by financing activities in 2017 included proceeds from stock options exercised and employee stock purchase plan activity ($21 million). 2016 compared to 2015. Net cash provided by operating activities of $2,359 million in 2016 decreased $1,236 million from $3,595 million in 2015 primarily reflecting a decrease in wellhead revenues ($907 million), an unfavorable change in the net cash received from the settlement of financial commodity derivative contracts ($752 million), unfavorable changes in working capital and other assets and liabilities ($197 million) and an increase in net cash paid for interest expense ($30 million), partially offset by a decrease in cash operating expenses ($442 million) and a decrease in net cash paid for income taxes ($80 million). Net cash used in investing activities of $1,253 million in 2016 decreased by $4,067 million from $5,320 million in 2015 primarily due to a decrease in additions to oil and gas properties ($2,235 million); an increase in proceeds from asset sales ($926 million); favorable changes in working capital associated with investing activities ($656 million); a decrease in additions to other property, plant and equipment ($195 million); and net cash received from the Yates transaction ($55 million). Net cash used for financing activities of $243 million in 2016 included repayments of long-term debt ($564 million), cash dividend payments ($373 million), net commercial paper repayments ($260 million) and purchases of treasury stock in connection with stock compensation plans ($82 million). Cash provided by financing activities in 2016 included net proceeds from the issuance of the Notes ($991 million), excess tax benefits from stock-based compensation ($29 million) and proceeds from stock options exercised and employee stock purchase plan activity ($23 million). Total Expenditures The table below sets out components of total expenditures for the years ended December 31, 2017, 2016 and 2015 (in millions): (1) Leasehold acquisitions included $256 million in 2017 related to non-cash property exchanges and $3,115 million in 2016 related to the Yates transaction. (2) Property acquisitions included $26 million in 2017 related to non-cash property exchanges and $735 million in 2016 related to the Yates transaction. (3) Other property, plant and equipment included $17 million in 2016 related to the Yates transaction. Exploration and development expenditures of $4,384 million for 2017 were $2,081 million lower than the prior year. The decrease was primarily due to decreased leasehold acquisitions ($2,790 million) and decreased property acquisitions ($676 million), partially offset by increased exploration and development drilling expenditures in the United States ($1,052 million), Trinidad ($106 million) and Other International ($17 million); increased facilities expenditures ($200 million); and increased geological and geophysical expenditures ($20 million). The 2017 exploration and development expenditures of $4,384 million included $3,661 million in development drilling and facilities, $623 million in exploration, $73 million in property acquisitions and $27 million in capitalized interest. The 2016 exploration and development expenditures of $6,465 million included $3,351 million in exploration, $2,334 million in development drilling and facilities, $749 million in property acquisitions and $31 million in capitalized interest. The 2015 exploration and development expenditures of $4,875 million included $4,007 million in development drilling and facilities, $481 million in property acquisitions, $345 million in exploration and $42 million in capitalized interest. The level of exploration and development expenditures, including acquisitions, will vary in future periods depending on energy market conditions and other related economic factors. EOG has significant flexibility with respect to financing alternatives and the ability to adjust its exploration and development expenditure budget as circumstances warrant. While EOG has certain continuing commitments associated with expenditure plans related to its operations, such commitments are not expected to be material when considered in relation to the total financial capacity of EOG. Derivative Transactions Commodity Derivative Contracts. Prices received by EOG for its crude oil production generally vary from U.S. New York Mercantile Exchange (NYMEX) West Texas Intermediate prices due to adjustments for delivery location (basis) and other factors. EOG has entered into crude oil basis swap contracts in order to fix the differential between pricing in Midland, Texas, and Cushing, Oklahoma (Midland Differential). Presented below is a comprehensive summary of EOG's Midland Differential basis swap contracts through February 20, 2018. The weighted average price differential expressed in dollars per barrel ($/Bbl) represents the amount of reduction to Cushing, Oklahoma, prices for the notional volumes expressed in barrels per day (Bbld) covered by the basis swap contracts. EOG has entered into additional crude oil basis swap contracts in order to fix the differential between pricing in the U.S. Gulf Coast and Cushing, Oklahoma (Gulf Coast Differential). Presented below is a comprehensive summary of EOG's Gulf Coast Differential basis swap contracts through February 20, 2018. The weighted average price differential expressed in $/Bbl represents the amount of addition to Cushing, Oklahoma, prices for the notional volumes expressed in Bbld covered by the basis swap contracts. On March 14, 2017, EOG executed the optional early termination provision granting EOG the right to terminate certain 2017 crude oil price swaps with notional volumes of 30,000 Bbld at a weighted average price of $50.05 per Bbl for the period March 1, 2017 through June 30, 2017. EOG received cash of $4.6 million for the early termination of these contracts, which are included in the table below. Presented below is a comprehensive summary of EOG's crude oil price swap contracts through February 20, 2018, with notional volumes expressed in Bbld and prices expressed in $/Bbl. On March 14, 2017, EOG entered into a crude oil price swap contract for the period March 1, 2017 through June 30, 2017, with notional volumes of 5,000 Bbld at a price of $48.81 per Bbl. This contract offset the remaining 2017 crude oil price swap contract for the same time period with notional volumes of 5,000 Bbld at a price of $50.00 per Bbl. The net cash EOG received for settling these contracts was $0.7 million. The offsetting contracts are excluded from the above table. Presented below is a comprehensive summary of EOG's natural gas price swap contracts through February 20, 2018, with notional volumes expressed in million British thermal units (MMBtu) per day (MMBtud) and prices expressed in dollars per MMBtu ($/MMBtu). EOG has sold call options which establish a ceiling price for the sale of notional volumes of natural gas as specified in the call option contracts. The call options require that EOG pay the difference between the call option strike price and either the average or last business day NYMEX Henry Hub natural gas price for the contract month (Henry Hub Index Price) in the event the Henry Hub Index Price is above the call option strike price. In addition, EOG has purchased put options which establish a floor price for the sale of notional volumes of natural gas as specified in the put option contracts. The put options grant EOG the right to receive the difference between the put option strike price and the Henry Hub Index Price in the event the Henry Hub Index Price is below the put option strike price. Presented below is a comprehensive summary of EOG's natural gas call and put option contracts through February 20, 2018, with notional volumes expressed in MMBtud and prices expressed in $/MMBtu. EOG has also entered into natural gas collar contracts, which establish ceiling and floor prices for the sale of notional volumes of natural gas as specified in the collar contracts. The collars require that EOG pay the difference between the ceiling price and the Henry Hub Index Price in the event the Henry Hub Index Price is above the ceiling price. The collars grant EOG the right to receive the difference between the floor price and the Henry Hub Index Price in the event the Henry Hub Index Price is below the floor price. Presented below is a comprehensive summary of EOG's natural gas collar contracts through February 20, 2018, with notional volumes expressed in MMBtud and prices expressed in $/MMbtu. Financing EOG's debt-to-total capitalization ratio was 28% at December 31, 2017, compared to 33% at December 31, 2016. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. At December 31, 2017 and 2016, respectively, EOG had outstanding $6,390 million and $6,990 million aggregate principal amount of senior notes which had estimated fair values of $6,602 million and $7,190 million, respectively. The estimated fair value was based upon quoted market prices and, where such prices were not available, other observable inputs regarding interest rates available to EOG at year-end. EOG's debt is at fixed interest rates. While changes in interest rates affect the fair value of EOG's senior notes, such changes do not expose EOG to material fluctuations in earnings or cash flow. During 2017, EOG funded its capital program primarily by utilizing cash provided by operating activities, proceeds from asset sales and cash provided by borrowings from its commercial paper program. While EOG maintains a $2.0 billion commercial paper program, the maximum outstanding at any time during 2017 was $803 million, and the amount outstanding at year-end was zero. There were no amounts outstanding under uncommitted credit facilities during 2017. The average borrowings outstanding under the commercial paper program were $84 million during the year 2017. EOG considers this excess availability, which is backed by its $2.0 billion senior unsecured revolving credit facility described in Note 2 to Consolidated Financial Statements, to be sufficient to meet its ongoing operating needs. Contractual Obligations The following table summarizes EOG's contractual obligations at December 31, 2017, (in thousands): (1) This table does not include the liability for unrecognized tax benefits, repatriation tax liability, EOG's pension or postretirement benefit obligations or liability for dismantlement, abandonment and asset retirement obligations (see Notes 6, 7 and 15, respectively, to Consolidated Financial Statements). (2) Amounts shown are based on current transportation and storage rates and the foreign currency exchange rates used to convert Canadian dollars and British pounds into United States dollars at December 31, 2017. Management does not believe that any future changes in these rates before the expiration dates of these commitments will have a material adverse effect on the financial condition or results of operations of EOG. (3) Amounts shown represent minimum future expenditures for drilling rig services. EOG's expenditures for drilling rig services will exceed such minimum amounts to the extent EOG utilizes the drilling rigs subject to a particular contractual commitment for a period greater than the period set forth in the governing contract or if EOG utilizes drilling rigs in addition to the drilling rigs subject to the particular contractual commitment (for example, pursuant to the exercise of an option to utilize additional drilling rigs provided for in the governing contract). Off-Balance Sheet Arrangements EOG does not participate in financial transactions that generate relationships with unconsolidated entities or financial partnerships. Such entities or partnerships, often referred to as variable interest entities (VIE) or special purpose entities (SPE), are generally established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. EOG was not involved in any unconsolidated VIE or SPE financial transactions or any other "off-balance sheet arrangement" (as defined in Item 303(a)(4)(ii) of Regulation S-K) during any of the periods covered by this report and currently has no intention of participating in any such transaction or arrangement in the foreseeable future. Foreign Currency Exchange Rate Risk During 2017, EOG was exposed to foreign currency exchange rate risk inherent in its operations in foreign countries, including Trinidad, the United Kingdom, China and Canada. The foreign currency most significant to EOG's operations during 2017 was the British pound. EOG continues to monitor the foreign currency exchange rates of countries in which it is currently conducting business and may implement measures to protect against foreign currency exchange rate risk. Outlook Pricing. Crude oil and natural gas prices have been volatile, and this volatility is expected to continue. As a result of the many uncertainties associated with the world political environment, worldwide supplies of, and demand for, crude oil and condensate, NGL and natural gas, the availabilities of other worldwide energy supplies and the relative competitive relationships of the various energy sources in the view of consumers, EOG is unable to predict what changes may occur in crude oil and condensate, NGLs, natural gas, ammonia and methanol prices in the future. The market price of crude oil and condensate, NGLs and natural gas in 2018 will impact the amount of cash generated from EOG's operating activities, which will in turn impact EOG's financial position. As of February 20, 2018, the average 2018 NYMEX crude oil and natural gas prices were $60.75 per barrel and $2.81 per MMBtu, respectively, representing an increase of 19% for crude oil and a decrease of 9% for natural gas from the average NYMEX prices in 2017. See ITEM 1A, Risk Factors. Including the impact of EOG's 2018 crude oil derivative contracts (exclusive of basis swaps) and based on EOG's tax position, EOG's price sensitivity in 2018 for each $1.00 per barrel increase or decrease in wellhead crude oil and condensate price, combined with the estimated change in NGL price, is approximately $82 million for net income and $106 million for cash flows from operating activities. Including the impact of EOG's 2018 natural gas derivative contracts (exclusive of call options) and based on EOG's tax position and the portion of EOG's anticipated natural gas volumes for 2018 for which prices have not been determined under long-term marketing contracts, EOG's price sensitivity for each $0.10 per Mcf increase or decrease in wellhead natural gas price is approximately $22 million for net income and $29 million for cash flows from operating activities. For information regarding EOG's crude oil and natural gas financial commodity derivative contracts through February 20, 2018, see "Derivative Transactions" above. Capital. EOG plans to continue to focus a substantial portion of its exploration and development expenditures in its major producing areas in the United States. In particular, EOG will be focused on United States crude oil drilling activity in its Eagle Ford, Delaware Basin and Rocky Mountain area where it generates its highest rates-of-return. To further enhance the economics of these plays, EOG expects to continue to improve well performance and lower drilling and completion costs through efficiency gains and lower service costs. The total anticipated 2018 capital expenditures of approximately $5.4 billion to $5.8 billion, excluding acquisitions, is structured to maintain EOG's strategy of capital discipline by funding its exploration, development and exploitation activities primarily from available internally generated cash flows and cash on hand. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program and other uncommitted credit facilities, bank borrowings, borrowings under its $2.0 billion senior unsecured revolving credit facility and equity and debt offerings. Operations. In 2018, both total production and total crude oil production are expected to increase from 2017 levels. In 2018, EOG expects to continue to focus on reducing operating costs through efficiency improvements. Summary of Critical Accounting Policies EOG prepares its financial statements and the accompanying notes in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions about future events that affect the reported amounts in the financial statements and the accompanying notes. EOG identifies certain accounting policies as critical based on, among other things, their impact on the portrayal of EOG's financial condition, results of operations or liquidity, and the degree of difficulty, subjectivity and complexity in their application. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. Management routinely discusses the development, selection and disclosure of each of the critical accounting policies. Following is a discussion of EOG's most critical accounting policies: Proved Oil and Gas Reserves EOG's engineers estimate proved oil and gas reserves in accordance with United States Securities and Exchange Commission (SEC) regulations, which directly impact financial accounting estimates, including depreciation, depletion and amortization and impairments of proved properties and related assets. Proved reserves represent estimated quantities of crude oil and condensate, NGLs and natural gas that geological and engineering data demonstrate, with reasonable certainty, to be recoverable in future years from known reservoirs under economic and operating conditions existing at the time the estimates were made. The process of estimating quantities of proved oil and gas reserves is complex, requiring significant subjective decisions in the evaluation of all available geological, engineering and economic data for each reservoir. The data for a given reservoir may also change substantially over time as a result of numerous factors including, but not limited to, additional development activity, evolving production history and continual reassessment of the viability of production under varying economic conditions. Consequently, material revisions (upward or downward) to existing reserve estimates may occur from time to time. For related discussion, see ITEM 1A, Risk Factors, and "Supplemental Information to Consolidated Financial Statements." Oil and Gas Exploration Costs EOG accounts for its crude oil and natural gas exploration and production activities under the successful efforts method of accounting. Oil and gas exploration costs, other than the costs of drilling exploratory wells, are charged to expense as incurred. The costs of drilling exploratory wells are capitalized pending determination of whether EOG has discovered proved commercial reserves. If proved commercial reserves are not discovered, such drilling costs are expensed. In some circumstances, it may be uncertain whether proved commercial reserves have been discovered when drilling has been completed. Such exploratory well drilling costs may continue to be capitalized if the reserve quantity is sufficient to justify its completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made. Costs to develop proved reserves, including the costs of all development wells and related equipment used in the production of crude oil and natural gas, are capitalized. Depreciation, Depletion and Amortization for Oil and Gas Properties The quantities of estimated proved oil and gas reserves are a significant component of EOG's calculation of depreciation, depletion and amortization expense, and revisions in such estimates may alter the rate of future expense. Holding all other factors constant, if reserves were revised upward or downward, earnings would increase or decrease, respectively. Depreciation, depletion and amortization of the cost of proved oil and gas properties is calculated using the unit-of-production method. The reserve base used to calculate depreciation, depletion and amortization for leasehold acquisition costs and the cost to acquire proved properties is the sum of proved developed reserves and proved undeveloped reserves. With respect to lease and well equipment costs, which include development costs and successful exploration drilling costs, the reserve base includes only proved developed reserves. Estimated future dismantlement, restoration and abandonment costs, net of salvage values, are taken into account. Oil and gas properties are grouped in accordance with the provisions of the Extractive Industries - Oil and Gas Topic of the ASC. The basis for grouping is a reasonable aggregation of properties with a common geological structural feature or stratigraphic condition, such as a reservoir or field. Depreciation, depletion and amortization rates are updated quarterly to reflect the addition of capital costs, reserve revisions (upwards or downwards) and additions, property acquisitions and/or property dispositions and impairments. Depreciation and amortization of other property, plant and equipment is calculated on a straight-line basis over the estimated useful life of the asset. Impairments Oil and gas lease acquisition costs are capitalized when incurred. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. Unproved properties with individually significant acquisition costs are reviewed individually for impairment. If the unproved properties are determined to be productive, the appropriate related costs are transferred to proved oil and gas properties. Lease rentals are expensed as incurred. When circumstances indicate that proved oil and gas properties may be impaired, EOG compares expected undiscounted future cash flows at a depreciation, depletion and amortization group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows, based on EOG's estimates of (and assumptions regarding) future crude oil and natural gas prices, operating costs, development expenditures, anticipated production from proved reserves and other relevant data, are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated using the Income Approach described in the Fair Value Measurement Topic of the ASC. In certain instances, EOG utilizes accepted offers from third-party purchasers as the basis for determining fair value. Estimates of undiscounted future cash flows require significant judgment, and the assumptions used in preparing such estimates are inherently uncertain. In addition, such assumptions and estimates are reasonably likely to change in the future. Crude oil and natural gas prices have exhibited significant volatility in the past, and EOG expects that volatility to continue in the future. During the five years ended December 31, 2017, West Texas Intermediate crude oil spot prices have fluctuated from approximately $26.19 per barrel to $110.62 per barrel, and Henry Hub natural gas spot prices have ranged from approximately $1.49 per MMBtu to $8.15 per MMBtu. EOG uses the five-year NYMEX futures strip for West Texas Intermediate crude oil and Henry Hub natural gas (in each case as of the applicable balance sheet date) as a basis to estimate future crude oil and natural gas prices. EOG's proved reserves estimates, including the timing of future production, are also subject to significant assumptions and judgment, and are frequently revised (upwards and downwards) as more information becomes available. Proved reserves are estimated using a trailing 12-month average price, in accordance with SEC rules. In the future, if any combination of crude oil, natural gas prices, actual production or operating costs diverge negatively from EOG's current estimates, impairment charges and downward adjustments to our proved reserves may be necessary. Income Taxes Income taxes are accounted for using the asset and liability approach. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax basis. EOG assesses the realizability of deferred tax assets and recognizes valuation allowances as appropriate. Significant assumptions used in estimating future taxable income include future oil and gas prices and changes in tax rates. Changes in such assumptions could materially affect the recognized amounts of valuation allowances. In December 2017, the U.S. enacted the TCJA, which made significant changes to U.S. federal income tax law. Shortly after enactment of the TCJA, the United States Securities and Exchange Commission's (SEC) staff issued Staff Accounting Bulletin No. 118 (SAB 118), which provides guidance on accounting for the impact of the TCJA. Under SAB 118, an entity would use a similar approach as the measurement period provided in the Business Combinations Topic of the ASC. An entity will recognize those matters for which the accounting can be completed. For matters that have not been completed, the entity would either (1) recognize provisional amounts to the extent that they are reasonably estimable and adjust them over time as more information becomes available or (2) for any specific income tax effects of the TCJA for which a reasonable estimate cannot be determined, continue to apply the Income Taxes Topic of the ASC on the basis of the provisions of the tax laws that were in effect immediately before the TCJA was signed into law. EOG has prepared its consolidated financial statements for the fiscal year ended December 31, 2017 in accordance with the Income Taxes Topic of the ASC as allowed by SAB 118. Stock-Based Compensation In accounting for stock-based compensation, judgments and estimates are made regarding, among other things, the appropriate valuation methodology to follow in valuing stock compensation awards and the related inputs required by those valuation methodologies. Assumptions regarding expected volatility of EOG's common stock, the level of risk-free interest rates, expected dividend yields on EOG's common stock, the expected term of the awards, expected volatility of the price of shares of EOG's peer companies and other valuation inputs are subject to change. Any such changes could result in different valuations and thus impact the amount of stock-based compensation expense recognized on the Consolidated Statements of Income (Loss) and Comprehensive Income (Loss). Information Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical facts, including, among others, statements and projections regarding EOG's future financial position, operations, performance, business strategy, returns, budgets, reserves, levels of production, costs and asset sales, statements regarding future commodity prices and statements regarding the plans and objectives of EOG's management for future operations, are forward-looking statements. EOG typically uses words such as "expect," "anticipate," "estimate," "project," "strategy," "intend," "plan," "target," "goal," "may," "will," "should" and "believe" or the negative of those terms or other variations or comparable terminology to identify its forward-looking statements. In particular, statements, express or implied, concerning EOG's future operating results and returns or EOG's ability to replace or increase reserves, increase production, reduce or otherwise control operating and capital costs, generate income or cash flows or pay dividends are forward-looking statements. Forward-looking statements are not guarantees of performance. Although EOG believes the expectations reflected in its forward-looking statements are reasonable and are based on reasonable assumptions, no assurance can be given that these assumptions are accurate or that any of these expectations will be achieved (in full or at all) or will prove to have been correct. Moreover, EOG's forward-looking statements may be affected by known, unknown or currently unforeseen risks, events or circumstances that may be outside EOG's control. Important factors that could cause EOG's actual results to differ materially from the expectations reflected in EOG's forward-looking statements include, among others: • the timing, extent and duration of changes in prices for, supplies of, and demand for, crude oil and condensate, natural gas liquids, natural gas and related commodities; • the extent to which EOG is successful in its efforts to acquire or discover additional reserves; • the extent to which EOG is successful in its efforts to economically develop its acreage in, produce reserves and achieve anticipated production levels from, and maximize reserve recovery from, its existing and future crude oil and natural gas exploration and development projects; • the extent to which EOG is successful in its efforts to market its crude oil and condensate, natural gas liquids, natural gas and related commodity production; • the availability, proximity and capacity of, and costs associated with, appropriate gathering, processing, compression, transportation and refining facilities; • the availability, cost, terms and timing of issuance or execution of, and competition for, mineral licenses and leases and governmental and other permits and rights-of-way, and EOG’s ability to retain mineral licenses and leases; • the impact of, and changes in, government policies, laws and regulations, including tax laws and regulations; environmental, health and safety laws and regulations relating to air emissions, disposal of produced water, drilling fluids and other wastes, hydraulic fracturing and access to and use of water; laws and regulations imposing conditions or restrictions on drilling and completion operations and on the transportation of crude oil and natural gas; laws and regulations with respect to derivatives and hedging activities; and laws and regulations with respect to the import and export of crude oil, natural gas and related commodities; • EOG's ability to effectively integrate acquired crude oil and natural gas properties into its operations, fully identify existing and potential problems with respect to such properties and accurately estimate reserves, production and costs with respect to such properties; • the extent to which EOG's third-party-operated crude oil and natural gas properties are operated successfully and economically; • competition in the oil and gas exploration and production industry for the acquisition of licenses, leases and properties, employees and other personnel, facilities, equipment, materials and services; • the availability and cost of employees and other personnel, facilities, equipment, materials (such as water) and services; • the accuracy of reserve estimates, which by their nature involve the exercise of professional judgment and may therefore be imprecise; • weather, including its impact on crude oil and natural gas demand, and weather-related delays in drilling and in the installation and operation (by EOG or third parties) of production, gathering, processing, refining, compression and transportation facilities; • the ability of EOG's customers and other contractual counterparties to satisfy their obligations to EOG and, related thereto, to access the credit and capital markets to obtain financing needed to satisfy their obligations to EOG; • EOG's ability to access the commercial paper market and other credit and capital markets to obtain financing on terms it deems acceptable, if at all, and to otherwise satisfy its capital expenditure requirements; • the extent to which EOG is successful in its completion of planned asset dispositions; • the extent and effect of any hedging activities engaged in by EOG; • the timing and extent of changes in foreign currency exchange rates, interest rates, inflation rates, global and domestic financial market conditions and global and domestic general economic conditions; • political conditions and developments around the world (such as political instability and armed conflict), including in the areas in which EOG operates; • the use of competing energy sources and the development of alternative energy sources; • the extent to which EOG incurs uninsured losses and liabilities or losses and liabilities in excess of its insurance coverage; • acts of war and terrorism and responses to these acts; • physical, electronic and cyber security breaches; and • the other factors described under ITEM 1A, Risk Factors, on pages 14 through 23 of this Annual Report on Form 10-K and any updates to those factors set forth in EOG's subsequent Quarterly Reports on Form 10-Q or Current Reports on Form 8-K. In light of these risks, uncertainties and assumptions, the events anticipated by EOG's forward-looking statements may not occur, and, if any of such events do, we may not have anticipated the timing of their occurrence or the duration and extent of their impact on our actual results. Accordingly, you should not place any undue reliance on any of EOG's forward-looking statements. EOG's forward-looking statements speak only as of the date made, and EOG undertakes no obligation, other than as required by applicable law, to update or revise its forward-looking statements, whether as a result of new information, subsequent events, anticipated or unanticipated circumstances or otherwise.

<s>[INST] EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (nonintegrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad, the United Kingdom and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. Each prospective drilling location is evaluated by its estimated rate of return. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a costeffective basis, allowing EOG to deliver longterm production growth while maintaining a strong balance sheet. EOG implements its strategy by emphasizing the drilling of internally generated prospects in order to find and develop lowcost reserves. Maintaining the lowest possible operating cost structure that is consistent with prudent and safe operations is also an important goal in the implementation of EOG's strategy. EOG realized net income of $2,583 million during 2017 as compared to a net loss of $1,097 million for 2016. At December 31, 2017, EOG's total estimated net proved reserves were 2,527 million barrels of oil equivalent (MMBoe), an increase of 380 MMBoe from December 31, 2016. During 2017, net proved crude oil and condensate and natural gas liquids (NGLs) reserves increased by 223 million barrels (MMBbl), and net proved natural gas reserves increased by 945 billion cubic feet or 158 MMBoe, in each case from December 31, 2016. Operations Several important developments have occurred since January 1, 2017. United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquidsrich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquidsrich reservoirs. During 2017, EOG continued to focus on increasing drilling, completion and operating efficiencies using precision lateral targeting and advanced completion methods and reducing operating and capital costs through efficiency improvements and service cost reductions. These efficiency gains along with certain realized lower service costs resulted in lower drilling and completion costs and decreased operating expenses during 2017. EOG continues to look for opportunities to add drilling inventory through leasehold acquisitions, farmins, exchanges or tactical acquisitions and to evaluate certain potential crude oil and liquidsrich natural gas exploration and development prospects. On a volumetric basis, as calculated using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGL production accounted for approximately 77% of United States production during 2017 as compared to 73% for 2016. During 2017, drilling and completion activities occurred primarily in the Eagle Ford play, Delaware Basin play and Rocky Mountain area. EOG's major producing areas in the United States are in New Mexico, North Dakota, Texas, Utah and Wyoming. Trinidad. In Trinidad, EOG continued to deliver natural gas under existing supply contracts. Several fields in the South East Coast Consortium (SECC) Block, Modified U(a) Block, Block 4(a), Modified U(b) Block, the Banyan Field and the Sercan Area have been developed and are producing natural gas which is sold to the National Gas Company of Trinidad and Tobago Limited and its subsidiary and crude oil and condensate which is sold to the Petroleum Company of Trinidad and Tobago Limited. In 2017, EOG completed and brought online two net wells finishing its program in the Sercan Area and drilled and completed five additional net wells in the [/INST] Negative. </s>

EOG RESOURCES INC

2019-02-26

2018-12-31

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (non-integrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. Each prospective drilling location is evaluated by its estimated rate of return. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a cost-effective basis, allowing EOG to deliver long-term production growth while maintaining a strong balance sheet. EOG implements its strategy primarily by emphasizing the drilling of internally generated prospects in order to find and develop low-cost reserves. Maintaining the lowest possible operating cost structure that is consistent with efficient, safe and environmentally responsible operations is also an important goal in the implementation of EOG's strategy. EOG realized net income of $3,419 million during 2018 as compared to net income of $2,583 million for 2017. At December 31, 2018, EOG's total estimated net proved reserves were 2,928 million barrels of oil equivalent (MMBoe), an increase of 401 MMBoe from December 31, 2017. During 2018, net proved crude oil and condensate and natural gas liquids (NGLs) reserves increased by 330 million barrels (MMBbl), and net proved natural gas reserves increased by 424 billion cubic feet or 71 MMBoe, in each case from December 31, 2017. Operations Several important developments have occurred since January 1, 2018. United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquids-rich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquids-rich reservoirs. During 2018, EOG continued to focus on increasing drilling, completion and operating efficiencies gained in prior years. In addition, EOG continued to evaluate certain potential crude oil and liquids-rich natural gas exploration and development prospects and to look for opportunities to add drilling inventory through leasehold acquisitions, farm-ins, exchanges or tactical acquisitions. On a volumetric basis, as calculated using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGL production accounted for approximately 77% of United States production during 2018 and 2017. During 2018, drilling and completion activities occurred primarily in the Eagle Ford play, Delaware Basin play and Rocky Mountain area. EOG's major producing areas in the United States are in New Mexico, North Dakota, Texas, Utah and Wyoming. Trinidad. In Trinidad, EOG continued to deliver natural gas under existing supply contracts. Several fields in the South East Coast Consortium (SECC) Block, Modified U(a) Block, Block 4(a), Modified U(b) Block, the Banyan Field and the Sercan Area have been developed and are producing natural gas which is sold to the National Gas Company of Trinidad and Tobago Limited and its subsidiary and crude oil and condensate which is sold to the Petroleum Company of Trinidad and Tobago Limited and its successor, Heritage Petroleum Company Limited. In 2018, EOG conducted an ocean bottom nodal seismic survey in the SECC Block and the Pelican Field and continued to process and review the initial data. Other International. In the Sichuan Basin, Sichuan Province, China, EOG entered 2018 with two drilled uncompleted wells and completed both wells. In addition, EOG drilled five natural gas wells and completed one of those wells in 2018 as part of the continuing development of the Bajiaochang Field, which natural gas is sold under a long-term contract to PetroChina. In the U.K., EOG produced crude oil from its 100% working interest East Irish Sea Conwy development project. EOG completed the sale of all of its interest in EOG Resources United Kingdom Limited during the fourth quarter of 2018. EOG no longer has any presence in the U.K. EOG continues to evaluate other select crude oil and natural gas opportunities outside the United States, primarily by pursuing exploitation opportunities in countries where indigenous crude oil and natural gas reserves have been identified. Capital Structure One of management's key strategies is to maintain a strong balance sheet with a consistently below average debt-to-total capitalization ratio as compared to those in EOG's peer group. EOG's debt-to-total capitalization ratio was 24% at December 31, 2018 and 28% at December 31, 2017. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. On October 1, 2018, EOG repaid upon maturity the $350 million aggregate principal amount of its 6.875% Senior Notes due 2018. During 2018, EOG funded $6.6 billion ($411 million of which was non-cash) in exploration and development and other property, plant and equipment expenditures (excluding asset retirement obligations), repaid $350 million aggregate principal amount of long-term debt, paid $438 million in dividends to common stockholders and purchased $63 million of treasury stock in connection with stock compensation plans, primarily by utilizing net cash provided from its operating activities and net proceeds of $227 million from the sale of assets. Total anticipated 2019 capital expenditures are estimated to range from approximately $6.1 billion to $6.5 billion, excluding acquisitions and non-cash exchanges. The majority of 2019 expenditures will be focused on United States crude oil drilling activities. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program and other uncommitted credit facilities, bank borrowings, borrowings under its $2.0 billion senior unsecured revolving credit facility, joint development agreements and similar agreements and equity and debt offerings. Management continues to believe EOG has one of the strongest prospect inventories in EOG's history. When it fits EOG's strategy, EOG will make acquisitions that bolster existing drilling programs or offer incremental exploration and/or production opportunities. Results of Operations The following review of operations for each of the three years in the period ended December 31, 2018, should be read in conjunction with the consolidated financial statements of EOG and notes thereto beginning on page. Operating Revenues and Other During 2018, operating revenues increased $6,067 million, or 54%, to $17,275 million from $11,208 million in 2017. Total wellhead revenues, which are revenues generated from sales of EOG's production of crude oil and condensate, NGLs and natural gas, increased $4,039 million, or 51%, to $11,946 million in 2018 from $7,907 million in 2017. Revenues from the sales of crude oil and condensate and NGLs in 2018 were approximately 89% of total wellhead revenues compared to 88% in 2017. During 2018, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $166 million compared to net gains of $20 million in 2017. Gathering, processing and marketing revenues increased $1,932 million during 2018, to $5,230 million from $3,298 million in 2017. Net gains on asset dispositions of $175 million in 2018 were primarily as a result of exchanges of producing properties and acreage in Texas and sales of producing properties and acreage in the United Kingdom, Texas and the Rocky Mountain area compared to net losses on asset dispositions of $99 million in 2017. Wellhead volume and price statistics for the years ended December 31, 2018, 2017 and 2016 were as follows: (1) Thousand barrels per day or million cubic feet per day, as applicable. (2) Other International includes EOG's United Kingdom, China, Canada and Argentina operations. The United Kingdom operations were sold in the fourth quarter of 2018. The Argentina operations were sold in the third quarter of 2016. (3) Dollars per barrel or per thousand cubic feet, as applicable. Excludes the impact of financial commodity derivative instruments (see Note 12 to Consolidated Financial Statements). (4) Includes a positive revenue adjustment of $0.44 per Mcf related to the adoption of ASU 2014-09, "Revenue From Contracts with Customers" (ASU 2014-09) (see Note 1 to the Consolidated Financial Statements). In connection with the adoption of ASU 2014-09, EOG presents natural gas processing fees related to certain processing and marketing agreements as Gathering and Processing Costs, instead of as a deduction to Natural Gas revenues. (5) Thousand barrels of oil equivalent per day or million barrels of oil equivalent, as applicable; includes crude oil and condensate, NGLs and natural gas. Crude oil equivalent volumes are determined using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas. MMBoe is calculated by multiplying the MBoed amount by the number of days in the period and then dividing that amount by one thousand. 2018 compared to 2017. Wellhead crude oil and condensate revenues in 2018 increased $3,261 million, or 52%, to $9,517 million from $6,256 million in 2017, due primarily to a higher composite average wellhead crude oil and condensate price ($2,088 million) and an increase in production ($1,173 million). EOG's composite wellhead crude oil and condensate price for 2018 increased 28% to $65.21 per barrel compared to $50.91 per barrel in 2017. Wellhead crude oil and condensate production in 2018 increased 19% to 400 MBbld as compared to 337 MBbld in 2017. The increased production was primarily in the Permian Basin and the Eagle Ford. NGL revenues in 2018 increased $398 million, or 55%, to $1,127 million from $729 million in 2017 primarily due to an increase in production ($229 million) and a higher composite average wellhead NGL price ($169 million). EOG's composite average wellhead NGL price increased 18% to $26.60 per barrel in 2018 compared to $22.61 per barrel in 2017. NGL production in 2018 increased 31% to 116 MBbld as compared to 88 MBbld in 2017. The increased production was primarily in the Permian Basin and the Eagle Ford. Wellhead natural gas revenues in 2018 increased $380 million, or 41%, to $1,302 million from $922 million in 2017, primarily due to a higher composite wellhead natural gas price ($282 million) and an increase in wellhead natural gas deliveries ($98 million). EOG's composite average wellhead natural gas price increased 28% to $2.92 per Mcf in 2018 compared to $2.29 per Mcf in 2017. This increase in composite wellhead natural gas prices includes a positive revenue adjustment of $0.44 per Mcf related to the adoption of ASU 2014-09. Natural gas deliveries in 2018 increased 11% to 1,219 MMcfd as compared to 1,103 MMcfd in 2017. The increase in production was primarily due to increased production in the United States (158 MMcfd), partially offset by decreased production in Trinidad (47 MMcfd). The increased production in the United States was due primarily to increased production of associated gas in the Permian Basin and Rocky Mountain area and higher volumes in the Marcellus Shale. The decrease in Trinidad was primarily attributable to higher contractual deliveries in 2017. During 2018, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $166 million, which included net cash paid for settlements of crude oil and natural gas financial derivative contracts of $259 million. During 2017, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $20 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $7 million. Gathering, processing and marketing revenues are revenues generated from sales of third-party crude oil, NGLs and natural gas, as well as gathering fees associated with gathering third-party natural gas and revenues from sales of EOG-owned sand. Purchases and sales of third-party crude oil and natural gas may be utilized in order to balance firm transportation capacity with production in certain areas and to utilize excess capacity at EOG-owned facilities. EOG sells sand in order to balance the timing of firm purchase agreements with completion operations and to utilize excess capacity at EOG-owned facilities. Marketing costs represent the costs to purchase third-party crude oil, natural gas and sand and the associated transportation costs, as well as costs associated with EOG-owned sand sold to third parties. Gathering, processing and marketing revenues less marketing costs in 2018 increased $59 million compared to 2017, primarily due to higher margins on crude oil and condensate marketing activities. 2017 compared to 2016. Wellhead crude oil and condensate revenues in 2017 increased $1,939 million, or 45%, to $6,256 million from $4,317 million in 2016, due primarily to a higher composite average wellhead crude oil and condensate price ($1,124 million) and an increase in production ($815 million). EOG's composite wellhead crude oil and condensate price for 2017 increased 22% to $50.91 per barrel compared to $41.76 per barrel in 2016. Wellhead crude oil and condensate deliveries in 2017 increased 19% to 337 MBbld as compared to 283 MBbld in 2016. The increased production was primarily due to higher production in the Permian Basin and Rocky Mountain area. NGL revenues in 2017 increased $292 million, or 67%, to $729 million from $437 million in 2016 primarily due to a higher composite wellhead NGL price ($257 million) and an increase in production ($35 million). EOG's composite average wellhead NGL price increased 55% to $22.61 per barrel in 2017 compared to $14.63 per barrel in 2016. The increased production was primarily due to higher production in the Permian Basin and Rocky Mountain area, partially offset by decreased production in the Fort Worth Barnett Shale, largely resulting from 2016 asset sales in this region. Wellhead natural gas revenues in 2017 increased $180 million, or 24%, to $922 million from $742 million in 2016, primarily due to a higher composite wellhead natural gas price ($227 million), partially offset by a decrease in wellhead natural gas deliveries ($47 million). EOG's composite average wellhead natural gas price increased 32% to $2.29 per Mcf in 2017 compared to $1.73 per Mcf in 2016. Natural gas deliveries in 2017 decreased 6% to 1,103 MMcfd as compared to 1,175 MMcfd in 2016. The decrease in production was primarily due to decreased production in the United States (45 MMcfd) and Trinidad (27 MMcfd). The decreased production in the United States was due primarily to lower volumes in the Fort Worth Barnett Shale, Upper Gulf Coast and South Texas areas, largely resulting from 2016 asset sales in these regions, partially offset by increased production of associated gas in the Permian Basin and Rocky Mountain area and from the 2016 mergers and related asset purchase transactions with Yates Petroleum Corporation and other affiliated entities (collectively, the Yates Entities). The decrease in Trinidad was primarily attributable to higher contractual deliveries in 2016. During 2017, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $20 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $7 million. During 2016, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $100 million, which included net cash paid for settlements of crude oil and natural gas financial derivative contracts of $22 million. Gathering, processing and marketing revenues less marketing costs in 2017 increased $9 million compared to 2016, primarily due to higher margins on natural gas and NGL marketing activities ($16 million), partially offset by lower margins on sand sales ($9 million). Operating and Other Expenses 2018 compared to 2017. During 2018, operating expenses of $12,806 million were $2,524 million higher than the $10,282 million incurred during 2017. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2018 and 2017: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2018 compared to 2017 are set forth below. See "Operating Revenues and Other" above for a discussion of production volumes. Lease and well expenses include expenses for EOG-operated properties, as well as expenses billed to EOG from other operators where EOG is not the operator of a property. Lease and well expenses can be divided into the following categories: costs to operate and maintain crude oil and natural gas wells, the cost of workovers and lease and well administrative expenses. Operating and maintenance costs include, among other things, pumping services, salt water disposal, equipment repair and maintenance, compression expense, lease upkeep and fuel and power. Workovers are operations to restore or maintain production from existing wells. Each of these categories of costs individually fluctuates from time to time as EOG attempts to maintain and increase production while maintaining efficient, safe and environmentally responsible operations. EOG continues to increase its operating activities by drilling new wells in existing and new areas. Operating and maintenance costs within these existing and new areas, as well as the costs of services charged to EOG by vendors, fluctuate over time. Lease and well expenses of $1,283 million in 2018 increased $238 million from $1,045 million in 2017 primarily due to higher operating and maintenance costs ($171 million), higher workover expenditures ($44 million) and higher lease and well administrative expenses ($41 million), all in the United States, partially offset by lower operating and maintenance costs in the United Kingdom ($18 million). Lease and well expenses increased in the United States primarily due to increased operating activities resulting in increased production. Transportation costs represent costs associated with the delivery of hydrocarbon products from the lease to a downstream point of sale. Transportation costs include transportation fees, the cost of compression (the cost of compressing natural gas to meet pipeline pressure requirements), dehydration (the cost associated with removing water from natural gas to meet pipeline requirements), gathering fees and fuel costs. Transportation costs of $747 million in 2018 increased $7 million from $740 million in 2017 primarily due to increased transportation costs in the Permian Basin ($116 million), partially offset by decreased transportation costs in the Barnett Shale ($52 million), the Eagle Ford ($31 million) and the Rocky Mountain area ($25 million). DD&A of the cost of proved oil and gas properties is calculated using the unit-of-production method. EOG's DD&A rate and expense are the composite of numerous individual DD&A group calculations. There are several factors that can impact EOG's composite DD&A rate and expense, such as field production profiles, drilling or acquisition of new wells, disposition of existing wells and reserve revisions (upward or downward) primarily related to well performance, economic factors and impairments. Changes to these factors may cause EOG's composite DD&A rate and expense to fluctuate from period to period. DD&A of the cost of other property, plant and equipment is generally calculated using the straight-line depreciation method over the useful lives of the assets. DD&A expenses in 2018 increased $26 million to $3,435 million from $3,409 million in 2017. DD&A expenses associated with oil and gas properties in 2018 were $24 million higher than in 2017 primarily due to an increase in production in the United States ($647 million) and the United Kingdom ($21 million), partially offset by lower unit rates in the United States ($625 million) and a decrease in production in Trinidad ($16 million). Unit rates in the United States decreased primarily due to upward reserve revisions and reserves added at lower costs as a result of increased efficiencies. G&A expenses of $427 million in 2018 decreased $7 million from $434 million in 2017 primarily due to decreased professional, legal and other services ($24 million); partially offset by increased employee-related expenses resulting from expanded operations ($15 million) and increased information systems costs ($10 million). Net interest expense of $245 million in 2018 was $29 million lower than 2017 primarily due to repayment of the $600 million aggregate principal amount of 5.875% Senior Notes due 2017 in September 2017 ($25 million) and the $350 million aggregate principal amount of 6.875% Senior Notes due 2018 in October 2018 ($6 million), partially offset by a decrease in capitalized interest ($3 million). Gathering and processing costs represent operating and maintenance expenses and administrative expenses associated with operating EOG's gathering and processing assets and beginning January 1, 2018, natural gas processing fees from third parties. EOG pays third parties to process a portion of its natural gas production to extract NGLs. See Note 1 to the Consolidated Financial Statements for discussion related to EOG's adoption of ASU 2014-09. Gathering and processing costs increased $288 million to $437 million in 2018 compared to $149 million in 2017 primarily due to the adoption of ASU 2014-09 ($204 million) and increased operating costs in the Permian Basin ($32 million), the United Kingdom ($28 million) and the Eagle Ford ($25 million). Exploration costs of $149 million in 2018 increased $4 million from $145 million in 2017 primarily due to increased general and administrative expenses in the United States ($7 million), partially offset by decreased geological and geophysical expenditures in Trinidad ($5 million). Impairments include amortization of unproved oil and gas property costs as well as impairments of proved oil and gas properties; other property, plant and equipment; and other assets. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. Unproved properties with individually significant acquisition costs are reviewed individually for impairment. When circumstances indicate that a proved property may be impaired, EOG compares expected undiscounted future cash flows at a DD&A group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated by using the Income Approach described in the Fair Value Measurement Topic of the Financial Accounting Standards Board's Accounting Standards Codification (ASC). In certain instances, EOG utilizes accepted offers from third-party purchasers as the basis for determining fair value. The following table represents impairments for the years ended December 31, 2018 and 2017 (in millions): Impairments of proved properties were primarily due to the write-down to fair value of legacy natural gas assets in 2018 and 2017. Taxes other than income include severance/production taxes, ad valorem/property taxes, payroll taxes, franchise taxes and other miscellaneous taxes. Severance/production taxes are generally determined based on wellhead revenues, and ad valorem/property taxes are generally determined based on the valuation of the underlying assets. Taxes other than income in 2018 increased $227 million to $772 million (6.5% of wellhead revenues) from $545 million (6.9% of wellhead revenues) in 2017. The increase in taxes other than income was primarily due to increases in severance/production taxes ($190 million) primarily as a result of increased wellhead revenues and an increase in ad valorem/property taxes ($33 million), both in the United States. Other income, net, was $17 million in 2018 compared to other income, net, of $9 million in 2017. The increase of $8 million in 2018 was primarily due to a decrease in deferred compensation expense ($12 million) and an increase in interest income ($4 million); partially offset by an increase in foreign currency transaction losses ($15 million). EOG recognized an income tax provision of $822 million in 2018 compared to an income tax benefit of $1,921 million in 2017, primarily due to the absence of certain 2017 tax benefits related to the Tax Cuts and Jobs Act (TCJA) and higher pretax income. The most significant impact of the TCJA on EOG was the reduction in the statutory income tax rate from 35% to 21% which required the existing net United States federal deferred income tax liability to be remeasured resulting in the recognition of an income tax benefit in 2017 of approximately $2.2 billion. The net effective tax rate for 2018 increased to 19% from (291%) in the prior year, primarily due to the absence of the TCJA tax benefits. 2017 compared to 2016. During 2017, operating expenses of $10,282 million were $1,406 million higher than the $8,876 million incurred during 2016. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2017 and 2016: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2017 compared to 2016 are set forth below. See "Operating Revenues and Other" above for a discussion of production volumes. Lease and well expenses of $1,045 million in 2017 increased $118 million from $927 million in 2016 primarily due to higher operating and maintenance costs in the United States ($71 million) and the United Kingdom ($30 million) and higher workover expenditures in the United States ($21 million). Lease and well expenses increased in the United States primarily due to increased operating activities resulting in increased production. Transportation costs of $740 million in 2017 decreased $24 million from $764 million in 2016 primarily due to divestitures in the Barnett Shale and Upper Gulf Coast ($85 million) and decreased transportation costs in the Eagle Ford ($8 million) and the United Kingdom ($8 million), partially offset by increased transportation costs related to higher production in the Permian Basin ($47 million) and the Rocky Mountain area ($20 million) and from the 2016 transactions with the Yates Entities ($13 million). DD&A expenses in 2017 decreased $144 million to $3,409 million from $3,553 million in 2016. DD&A expenses associated with oil and gas properties in 2017 were $141 million lower than in 2016 primarily due to lower unit rates in the United States ($449 million) and Trinidad ($19 million) and a decrease in production in the United Kingdom ($16 million) and Trinidad ($11 million), partially offset by an increase in production in the United States ($354 million). Unit rates in the United States decreased primarily due to upward reserve revisions and reserves added at lower costs as a result of increased efficiencies. G&A expenses of $434 million in 2017 increased $39 million from $395 million in 2016 primarily due to increased employee-related expenses resulting from expanded operations and from the 2016 transactions with the Yates Entities ($45 million) and increased professional, legal and other services ($30 million), partially offset by 2016 employee related expenses in connection with certain voluntary retirements ($42 million). Net interest expense of $274 million in 2017 was $8 million lower than 2016 primarily due to repayment of the $600 million aggregate principal amount of 5.875% Senior Notes due 2017 in September 2017 ($11 million), partially offset by a decrease in capitalized interest ($4 million). Gathering and processing costs increased $26 million to $149 million in 2017 compared to $123 million in 2016 due to increased activities in the Permian Basin ($12 million) and the Rocky Mountain area ($8 million). Exploration costs of $145 million in 2017 increased $20 million from $125 million in 2016 primarily due to increased geological and geophysical expenditures in Trinidad. The following table represents impairments for the years ended December 31, 2017 and 2016 (in millions): Impairments of proved properties were primarily due to the write-down to fair value of divested legacy natural gas assets in 2017 and 2016. EOG recognized additional impairment charges in 2016 of $61 million related to obsolete inventory and $138 million related to firm commitment contracts related to divested Haynesville natural gas assets. Taxes other than income in 2017 increased $195 million to $545 million (6.9% of wellhead revenues) from $350 million (6.4% of wellhead revenues) in 2016. The increase in taxes other than income was primarily due to increases in severance/production taxes ($171 million) and in ad valorem/property taxes ($18 million), both primarily as a result of increased wellhead revenues in the United States. Other income, net, was $9 million in 2017 compared to other expense, net, of $51 million in 2016. The increase of $60 million was primarily due to an increase in foreign currency transaction gains in 2017 ($49 million) and interest income ($5 million). EOG recognized an income tax benefit of $1,921 million in 2017 compared to an income tax benefit of $461 million in 2016, primarily due to the enactment of the TCJA in December 2017. The most significant impact of the TCJA on EOG was the reduction in the statutory income tax rate from 35% to 21%, which required the existing net United States federal deferred income tax liability to be remeasured, resulting in the recognition of an income tax benefit of approximately $2.2 billion. Due largely to this tax rate reduction, the net effective tax rate for 2017 decreased to (291)% from 30% in the prior year. Capital Resources and Liquidity Cash Flow The primary sources of cash for EOG during the three-year period ended December 31, 2018, were funds generated from operations and proceeds from asset sales. The primary uses of cash were funds used in operations; exploration and development expenditures; other property, plant and equipment expenditures; dividend payments to stockholders; repayments of debt; and purchases of treasury stock in connection with stock compensation plans. 2018 compared to 2017. Net cash provided by operating activities of $7,769 million in 2018 increased $3,504 million from $4,265 million in 2017 primarily reflecting an increase in wellhead revenues ($4,039 million), favorable changes in working capital and other assets and liabilities ($758 million) and a favorable change in the cash paid for income taxes ($113 million), partially offset by an increase in cash operating expenses ($746 million) and an unfavorable change in the net cash paid for the settlement of financial commodity derivative contracts ($266 million). Net cash used in investing activities of $6,170 million in 2018 increased by $2,183 million from $3,987 million in 2017 primarily due to an increase in additions to oil and gas properties ($1,888 million); unfavorable changes in working capital associated with investing activities ($211 million); and an increase in additions to other property, plant and equipment ($64 million). Net cash used in financing activities of $839 million in 2018 included cash dividend payments ($438 million), repayments of long-term debt ($350 million) and purchases of treasury stock in connection with stock compensation plans ($63 million). Cash provided by financing activities in 2018 included proceeds from stock options exercised and employee stock purchase plan activity ($21 million). 2017 compared to 2016. Net cash provided by operating activities of $4,265 million in 2017 increased $1,906 million from $2,359 million in 2016 primarily reflecting an increase in wellhead revenues ($2,411 million) and a favorable change in the net cash received from the settlement of financial commodity derivative contracts ($30 million), partially offset by an increase in cash operating expenses ($362 million), an increase in net cash paid for income taxes ($228 million), an increase in net cash paid for interest expense ($23 million) and unfavorable changes in working capital and other assets and liabilities ($10 million). Net cash used in investing activities of $3,987 million in 2017 increased by $2,734 million from $1,253 million in 2016 primarily due to an increase in additions to oil and gas properties ($1,461 million); a decrease in proceeds from asset sales ($892 million); unfavorable changes in working capital associated with investing activities ($246 million); and an increase in additions to other property, plant and equipment ($80 million). Net cash used in financing activities of $1,036 million in 2017 included repayments of long-term debt ($600 million), cash dividend payments ($387 million) and purchases of treasury stock in connection with stock compensation plans ($63 million). Cash provided by financing activities in 2017 included proceeds from stock options exercised and employee stock purchase plan activity ($21 million). Total Expenditures The table below sets out components of total expenditures for the years ended December 31, 2018, 2017 and 2016 (in millions): (1) Leasehold acquisitions included $291 million and $256 million related to non-cash property exchanges in 2018 and 2017, respectively, and $3,115 million in 2016 related to the Yates transaction. (2) Property acquisitions included $71 million and $26 million related to non-cash property exchanges in 2018 and 2017, respectively, and $735 million in 2016 related to the Yates transaction. (3) Other property, plant and equipment included $49 million of non-cash additions in 2018 primarily related to a capital lease transaction in the Permian Basin and $17 million in 2016 related to the Yates transaction. Exploration and development expenditures of $6,350 million for 2018 were $1,966 million higher than the prior year. The increase was primarily due to increased exploration and development drilling expenditures in the United States ($1,932 million) and Other International ($11 million), increased leasehold acquisitions ($61 million), increased property acquisitions ($51 million) and increased facility expenditures ($50 million), partially offset by decreased exploration and development drilling expenditures in Trinidad ($140 million). The 2018 exploration and development expenditures of $6,350 million included $5,546 million in development drilling and facilities, $656 million in exploration, $124 million in property acquisitions and $24 million in capitalized interest. The 2017 exploration and development expenditures of $4,384 million included $3,661 million in development drilling and facilities, $623 million in exploration, $73 million in property acquisitions and $27 million in capitalized interest. The 2016 exploration and development expenditures of $6,465 million included $3,351 million in exploration, $2,334 million in development drilling and facilities, $749 million in property acquisitions and $31 million in capitalized interest. The level of exploration and development expenditures, including acquisitions, will vary in future periods depending on energy market conditions and other related economic factors. EOG has significant flexibility with respect to financing alternatives and the ability to adjust its exploration and development expenditure budget as circumstances warrant. While EOG has certain continuing commitments associated with expenditure plans related to its operations, such commitments are not expected to be material when considered in relation to the total financial capacity of EOG. Derivative Transactions Commodity Derivative Contracts. Prices received by EOG for its crude oil production generally vary from U.S. New York Mercantile Exchange (NYMEX) West Texas Intermediate prices due to adjustments for delivery location (basis) and other factors. EOG has entered into crude oil basis swap contracts in order to fix the differential between pricing in Midland, Texas, and Cushing, Oklahoma (Midland Differential). Presented below is a comprehensive summary of EOG's Midland Differential basis swap contracts through February 19, 2019. The weighted average price differential expressed in dollars per barrel ($/Bbl) represents the amount of reduction to Cushing, Oklahoma, prices for the notional volumes expressed in barrels per day (Bbld) covered by the basis swap contracts. EOG has also entered into crude oil basis swap contracts in order to fix the differential between pricing in the U.S. Gulf Coast and Cushing, Oklahoma (Gulf Coast Differential). Presented below is a comprehensive summary of EOG's Gulf Coast Differential basis swap contracts through February 19, 2019. The weighted average price differential expressed in $/Bbl represents the amount of addition to Cushing, Oklahoma, prices for the notional volumes expressed in Bbld covered by the basis swap contracts. Presented below is a comprehensive summary of EOG's crude oil price swap contracts through February 19, 2019, with notional volumes expressed in Bbld and prices expressed in $/Bbl. On November 20, 2018, EOG entered into crude oil price swap contracts for the period December 1, 2018 through December 31, 2018, with notional volumes of 134,000 Bbld at an average price of $53.75 per Bbl. These contracts offset the crude oil price swap contracts for the same time period with notional volumes of 134,000 Bbld at an average price of $60.04 per Bbl. The net cash EOG received for settling these contracts was $26.1 million. The offsetting contracts are excluded from the above table. Presented below is a comprehensive summary of EOG's natural gas price swap contracts through February 19, 2019, with notional volumes expressed in million British thermal units (MMBtu) per day (MMBtud) and prices expressed in dollars per MMBtu ($/MMBtu). EOG has sold call options which establish a ceiling price for the sale of notional volumes of natural gas as specified in the call option contracts. The call options require that EOG pay the difference between the call option strike price and either the average or last business day NYMEX Henry Hub natural gas price for the contract month (Henry Hub Index Price) in the event the Henry Hub Index Price is above the call option strike price. In addition, EOG has purchased put options which establish a floor price for the sale of notional volumes of natural gas as specified in the put option contracts. The put options grant EOG the right to receive the difference between the put option strike price and the Henry Hub Index Price in the event the Henry Hub Index Price is below the put option strike price. Presented below is a comprehensive summary of EOG's natural gas call and put option contracts through February 19, 2019, with notional volumes expressed in MMBtud and prices expressed in $/MMBtu. Financing EOG's debt-to-total capitalization ratio was 24% at December 31, 2018, compared to 28% at December 31, 2017. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. At December 31, 2018 and 2017, respectively, EOG had outstanding $6,040 million and $6,390 million aggregate principal amount of senior notes which had estimated fair values of $6,027 million and $6,602 million, respectively. The estimated fair value was based upon quoted market prices and, where such prices were not available, other observable inputs regarding interest rates available to EOG at year-end. EOG's debt is at fixed interest rates. While changes in interest rates affect the fair value of EOG's senior notes, such changes do not expose EOG to material fluctuations in earnings or cash flow. During 2018, EOG funded its capital program primarily by utilizing cash provided by operating activities, proceeds from asset sales and cash provided by borrowings from its commercial paper program. While EOG maintains a $2.0 billion commercial paper program, the maximum outstanding at any time during 2018 was $208 million, and the amount outstanding at year-end was zero. There were no amounts outstanding under uncommitted credit facilities during 2018. The average borrowings outstanding under the commercial paper program were $8 million during the year 2018. EOG considers this excess availability, which is backed by its $2.0 billion senior unsecured revolving credit facility described in Note 2 to Consolidated Financial Statements, to be sufficient to meet its ongoing operating needs. Contractual Obligations The following table summarizes EOG's contractual obligations at December 31, 2018, (in thousands): (1) This table does not include the liability for unrecognized tax benefits, EOG's pension or postretirement benefit obligations or liability for dismantlement, abandonment and asset retirement obligations (see Notes 6, 7 and 15, respectively, to Consolidated Financial Statements). These amounts are excluded because they are subject to estimates and the timing of settlement is unknown. (2) This table does not include the liability for commitments to purchase fixed quantities of crude oil and natural gas. The amounts are excluded because they are variable and based on future commodity prices. At December 31, 2018, EOG is committed to purchase 3.6 MMBbls of crude oil and 15 Bcf of natural gas in 2019. (3) Amounts shown are based on current transportation and storage rates and the foreign currency exchange rates used to convert Canadian dollars into United States dollars at December 31, 2018. Management does not believe that any future changes in these rates before the expiration dates of these commitments will have a material adverse effect on the financial condition or results of operations of EOG. (4) Amounts shown represent minimum future expenditures for drilling rig services. EOG's expenditures for drilling rig services will exceed such minimum amounts to the extent EOG utilizes the drilling rigs subject to a particular contractual commitment for a period greater than the period set forth in the governing contract or if EOG utilizes drilling rigs in addition to the drilling rigs subject to the particular contractual commitment (for example, pursuant to the exercise of an option to utilize additional drilling rigs provided for in the governing contract). Off-Balance Sheet Arrangements EOG does not participate in financial transactions that generate relationships with unconsolidated entities or financial partnerships. Such entities or partnerships, often referred to as variable interest entities (VIE) or special purpose entities (SPE), are generally established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. EOG was not involved in any unconsolidated VIE or SPE financial transactions or any other "off-balance sheet arrangement" (as defined in Item 303(a)(4)(ii) of Regulation S-K) during any of the periods covered by this report and currently has no intention of participating in any such transaction or arrangement in the foreseeable future. Foreign Currency Exchange Rate Risk During 2018, EOG was exposed to foreign currency exchange rate risk inherent in its operations in foreign countries, including Trinidad, China and Canada and, through November 2018, the U.K. The foreign currency most significant to EOG's operations during 2018 was the British pound. EOG continues to monitor the foreign currency exchange rates of countries in which it is currently conducting business and may implement measures to protect against foreign currency exchange rate risk. Outlook Pricing. Crude oil and natural gas prices have been volatile, and this volatility is expected to continue. As a result of the many uncertainties associated with the world political environment, worldwide supplies of, and demand for, crude oil and condensate, NGL and natural gas, the availabilities of other worldwide energy supplies and the relative competitive relationships of the various energy sources in the view of consumers, EOG is unable to predict what changes may occur in crude oil and condensate, NGLs, natural gas, ammonia and methanol prices in the future. The market price of crude oil and condensate, NGLs and natural gas in 2019 will impact the amount of cash generated from EOG's operating activities, which will in turn impact EOG's financial position. As of February 19, 2019, the average 2019 NYMEX crude oil and natural gas prices were $57.15 per barrel and $2.89 per MMBtu, respectively, representing a decrease of 12% for crude oil and a decrease of 6% for natural gas from the average NYMEX prices in 2018. See ITEM 1A, Risk Factors. Based on EOG's tax position, EOG's price sensitivity (exclusive of basis swaps) in 2019 for each $1.00 per barrel increase or decrease in wellhead crude oil and condensate price, combined with the estimated change in NGL price, is approximately $133 million for net income and $173 million for pretax cash flows from operating activities. Based on EOG's tax position and the portion of EOG's anticipated natural gas volumes for 2019 for which prices have not been determined under long-term marketing contracts, EOG's price sensitivity for each $0.10 per Mcf increase or decrease in wellhead natural gas price is approximately $29 million for net income and $37 million for pretax cash flows from operating activities. For information regarding EOG's crude oil and natural gas financial commodity derivative contracts through February 19, 2019, see "Derivative Transactions" above. Capital. EOG plans to continue to focus a substantial portion of its exploration and development expenditures in its major producing areas in the United States. In particular, EOG will be focused on United States crude oil drilling activity in its Eagle Ford, Delaware Basin and Rocky Mountain area where it generates its highest rates-of-return. To further enhance the economics of these plays, EOG expects to continue to improve well performance and lower drilling and completion costs through efficiency gains and lower service costs. The total anticipated 2019 capital expenditures of approximately $6.1 billion to $6.5 billion, excluding acquisitions and non-cash exchanges, is structured to maintain EOG's strategy of capital discipline by funding its exploration, development and exploitation activities primarily from available internally generated cash flows and cash on hand. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program and other uncommitted credit facilities, bank borrowings, borrowings under its $2.0 billion senior unsecured revolving credit facility and equity and debt offerings. Operations. In 2019, both total production and total crude oil production are expected to increase from 2018 levels. In 2019, EOG expects to continue to focus on reducing operating costs through efficiency improvements. Summary of Critical Accounting Policies EOG prepares its financial statements and the accompanying notes in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions about future events that affect the reported amounts in the financial statements and the accompanying notes. EOG identifies certain accounting policies as critical based on, among other things, their impact on the portrayal of EOG's financial condition, results of operations or liquidity, and the degree of difficulty, subjectivity and complexity in their application. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. Management routinely discusses the development, selection and disclosure of each of the critical accounting policies. Following is a discussion of EOG's most critical accounting policies: Proved Oil and Gas Reserves EOG's engineers estimate proved oil and gas reserves in accordance with United States Securities and Exchange Commission (SEC) regulations, which directly impact financial accounting estimates, including depreciation, depletion and amortization and impairments of proved properties and related assets. Proved reserves represent estimated quantities of crude oil and condensate, NGLs and natural gas that geological and engineering data demonstrate, with reasonable certainty, to be recoverable in future years from known reservoirs under economic and operating conditions existing at the time the estimates were made. The process of estimating quantities of proved oil and gas reserves is complex, requiring significant subjective decisions in the evaluation of available geological, engineering and economic data for each reservoir. The data for a given reservoir may also change substantially over time as a result of numerous factors including, but not limited to, additional development activity, evolving production history and continual reassessment of the viability of production under varying economic conditions. Consequently, material revisions (upward or downward) to existing reserve estimates may occur from time to time. For related discussion, see ITEM 1A, Risk Factors, and "Supplemental Information to Consolidated Financial Statements." Oil and Gas Exploration Costs EOG accounts for its crude oil and natural gas exploration and production activities under the successful efforts method of accounting. Oil and gas exploration costs, other than the costs of drilling exploratory wells, are expensed as incurred. The costs of drilling exploratory wells are capitalized pending determination of whether EOG has discovered proved commercial reserves. If proved commercial reserves are not discovered, such drilling costs are expensed. In some circumstances, it may be uncertain whether proved commercial reserves have been discovered when drilling has been completed. Such exploratory well drilling costs may continue to be capitalized if the reserve quantity is sufficient to justify its completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made. Costs to develop proved reserves, including the costs of all development wells and related equipment used in the production of crude oil and natural gas, are capitalized. Depreciation, Depletion and Amortization for Oil and Gas Properties The quantities of estimated proved oil and gas reserves are a significant component of EOG's calculation of depreciation, depletion and amortization expense, and revisions in such estimates may alter the rate of future expense. Holding all other factors constant, if reserves were revised upward or downward, earnings would increase or decrease, respectively. Depreciation, depletion and amortization of the cost of proved oil and gas properties is calculated using the unit-of-production method. The reserve base used to calculate depreciation, depletion and amortization for leasehold acquisition costs and the cost to acquire proved properties is the sum of proved developed reserves and proved undeveloped reserves. With respect to lease and well equipment costs, which include development costs and successful exploration drilling costs, the reserve base includes only proved developed reserves. Estimated future dismantlement, restoration and abandonment costs, net of salvage values, are taken into account. Oil and gas properties are grouped in accordance with the provisions of the Extractive Industries - Oil and Gas Topic of the ASC. The basis for grouping is a reasonable aggregation of properties with a common geological structural feature or stratigraphic condition, such as a reservoir or field. Depreciation, depletion and amortization rates are updated quarterly to reflect the addition of capital costs, reserve revisions (upwards or downwards) and additions, property acquisitions and/or property dispositions and impairments. Depreciation and amortization of other property, plant and equipment is calculated on a straight-line basis over the estimated useful life of the asset. Impairments Oil and gas lease acquisition costs are capitalized when incurred. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. Unproved properties with individually significant acquisition costs are reviewed individually for impairment. If the unproved properties are determined to be productive, the appropriate related costs are transferred to proved oil and gas properties. Lease rentals are expensed as incurred. When circumstances indicate that proved oil and gas properties may be impaired, EOG compares expected undiscounted future cash flows at a depreciation, depletion and amortization group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows, based on EOG's estimates of (and assumptions regarding) future crude oil and natural gas prices, operating costs, development expenditures, anticipated production from proved reserves and other relevant data, are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated using the Income Approach described in the Fair Value Measurement Topic of the ASC. In certain instances, EOG utilizes accepted offers from third-party purchasers as the basis for determining fair value. Estimates of undiscounted future cash flows require significant judgment, and the assumptions used in preparing such estimates are inherently uncertain. In addition, such assumptions and estimates are reasonably likely to change in the future. Crude oil and natural gas prices have exhibited significant volatility in the past, and EOG expects that volatility to continue in the future. During the five years ended December 31, 2018, West Texas Intermediate crude oil spot prices have fluctuated from approximately $26.19 per barrel to $107.95 per barrel, and Henry Hub natural gas spot prices have ranged from approximately $1.49 per MMBtu to $8.15 per MMBtu. EOG uses the five-year NYMEX futures strip for West Texas Intermediate crude oil and Henry Hub natural gas (in each case as of the applicable balance sheet date) as a basis to estimate future crude oil and natural gas prices. EOG's proved reserves estimates, including the timing of future production, are also subject to significant assumptions and judgment, and are frequently revised (upwards and downwards) as more information becomes available. Proved reserves are estimated using a trailing 12-month average price, in accordance with SEC rules. In the future, if any combination of crude oil prices, natural gas prices, actual production or operating costs diverge negatively from EOG's current estimates, impairment charges and downward adjustments to our estimated proved reserves may be necessary. Income Taxes Income taxes are accounted for using the asset and liability approach. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax basis. EOG assesses the realizability of deferred tax assets and recognizes valuation allowances as appropriate. Significant assumptions used in estimating future taxable income include future oil and gas prices and levels of capital reinvestment. Changes in such assumptions or changes in tax laws and regulations could materially affect the recognized amounts of valuation allowances. Stock-Based Compensation In accounting for stock-based compensation, judgments and estimates are made regarding, among other things, the appropriate valuation methodology to follow in valuing stock compensation awards and the related inputs required by those valuation methodologies. Assumptions regarding expected volatility of EOG's common stock, the level of risk-free interest rates, expected dividend yields on EOG's common stock, the expected term of the awards, expected volatility in the price of shares of EOG's peer companies and other valuation inputs are subject to change. Any such changes could result in different valuations and thus impact the amount of stock-based compensation expense recognized on the Consolidated Statements of Income (Loss) and Comprehensive Income (Loss). Information Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical facts, including, among others, statements and projections regarding EOG's future financial position, operations, performance, business strategy, returns, budgets, reserves, levels of production, capital expenditures, costs and asset sales, statements regarding future commodity prices and statements regarding the plans and objectives of EOG's management for future operations, are forward-looking statements. EOG typically uses words such as "expect," "anticipate," "estimate," "project," "strategy," "intend," "plan," "target," “aims,” "goal," "may," "will," "should" and "believe" or the negative of those terms or other variations or comparable terminology to identify its forward-looking statements. In particular, statements, express or implied, concerning EOG's future operating results and returns or EOG's ability to replace or increase reserves, increase production, generate returns, replace or increase drilling locations, reduce or otherwise control operating costs and capital expenditures, generate cash flows, pay down or refinance indebtedness or pay and/or increase dividends are forward-looking statements. Forward-looking statements are not guarantees of performance. Although EOG believes the expectations reflected in its forward-looking statements are reasonable and are based on reasonable assumptions, no assurance can be given that these assumptions are accurate or that any of these expectations will be achieved (in full or at all) or will prove to have been correct. Moreover, EOG's forward-looking statements may be affected by known, unknown or currently unforeseen risks, events or circumstances that may be outside EOG's control. Important factors that could cause EOG's actual results to differ materially from the expectations reflected in EOG's forward-looking statements include, among others: • the timing, extent and duration of changes in prices for, supplies of, and demand for, crude oil and condensate, natural gas liquids, natural gas and related commodities; • the extent to which EOG is successful in its efforts to acquire or discover additional reserves; • the extent to which EOG is successful in its efforts to economically develop its acreage in, produce reserves and achieve anticipated production levels from, and maximize reserve recovery from, its existing and future crude oil and natural gas exploration and development projects; • the extent to which EOG is successful in its efforts to market its crude oil and condensate, natural gas liquids, natural gas and related commodity production; • the availability, proximity and capacity of, and costs associated with, appropriate gathering, processing, compression, storage, transportation and refining facilities; • the availability, cost, terms and timing of issuance or execution of, and competition for, mineral licenses and leases and governmental and other permits and rights-of-way, and EOG’s ability to retain mineral licenses and leases; • the impact of, and changes in, government policies, laws and regulations, including tax laws and regulations; climate change and other environmental, health and safety laws and regulations relating to air emissions, disposal of produced water, drilling fluids and other wastes, hydraulic fracturing and access to and use of water; laws and regulations imposing conditions or restrictions on drilling and completion operations and on the transportation of crude oil and natural gas; laws and regulations with respect to derivatives and hedging activities; and laws and regulations with respect to the import and export of crude oil, natural gas and related commodities; • EOG's ability to effectively integrate acquired crude oil and natural gas properties into its operations, fully identify existing and potential problems with respect to such properties and accurately estimate reserves, production and costs with respect to such properties; • the extent to which EOG's third-party-operated crude oil and natural gas properties are operated successfully and economically; • competition in the oil and gas exploration and production industry for the acquisition of licenses, leases and properties, employees and other personnel, facilities, equipment, materials and services; • the availability and cost of employees and other personnel, facilities, equipment, materials (such as water and tubulars) and services; • the accuracy of reserve estimates, which by their nature involve the exercise of professional judgment and may therefore be imprecise; • weather, including its impact on crude oil and natural gas demand, and weather-related delays in drilling and in the installation and operation (by EOG or third parties) of production, gathering, processing, refining, compression, storage and transportation facilities; • the ability of EOG's customers and other contractual counterparties to satisfy their obligations to EOG and, related thereto, to access the credit and capital markets to obtain financing needed to satisfy their obligations to EOG; • EOG's ability to access the commercial paper market and other credit and capital markets to obtain financing on terms it deems acceptable, if at all, and to otherwise satisfy its capital expenditure requirements; • the extent to which EOG is successful in its completion of planned asset dispositions; • the extent and effect of any hedging activities engaged in by EOG; • the timing and extent of changes in foreign currency exchange rates, interest rates, inflation rates, global and domestic financial market conditions and global and domestic general economic conditions; • geopolitical factors and political conditions and developments around the world (such as the imposition of tariffs or trade or other economic sanctions, political instability and armed conflict), including in the areas in which EOG operates; • the use of competing energy sources and the development of alternative energy sources; • the extent to which EOG incurs uninsured losses and liabilities or losses and liabilities in excess of its insurance coverage; • acts of war and terrorism and responses to these acts; • physical, electronic and cybersecurity breaches; and • the other factors described under ITEM 1A, Risk Factors, on pages 13 through 22 of this Annual Report on Form 10-K and any updates to those factors set forth in EOG's subsequent Quarterly Reports on Form 10-Q or Current Reports on Form 8-K. In light of these risks, uncertainties and assumptions, the events anticipated by EOG's forward-looking statements may not occur, and, if any of such events do, we may not have anticipated the timing of their occurrence or the duration or extent of their impact on our actual results. Accordingly, you should not place any undue reliance on any of EOG's forward-looking statements. EOG's forward-looking statements speak only as of the date made, and EOG undertakes no obligation, other than as required by applicable law, to update or revise its forward-looking statements, whether as a result of new information, subsequent events, anticipated or unanticipated circumstances or otherwise.

<s>[INST] EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (nonintegrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. Each prospective drilling location is evaluated by its estimated rate of return. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a costeffective basis, allowing EOG to deliver longterm production growth while maintaining a strong balance sheet. EOG implements its strategy primarily by emphasizing the drilling of internally generated prospects in order to find and develop lowcost reserves. Maintaining the lowest possible operating cost structure that is consistent with efficient, safe and environmentally responsible operations is also an important goal in the implementation of EOG's strategy. EOG realized net income of $3,419 million during 2018 as compared to net income of $2,583 million for 2017. At December 31, 2018, EOG's total estimated net proved reserves were 2,928 million barrels of oil equivalent (MMBoe), an increase of 401 MMBoe from December 31, 2017. During 2018, net proved crude oil and condensate and natural gas liquids (NGLs) reserves increased by 330 million barrels (MMBbl), and net proved natural gas reserves increased by 424 billion cubic feet or 71 MMBoe, in each case from December 31, 2017. Operations Several important developments have occurred since January 1, 2018. United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquidsrich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquidsrich reservoirs. During 2018, EOG continued to focus on increasing drilling, completion and operating efficiencies gained in prior years. In addition, EOG continued to evaluate certain potential crude oil and liquidsrich natural gas exploration and development prospects and to look for opportunities to add drilling inventory through leasehold acquisitions, farmins, exchanges or tactical acquisitions. On a volumetric basis, as calculated using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGL production accounted for approximately 77% of United States production during 2018 and 2017. During 2018, drilling and completion activities occurred primarily in the Eagle Ford play, Delaware Basin play and Rocky Mountain area. EOG's major producing areas in the United States are in New Mexico, North Dakota, Texas, Utah and Wyoming. Trinidad. In Trinidad, EOG continued to deliver natural gas under existing supply contracts. Several fields in the South East Coast Consortium (SECC) Block, Modified U(a) Block, Block 4(a), Modified U(b) Block, the Banyan Field and the Sercan Area have been developed and are producing natural gas which is sold to the National Gas Company of Trinidad and Tobago Limited and its subsidiary and crude oil and condensate which is sold to the Petroleum Company of Trinidad and Tobago Limited and its successor, Heritage Petroleum Company Limited. In 2018, EOG conducted an ocean bottom nodal seismic survey in the SECC Block and the Pelican Field and continued to process and review the initial data. Other International. In the Sichuan Basin, Sichuan Province, China, EOG entered 2018 with two drilled uncompleted wells and completed both wells. In addition, [/INST] Positive. </s>

EOG RESOURCES INC

2020-02-27

2019-12-31

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Overview EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (non-integrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. Each prospective drilling location is evaluated by its estimated rate of return. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a cost-effective basis, allowing EOG to deliver long-term production growth while maintaining a strong balance sheet. EOG implements its strategy primarily by emphasizing the drilling of internally generated prospects in order to find and develop low-cost reserves. Maintaining the lowest possible operating cost structure that is consistent with efficient, safe and environmentally responsible operations is also an important goal in the implementation of EOG's strategy. EOG realized net income of $2,735 million during 2019 as compared to net income of $3,419 million for 2018. At December 31, 2019, EOG's total estimated net proved reserves were 3,329 million barrels of oil equivalent (MMBoe), an increase of 401 MMBoe from December 31, 2018. During 2019, net proved crude oil and condensate and natural gas liquids (NGLs) reserves increased by 287 million barrels (MMBbl), and net proved natural gas reserves increased by 683 billion cubic feet or 114 MMBoe, in each case from December 31, 2018. Operations Several important developments have occurred since January 1, 2019. United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquids-rich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquids-rich reservoirs. During 2019, EOG continued to focus on increasing drilling, completion and operating efficiencies gained in prior years. In addition, EOG continued to evaluate certain potential crude oil and liquids-rich natural gas exploration and development prospects and to look for opportunities to add drilling inventory through leasehold acquisitions, farm-ins, exchanges or tactical acquisitions. On a volumetric basis, as calculated using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGLs production accounted for approximately 77% of United States production during both 2019 and 2018. During 2019, drilling and completion activities occurred primarily in the Eagle Ford play, Delaware Basin play and Rocky Mountain area. EOG's major producing areas in the United States are in New Mexico, North Dakota, Texas and Wyoming. Trinidad. In Trinidad, EOG continues to deliver natural gas under existing supply contracts. Several fields in the South East Coast Consortium (SECC) Block, Modified U(a) Block, Block 4(a), Modified U(b) Block, the Banyan Field and the Sercan Area have been developed and are producing natural gas which is sold to the National Gas Company of Trinidad and Tobago Limited and its subsidiary (NGC), and crude oil and condensate which is sold to Heritage Petroleum Company Limited. In 2019, EOG drilled and completed two net wells in Trinidad and was in the process of drilling another exploratory well at December 31, 2019. One of these wells was a successful development well, while the other well was determined to be an unsuccessful exploratory well. In addition, EOG drilled one stratigraphic exploratory well in Trinidad, which discovered commercially economic reserves. Other International. In the Sichuan Basin, Sichuan Province, China, EOG drilled two natural gas wells in 2019 to complete the drilling program started in 2018. In 2019, EOG also completed two natural gas wells that were drilled during the 2018 drilling program. All natural gas produced from the Baijaochang Field is sold under a long-term contract to PetroChina. EOG continues to evaluate other select crude oil and natural gas opportunities outside the United States, primarily by pursuing exploitation opportunities in countries where indigenous crude oil and natural gas reserves have been identified. Capital Structure One of management's key strategies is to maintain a strong balance sheet with a consistently below average debt-to-total capitalization ratio as compared to those in EOG's peer group. EOG's debt-to-total capitalization ratio was 19% at December 31, 2019 and 24% at December 31, 2018. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. On June 3, 2019, EOG repaid upon maturity the $900 million aggregate principal amount of its 5.625% Senior Notes due 2019. On June 27, 2019, EOG entered into a new $2.0 billion senior unsecured Revolving Credit Agreement (New Facility) with domestic and foreign lenders (Banks). The New Facility replaced EOG's $2.0 billion senior unsecured Revolving Credit Agreement, dated as of July 21, 2015, which had a scheduled maturity date of July 21, 2020. The New Facility has a scheduled maturity date of June 27, 2024, and includes an option for EOG to extend, on up to two occasions, the term for successive one-year periods subject to certain terms and conditions. The New Facility (i) commits the Banks to provide advances up to an aggregate principal amount of $2.0 billion at any one time outstanding, with an option for EOG to request increases in the aggregate commitments to an amount not to exceed $3.0 billion, subject to certain terms and conditions, and (ii) includes a swingline subfacility and a letter of credit subfacility. Effective January 1, 2019, EOG adopted the provisions of Accounting Standards Update (ASU) 2016-02, "Leases (Topic 842)" (ASU 2016-02). ASU 2016-02 and other related ASUs resulted in the recognition of right-of-use assets and related lease liabilities representing the obligation to make lease payments for certain lease transactions and the disclosure of additional leasing information. The adoption of ASU 2016-02 and other related ASUs resulted in a significant increase to assets and liabilities related to operating leases on the Consolidated Balance Sheet at December 31, 2019. Financial results prior to January 1, 2019, are unchanged. See Note 1 "Summary of Significant Accounting Policies" and Note 18 "Leases" to EOG's Consolidated Financial Statements in this Annual Report on Form 10-K. During 2019, EOG funded $6.7 billion ($152 million of which was non-cash) in exploration and development and other property, plant and equipment expenditures (excluding asset retirement obligations), repaid $900 million aggregate principal amount of long-term debt, paid $588 million in dividends to common stockholders and purchased $25 million of treasury stock in connection with stock compensation plans, primarily by utilizing net cash provided from its operating activities and net proceeds of $140 million from the sale of assets. Total anticipated 2020 capital expenditures are estimated to range from approximately $6.3 billion to $6.7 billion, excluding acquisitions and non-cash exchanges. The majority of 2020 expenditures will be focused on United States crude oil drilling activities. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program, bank borrowings, borrowings under its New Facility, joint development agreements and similar agreements and equity and debt offerings. Management continues to believe EOG has one of the strongest prospect inventories in EOG's history. When it fits EOG's strategy, EOG will make acquisitions that bolster existing drilling programs or offer incremental exploration and/or production opportunities. Results of Operations The following review of operations for each of the three years in the period ended December 31, 2019, should be read in conjunction with the consolidated financial statements of EOG and notes thereto beginning on page. Operating Revenues and Other During 2019, operating revenues increased $105 million, or 1%, to $17,380 million from $17,275 million in 2018. Total wellhead revenues, which are revenues generated from sales of EOG's production of crude oil and condensate, NGLs and natural gas, decreased $365 million, or 3%, to $11,581 million in 2019 from $11,946 million in 2018. Revenues from the sales of crude oil and condensate and NGLs in 2019 were approximately 90% of total wellhead revenues compared to 89% in 2018. During 2019, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $180 million compared to net losses of $166 million in 2018. Gathering, processing and marketing revenues increased $130 million during 2019, to $5,360 million from $5,230 million in 2018. Net gains on asset dispositions of $124 million in 2019 were primarily as a result of sales of producing properties, acreage and other assets, as well as non-cash property exchanges, in New Mexico compared to net gains on asset dispositions of $175 million in 2018. Wellhead volume and price statistics for the years ended December 31, 2019, 2018 and 2017 were as follows: (1) Thousand barrels per day or million cubic feet per day, as applicable. (2) Other International includes EOG's United Kingdom, China and Canada operations. The United Kingdom operations were sold in the fourth quarter of 2018. (3) Dollars per barrel or per thousand cubic feet, as applicable. Excludes the impact of financial commodity derivative instruments (see Note 12 to Consolidated Financial Statements). (4) Includes a positive revenue adjustment of $0.44 per Mcf related to the adoption of ASU 2014-09, "Revenue From Contracts with Customers" (ASU 2014-09) (see Note 1 to the Consolidated Financial Statements). In connection with the adoption of ASU 2014-09, EOG presents natural gas processing fees related to certain processing and marketing agreements as Gathering and Processing Costs, instead of as a deduction to Natural Gas revenues. (5) Thousand barrels of oil equivalent per day or million barrels of oil equivalent, as applicable; includes crude oil and condensate, NGLs and natural gas. Crude oil equivalent volumes are determined using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas. MMBoe is calculated by multiplying the MBoed amount by the number of days in the period and then dividing that amount by one thousand. 2019 compared to 2018. Wellhead crude oil and condensate revenues in 2019 increased $96 million, or 1%, to $9,613 million from $9,517 million in 2018, due primarily to an increase in production ($1,351 million), partially offset by a lower composite average wellhead crude oil and condensate price ($1,255 million). EOG's composite wellhead crude oil and condensate price for 2019 decreased 11% to $57.72 per barrel compared to $65.21 per barrel in 2018. Wellhead crude oil and condensate production in 2019 increased 14% to 456 MBbld as compared to 400 MBbld in 2018. The increased production was primarily in the Permian Basin and the Eagle Ford. NGLs revenues in 2019 decreased $343 million, or 30%, to $784 million from $1,127 million in 2018 primarily due to a lower composite average wellhead NGLs price ($518 million), partially offset by an increase in production ($175 million). EOG's composite average wellhead NGLs price decreased 40% to $16.03 per barrel in 2019 compared to $26.60 per barrel in 2018. NGL production in 2019 increased 16% to 134 MBbld as compared to 116 MBbld in 2018. The increased production was primarily in the Permian Basin. Wellhead natural gas revenues in 2019 decreased $118 million, or 9%, to $1,184 million from $1,302 million in 2018, primarily due to a lower composite wellhead natural gas price ($280 million), partially offset by an increase in natural gas deliveries ($162 million). EOG's composite average wellhead natural gas price decreased 18% to $2.38 per Mcf in 2019 compared to $2.92 per Mcf in 2018. Natural gas deliveries in 2019 increased 12% to 1,366 MMcfd as compared to 1,219 MMcfd in 2018. The increase in production was primarily due to higher deliveries in the United States resulting from increased production of associated natural gas from the Permian Basin and higher natural gas volumes in South Texas. During 2019, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $180 million, which included net cash received for settlements of crude oil and natural gas financial derivative contracts of $231 million. During 2018, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $166 million, which included net cash paid for settlements of crude oil and natural gas financial derivative contracts of $259 million. Gathering, processing and marketing revenues are revenues generated from sales of third-party crude oil, NGLs and natural gas, as well as fees associated with gathering third-party natural gas and revenues from sales of EOG-owned sand. Purchases and sales of third-party crude oil and natural gas may be utilized in order to balance firm transportation capacity with production in certain areas and to utilize excess capacity at EOG-owned facilities. EOG sells sand in order to balance the timing of firm purchase agreements with completion operations and to utilize excess capacity at EOG-owned facilities. Marketing costs represent the costs to purchase third-party crude oil, natural gas and sand and the associated transportation costs, as well as costs associated with EOG-owned sand sold to third parties. Gathering, processing and marketing revenues less marketing costs in 2019 decreased $18 million compared to 2018, primarily due to lower margins on crude oil and condensate marketing activities, partially offset by higher margins on natural gas marketing activities. 2018 compared to 2017. Wellhead crude oil and condensate revenues in 2018 increased $3,261 million, or 52%, to $9,517 million from $6,256 million in 2017, due primarily to a higher composite average wellhead crude oil and condensate price ($2,088 million) and an increase in production ($1,173 million). EOG's composite wellhead crude oil and condensate price for 2018 increased 28% to $65.21 per barrel compared to $50.91 per barrel in 2017. Wellhead crude oil and condensate production in 2018 increased 19% to 400 MBbld as compared to 337 MBbld in 2017. The increased production was primarily in the Permian Basin and the Eagle Ford. NGLs revenues in 2018 increased $398 million, or 55%, to $1,127 million from $729 million in 2017 primarily due to an increase in production ($229 million) and a higher composite average wellhead NGLs price ($169 million). EOG's composite average wellhead NGLs price increased 18% to $26.60 per barrel in 2018 compared to $22.61 per barrel in 2017. NGLs production in 2018 increased 31% to 116 MBbld as compared to 88 MBbld in 2017. The increased production was primarily in the Permian Basin and the Eagle Ford. Wellhead natural gas revenues in 2018 increased $380 million, or 41%, to $1,302 million from $922 million in 2017, primarily due to a higher composite wellhead natural gas price ($282 million) and an increase in wellhead natural gas deliveries ($98 million). EOG's composite average wellhead natural gas price increased 28% to $2.92 per Mcf in 2018 compared to $2.29 per Mcf in 2017. This increase in composite wellhead natural gas prices includes a positive revenue adjustment of $0.44 per Mcf related to the adoption of ASU 2014-09. Natural gas deliveries in 2018 increased 11% to 1,219 MMcfd as compared to 1,103 MMcfd in 2017. The increase in production was primarily due to increased production in the United States (158 MMcfd), partially offset by decreased production in Trinidad (47 MMcfd). The increased production in the United States was due primarily to increased production of associated gas in the Permian Basin and Rocky Mountain area and higher volumes in the Marcellus Shale. The decrease in Trinidad was primarily attributable to higher contractual deliveries in 2017. During 2018, EOG recognized net losses on the mark-to-market of financial commodity derivative contracts of $166 million, which included net cash paid for settlements of crude oil and natural gas financial derivative contracts of $259 million. During 2017, EOG recognized net gains on the mark-to-market of financial commodity derivative contracts of $20 million, which included net cash received from settlements of crude oil and natural gas financial derivative contracts of $7 million. Gathering, processing and marketing revenues less marketing costs in 2018 increased $59 million compared to 2017, primarily due to higher margins on crude oil and condensate marketing activities. Operating and Other Expenses 2019 compared to 2018. During 2019, operating expenses of $13,681 million were $875 million higher than the $12,806 million incurred during 2018. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2019 and 2018: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2019 compared to 2018 are set forth below. See "Operating Revenues and Other" above for a discussion of production volumes. Lease and well expenses include expenses for EOG-operated properties, as well as expenses billed to EOG from other operators where EOG is not the operator of a property. Lease and well expenses can be divided into the following categories: costs to operate and maintain crude oil and natural gas wells, the cost of workovers and lease and well administrative expenses. Operating and maintenance costs include, among other things, pumping services, salt water disposal, equipment repair and maintenance, compression expense, lease upkeep and fuel and power. Workovers are operations to restore or maintain production from existing wells. Each of these categories of costs individually fluctuates from time to time as EOG attempts to maintain and increase production while maintaining efficient, safe and environmentally responsible operations. EOG continues to increase its operating activities by drilling new wells in existing and new areas. Operating and maintenance costs within these existing and new areas, as well as the costs of services charged to EOG by vendors, fluctuate over time. Lease and well expenses of $1,367 million in 2019 increased $84 million from $1,283 million in 2018 primarily due to higher operating and maintenance costs ($76 million) and higher lease and well administrative expenses ($29 million) in the United States, partially offset by lower operating and maintenance costs in the United Kingdom ($15 million) due to the sale of operations in the fourth quarter of 2018 and in Canada ($11 million). Lease and well expenses increased in the United States primarily due to increased operating activities resulting in increased production. Transportation costs represent costs associated with the delivery of hydrocarbon products from the lease to a downstream point of sale. Transportation costs include transportation fees, the cost of compression (the cost of compressing natural gas to meet pipeline pressure requirements), the cost of dehydration (the cost associated with removing water from natural gas to meet pipeline requirements), gathering fees and fuel costs. Transportation costs of $758 million in 2019 increased $11 million from $747 million in 2018 primarily due to increased transportation costs in the Permian Basin ($91 million) and South Texas ($11 million), partially offset by decreased transportation costs in the Eagle Ford ($77 million) and the Fort Worth Basin Barnett Shale ($13 million). DD&A of the cost of proved oil and gas properties is calculated using the unit-of-production method. EOG's DD&A rate and expense are the composite of numerous individual DD&A group calculations. There are several factors that can impact EOG's composite DD&A rate and expense, such as field production profiles, drilling or acquisition of new wells, disposition of existing wells and reserve revisions (upward or downward) primarily related to well performance, economic factors and impairments. Changes to these factors may cause EOG's composite DD&A rate and expense to fluctuate from period to period. DD&A of the cost of other property, plant and equipment is generally calculated using the straight-line depreciation method over the useful lives of the assets. DD&A expenses in 2019 increased $315 million to $3,750 million from $3,435 million in 2018. DD&A expenses associated with oil and gas properties in 2019 were $337 million higher than in 2018 primarily due to an increase in production in the United States ($489 million), partially offset by lower unit rates in the United States ($119 million) and the sale of the United Kingdom operations in the fourth quarter of 2018 ($33 million). Unit rates in the United States decreased primarily due to upward reserve revisions and reserves added at lower costs as a result of increased efficiencies. G&A expenses of $489 million in 2019 increased $62 million from $427 million in 2018 primarily due to increased employee-related expenses ($48 million) and increased information systems costs ($8 million) resulting from expanded operations. Net interest expense of $185 million in 2019 was $60 million lower than 2018 primarily due to repayment of the $900 million aggregate principal amount of 5.625% Senior Notes due 2019 in June 2019 ($30 million) and the $350 million aggregate principal amount of 6.875% Senior Notes due 2018 in October 2018 ($18 million) and an increase in capitalized interest ($14 million). Gathering and processing costs represent operating and maintenance expenses and administrative expenses associated with operating EOG's gathering and processing assets as well as natural gas processing fees and certain NGLs fractionation fees paid to third parties. EOG pays third parties to process the majority of its natural gas production to extract NGLs. See Note 1 to the Consolidated Financial Statements for discussion related to EOG's adoption of ASU 2014-09. Gathering and processing costs increased $42 million to $479 million in 2019 compared to $437 million in 2018 primarily due to increased operating costs and fees in the Permian Basin ($52 million), the Rocky Mountain area ($13 million) and South Texas ($5 million); partially offset by decreased operating costs in the United Kingdom ($33 million) due to the sale of operations in the fourth quarter of 2018. Exploration costs of $140 million in 2019 decreased $9 million from $149 million in 2018 primarily due to decreased geological and geophysical expenditures in Trinidad ($17 million), partially offset by increased general and administrative expenses in the United States ($7 million). Impairments include amortization of unproved oil and gas property costs as well as impairments of proved oil and gas properties; other property, plant and equipment; and other assets. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. Unproved properties with individually significant acquisition costs are reviewed individually for impairment. When circumstances indicate that a proved property may be impaired, EOG compares expected undiscounted future cash flows at a DD&A group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows, based on EOG's estimates of (and assumptions regarding) future crude oil and natural gas prices, operating costs, development expenditures, anticipated production from proved reserves and other relevant data, are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated by using the Income Approach described in the Fair Value Measurement Topic of the Financial Accounting Standards Board's Accounting Standards Codification (ASC). In certain instances, EOG utilizes accepted offers from third-party purchasers as the basis for determining fair value. The following table represents impairments for the years ended December 31, 2019 and 2018 (in millions): Impairments of proved properties were primarily due to the write-down to fair value of legacy natural gas assets in 2019 and 2018. Taxes other than income include severance/production taxes, ad valorem/property taxes, payroll taxes, franchise taxes and other miscellaneous taxes. Severance/production taxes are generally determined based on wellhead revenues, and ad valorem/property taxes are generally determined based on the valuation of the underlying assets. Taxes other than income in 2019 increased $28 million to $800 million (6.9% of wellhead revenues) from $772 million (6.5% of wellhead revenues) in 2018. The increase in taxes other than income was primarily due to an increase in ad valorem/property taxes ($53 million), partially offset by an increase in credits available to EOG in 2019 for state incentive severance tax rate reductions ($12 million) and a decrease in severance/production taxes ($12 million) primarily as a result of decreased wellhead revenues, all in the United States. Other income, net, was $31 million in 2019 compared to other income, net, of $17 million in 2018. The increase of $14 million in 2019 was primarily due to an increase in interest income ($14 million) and an increase in foreign currency transaction gains ($9 million), partially offset by an increase in deferred compensation expense ($4 million). EOG recognized an income tax provision of $810 million in 2019 compared to an income tax provision of $822 million in 2018, primarily due to decreased pretax income, partially offset by the absence of tax benefits from certain tax reform measurement-period adjustments. The net effective tax rate for 2019 increased to 23% from 19% in the prior year, primarily due to the absence of tax benefits from certain tax reform measurement-period adjustments. 2018 compared to 2017. During 2018, operating expenses of $12,806 million were $875 million higher than the $10,282 million incurred during 2017. The following table presents the costs per barrel of oil equivalent (Boe) for the years ended December 31, 2018 and 2017: (1) Total excludes gathering and processing costs, exploration costs, dry hole costs, impairments, marketing costs and taxes other than income. The primary factors impacting the cost components of per-unit rates of lease and well, transportation costs, DD&A, G&A and net interest expense for 2018 compared to 2017 are set forth below. See "Operating Revenues and Other" above for a discussion of production volumes. Lease and well expenses of $1,283 million in 2018 increased $238 million from $1,045 million in 2017 primarily due to higher operating and maintenance costs ($171 million), higher workover expenditures ($44 million) and higher lease and well administrative expenses ($41 million), all in the United States, partially offset by lower operating and maintenance costs in the United Kingdom ($18 million). Lease and well expenses increased in the United States primarily due to increased operating activities resulting in increased production. Transportation costs of $747 million in 2018 increased $7 million from $740 million in 2017 primarily due to increased transportation costs in the Permian Basin ($116 million), partially offset by decreased transportation costs in the Fort Worth Basin Barnett Shale ($52 million), the Eagle Ford ($31 million) and the Rocky Mountain area ($25 million). DD&A expenses in 2018 increased $26 million to $3,435 million from $3,409 million in 2017. DD&A expenses associated with oil and gas properties in 2018 were $24 million higher than in 2017 primarily due to an increase in production in the United States ($647 million) and the United Kingdom ($21 million), partially offset by lower unit rates in the United States ($625 million) and a decrease in production in Trinidad ($16 million). Unit rates in the United States decreased primarily due to upward reserve revisions and reserves added at lower costs as a result of increased efficiencies. G&A expenses of $427 million in 2018 decreased $7 million from $434 million in 2017 primarily due to decreased professional, legal and other services ($24 million); partially offset by increased employee-related expenses resulting from expanded operations ($15 million) and increased information systems costs ($10 million). Net interest expense of $245 million in 2018 was $29 million lower than 2017 primarily due to repayment of the $600 million aggregate principal amount of 5.875% Senior Notes due 2017 in September 2017 ($25 million) and the $350 million aggregate principal amount of 6.875% Senior Notes due 2018 in October 2018 ($6 million), partially offset by a decrease in capitalized interest ($3 million). Gathering and processing costs increased $288 million to $437 million in 2018 compared to $149 million in 2017 primarily due to the adoption of ASU 2014-09 ($204 million) and increased operating costs in the Permian Basin ($32 million), the United Kingdom ($28 million) and the Eagle Ford ($25 million). Exploration costs of $149 million in 2018 increased $4 million from $145 million in 2017 primarily due to increased general and administrative expenses in the United States ($7 million), partially offset by decreased geological and geophysical expenditures in Trinidad ($5 million). The following table represents impairments for the years ended December 31, 2018 and 2017 (in millions): Impairments of proved properties were primarily due to the write-down to fair value of legacy natural gas assets in 2018 and 2017. Taxes other than income in 2018 increased $227 million to $772 million (6.5% of wellhead revenues) from $545 million (6.9% of wellhead revenues) in 2017. The increase in taxes other than income was primarily due to increases in severance/production taxes ($190 million) primarily as a result of increased wellhead revenues and an increase in ad valorem/property taxes ($33 million), both in the United States. Other income, net, was $17 million in 2018 compared to other income, net, of $9 million in 2017. The increase of $8 million in 2018 was primarily due to a decrease in deferred compensation expense ($12 million) and an increase in interest income ($4 million), partially offset by an increase in foreign currency transaction losses ($15 million). EOG recognized an income tax provision of $822 million in 2018 compared to an income tax benefit of $1,921 million in 2017, primarily due to the absence of certain 2017 tax benefits related to the Tax Cuts and Jobs Act (TCJA) and higher pretax income. The most significant impact of the TCJA on EOG was the reduction in the statutory income tax rate from 35% to 21% which required the existing net United States federal deferred income tax liability to be remeasured resulting in the recognition of an income tax benefit in 2017 of approximately $2.2 billion. The net effective tax rate for 2018 increased to 19% from (291%) in the prior year, primarily due to the absence of the TCJA tax benefits. Capital Resources and Liquidity Cash Flow The primary sources of cash for EOG during the three-year period ended December 31, 2019, were funds generated from operations and proceeds from asset sales. The primary uses of cash were funds used in operations; exploration and development expenditures; repayments of debt; dividend payments to stockholders; other property, plant and equipment expenditures; and purchases of treasury stock in connection with stock compensation plans. 2019 compared to 2018. Net cash provided by operating activities of $8,163 million in 2019 increased $394 million from $7,769 million in 2018 primarily reflecting an increase in cash received for settlements of commodity derivative contracts ($490 million), a decrease in net cash paid for income taxes ($367 million) and favorable changes in working capital and other assets and liabilities ($122 million); partially offset by a decrease in wellhead revenues ($365 million) and an increase in cash operating expenses ($202 million). Net cash used in investing activities of $6,177 million in 2019 increased by $7 million from $6,170 million in 2018 primarily due to an increase in additions to oil and gas properties ($313 million), a decrease in proceeds from the sale of assets ($87 million) and an increase in additions to other property, plant and equipment ($33 million); partially offset by favorable changes in working capital associated with investing activities ($416 million) and a decrease in other investing activities ($10 million). Net cash used in financing activities of $1,513 million in 2019 included repayments of long-term debt ($900 million), cash dividend payments ($588 million) and purchases of treasury stock in connection with stock compensation plans ($25 million). Cash provided by financing activities in 2019 included proceeds from stock options exercised and employee stock purchase plan activity ($18 million). 2018 compared to 2017. Net cash provided by operating activities of $7,769 million in 2018 increased $3,504 million from $4,265 million in 2017 primarily reflecting an increase in wellhead revenues ($4,039 million), favorable changes in working capital and other assets and liabilities ($758 million) and a favorable change in the cash paid for income taxes ($113 million), partially offset by an increase in cash operating expenses ($746 million) and an unfavorable change in the net cash paid for the settlement of financial commodity derivative contracts ($266 million). Net cash used in investing activities of $6,170 million in 2018 increased by $2,183 million from $3,987 million in 2017 primarily due to an increase in additions to oil and gas properties ($1,888 million); unfavorable changes in working capital associated with investing activities ($211 million); and an increase in additions to other property, plant and equipment ($64 million). Net cash used in financing activities of $839 million in 2018 included cash dividend payments ($438 million), repayments of long-term debt ($350 million) and purchases of treasury stock in connection with stock compensation plans ($63 million). Cash provided by financing activities in 2018 included proceeds from stock options exercised and employee stock purchase plan activity ($21 million). Total Expenditures The table below sets out components of total expenditures for the years ended December 31, 2019, 2018 and 2017 (in millions): (1) Leasehold acquisitions included $98 million, $291 million and $256 million related to non-cash property exchanges in 2019, 2018 and 2017, respectively. (2) Property acquisitions included $52 million, $71 million and $26 million related to non-cash property exchanges in 2019, 2018 and 2017, respectively. (3) Other property, plant and equipment included $49 million of non-cash additions in 2018, respectively, primarily related to a finance lease transaction in the Permian Basin. Exploration and development expenditures of $6,442 million for 2019 were $92 million higher than the prior year. The increase was primarily due to increased property acquisitions ($256 million), increased exploration and development drilling expenditures in Trinidad ($53 million) and increased capitalized interest ($14 million), partially offset by decreased leasehold acquisitions ($212 million) and decreased exploration and development drilling expenditures in the United States ($19 million) and Other International ($19 million). The 2019 exploration and development expenditures of $6,442 million included $5,513 million in development drilling and facilities, $511 million in exploration, $380 million in property acquisitions and $38 million in capitalized interest. The 2018 exploration and development expenditures of $6,350 million included $5,546 million in development drilling and facilities, $656 million million in exploration, $124 million in property acquisitions and $24 million in capitalized interest. The 2017 exploration and development expenditures of $4,384 million included $3,661 million in development drilling and facilities, $623 million in exploration, $73 million in property acquisitions and $27 million in capitalized interest. The level of exploration and development expenditures, including acquisitions, will vary in future periods depending on energy market conditions and other related economic factors. EOG has significant flexibility with respect to financing alternatives and the ability to adjust its exploration and development expenditure budget as circumstances warrant. While EOG has certain continuing commitments associated with expenditure plans related to its operations, such commitments are not expected to be material when considered in relation to the total financial capacity of EOG. Commodity Derivative Transactions Crude Oil Derivative Contracts. Prices received by EOG for its crude oil production generally vary from U.S. New York Mercantile Exchange (NYMEX) West Texas Intermediate (WTI) prices due to adjustments for delivery location (basis) and other factors. EOG has entered into crude oil basis swap contracts in order to fix the differential between pricing in Midland, Texas, and Cushing, Oklahoma (Midland Differential). Presented below is a comprehensive summary of EOG's Midland Differential basis swap contracts through February 19, 2020. The weighted average price differential expressed in $/Bbl represents the amount of reduction to Cushing, Oklahoma, prices for the notional volumes expressed in barrels per day (Bbld) covered by the basis swap contracts. EOG has also entered into crude oil basis swap contracts in order to fix the differential between pricing in the U.S. Gulf Coast and Cushing, Oklahoma (Gulf Coast Differential). Presented below is a comprehensive summary of EOG's Gulf Coast Differential basis swap contracts through February 19, 2020. The weighted average price differential expressed in $/Bbl represents the amount of addition to Cushing, Oklahoma, prices for the notional volumes expressed in Bbld covered by the basis swap contracts. EOG has also entered into crude oil swaps to fix the differential in pricing between the NYMEX calendar month average and the physical crude oil delivery month (Roll Differential). Presented below is a comprehensive summary of EOG's Roll Differential swap contracts through February 19, 2020. The weighted average price differential expressed in $/Bbl represents the amount of addition to delivery month prices for the notional volumes expressed in Bbld covered by the swap contracts. Presented below is a comprehensive summary of EOG's crude oil price swap contracts through February 19, 2020, with notional volumes expressed in Bbld and prices expressed in $/Bbl. NGLs Derivative Contracts. Presented below is a comprehensive summary of EOG's Mont Belvieu propane (non-TET) price swap contracts through February 19, 2020, with notional volumes expressed in Bbld and prices expressed in $/Bbl. Natural Gas Derivative Contracts. Presented below is a comprehensive summary of EOG's natural gas price swap contracts through February 19, 2020, with notional volumes expressed in million British thermal units (MMBtu) per day (MMBtud) and prices expressed in dollars per MMBtu ($/MMBtu). EOG has also entered into natural gas collar contracts, which establish ceiling and floor prices for the sale of notional volumes of natural gas as specified in the collar contracts. The collars require that EOG pay the difference between the ceiling price and the NYMEX Henry Hub natural gas price for the contract month (Henry Hub Index Price) in the event the Henry Hub Index Price is above the ceiling price. The collars grant EOG the right to receive the difference between the floor price and the Henry Hub Index Price in the event the Henry Hub Index Price is below the floor price. Presented below is a comprehensive summary of EOG's natural gas collar contracts through February 19, 2020, with notional volumes expressed in MMBtud and prices expressed in $/MMBtu. Prices received by EOG for its natural gas production generally vary from NYMEX Henry Hub prices due to adjustments for delivery location (basis) and other factors. EOG has entered into natural gas basis swap contracts in order to fix the differential between pricing in the Rocky Mountain area and NYMEX Henry Hub prices (Rockies Differential). Presented below is a comprehensive summary of EOG's Rockies Differential basis swap contracts through February 19, 2020. The weighted average price differential expressed in $/MMBtu represents the amount of reduction to NYMEX Henry Hub prices for the notional volumes expressed in MMBtud covered by the basis swap contracts. EOG has also entered into natural gas basis swap contracts in order to fix the differential between pricing at the Houston Ship Channel (HSC) and NYMEX Henry Hub prices (HSC Differential). Presented below is a comprehensive summary of EOG's HSC Differential basis swap contracts through February 19, 2020. The weighted average price differential expressed in $/MMBtu represents the amount of reduction to NYMEX Henry Hub prices for the notional volumes expressed in MMBtud covered by the basis swap contracts. EOG has also entered into natural gas basis swap contracts in order to fix the differential between pricing at the Waha Hub in West Texas and NYMEX Henry Hub prices (Waha Differential). Presented below is a comprehensive summary of EOG's Waha Differential basis swap contracts through February 19, 2020. The weighted average price differential expressed in $/MMBtu represents the amount of reduction to NYMEX Henry Hub prices for the notional volumes expressed in MMBtud covered by the basis swap contracts. Financing EOG's debt-to-total capitalization ratio was 19% at December 31, 2019, compared to 24% at December 31, 2018. As used in this calculation, total capitalization represents the sum of total current and long-term debt and total stockholders' equity. At December 31, 2019 and 2018, respectively, EOG had outstanding $5,140 million and $6,040 million aggregate principal amount of senior notes which had estimated fair values of $5,452 million and $6,027 million, respectively. The estimated fair value of debt was based upon quoted market prices and, where such prices were not available, other observable inputs regarding interest rates available to EOG at year-end. EOG's debt is at fixed interest rates. While changes in interest rates affect the fair value of EOG's senior notes, such changes do not expose EOG to material fluctuations in earnings or cash flow. During 2019, EOG funded its capital program primarily by utilizing cash provided by operating activities and proceeds from asset sales. While EOG maintains a $2.0 billion revolving credit facility to back its commercial paper program, there were no borrowings outstanding at any time during 2019 and the amount outstanding at year-end was zero. EOG considers the availability of its $2.0 billion senior unsecured revolving credit facility, as described in Note 2 to Consolidated Financial Statements, to be sufficient to meet its ongoing operating needs. Contractual Obligations The following table summarizes EOG's contractual obligations at December 31, 2019 (in millions): (1) This table does not include the liability for unrecognized tax benefits, EOG's pension or postretirement benefit obligations or liability for dismantlement, abandonment and asset retirement obligations (see Notes 6, 7 and 15, respectively, to Consolidated Financial Statements). These amounts are excluded because they are subject to estimates and the timing of settlement is unknown. (2) This table does not include the liability for commitments to purchase fixed quantities of crude oil and natural gas. The amounts are excluded because they are variable and based on future commodity prices. At December 31, 2019, EOG is committed to purchase 1.8 MMBbls of crude oil and 5.5 Bcf of natural gas in 2020 and 1.4 MMBls of crude oil in 2021. (3) For more information on contracts that meet the definition of a lease under ASU 2016-02, see Note 18 to Consolidated Financial Statements. (4) Amounts exclude transportation and storage service commitments that meet the definition of a lease. Amounts shown are based on current transportation and storage rates and the foreign currency exchange rates used to convert Canadian dollars into United States dollars at December 31, 2019. Management does not believe that any future changes in these rates before the expiration dates of these commitments will have a material adverse effect on the financial condition or results of operations of EOG. Off-Balance Sheet Arrangements EOG does not participate in financial transactions that generate relationships with unconsolidated entities or financial partnerships. Such entities or partnerships, often referred to as variable interest entities (VIE) or special purpose entities (SPE), are generally established for the purpose of facilitating off-balance sheet arrangements or other limited purposes. EOG was not involved in any unconsolidated VIE or SPE financial transactions or any other "off-balance sheet arrangement" (as defined in Item 303(a)(4)(ii) of Regulation S-K) during any of the periods covered by this report and currently has no intention of participating in any such transaction or arrangement in the foreseeable future. Foreign Currency Exchange Rate Risk During 2019, EOG was exposed to foreign currency exchange rate risk inherent in its operations in foreign countries, including Trinidad, China and Canada. EOG continues to monitor the foreign currency exchange rates of countries in which it is currently conducting business and may implement measures to protect against foreign currency exchange rate risk. Outlook Pricing. Crude oil and natural gas prices have been volatile, and this volatility is expected to continue. As a result of the many uncertainties associated with the world political environment, worldwide supplies of, and demand for, crude oil and condensate, NGLs and natural gas, the availabilities of other worldwide energy supplies and the relative competitive relationships of the various energy sources in the view of consumers, EOG is unable to predict what changes may occur in crude oil and condensate, NGLs, natural gas, ammonia and methanol prices in the future. The market price of crude oil and condensate, NGLs and natural gas in 2020 will impact the amount of cash generated from EOG's operating activities, which will in turn impact EOG's financial position. As of February 19, 2020, the average 2020 NYMEX crude oil and natural gas prices were $53.75 per barrel and $2.12 per MMBtu, respectively, representing a decrease of 6% for crude oil and a decrease of 20% for natural gas from the average NYMEX prices in 2019. See ITEM 1A, Risk Factors. Based on EOG's tax position, EOG's price sensitivity (exclusive of basis swaps) in 2020 for each $1.00 per barrel increase or decrease in wellhead crude oil and condensate price, combined with the estimated change in NGL price, is approximately $117 million for net income and $152 million for pretax cash flows from operating activities. Based on EOG's tax position and the portion of EOG's anticipated natural gas volumes for 2020 for which prices have not been determined under long-term marketing contracts, EOG's price sensitivity for each $0.10 per Mcf increase or decrease in wellhead natural gas price is approximately $31 million for net income and $40 million for pretax cash flows from operating activities. For information regarding EOG's crude oil and natural gas financial commodity derivative contracts through February 19, 2020, see "Derivative Transactions" above. Capital. EOG plans to continue to focus a substantial portion of its exploration and development expenditures in its major producing areas in the United States. In particular, EOG will be focused on United States crude oil drilling activity in its Delaware Basin, Eagle Ford and Rocky Mountain area where it generates its highest rates-of-return. To further enhance the economics of these plays, EOG expects to continue to improve well performance and lower drilling and completion costs through efficiency gains and lower service costs. The total anticipated 2020 capital expenditures of approximately $6.3 billion to $6.7 billion, excluding acquisitions and non-cash exchanges, is structured to maintain EOG's strategy of capital discipline by funding its exploration, development and exploitation activities primarily from available internally generated cash flows and cash on hand. EOG has significant flexibility with respect to financing alternatives, including borrowings under its commercial paper program, bank borrowings, borrowings under its $2.0 billion senior unsecured revolving credit facility and equity and debt offerings. Operations. In 2020, both total production and total crude oil production are expected to increase from 2019 levels. In 2020, EOG expects to continue to focus on reducing operating costs through efficiency improvements. Summary of Critical Accounting Policies EOG prepares its financial statements and the accompanying notes in conformity with accounting principles generally accepted in the United States, which require management to make estimates and assumptions about future events that affect the reported amounts in the financial statements and the accompanying notes. EOG identifies certain accounting policies as critical based on, among other things, their impact on the portrayal of EOG's financial condition, results of operations or liquidity, and the degree of difficulty, subjectivity and complexity in their application. Critical accounting policies cover accounting matters that are inherently uncertain because the future resolution of such matters is unknown. Management routinely discusses the development, selection and disclosure of each of the critical accounting policies. Following is a discussion of EOG's most critical accounting policies: Proved Oil and Gas Reserves EOG's engineers estimate proved oil and gas reserves in accordance with United States Securities and Exchange Commission (SEC) regulations, which directly impact financial accounting estimates, including depreciation, depletion and amortization and impairments of proved properties and related assets. Proved reserves represent estimated quantities of crude oil and condensate, NGLs and natural gas that geological and engineering data demonstrate, with reasonable certainty, to be recoverable in future years from known reservoirs under economic and operating conditions existing at the time the estimates were made. The process of estimating quantities of proved oil and gas reserves is complex, requiring significant subjective decisions in the evaluation of available geological, engineering and economic data for each reservoir. The data for a given reservoir may also change substantially over time as a result of numerous factors including, but not limited to, additional development activity, evolving production history and continual reassessment of the viability of production under varying economic conditions. Consequently, material revisions (upward or downward) to existing reserve estimates may occur from time to time. For related discussion, see ITEM 1A, Risk Factors, and "Supplemental Information to Consolidated Financial Statements." Oil and Gas Exploration Costs EOG accounts for its crude oil and natural gas exploration and production activities under the successful efforts method of accounting. Oil and gas exploration costs, other than the costs of drilling exploratory wells, are expensed as incurred. The costs of drilling exploratory wells are capitalized pending determination of whether EOG has discovered proved commercial reserves. If proved commercial reserves are not discovered, such drilling costs are expensed. In some circumstances, it may be uncertain whether proved commercial reserves have been discovered when drilling has been completed. Such exploratory well drilling costs may continue to be capitalized if the reserve quantity is sufficient to justify its completion as a producing well and sufficient progress in assessing the reserves and the economic and operating viability of the project is being made. Costs to develop proved reserves, including the costs of all development wells and related equipment used in the production of crude oil and natural gas, are capitalized. Depreciation, Depletion and Amortization for Oil and Gas Properties The quantities of estimated proved oil and gas reserves are a significant component of EOG's calculation of depreciation, depletion and amortization expense, and revisions in such estimates may alter the rate of future expense. Holding all other factors constant, if reserves were revised upward or downward, earnings would increase or decrease, respectively. Depreciation, depletion and amortization of the cost of proved oil and gas properties is calculated using the unit-of-production method. The reserve base used to calculate depreciation, depletion and amortization for leasehold acquisition costs and the cost to acquire proved properties is the sum of proved developed reserves and proved undeveloped reserves. With respect to lease and well equipment costs, which include development costs and successful exploration drilling costs, the reserve base includes only proved developed reserves. Estimated future dismantlement, restoration and abandonment costs, net of salvage values, are taken into account. Oil and gas properties are grouped in accordance with the provisions of the Extractive Industries - Oil and Gas Topic of the ASC. The basis for grouping is a reasonable aggregation of properties with a common geological structural feature or stratigraphic condition, such as a reservoir or field. Depreciation, depletion and amortization rates are updated quarterly to reflect the addition of capital costs, reserve revisions (upwards or downwards) and additions, property acquisitions and/or property dispositions and impairments. Depreciation and amortization of other property, plant and equipment is calculated on a straight-line basis over the estimated useful life of the asset. Impairments Oil and gas lease acquisition costs are capitalized when incurred. Unproved properties with acquisition costs that are not individually significant are aggregated, and the portion of such costs estimated to be nonproductive is amortized over the remaining lease term. Unproved properties with individually significant acquisition costs are reviewed individually for impairment. If the unproved properties are determined to be productive, the appropriate related costs are transferred to proved oil and gas properties. Lease rentals are expensed as incurred. When circumstances indicate that proved oil and gas properties may be impaired, EOG compares expected undiscounted future cash flows at a depreciation, depletion and amortization group level to the unamortized capitalized cost of the asset. If the expected undiscounted future cash flows, based on EOG's estimates of (and assumptions regarding) future crude oil and natural gas prices, operating costs, development expenditures, anticipated production from proved reserves and other relevant data, are lower than the unamortized capitalized cost, the capitalized cost is reduced to fair value. Fair value is generally calculated using the Income Approach described in the Fair Value Measurement Topic of the ASC. In certain instances, EOG utilizes accepted offers from third-party purchasers as the basis for determining fair value. Estimates of undiscounted future cash flows require significant judgment, and the assumptions used in preparing such estimates are inherently uncertain. In addition, such assumptions and estimates are reasonably likely to change in the future. Crude oil, NGLs and natural gas prices have exhibited significant volatility in the past, and EOG expects that volatility to continue in the future. During the five years ended December 31, 2019, WTI crude oil spot prices have fluctuated from approximately $26.19 per barrel to $77.41 per barrel, and Henry Hub natural gas spot prices have ranged from approximately $1.49 per MMBtu to $6.24 per MMBtu. Market prices for NGLs are influenced by the production composition of ethane, propane, butane and natural gasoline and the respective market pricing for each component. EOG uses the five-year NYMEX futures strip for WTI crude oil and Henry Hub natural gas (in each case as of the applicable balance sheet date) as a basis to estimate future crude oil and natural gas prices. EOG's proved reserves estimates, including the timing of future production, are also subject to significant assumptions and judgment, and are frequently revised (upwards and downwards) as more information becomes available. Proved reserves are estimated using a trailing 12-month average price, in accordance with SEC rules. In the future, if any combination of crude oil prices, natural gas prices, actual production or operating costs diverge negatively from EOG's current estimates, impairment charges and downward adjustments to our estimated proved reserves may be necessary. Income Taxes Income taxes are accounted for using the asset and liability approach. Under this approach, deferred tax assets and liabilities are recognized based on anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax basis. EOG assesses the realizability of deferred tax assets and recognizes valuation allowances as appropriate. Significant assumptions used in estimating future taxable income include future oil and gas prices and levels of capital reinvestment. Changes in such assumptions or changes in tax laws and regulations could materially affect the recognized amounts of valuation allowances. Stock-Based Compensation In accounting for stock-based compensation, judgments and estimates are made regarding, among other things, the appropriate valuation methodology to follow in valuing stock compensation awards and the related inputs required by those valuation methodologies. Assumptions regarding expected volatility of EOG's common stock, the level of risk-free interest rates, expected dividend yields on EOG's common stock, the expected term of the awards, expected volatility in the price of shares of EOG's peer companies and other valuation inputs are subject to change. Any such changes could result in different valuations and thus impact the amount of stock-based compensation expense recognized on the Consolidated Statements of Income and Comprehensive Income. Information Regarding Forward-Looking Statements This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of historical facts, including, among others, statements and projections regarding EOG's future financial position, operations, performance, business strategy, returns, budgets, reserves, levels of production, capital expenditures, costs and asset sales, statements regarding future commodity prices and statements regarding the plans and objectives of EOG's management for future operations, are forward-looking statements. EOG typically uses words such as "expect," "anticipate," "estimate," "project," "strategy," "intend," "plan," "target," “aims,” "goal," "may," "will," "should" and "believe" or the negative of those terms or other variations or comparable terminology to identify its forward-looking statements. In particular, statements, express or implied, concerning EOG's future operating results and returns or EOG's ability to replace or increase reserves, increase production, generate returns, replace or increase drilling locations, reduce or otherwise control operating costs and capital expenditures, generate cash flows, pay down or refinance indebtedness or pay and/or increase dividends are forward-looking statements. Forward-looking statements are not guarantees of performance. Although EOG believes the expectations reflected in its forward-looking statements are reasonable and are based on reasonable assumptions, no assurance can be given that these assumptions are accurate or that any of these expectations will be achieved (in full or at all) or will prove to have been correct. Moreover, EOG's forward-looking statements may be affected by known, unknown or currently unforeseen risks, events or circumstances that may be outside EOG's control. Important factors that could cause EOG's actual results to differ materially from the expectations reflected in EOG's forward-looking statements include, among others: • the timing, extent and duration of changes in prices for, supplies of, and demand for, crude oil and condensate, natural gas liquids, natural gas and related commodities; • the extent to which EOG is successful in its efforts to acquire or discover additional reserves; • the extent to which EOG is successful in its efforts to (i) economically develop its acreage in, (ii) produce reserves and achieve anticipated production levels and rates of return from, (iii) decrease or otherwise control its drilling, completion, operating and capital costs related to, and (iv) maximize reserve recovery from, its existing and future crude oil and natural gas exploration and development projects and associated potential and existing drilling locations; • the extent to which EOG is successful in its efforts to market its crude oil and condensate, natural gas liquids, natural gas and related commodity production; • security threats, including cybersecurity threats and disruptions to our business and operations from breaches of our information technology systems, physical breaches of our facilities and other infrastructure or breaches of the information technology systems, facilities and infrastructure of third parties with which we transact business; • the availability, proximity and capacity of, and costs associated with, appropriate gathering, processing, compression, storage, transportation and refining facilities; • the availability, cost, terms and timing of issuance or execution of, and competition for, mineral licenses and leases and governmental and other permits and rights-of-way, and EOG’s ability to retain mineral licenses and leases; • the impact of, and changes in, government policies, laws and regulations, including tax laws and regulations; climate change and other environmental, health and safety laws and regulations relating to air emissions, disposal of produced water, drilling fluids and other wastes, hydraulic fracturing and access to and use of water; laws and regulations imposing conditions or restrictions on drilling and completion operations and on the transportation of crude oil and natural gas; laws and regulations with respect to derivatives and hedging activities; and laws and regulations with respect to the import and export of crude oil, natural gas and related commodities; • EOG's ability to effectively integrate acquired crude oil and natural gas properties into its operations, fully identify existing and potential problems with respect to such properties and accurately estimate reserves, production and drilling, completing and operating costs with respect to such properties; • the extent to which EOG's third-party-operated crude oil and natural gas properties are operated successfully and economically; • competition in the oil and gas exploration and production industry for the acquisition of licenses, leases and properties, employees and other personnel, facilities, equipment, materials and services; • the availability and cost of employees and other personnel, facilities, equipment, materials (such as water and tubulars) and services; • the accuracy of reserve estimates, which by their nature involve the exercise of professional judgment and may therefore be imprecise; • weather, including its impact on crude oil and natural gas demand, and weather-related delays in drilling and in the installation and operation (by EOG or third parties) of production, gathering, processing, refining, compression, storage and transportation facilities; • the ability of EOG's customers and other contractual counterparties to satisfy their obligations to EOG and, related thereto, to access the credit and capital markets to obtain financing needed to satisfy their obligations to EOG; • EOG's ability to access the commercial paper market and other credit and capital markets to obtain financing on terms it deems acceptable, if at all, and to otherwise satisfy its capital expenditure requirements; • the extent to which EOG is successful in its completion of planned asset dispositions; • the extent and effect of any hedging activities engaged in by EOG; • the timing and extent of changes in foreign currency exchange rates, interest rates, inflation rates, global and domestic financial market conditions and global and domestic general economic conditions; • geopolitical factors and political conditions and developments around the world (such as the imposition of tariffs or trade or other economic sanctions, political instability and armed conflict), including in the areas in which EOG operates; • the use of competing energy sources and the development of alternative energy sources; • the extent to which EOG incurs uninsured losses and liabilities or losses and liabilities in excess of its insurance coverage; • acts of war and terrorism and responses to these acts; and • the other factors described under ITEM 1A, Risk Factors, on pages 13 through 23 of this Annual Report on Form 10-K and any updates to those factors set forth in EOG's subsequent Quarterly Reports on Form 10-Q or Current Reports on Form 8-K. In light of these risks, uncertainties and assumptions, the events anticipated by EOG's forward-looking statements may not occur, and, if any of such events do, we may not have anticipated the timing of their occurrence or the duration or extent of their impact on our actual results. Accordingly, you should not place any undue reliance on any of EOG's forward-looking statements. EOG's forward-looking statements speak only as of the date made, and EOG undertakes no obligation, other than as required by applicable law, to update or revise its forward-looking statements, whether as a result of new information, subsequent events, anticipated or unanticipated circumstances or otherwise.

<s>[INST] EOG Resources, Inc., together with its subsidiaries (collectively, EOG), is one of the largest independent (nonintegrated) crude oil and natural gas companies in the United States with proved reserves in the United States, Trinidad and China. EOG operates under a consistent business and operational strategy that focuses predominantly on maximizing the rate of return on investment of capital by controlling operating and capital costs and maximizing reserve recoveries. Each prospective drilling location is evaluated by its estimated rate of return. This strategy is intended to enhance the generation of cash flow and earnings from each unit of production on a costeffective basis, allowing EOG to deliver longterm production growth while maintaining a strong balance sheet. EOG implements its strategy primarily by emphasizing the drilling of internally generated prospects in order to find and develop lowcost reserves. Maintaining the lowest possible operating cost structure that is consistent with efficient, safe and environmentally responsible operations is also an important goal in the implementation of EOG's strategy. EOG realized net income of $2,735 million during 2019 as compared to net income of $3,419 million for 2018. At December 31, 2019, EOG's total estimated net proved reserves were 3,329 million barrels of oil equivalent (MMBoe), an increase of 401 MMBoe from December 31, 2018. During 2019, net proved crude oil and condensate and natural gas liquids (NGLs) reserves increased by 287 million barrels (MMBbl), and net proved natural gas reserves increased by 683 billion cubic feet or 114 MMBoe, in each case from December 31, 2018. Operations Several important developments have occurred since January 1, 2019. United States. EOG's efforts to identify plays with large reserve potential have proven to be successful. EOG continues to drill numerous wells in large acreage plays, which in the aggregate have contributed substantially to, and are expected to continue to contribute substantially to, EOG's crude oil and liquidsrich natural gas production. EOG has placed an emphasis on applying its horizontal drilling and completion expertise to unconventional crude oil and liquidsrich reservoirs. During 2019, EOG continued to focus on increasing drilling, completion and operating efficiencies gained in prior years. In addition, EOG continued to evaluate certain potential crude oil and liquidsrich natural gas exploration and development prospects and to look for opportunities to add drilling inventory through leasehold acquisitions, farmins, exchanges or tactical acquisitions. On a volumetric basis, as calculated using a ratio of 1.0 barrel of crude oil and condensate or NGLs to 6.0 thousand cubic feet of natural gas, crude oil and condensate and NGLs production accounted for approximately 77% of United States production during both 2019 and 2018. During 2019, drilling and completion activities occurred primarily in the Eagle Ford play, Delaware Basin play and Rocky Mountain area. EOG's major producing areas in the United States are in New Mexico, North Dakota, Texas and Wyoming. Trinidad. In Trinidad, EOG continues to deliver natural gas under existing supply contracts. Several fields in the South East Coast Consortium (SECC) Block, Modified U(a) Block, Block 4(a), Modified U(b) Block, the Banyan Field and the Sercan Area have been developed and are producing natural gas which is sold to the National Gas Company of Trinidad and Tobago Limited and its subsidiary (NGC), and crude oil and condensate which is sold to Heritage Petroleum Company Limited. In 2019, EOG drilled and completed two net wells in Trinidad and was in the process of drilling another exploratory well at December 31, 2019. One of these wells was a successful development well, while the other well was determined to be an unsuccessful exploratory well. In addition, EOG drilled one stratigraphic exploratory well in Trinidad, which [/INST] Positive. </s>

OSHKOSH CORP

2015-11-13

2015-09-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS General The Company is a leading designer, manufacturer and marketer of a wide range of specialty vehicles and vehicle bodies, including access equipment, defense trucks and trailers, fire & emergency vehicles, concrete mixers and refuse collection vehicles. The Company is a leading global manufacturer of aerial work platforms under the “JLG” brand name. The Company is among the worldwide leaders in the manufacturing of telehandlers under the “JLG” and “SkyTrak” brand names. Under the “Jerr-Dan” brand name, the Company is a leading domestic manufacturer and marketer of towing and recovery equipment. The Company manufactures defense trucks under the “Oshkosh” brand name and is a leading manufacturer of severe-duty, tactical wheeled vehicles for the DoD. Under the “Pierce” brand name, the Company is among the leading global manufacturers of fire apparatus assembled on both custom and commercial chassis. Under the “Frontline” brand name, the Company is a leading domestic manufacturer and marketer of broadcast vehicles. The Company manufactures ARFF and airport snow removal vehicles under the “Oshkosh” brand name. Under the “McNeilus,” “Oshkosh,” “London” and “CON-E-CO” brand names, the Company manufactures rear- and front-discharge concrete mixers and portable and stationary concrete batch plants. Under the “McNeilus” brand name, the Company manufactures a wide range of automated, rear, front, side and top loading refuse collection vehicles. Under the “IMT” brand name, the Company is a leading domestic manufacturer of field service vehicles and truck-mounted cranes. Major products manufactured and marketed by each of the Company’s business segments are as follows: Access equipment - aerial work platforms and telehandlers used in a wide variety of construction, agricultural, industrial, institutional and general maintenance applications to position workers and materials at elevated heights, as well as wreckers and carriers. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and towing companies in the U.S. and abroad. Defense - tactical trucks, trailers and supply parts and services sold to the U.S. military and to other militaries around the world. Fire & emergency - custom and commercial firefighting vehicles and equipment, ARFF vehicles, snow removal vehicles, simulators and other emergency vehicles primarily sold to fire departments, airports and other governmental units, and broadcast vehicles sold to broadcasters and TV stations in the U.S. and abroad. Commercial - concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to ready-mix companies and commercial and municipal waste haulers in the Americas and other international markets and field service vehicles and truck-mounted cranes sold to mining, construction and other companies in the U.S. and abroad. All estimates referred to in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refer to the Company’s estimates as of November 13, 2015. Executive Overview In fiscal 2015, the Company faced two difficult conditions. First, the multi-year decline in U.S. defense spending caused the Company's defense sales and earnings to reach a trough, marginally profitable levels, consistent with the Company's expectations. However, the Company did not anticipate a broad-based decline in construction equipment sales in North America during a period of improving residential and non-residential construction spending. The decline in fiscal 2015 was caused by a number of contributing factors including severe weather in the Northeast and rains across the Southern U.S. which shortened the construction season and a decline in oil and gas related construction activity which accelerated into fiscal 2015 a mid-cycle dip in demand for access equipment as a result of low purchases of access equipment in the 2009-2010 time-period. This led to sales declines in the Company's access equipment and concrete mixer businesses at a time that the Company believed it was in position to achieve its long-term target for fiscal 2015 earnings per share. Despite these difficult conditions, the Company delivered solid results in fiscal 2015, which represented a 9.5% compound annual growth rate of earnings per share on an adjusted basis from fiscal 2012 to fiscal 2015 and believes it has set the foundation for improved earnings performance in fiscal 2016 and beyond. Specific examples of this include the following: • The Company delivered higher sales and margins in its fire & emergency and commercial segments. Due largely to market share gains, in marginally improving markets, sales grew by 7.8% and 12.9% in the fire & emergency and commercial segments, respectively, in fiscal 2015. Importantly, by executing strategic growth road maps for each segment, operating income margins increased by 190 and 40 basis points, respectively, which yielded a combined 35% increase in the operating income of these two segments. The improvement in commercial segment margins was muted by investments intended to raise margins further in fiscal 2016. • The Company set the foundation for defense segment earnings recovery in fiscal 2016. Extensive efforts over multiple years expanding the number of M-ATV variants and marketing them globally resulted in the defense segment securing an order in August 2015 from an international customer for an additional 273 M-ATVs for sale in fiscal 2016. In addition, the defense segment expects to secure a contract for more than 1,000 additional M-ATVs in the first quarter of fiscal 2016, the majority of which the Company expects to sell in fiscal 2016. The Company's defense segment continues to pursue opportunities to sell thousands of M-ATVs over the next few years. • The Company's defense segment achieved a historic award of the JLTV production contract. The award of the $6.7 billion JLTV contract positions the defense business with a strong, profitable base of business for at least the next eight years. The JLTV will become the tactical workhorse for transporting the next generation of U.S. soldiers and Marines around the battlefield. The JLTV contract award is currently being protested by one of the competing bidders, and the DoD has issued a stop-work order on the JLTV program pending resolution of the protest. The Company expects a decision on the protest in December 2015. Additionally, the Company repurchased 4.9 million shares of its Common Stock, or 6.1% of its shares outstanding in fiscal 2015, signaled its intention to repurchase additional shares in fiscal 2016, increased its quarterly cash dividend by 13% in December 2014 and announced an additional 12% increase beginning in November 2015. Looking forward to fiscal 2016, the Company expects consolidated sales will increase to a range of $6.2 billion to $6.5 billion, despite an expected 10% - 15% decline in access equipment segment sales. The Company believes the longer term fundamental drivers for access equipment demand remain solid. Specifically, the Company believes residential and non-residential construction in the U.S. will continue to improve slowly to drive modest rental fleet expansion of access equipment and that rental company metrics will remain solid. The Company also believes that global adoption of the use of access equipment as a safe, cost effective tool will help propel additional access equipment demand. However, in the near term, the Company expects lower replacement-driven demand and market cautiousness to contribute to lower access equipment sales in fiscal 2016. The Company believes that fiscal 2015 was a trough year for its defense segment and that this segment’s sales will increase approximately 65% in fiscal 2016, more than offsetting the expected decline in access equipment segment sales. The Company believes its defense segment sales will rise in fiscal 2016 due to the restart of FHTV production and the expected sale of approximately 1,000 M-ATVs internationally. The Company also believes that the fire & emergency and commercial segments will report sales growth in fiscal 2016. The Company expects operating income of $400 million to $440 million and earnings per share of $3.00 to $3.40 in fiscal 2016, assuming an average share count of approximately 75 million. The Company expects that earnings per share in fiscal 2016 will be weighted toward the second half of the year, with fiscal first quarter earnings being slightly profitable, due to the continued lower expected access equipment replacement demand, seasonality factors and the expected significant increase in defense segment sales not beginning until the third fiscal quarter. MOVE Strategy In fiscal 2011, the Company completed a comprehensive strategic planning process to, among other things, assess the outlook for each of its markets, consider strategic alternatives and develop strategic initiatives to address the difficult market forces then facing the Company. Those difficult market forces involved non-defense markets, which were down 40% to more than 90% from peak, an uncertain economic recovery and a likely sharp downturn in U.S. defense spending beginning in 2011. The study culminated in the creation of the Company’s planned roadmap to deliver long-term earnings growth and increased shareholder value over the next business cycle and beyond. The Company’s roadmap, named MOVE, entails aggressive cost reduction and prudent organic growth initiatives until a market recovery provides an opportunity for both significant earnings leverage and cash flow, at which time the Company's strategic options could expand. In September 2012, the Company announced various targets for shareholders to assess its overall performance under its MOVE strategy, including an ambitious target to approximately double its fiscal 2012 adjusted earnings per share by fiscal 2015 despite an expected sharp downturn in the defense segment. The Company made good progress towards its earnings per share target in fiscal 2013 and 2014. However, due to adverse weather conditions in parts of the U.S. and the impact of a sudden and significant drop in the price of oil and gas on oil and gas exploration and related construction activity, which accelerated the mid-cycle dip in access equipment demand into fiscal 2015, access equipment segment sales and operating income fell short of the Company's previous estimates for fiscal 2015, causing the Company not to achieve its overall target of approximately doubling its earnings per share from fiscal 2012 to fiscal 2015. The Company's performance in executing the four key strategic initiatives of the MOVE strategy through fiscal 2015 follows: • Market recovery and growth - The Company plans to capture or improve its historical share of a market recovery. The Company estimated at its Analyst Day in September 2012 that even a modest market recovery represented a $220 million operating income opportunity in its non-defense businesses between fiscal 2012 and fiscal 2015 at historical margins and assuming no major market share gains. As a result of the impact of adverse weather in the Northeast and Southern U.S. in 2015 on the construction season in the U.S. and the impact of the sudden and significant decline in oil and gas prices on exploration activity, access equipment demand and, to a lesser extent, concrete mixer demand did not meet the Company's expectations and as a result, the Company fell short of its fiscal 2015 target for the Market Recovery and Growth initiative. • Optimize cost and capital structure - The Company is executing plans to optimize its cost and capital structure (“O” initiative) to provide value for customers and shareholders by aggressively attacking its product, process and overhead costs. The Company had targeted 250 basis points of operating income margin improvement between fiscal 2012 and fiscal 2015 through this initiative. The Company's actual operating income margin improvement from cost optimization activities exceeded the 250 basis point target. The Company is also executing a prudent capital allocation strategy as part of its optimize cost and capital structure initiative, which the Company expects to incrementally benefit earnings as well as returns for shareholders. As part of this strategy, the Company repurchased approximately 0.5 million, 6.1 million, 8.3 million and 4.9 million shares of its Common Stock during fiscal 2012, 2013, 2014 and 2015, respectively, at an aggregate cost of $818.8 million. Earnings per share in fiscal 2015 improved $0.22 compared to the prior year as a result of lower average shares outstanding. In addition, in November 2013, the Company reinstated its quarterly cash dividend at a rate of $0.15 per share. In October 2014, the Company announced as part of its capital allocation strategy that it was increasing its quarterly cash dividend by 13% to $0.17 per share. In October 2015, the Company announced that it was increasing its quarterly cash dividend by an additional 12%, declaring a dividend of $0.19 per share payable on November 30, 2015 to shareholders of record on November 15, 2015. • Value innovation - The Company has maintained its emphasis on new product development as it seeks to expand sales and margins by leading its core markets in the introduction of new or improved products and new technologies. The Company had targeted this initiative to achieve $350 million of incremental annual revenue by fiscal 2015 compared to fiscal 2012. As part of this initiative, the Company launched more than 20 new products in fiscal 2014 and approximately 30 new products in fiscal 2015. The Company's incremental revenue from new products in fiscal 2015 compared to fiscal 2012 exceeded the Company's $350 million target. • Emerging market expansion - The Company is driving expansion in targeted international geographies where it believes that there are significant opportunities for growth. The Company targeted to derive 25% of its revenues from outside the U.S. by fiscal 2015. The Company has continued to invest in international business development resources, including opening new access equipment segment sales and service offices in fiscal 2014 and 2015. The Company's revenue from outside of the U.S. in fiscal 2015 was approximately 21%, 23% on a constant currency basis, of its consolidated fiscal 2015 revenues. Achievement of the original target was adversely impacted by significant weakening of currencies against the U.S. dollar in fiscal 2015. The Company expects to continue to pursue its MOVE strategy in fiscal 2016 and beyond, with the belief that this strategy will continue to drive actions that will position the Company to deliver strong shareholder value in the coming years. Non-GAAP Financial Measures The Company is comparing earnings per share from continuing operations excluding items that affect comparability. When the Company is comparing earnings per share from continuing operations, excluding items, these are considered non-GAAP financial measures. The Company believes excluding the impact of these items is useful to investors to allow a more accurate comparison of the Company's operating performance between periods. Non-GAAP financial measures should be viewed in addition to, and not as an alternative for, the Company's results prepared in accordance with GAAP. The table below presents a reconciliation of the Company's presented non-GAAP measures to the most directly comparable GAAP measures: Results of Operations Consolidated Net Sales - Three Years Ended September 30, 2015 The following table presents net sales (see definition of net sales contained in Note 2 of the Notes to Consolidated Financial Statements) by business segment (in millions): The following table presents net sales by geographic region based on product shipment destination (in millions): Fiscal 2015 Compared to Fiscal 2014 Consolidated net sales decreased $710.1 million, or 10.4%, to $6.10 billion in fiscal 2015 compared to fiscal 2014 largely as a result of an expected significant decline in defense segment sales. Foreign currency exchange rates also adversely impacted sales by $103 million compared to the prior year. Access equipment segment net sales decreased $105.9 million, or 3.0%, to $3.40 billion in fiscal 2015 compared to fiscal 2014, due largely to an unfavorable currency impact of $94 million as a result of the weakening of most major currencies against the U.S. dollar during the year. Access equipment segment sales were also negatively impacted in the second half of the fiscal year as a result of the beginning of a mid-cycle dip in North American demand. Defense segment net sales decreased $784.7 million, or 45.5%, to $939.8 million in fiscal 2015 compared to fiscal 2014. The decrease in defense segment sales was primarily due to an expected decline in sales to the DoD (down $706 million) and lower international sales of M-ATVs. Fire & emergency segment net sales increased $58.6 million, or 7.8%, to $815.1 million in fiscal 2015 compared to fiscal 2014. The increase in sales primarily reflected higher fire apparatus deliveries (up $46 million) as a result of improved production rates and improved pricing (up $14 million). Commercial segment net sales increased $112.1 million, or 12.9%, to $978.0 million in fiscal 2015 compared to fiscal 2014. The increase in commercial segment sales was primarily attributable to higher refuse collection vehicle unit volume (up $46 million), an increase in sales of higher content units with both chassis and bodies (up $42 million) and improved aftermarket parts and service sales (up $20 million). Fiscal 2014 Compared to Fiscal 2013 Consolidated net sales decreased $856.9 million, or 11.2%, to $6.81 billion in fiscal 2014 compared to fiscal 2013. An expected significant decline in defense segment sales was partially offset by increased sales in the access equipment and commercial segments. Access equipment segment net sales increased $385.7 million, or 12.4%, to $3.51 billion in fiscal 2014 compared to fiscal 2013. The increase in access equipment segment sales was principally the result of higher unit volumes resulting from higher global demand (up $416 million) and higher pricing (up $44 million), in part to address an increase in Tier IV engine costs, offset in part by lower U.S. military telehandler sales (down $81 million) under a contract that was completed in the fourth quarter of fiscal 2013. Defense segment net sales decreased $1.33 billion, or 43.5%, to $1.72 billion in fiscal 2014 compared to fiscal 2013. The decrease in defense segment sales was primarily due to an expected decline in sales to the DoD (down $1.08 billion) and lower international sales of M-ATVs. Fire & emergency segment net sales decreased $35.9 million, or 4.5%, to $756.5 million in fiscal 2014 compared to fiscal 2013. The decrease in fire & emergency segment sales primarily reflected lower sales volume (down $54 million), offset in part by improved pricing (up $14 million). Commercial segment net sales increased $99.0 million, or 12.9%, to $865.9 million in fiscal 2014 compared to fiscal 2013. The increase in commercial segment sales was primarily attributable to improved concrete placement volume resulting from higher construction in North America (up $84 million), offset in part by a reduction in intersegment defense sales (down $13 million). Consolidated Cost of Sales - Three Years Ended September 30, 2015 The following table presents costs of sales by business segment (in millions): Fiscal 2015 Compared to Fiscal 2014 Consolidated cost of sales was $5.06 billion, or 83.0% of sales, in fiscal 2015 compared to $5.63 billion, or 82.6% of sales, in fiscal 2014. The 40 basis point increase in cost of sales as a percentage of sales in fiscal 2015 was primarily due to adverse absorption of fixed costs due to the lower production rates in the defense segment and a higher concentration of less profitable telehandler sales in the access equipment segment. Access equipment segment cost of sales was $2.70 billion, or 79.3% of sales, in fiscal 2015 compared to $2.71 billion, or 77.2% of sales, in fiscal 2014. The 210 basis point increase in cost of sales as a percentage of sales in fiscal 2015 was primarily due to a higher concentration of less profitable telehandler sales (160 basis points) and adverse production variances (80 basis points). Defense segment cost of sales was $862.7 million, or 91.8% of sales, in fiscal 2015 compared to $1.57 billion, or 90.8% of sales, in fiscal 2014. The 100 basis point increase in cost of sales as a percentage of sales was primarily attributable to adverse production absorption (310 basis points) on significantly lower sales, offset in part by the combined impact of pension and OPEB curtailments in fiscal 2015 and fiscal 2014 (100 basis points) and favorable product mix (60 basis points). Fire & emergency segment cost of sales was $703.9 million, or 86.4% of sales, in fiscal 2015 compared to $666.3 million, or 88.1% of sales, in fiscal 2014. The 170 basis point decline in cost of sales as a percentage of sales in fiscal 2015 compared to fiscal 2014 was largely attributable to improved product mix (50 basis points), favorable overhead absorption (50 basis points) and improved pricing (50 basis points). Commercial segment cost of sales of $820.6 million, or 83.9% of sales, in fiscal 2015 was largely unchanged as a percentage of sales compared to $727.6 million, or 84.0% of sales, in fiscal 2014 as adverse sales mix (30 basis points) and higher material costs (30 basis points) were offset by lower warranty expenses (60 basis points). Fiscal 2014 Compared to Fiscal 2013 Consolidated cost of sales was $5.63 billion, or 82.6% of sales, in fiscal 2014 compared to $6.47 billion, or 84.5% of sales, in fiscal 2013. The 190 basis point decrease in cost of sales as a percentage of sales in fiscal 2014 was primarily due to favorable product mix (120 basis points), the favorable impact of cost reduction initiatives (100 basis points) and higher sales prices (80 basis points), offset in part by higher new product development spending (60 basis points). The favorable product mix was largely a result of a lower mix of FMTV sales in the defense segment, which have lower margins and higher relative costs of sales, and a higher mix of aerial work platform sales in the access equipment segment, which have higher margins and lower relative costs of sales. Access equipment segment cost of sales was $2.71 billion, or 77.2% of sales, in fiscal 2014 compared to $2.46 billion, or 78.8% of sales, in fiscal 2013. The 160 basis point decrease in cost of sales as a percentage of sales in fiscal 2014 was primarily due to the favorable impact of cost reduction initiatives (160 basis points) and higher sales prices (90 basis points), offset in part by higher new product development spending (80 basis points). Defense segment cost of sales was $1.57 billion, or 90.8% of sales, in fiscal 2014 compared to $2.73 billion, or 89.4% of sales, in fiscal 2013. The 140 basis point increase in cost of sales as a percentage of sales in fiscal 2014 was primarily due to relatively flat new product development spending on lower sales (130 basis points). Fire & emergency segment cost of sales of $666.3 million, or 88.1% of sales, in fiscal 2014 was largely unchanged as a percent of sales compared to $700.9 million, or 88.4% of sales, in fiscal 2013. Commercial segment cost of sales was $727.6 million, or 84.0% of sales, in fiscal 2014 compared to $649.2 million, or 84.7% of sales, in fiscal 2013. The 70 basis point decrease in cost of sales as a percentage of sales in fiscal 2014 was primarily due to improved product mix (20 basis points) and the absence of restructuring-related costs that the Company incurred in fiscal 2013 (20 basis points). Consolidated Operating Income (Loss) - Three Years Ended September 30, 2015 The following table presents operating income (loss) by business segment (in millions): Fiscal 2015 Compared to Fiscal 2014 Consolidated operating income decreased 20.8% to $398.6 million, or 6.5% of sales, in fiscal 2015 compared to $503.3 million, or 7.4% of sales, in fiscal 2014. Reductions in corporate expenses and improved performance in the fire & emergency and commercial segments were not sufficient to offset the adverse product mix in the access equipment segment as well as the impact of significantly lower sales volumes in the defense segment. Access equipment segment operating income decreased 18.8% to $407.0 million, or 12.0% of sales, in fiscal 2015 compared to $501.1 million, or 14.3% of sales, in fiscal 2014. The decrease in operating income was primarily the result of an adverse product mix (down $56 million) and unfavorable production variances (up $25 million). Defense segment operating income decreased 87.9% to $9.2 million, or 1.0% of sales, in fiscal 2015 compared to $76.4 million, or 4.4% of sales, in fiscal 2014. The decrease in operating income was largely due to lower gross income associated with lower sales (down $111 million), partially offset by lower operating expenses (down $14 million) and lower engineering costs (down $10 million). Operating income in fiscal 2014 was adversely impacted by an $8.9 million reduction to net sales as a result of the reversal of billings to the DoD for other post-employment benefit costs determined to be unallowable under cost-plus government contracts. Fire & emergency segment operating income increased 64.5% to $43.8 million, or 5.4% of sales, in fiscal 2015, compared to $26.6 million, or 3.5% of sales, in fiscal 2014. The increase in operating income was largely due to higher gross income on increased sales (up $8 million), improved pricing, net of higher input costs (up a combined $7 million) and improved absorption (up $4 million), partially offset by increased operating expenses (up $4 million). Commercial segment operating income increased 19.7% to $64.5 million, or 6.6% of sales, in fiscal 2015 compared to $53.9 million, or 6.2% of sales, in fiscal 2014. The increase in operating income was primarily a result of gross income associated with higher sales volume (up $28 million) and favorable warranty performance (down $4 million), partially offset by increased operating expenses (up $9 million), including investments in MOVE initiatives. Corporate operating expenses decreased $28.7 million to $126.0 million in fiscal 2015 compared to fiscal 2014. The decrease in corporate operating expenses in fiscal 2015 was primarily due to lower incentive compensation expense (down $12 million), lower information technology expense (down $9 million) and lower stock-based compensation expense (down $7 million), partially offset by costs to support the start-up of a corporate-led manufacturing facility to support multiple business segments. Stock-based compensation expense declined because the Company granted few equity-based long-term incentive awards in fiscal 2015 because it moved the annual employee stock-based compensation grants from September to November. Consolidated selling, general and administrative expenses decreased 5.9% to $587.4 million, or 9.6% of sales, in fiscal 2015 compared to $624.1 million, or 9.2% of sales, in fiscal 2014. The decrease in selling, general and administrative expenses was largely the result of lower incentive compensation expense for fiscal 2015 compared to fiscal 2014. The increase in consolidated selling, general and administrative expenses as a percentage of sales was largely due to a shift in the percentage of consolidated sales to segments (non-defense) that have a higher percentage of selling, general and administrative expenses. The Company’s defense segment generally has lower selling, general and administrative costs as a percentage of sales compared to its other segments, in large part due to concentration of business with the DoD. For example, the defense segment has limited sales and marketing expenses and has operations/locations primarily in the United States, as compared to the Company’s access equipment segment, which has a diverse customer base with a significant number of customers, significant sales and marketing costs, and operations/locations in various regions of the world. As the Company’s defense segment sales decreased and the Company’s non-defense segment sales increased as a percentage of consolidated sales, consolidated selling, general and administrative expenses as a percentage of sales increased. Fiscal 2014 Compared to Fiscal 2013 Consolidated operating income decreased 0.5%, to $503.3 million, or 7.4% of sales, in fiscal 2014 compared to $505.7 million, or 6.6% of sales, in fiscal 2013. Operating income margins improved in fiscal 2014 as a result of favorable performance in the Company’s access equipment segment, offset in part by the impact of lower sales volume in the defense segment. Operating income in fiscal 2014 was adversely impacted by an $8.9 million reduction to net sales as a result of the reversal of billings to the DoD for other post-employment benefit costs determined to be unallowable under cost-plus government contracts in the defense segment. Operating income in fiscal 2013 included costs of $16.3 million incurred by the Company in connection with an unsolicited tender offer for the Company's Common Stock and a threatened proxy contest, a non-cash intangible asset impairment charge in the access equipment segment of $9.0 million and charges of $3.8 million related to the ratification of a five-year union contract extension in the defense segment. Access equipment segment operating income increased 32.0% to $501.1 million, or 14.3% of sales, in fiscal 2014 compared to $379.6 million, or 12.2% of sales, in fiscal 2013. The increase in operating income was primarily the result of higher gross profit due to higher sales volume (up $71 million), the favorable impact of cost reduction initiatives ($61 million) and higher pricing (up $44 million), offset in part by higher spending on new product development (up $36 million) and higher operating expenses (up $26 million). Operating results in fiscal 2014 also benefited by $7.5 million as a result of the Company reaching an agreement on the final pricing of a multi-year U.S. military contract during the first quarter of fiscal 2014. Operating results in fiscal 2013 included a non-cash intangible asset impairment charge of $9.0 million. Defense segment operating income decreased 66.1% to $76.4 million, or 4.4% of sales, in fiscal 2014 compared to $224.9 million, or 7.4% of sales, in fiscal 2013. The decrease in operating income was largely due to lower gross profit related to lower sales volume. Operating income in fiscal 2014 was adversely impacted by an $8.9 million reduction to net sales as a result of the reversal of billings to the DoD for other post-employment benefit costs determined to be unallowable under cost-plus government contracts. Fiscal 2014 results also included a net benefit of $1.8 million related to pension and other post-employment benefit curtailments and settlements and $1.6 million of asset impairment charges. Fire & emergency segment operating income increased 11.7% to $26.6 million, or 3.5% of sales, in fiscal 2014, compared to $23.8 million, or 3.0% of sales, in fiscal 2013. The increase in operating income was largely the result of improved pricing (up $14 million), offset in part by lower gross profit due to lower sales volume. Commercial segment operating income increased 30.5% to $53.9 million, or 6.2% of sales, in fiscal 2014 compared to $41.3 million, or 5.4% of sales, in fiscal 2013. Higher gross profit due to higher sales volume (up $19 million) was offset in part by higher investments in MOVE initiatives. Corporate operating expenses decreased $9.2 million to $154.7 million in fiscal 2014 compared to fiscal 2013. The decrease in corporate operating expenses was primarily due to $16.3 million of costs that the Company incurred in fiscal 2013 related to an unsolicited tender offer for the Company’s Common Stock and a threatened proxy contest and lower share-based compensation expense (down $12 million) due in part to the impact of variability in the Company’s share price between fiscal 2014 and 2013 on outstanding variable awards, offset in part by increased information technology spending (up $10 million), and higher depreciation and software amortization (up $5 million). Consolidated selling, general and administrative expenses increased 0.6% to $624.1 million, or 9.2% of sales, in fiscal 2014 compared to $620.5 million, or 8.1% of sales, in fiscal 2013. The increase in selling, general and administrative expenses was largely the result of higher information technology spending (up $17 million), increased net wages and incentive compensation (up $7 million), and higher advertising, promotion and trade shows (up $5 million), offset by lower share-based compensation expense (down $12 million) due to the impact of variability in the Company’s share price between fiscal 2014 and 2013 on outstanding variable awards, and the absence of costs the Company incurred in fiscal 2013 related to an unsolicited tender offer for the Company’s Common Stock and a threatened proxy contest (down $16 million). The increase in consolidated selling, general and administrative expenses as a percentage of sales was largely due to a shift in sales to segments (non-defense) that have a higher percentage of selling, general and administrative expenses. Non-Operating Income (Expense) - Three Years Ended September 30, 2015 Fiscal 2015 Compared to Fiscal 2014 Interest expense net of interest income decreased $1.8 million to $67.6 million in fiscal 2015 compared to fiscal 2014 primarily as a result of lower interest rates on the Company's senior notes refinanced in the second quarters of fiscal 2015 and fiscal 2014. Included in interest expense are $14.7 million and $10.9 million of debt extinguishment costs in connection with the refinancing of portions of the Company’s long-term debt during fiscal 2015 and 2014, respectively. Other miscellaneous expense of $4.9 million in fiscal 2015 and $2.0 million in fiscal 2014 primarily related to net foreign currency transaction losses. Fiscal 2014 Compared to Fiscal 2013 Interest expense net of interest income increased $14.8 million to $69.4 million in fiscal 2014 compared to fiscal 2013, as a result of refinancing costs in fiscal 2014 and interest income recognized in fiscal 2013, offset in part by the benefit of lower interest rates due to the refinancing of the Company's senior notes due 2017 during the second quarter of fiscal 2014. Interest expense in fiscal 2014 included $10.9 million of debt extinguishment costs as a result of the Company’s refinancing of its credit agreement and the senior notes due 2017. In fiscal 2013, the Company recognized $9.9 million of interest income upon receipt of payments on a note receivable from a customer on nonaccrual status. Other miscellaneous expense of $2.0 million in fiscal 2014 and $6.1 million in fiscal 2013 primarily related to net foreign currency transaction losses. Provision for Income Taxes - Three Years Ended September 30, 2015 Fiscal 2015 Compared to Fiscal 2014 The Company recorded income tax expense of $99.2 million in fiscal 2015, or 30.4% of pre-tax income, compared to $125.0 million, or 29.0% of pre-tax income in fiscal 2014. Results for fiscal 2015, when compared to the U.S. statutory tax rate, were favorably impacted by a reduction of income tax reserves as a result of favorable tax audit settlements (260 basis points) and the benefit resulting from the reinstatement of the U.S. research and development tax credit (130 basis points). Results for fiscal 2014, when compared to the U.S. statutory tax rate, were favorably impacted by a reduction in valuation allowance on foreign, state and capital loss carryforwards (240 basis points) largely due to a favorable tax ruling in Europe, the benefit of tax audit settlements (230 basis points) and the U.S. domestic manufacturing deduction benefit (220 basis points), offset by state taxes (210 basis points) which increased due to provisions for uncertain tax benefits. Fiscal 2014 Compared to Fiscal 2013 The Company recorded a provision for income taxes of 29.0% of pre-tax income in fiscal 2014 compared to 29.6% in fiscal 2013. Results for fiscal 2014, when compared to the U.S. statutory tax rate, were favorably impacted by a reduction in valuation allowance on foreign, state and capital loss carryforwards (240 basis points) largely due to a favorable tax ruling in Europe, the benefit of tax audit settlements (230 basis points) and the U.S. domestic manufacturing deduction benefit (220 basis points), offset by state taxes (210 basis points) which increased due to provisions for uncertain tax benefits. Results for fiscal 2013, when compared to the U.S. statutory tax rate, were favorably impacted by the U.S. domestic manufacturing deduction benefit (380 basis points) and the benefit of the reinstated U.S. research and development tax credit (130 basis points). Equity in Earnings of Unconsolidated Affiliates - Three Years Ended September 30, 2015 Fiscal 2015 Compared to Fiscal 2014 Equity in earnings of unconsolidated affiliates of $2.6 million in fiscal 2015 and $2.4 million in fiscal 2014 primarily represented the Company's equity interest in a commercial entity in Mexico and a joint venture in Europe. Fiscal 2014 Compared to Fiscal 2013 Equity in earnings of unconsolidated affiliates of $2.4 million in fiscal 2014 and $3.0 million in fiscal 2013 primarily represented the Company's equity interest in a commercial entity in Mexico and a joint venture in Europe. Analysis of Discontinued Operations - Three Years Ended September 30, 2015 Fiscal 2014 Compared to Fiscal 2013 In March 2013, the Company discontinued production of ambulances. The ambulance business, which was included in the Company's fire & emergency segment, had sales of $20.6 million in fiscal 2013. The Company has reflected the financial results of the business as discontinued operations in the Consolidated Statements of Income. Liquidity and Capital Resources Financial Condition at September 30, 2015 The Company’s cash and cash equivalents and capitalization were as follows (in millions): The Company generates significant capital resources from operating activities, which is the expected primary source of funding for its operations. At September 30, 2015, the Company had cash and cash equivalents of $42.9 million, a majority of which is located in the United States. The Company expects to meet its fiscal 2016 U.S. funding needs without repatriating undistributed profits that are indefinitely reinvested outside the United States. In addition to cash and cash equivalents, the Company had $723.9 million of unused available capacity under the Revolving Credit Facility (as defined in “Liquidity”) as of September 30, 2015. Borrowings under the Revolving Credit Facility could, as discussed below, be limited by the financial covenants contained within the Credit Agreement (as defined in “Liquidity”). The Company's ratio of debt to total capitalization of 32.9% at September 30, 2015 remained within its targeted range. The Company's capital structure was impacted in fiscal 2015 by the Company's repurchase of 4.9 million shares of its Common Stock at an aggregate cost of $200.4 million. As of September 30, 2015, the Company had approximately 10.0 million shares of Common Stock remaining under the repurchase authorization approved by the Company's Board of Directors in August 2015. Consolidated days sales outstanding (defined as “Trade Receivables” at quarter end divided by “Net Sales” for the most recent quarter multiplied by 90 days) were 50 days at both September 30, 2015 and September 30, 2014. Days sales outstanding for segments other than the defense segment were 53 days at September 30, 2015, down from 54 days at September 30, 2014. This decrease in days sales outstanding was primarily due to a decrease in accounts receivable in the access equipment segment at September 30, 2015 as a result of the beginning of a mid-cycle dip in access equipment demand. Consolidated inventory turns (defined as “Cost of Sales” on an annualized basis, divided by the average “Inventory” at the past five quarter end periods) was 4.3 times at September 30, 2015, down from 5.8 times at September 30, 2014. The decrease in inventory turns was largely due to higher inventory levels in the access equipment and defense segments as each segment executed strategic initiatives to meet expected customer demand. Cash Flows Operating Cash Flows The Company generated $82.5 million of cash from operating activities during fiscal 2015 compared to $170.4 million during fiscal 2014 and $438.0 million during fiscal 2013. The decrease in cash generated from operating activities in fiscal 2015 compared to fiscal 2014 was primarily due to lower operating income and higher inventory levels in the access equipment and defense segments at September 30, 2015, partially offset by increased customer advances on higher order backlog in the fire & emergency segment. Increased inventory in the access equipment segment (up $182.8 million) resulted from the combination of a plan to level-load production during the year to address seasonal fluctuations in demand and a subsequent reduction in access equipment third and fourth quarter sales compared to previous estimates as a result of the start of a mid-cycle dip in North American demand for access equipment. Defense inventory levels grew (up $134.0 million) to support new contracts, both domestic and international. The magnitude and duration of these contracts has resulted in heightened working capital requirements in the defense segment. The decrease in cash from operating activities in fiscal 2014 compared to fiscal 2013 was primarily due to an increase in accounts receivable in the access equipment segment in fiscal 2014 as a result of a larger concentration of sales in the last month of fiscal 2014 and increased inventory levels in the access equipment and commercial segments at September 30, 2014. Investing Cash Flows Net cash used in investing activities in fiscal 2015 was $140.1 million compared to $114.7 million in fiscal 2014 and $74.7 million in fiscal 2013. Additions to property, plant and equipment of $131.7 million in fiscal 2015 reflected an increase in capital spending of $39.5 million compared to fiscal 2014 as a result of investments in the Company's vertical integration strategy and global information systems replacement initiative. In fiscal 2016, the Company expects capital spending to decrease to approximately $100 million. In fiscal 2013, the Company made an initial contribution of $19.4 million to a rabbi trust established to fund obligations under the Company's non-qualified supplemental executive retirement plans. Financing Cash Flows Financing activities resulted in a net use of cash of $212.9 million in fiscal 2015 compared to $476.0 million in fiscal 2014 and $170.0 million in fiscal 2013. The Company made required quarterly debt payments during fiscal 2015 totaling $20.0 million compared to $37.5 million in fiscal 2014. The Company also prepaid $22.5 million of term debt in fiscal 2014 as part of refinancing the Credit Agreement. No debt payments were required in fiscal 2013 as the Company made all required quarterly payments in fiscal 2012. In fiscal 2015, 2014 and 2013 the Company repurchased approximately 4.9 million, 8.3 million and 6.1 million shares of its Common Stock, respectively, under its share repurchase authorization at an aggregate cost of $200.4 million, $403.3 million and $201.8 million, respectively. The Company expects to continue to repurchase shares of its Common Stock in fiscal 2016, subject to maintaining prudent leverage and the price of the Company's Common Stock. In addition, the Company paid dividends of $53.1 million and $50.7 million in fiscal 2015 and 2014, respectively. Liquidity The Company's primary sources of liquidity are the cash flow generated from operations, availability under the Revolving Credit Facility and available cash and cash equivalents. In addition to cash and cash equivalents of $42.9 million, the majority of which is located in the United States, the Company had $723.9 million of unused availability under the Revolving Credit Facility as of September 30, 2015. These sources of liquidity are needed to fund the Company's working capital requirements, debt service requirements, capital expenditures, share repurchases and dividends. The Company expects to have sufficient liquidity to finance its operations over the next twelve months. Senior Secured Credit Agreement On March 21, 2014, the Company entered into an Amended and Restated Credit Agreement with various lenders (the “Credit Agreement”). The Credit Agreement provides for (i) a revolving credit facility (“Revolving Credit Facility”) that matures in March 2019 with an initial maximum aggregate amount of availability of $600 million and (ii) a $400 million term loan due in quarterly principal installments of $5.0 million with a balloon payment of $310.0 million due at maturity in March 2019. On January 22, 2015, the Company entered into an agreement with lenders under the Credit Agreement that increased the Revolving Credit Facility by $250.0 million to an aggregate maximum amount of $850.0 million effective January 26, 2015. Refer to Note 11 of the Notes to Consolidated Financial Statements for additional information regarding the Credit Agreement. The Company’s obligations under the Credit Agreement are guaranteed by certain of its domestic subsidiaries, and the Company will guarantee the obligations of certain of its subsidiaries under the Credit Agreement. Subject to certain exceptions, the Credit Agreement is collateralized by (i) a first-priority perfected lien and security interests in substantially all of the personal property of the Company, each material subsidiary of the Company and each subsidiary guarantor, (ii) mortgages upon certain real property of the Company and certain of its domestic subsidiaries and (iii) a pledge of the equity of each material subsidiary of the Company. Under the Credit Agreement, the Company must pay (i) an unused commitment fee ranging from 0.225% to 0.35% per annum of the average daily unused portion of the aggregate revolving credit commitments under the Credit Agreement and (ii) a fee ranging from 0.625% to 2.00% per annum of the maximum amount available to be drawn for each letter of credit issued and outstanding under the Credit Agreement. Borrowings under the Credit Agreement bear interest at a variable rate equal to (i) LIBOR plus a specified margin, which may be adjusted upward or downward depending on whether certain criteria are satisfied, or (ii) for dollar-denominated loans only, the base rate (which is the highest of (a) the administrative agent's prime rate, (b) the federal funds rate plus 0.50% or (c) the sum of 1% plus one-month LIBOR) plus a specified margin, which may be adjusted upward or downward depending on whether certain criteria are satisfied. Covenant Compliance The Credit Agreement contains various restrictions and covenants, including requirements that the Company maintain certain financial ratios at prescribed levels and restrictions, subject to certain exceptions, on the ability of the Company and certain of its subsidiaries to consolidate or merge, create liens, incur additional indebtedness, dispose of assets, consummate acquisitions and make investments in joint ventures and foreign subsidiaries. The Credit Agreement contains the following financial covenants: • Leverage Ratio: A maximum leverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated indebtedness to consolidated net income before interest, taxes, depreciation, amortization, non-cash charges and certain other items (“EBITDA”)) as of the last day of any fiscal quarter of 4.50 to 1.0. • Interest Coverage Ratio: A minimum interest coverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated EBITDA to the Company’s consolidated cash interest expense) as of the last day of any fiscal quarter of 2.50 to 1.0. • Senior Secured Leverage Ratio: A maximum senior secured leverage ratio (defined as, with certain adjustments, the ratio of the Company’s consolidated secured indebtedness to the Company’s consolidated EBITDA) of 3.00 to 1.0. With certain exceptions, the Company may elect to have the collateral pledged in connection with the Credit Agreement released during any period that the Company maintains an investment grade corporate family rating from either Standard & Poor’s Ratings Group or Moody’s Investor Service Inc. During any such period when the collateral has been released, the Company’s leverage ratio as of the last day of any fiscal quarter must not be greater than 3.75 to 1.0, and the Company would not be subject to any additional requirement to limit its senior secured leverage ratio. The Company was in compliance with the financial covenants contained in the Credit Agreement as of September 30, 2015 and expects to be able to meet the financial covenants contained in the Credit Agreement over the next twelve months. Additionally, with certain exceptions, the Credit Agreement limits the ability of the Company to pay dividends and other distributions, including repurchases of shares of its Common Stock. However, so long as no event of default exists under the Credit Agreement or would result from such payment, the Company may pay dividends and other distributions after March 3, 2010 in an aggregate amount not exceeding the sum of: i. 50% of the consolidated net income of the Company and its subsidiaries (or if such consolidated net income is a deficit, minus 100% of such deficit), accrued on a cumulative basis during the period beginning on January 1, 2010 and ending on the last day of the fiscal quarter immediately preceding the date of the applicable proposed dividend or distribution; and ii. 100% of the aggregate net proceeds received by the Company subsequent to March 3, 2010 either as a contribution to its common equity capital or from the issuance and sale of its Common Stock. Senior Notes In March 2010, the Company issued $250.0 million of 8¼% unsecured senior notes due March 1, 2017 (the “2017 Senior Notes”) and $250.0 million of 8½% unsecured senior notes due March 1, 2020 (the “2020 Senior Notes”). On February 21, 2014, the Company issued $250.0 million of 5.375% unsecured senior notes due March 1, 2022 (the “2022 Senior Notes”). The Company used the net proceeds from the sale of the 2022 Senior Notes, together with available cash, to redeem all of the outstanding 2017 Senior Notes at a price of 104.125%. On March 2, 2015, the Company issued $250.0 million of 5.375% unsecured senior notes due March 1, 2025 (the “2025 Senior Notes”). The Company used the net proceeds from the sale of the 2025 Senior Notes, together with available cash, to redeem all of the outstanding 2020 Senior Notes at a price of 104.250%. The Company has the option to redeem the 2022 Senior Notes and the 2025 Senior Notes for a premium after March 1, 2017 and March 1, 2020, respectively. The 2022 Senior Notes and the 2025 Senior Notes were issued pursuant to separate indentures (the “Indentures”) among the Company, the subsidiary guarantors named therein and a trustee. The Indentures contain customary affirmative and negative covenants. Certain of the Company’s subsidiaries jointly, severally, fully and unconditionally guarantee the Company’s obligations under the 2022 Senior Notes and 2025 Senior Notes. See Note 24 of the Notes to Consolidated Financial Statements for separate financial information of the subsidiary guarantors. Refer to Note 11 of the Notes to Consolidated Financial Statements for additional information regarding the Company’s outstanding debt as of September 30, 2015. Contractual Obligations, Commitments and Off-Balance Sheet Arrangements Following is a summary of the Company’s contractual obligations and payments due by period following September 30, 2015 (in millions): _________________________ (1) Interest was calculated based upon the interest rate in effect on September 30, 2015. (2) The Company utilizes blanket purchase orders to communicate expected annual requirements to many of its suppliers or contractors. Requirements under blanket purchase orders generally do not become “firm” until four weeks prior to the Company’s scheduled unit production. The purchase obligations amounts included above represent the values of commitments considered firm, plus the value of all outstanding subcontracts. (3) Due to the uncertainty of the timing of settlement with taxing authorities, the Company is unable to make reasonably reliable estimates of the period of cash settlement of unrecognized tax benefits for the remaining uncertain tax liabilities. Therefore, $27.0 million of unrecognized tax benefits as of September 30, 2015 have been excluded from the Contractual Obligations table above. See Note 19 of the Notes to Consolidated Financial Statements for additional information regarding the Company’s unrecognized tax benefits as of September 30, 2015. (4) Represents other long-term liabilities on the Company's Consolidated Balance Sheet, including the current portion of these liabilities. The projected timing of cash flows associated with these obligations is based on management's estimates, which are based largely on historical experience. This amount also includes all liabilities under the Company's pension and other postretirement benefit plans. See Note 18 of the Notes to Consolidated Financial Statements for information regarding these liabilities and the plan assets available to satisfy them. The following is a summary of the Company’s commitments by period following September 30, 2015 (in millions): The Company incurs contingent limited recourse liabilities with respect to customer financing activities primarily in the access equipment segment. For additional information relative to guarantees, see Note 13 of the Notes to Consolidated Financial Statements. Fiscal 2016 Outlook The Company believes consolidated net sales will increase approximately 2% to 6% in fiscal 2016 compared to fiscal 2015, resulting in consolidated sales of between $6.2 billion and $6.5 billion. The high end of the estimates assumes higher sales in each of the Company's non-access equipment segments, led by an expected significant percentage increase in defense segment sales as a result of the expected sale of approximately 1,000 M-ATVs internationally and a full year of FHTV sales, after signing a new five year contract in June 2015 following a six-month break in production while the new contract was being negotiated. The Company expects access equipment segment sales to decline 10%-15% compared to fiscal 2015 as a result of continuation of the mid-cycle dip that the access equipment market began to experience in fiscal 2015. The Company expects consolidated operating income will be in the range of $400 million to $440 million, with earnings per share of approximately $3.00 to $3.40 assuming a full year average share count of approximately 75 million shares. The Company believes access equipment segment sales will be between $2.90 billion and $3.05 billion in fiscal 2016, representing a decrease of 10%-15% compared to fiscal 2015. The Company expects the sales decrease will be a result of the continuation of the mid-cycle dip that began in fiscal 2015. The Company expects operating income margin in the access equipment segment will be approximately 10.5%, compared to an operating income margin of 12.0% in fiscal 2015, reflecting the impact of lower sales and under-absorption of fixed overhead as this segment works to align inventory levels with lower expected demand. The Company expects that defense segment sales will be approximately $1.55 billion in fiscal 2016, an increase of approximately 65% from fiscal 2015 sales. The Company is assuming that it will secure an additional international contract in time to record sales of approximately 1,000 M-ATVs in fiscal 2016. The Company believes operating income margins in this segment will be approximately 8.75%. The Company expects defense segment margins to be positively impacted by higher sales. The Company expects fire & emergency segment sales will be approximately $900 million in fiscal 2016, reflecting the continued recovery in the municipal fire apparatus market and increased production rates. The Company expects operating income margins in this segment to increase to approximately 6.0% in fiscal 2016 as a result of the higher sales volumes and improved operating efficiencies. The Company believes commercial segment sales will be approximately $1.0 billion in fiscal 2016, a 2% improvement over fiscal 2015, driven by an expected continued recovery in the U.S. refuse collection vehicle market and share gains, partially offset by expected lower concrete placement product sales. The Company expects operating income margins in this segment to be approximately 7.0% in fiscal 2016, reflecting the benefits of higher sales and the impact of other MOVE initiatives. The Company expects corporate expenses in fiscal 2016 will be between $144 million and $152 million reflecting an assumed target level bonus after minimal bonuses were earned in fiscal 2015 and continued start-up costs of a shared production facility. The Company estimates its effective tax rate for fiscal 2016 will be approximately 34%. The Company is assuming a fiscal 2016 full year share count of approximately 75 million. The Company expects capital expenditures to be approximately $100 million in fiscal 2016, down from $131.7 million in fiscal 2015. The Company also expects a significant increase in cash flow from operations in fiscal 2016 due to strong earnings and a targeted reduction in inventory levels. Critical Accounting Policies The Company’s significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements. The Company considers the following policies to be the most critical in understanding the judgments that are involved in the preparation of the Company’s consolidated financial statements and the uncertainties that could impact the Company’s financial condition, results of operations and cash flows. Revenue Recognition. The Company recognizes revenue on equipment and parts sales when contract terms are met, collectability is reasonably assured and a product is shipped or risk of ownership has been transferred to and accepted by the customer. Revenue from service agreements is recognized as earned, when services have been rendered. Appropriate provisions are made for discounts, returns and sales allowances. Sales are recorded net of amounts invoiced for taxes imposed on the customer such as excise or value-added taxes. Sales to the U.S. government of non-commercial products manufactured to the government’s specifications are recognized using the units-of-delivery measure under the percentage-of-completion accounting method as units are accepted by the government. Under the units-of-delivery measure, the Company records sales as units are accepted by the DoD based on unit sales values stated in the respective contracts. Costs of sales are based on actual costs incurred to produce the units delivered under the contract. The Company includes amounts representing contract change orders, claims or other items in sales only when they can be reliably estimated and realization is probable. The Company charges anticipated losses on contracts or programs in progress to earnings when identified. Approximately 13% of the Company’s revenues for fiscal 2015 were recognized under the percentage-of-completion accounting method. The Company accounts for certain equipment lease contracts as sales-type leases. The present value of all payments, net of executory costs (such as legal fees), is recorded as revenue, the related cost of the equipment is charged to cost of sales, certain profit is deferred in accordance with lease accounting rules and interest income is recognized over the terms of the leases using the effective interest method. The Company enters into rental purchase guarantee agreements with some of its customers. These agreements are normally for a term of no greater than twelve months and provide for rental payments with a guaranteed purchase at the end of the agreement. At the inception of the agreement, the Company records the full amount due under the agreement as revenue and the related cost of the equipment is charged to cost of sales. Sales Incentives. The terms for sales transactions with some of the Company’s distributors and customers may include specific volume-based incentives, which are calculated and paid or credited on account as a percentage of actual sales. The Company accounts for these incentives as sales discounts at the time of revenue recognition, which are recorded as a direct reduction of sales. The Company reviews its accrual for sales incentives on a quarterly basis and any adjustments are reflected in current earnings. Impairment of Goodwill and Indefinite-Lived Intangible Assets. Goodwill and indefinite-lived intangible assets are tested for impairment annually, or more frequently if events or changes in circumstances indicate that the assets might be impaired. Such circumstances include a significant adverse change in the business climate for one of the Company's reporting units, a material negative change in relationships with significant customers, or strategic decisions made in response to economic and competitive conditions. The Company performs its annual review at the beginning of the fourth quarter of each fiscal year. See “Critical Accounting Estimates.” The Company evaluates the recoverability of goodwill by estimating the fair value of the businesses to which the goodwill relates. A reporting unit is an operating segment or, under certain circumstances, a component of an operating segment that constitutes a business. When the fair value of the reporting unit is less than the carrying value of the reporting unit, a further analysis is performed to measure and recognize the amount of the impairment loss, if any. Impairment losses, limited to the carrying value of goodwill, represent the excess of the carrying amount of a reporting unit’s goodwill over the implied fair value of that goodwill. The Company evaluates the recoverability of indefinite-lived trade names based upon a “relief from royalty” method. This methodology determines the fair value of each trade name through use of a discounted cash flow model that incorporates an estimated “royalty rate” the Company would be able to charge a third party for the use of the particular trade name. In determining the estimated future cash flows, the Company considers projected future sales, a fair market royalty rate for each applicable trade name and an appropriate discount rate to measure the present value of the anticipated cash flows. During fiscal 2013, the Company recognized an impairment of a trade name in the access equipment segment of $9.0 million. Impairment of Long-Lived and Amortized Intangible Assets. The Company performs impairment evaluations of its long-lived assets, including property, plant and equipment and intangible assets with finite lives, whenever business conditions or events indicate that those assets may be impaired. When the estimated future undiscounted cash flows to be generated by the assets are less than the carrying value of the long-lived assets, the assets are written down to fair market value and a charge is recorded to current operations. During fiscal 2014, the Company recorded a $1.6 million charge for the impairment of long-lived assets in the defense segment. Guarantees of the Indebtedness of Others. The Company enters into agreements with finance companies whereby the Company will guarantee the indebtedness of third-party end-users to whom the finance company lends to purchase the Company’s equipment. In some instances, the Company retains an obligation to the finance companies in the event the customer defaults on the financing. In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 460, Guarantees, the Company recognizes the greater of the fair value of the guarantee or the contingent liability required by FASB ASC Topic 450, Contingencies. Reserves are initially established related to these guarantees at the fair value of the guarantee based upon the Company’s understanding of the current financial position of the underlying customers and based on estimates and judgments made from information available at that time. If the Company becomes aware of deterioration in the financial condition of the customer/borrower or of any impairment of the customer/borrower’s ability to make payments, additional allowances are considered. Although the Company may be liable for the entire amount of a customer/borrower’s financial obligation under guarantees, its losses would generally be mitigated by the value of any underlying collateral including financed equipment, the finance company’s inability to provide clear title of foreclosed equipment to the Company, loss pools established in accordance with the agreements and other conditions. During periods of economic downturn, the value of the underlying collateral supporting these guarantees can decline sharply to further increase losses in the event of a customer/borrower’s default. Critical Accounting Estimates “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is based on the Company's Consolidated Financial Statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”). The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and judgments that affect reported amounts and related disclosures. On an ongoing basis, management evaluates and updates its estimates. Management employs judgment in making its estimates but they are based on historical experience and currently available information and various other assumptions that the Company believes to be reasonable under the circumstances. The results of these estimates form the basis for making judgments about the carrying values of assets and liabilities that are not readily available from other sources. Actual results could differ from those estimates. Management believes that its judgment is applied consistently and produces financial information that fairly depicts the results of operations for all periods presented. Definitization of Undefinitized Contracts. The Company recognizes revenue on undefinitized contracts with the DoD to the extent that it can reasonably and reliably estimate the expected final contract price and when collectability is reasonably assured. Undefinitized contracts are used when the Company and the DoD have not agreed upon all contract terms before the Company begins performance under the contracts. To the extent that contract definitization results in changes or adjustments to previously recognized revenues or estimated or incurred costs, including charges from subcontractors, the Company records those adjustments as a change in estimate in the period of change. The Company updated its estimated costs under several undefinitized change orders and recorded $7.5 million and $13.8 million of revenue related to such updates during fiscal 2014 and 2013, respectively. As the majority of costs associated with these contracts had previously been expensed, the definitization of contracts increased net income by $4.7 million, or $0.06 per share, and $6.6 million, or $0.07 per share, for fiscal 2014 and 2013, respectively. Allowance for Doubtful Accounts. The allowance for doubtful accounts requires management to estimate a customer’s ability to satisfy its obligations. The estimate of the allowance for doubtful accounts is particularly critical in the Company’s access equipment segment where the majority of the Company’s trade receivables are recorded. In circumstances where the Company is aware of a specific customer’s inability to meet its financial obligations, a specific reserve is recorded against amounts due to reduce the net recognized receivable to the amount reasonably expected to be collected. Additional reserves are established based upon the Company’s perception of the quality of the current receivables, including the length of time the receivables are past due, past experience of collectability and underlying economic conditions. At September 30, 2015, reserves for potentially uncollectible accounts receivable totaled $20.3 million. If the financial condition of the Company’s customers were to deteriorate resulting in an impairment of their ability to make payments, additional reserves would be required. Inventories. Inventories are stated at the lower of cost or market (“LCM”) value. In valuing inventory, the Company is required to make assumptions regarding the level of reserves required to value potentially obsolete or over-valued items. These assumptions require the Company to analyze the aging of and forecasted demand for its inventory, forecast future product sales prices, pricing trends and margins, and to make judgments and estimates regarding obsolete or excess inventory. Future product sales prices, pricing trends and margins are based on the best available information at that time including actual orders received, negotiations with customers for future orders, including their plans for expenditures, and market trends for similar products. The Company's judgments and estimates for excess or obsolete inventory are based on analysis of actual and forecasted usage. The valuation of used equipment taken in trade from customers requires the Company to use the best information available to determine the value of the equipment to potential customers. This value is subject to change based on numerous conditions. Inventory reserves are established taking into account age, frequency of use, or sale, and in the case of repair parts, the installed base of machines. While calculations are made involving these factors, significant management judgment regarding expectations for future events is involved. Future events that could significantly influence the Company's judgment and related estimates include general economic conditions in markets where the Company's products are sold, new equipment price fluctuations, actions of the Company's competitors, including the introduction of new products and technological advances. The Company makes adjustments to its inventory reserves based on the identification of specific situations and increases its inventory reserves accordingly. At September 30, 2015, reserves for LCM, excess and obsolete inventory totaled $84.9 million. Goodwill. In evaluating the recoverability of goodwill, it is necessary to estimate the fair value of the reporting units. The estimate of the fair value of the reporting units is generally determined on the basis of discounted future cash flows and a market approach. In estimating the fair value, management must make assumptions and projections regarding such items as the Company performance and profitability under existing contracts, its success in securing future business, the appropriate risk-adjusted interest rate used to discount the projected cash flows, and terminal value growth and earnings rates. The assumptions used in the estimate of fair value are generally consistent with the past performance of each reporting unit and are also consistent with the projections and assumptions that are used in current operating plans. Such assumptions are subject to change as a result of changing economic and competitive conditions. The rate used to discount estimated cash flows is a rate corresponding to the Company’s cost of capital, adjusted for risk where appropriate, and is dependent upon interest rates at a point in time. To assess the reasonableness of the discounted projected cash flows, the Company compares the sum of its reporting units' fair value to the Company's market capitalization and calculates an implied control premium (the excess of the sum of the reporting units' fair values over the market capitalization). The reasonableness of this control premium is evaluated by comparing it to control premiums for recent comparable market transactions. Consistent with prior years, the Company weighted the income approach more heavily (75%) as the income approach uses long-term estimates that consider the expected operating profit of each reporting unit during periods where residential and non-residential construction and other macroeconomic indicators are nearer historical averages. The Company believes the income approach more accurately considers the expected recovery in the U.S. and European construction markets than the market approach. There are inherent uncertainties related to these factors and management’s judgment in applying them to the analysis of goodwill impairment. It is possible that assumptions underlying the impairment analysis will change in such a manner to cause further impairment of goodwill, which could have a material impact on the Company’s results of operations. The Company completed the required goodwill impairment test as of July 1, 2015. The Company identified no indicators of goodwill impairment in the test performed as of July 1, 2015. In order to evaluate the sensitivity of any quantitative fair value calculations on the goodwill impairment test, a hypothetical 10% decrease to the fair values of any reporting unit was calculated. This hypothetical 10% decrease would still result in excess fair value over carrying value for the reporting units as of July 1, 2015. Approximately 90% of the Company’s recorded goodwill and indefinite-lived purchased intangibles are concentrated within the JLG reporting unit in the access equipment segment. Assumptions utilized in the impairment analysis are highly judgmental. While the Company currently believes that an impairment of intangible assets at JLG is unlikely, events and conditions that could result in the impairment of intangibles at JLG include a sharp decline in economic conditions, pricing pressure on JLG's margins or other factors leading to reductions in expected long-term sales or profitability at JLG. Guarantees of the Indebtedness of Others. The reserve for guarantees of the indebtedness of others requires management to estimate a customer’s ability to satisfy its obligations. The estimate is particularly critical in the Company’s access equipment segment where the majority of the Company’s guarantees are granted. The Company evaluates the reserve based on a combination of factors. In circumstances where the Company is aware of a specific customer’s inability to meet its financial obligations, a specific reserve is recorded in accordance with FASB ASC Topic 450, Contingencies. In most cases, the financing company is required to provide clear title to the equipment under the financing program. The Company considers the residual value of the equipment to reduce the amount of exposure. Residual values are estimated based upon recent auctions, used equipment sales and periodic studies performed by a third-party. Additional reserves, based upon historical loss percentages, are established at the time of sale of the equipment based upon the requirement of FASB ASC Topic 460, Guarantees. If the financial condition of the Company’s customers were to deteriorate resulting in an impairment of their ability to make payments, additional reserves would be required. Product Liability. Due to the nature of the Company’s products, the Company is subject to product liability claims in the normal course of business. A substantial portion of these claims and lawsuits involve the Company’s access equipment, concrete placement and refuse collection vehicle businesses, while such lawsuits in the Company’s defense and fire & emergency businesses have historically been limited. To the extent permitted under applicable law, the Company maintains insurance to reduce or eliminate risk to the Company. Most insurance coverage includes self-insured retentions that vary by business segment and by year. As of September 30, 2015, the Company was generally self-insured for future claims up to $5.0 million per claim. The Company establishes product liability reserves for its self-insured retention portion of any known outstanding matters based on the likelihood of loss and the Company’s ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. The Company makes estimates based on available information and the Company’s best judgment after consultation with appropriate experts. The Company periodically revises estimates based upon changes to facts or circumstances. The Company also utilizes actuarial methodologies to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of the adverse development of claims over time. Warranty. Sales of the Company’s products generally carry typical explicit manufacturers’ warranties that extend from six months to five years, based on terms that are generally accepted in the Company's marketplaces. Selected components included in the Company’s end products (such as engines, transmissions, tires, etc.) may include manufacturers’ warranties. These manufacturers’ warranties are generally passed on to the end customer of the Company’s products and the customer would generally deal directly with the component manufacturer. The Company records provisions for estimated warranty and other related costs at the time of sale based on historical warranty loss experience and periodically adjusts these provisions to reflect actual experience. Certain warranty and other related claims involve matters of dispute that ultimately are resolved by negotiation, arbitration or litigation. At times, warranty issues arise that are beyond the scope of the Company’s historical experience. The Company provides for any such warranty issues as they become known and estimable. It is reasonably possible that from time to time additional warranty and other related claims could arise from disputes or other matters beyond the scope of the Company’s historical experience. Historically, the cost of fulfilling the Company’s warranty obligations has principally involved replacement parts, labor and sometimes travel for any field retrofit campaigns. Over the past five fiscal years, the Company’s warranty cost as a percentage of sales has ranged from 0.39% of sales to 0.87% of sales. Warranty costs tend to be higher shortly after new product introductions, especially those introductions involving new technologies, when field warranty campaigns may be necessary to correct or retrofit certain items. Accordingly, the Company must make assumptions about the number and cost of anticipated field warranty campaigns. The Company’s estimates are based on historical experience, the extent of pre-production testing, the number of units involved and the extent of new features/components included in new product models. Each quarter, the Company reviews actual warranty claims experience to determine if there are any systemic defects that would require a field campaign. Also, based upon historical experience, warranty provision rates on new product introductions are established at higher than standard rates to reflect increased expected warranty costs associated with any new product introduction. Defined Benefit Plans. The pension benefit obligation and related pension income are calculated in accordance with FASB ASC Topic 715, Compensation - Retirement Benefits. Determination of defined benefit pension and postretirement plan obligations and their associated expenses requires the use of actuarial valuations to estimate the benefits that employees earn while working, as well as the present value of those benefits. The Company uses the services of independent actuaries to assist with these calculations. Inherent in these valuations are economic assumptions, including the expected rate of return on plan assets, discount rates at which liabilities may be settled, rates of increase of health care costs as well as employee demographic assumptions such as retirement patterns, mortality and turnover. The actuarial assumptions used may differ materially from actual results due to changing market and economic conditions, higher or lower turnover rates, or longer or shorter life spans of participants. Actual results that differ from the actuarial assumptions used are recorded as unrecognized gains and losses. Unrecognized gains and losses that exceed 10% of the greater of the plan's projected benefit obligations or the market-related value of assets are amortized to earnings over the shorter of the estimated future service period of the plan participants or the period until any anticipated final plan settlements. The Company determines the discount rate used each year based on the rate of return currently available on a portfolio of high-quality fixed-income investments with a maturity that is consistent with the projected benefit payout period. The Company's long-term rate of return on assets is based on consideration of historical and forward-looking returns and the current asset allocation strategy. Actuarial valuations at September 30, 2015 used a weighted-average discount rate of 4.45% and an expected return on plan assets of 6.03%. A 50 basis point decrease in the discount rate would increase the Company's annual pension expense by $2.0 million. A 50 basis point decrease in the expected return on plan assets would increase the Company’s annual pension expense by $1.4 million. Income Taxes. The Company records deferred income tax assets and liabilities for differences between the book basis and tax basis of the related net assets. The Company records a valuation allowance, when appropriate, to adjust deferred tax asset balances to the amount management expects to realize. Management considers, as applicable, the amount of taxable income available in carryback years, future taxable income and potential tax planning strategies in assessing the need for a valuation allowance. The Company accounts for uncertain tax positions in accordance with FASB ASC Topic 740, Income Taxes. ASC Topic 740 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. ASC Topic 740 also provides guidance on derecognition, classification, interest and penalties, disclosure and transition. The evaluation of a tax position in accordance with ASC Topic 740 is a two-step process. The first step is recognition, where the Company evaluates whether an individual tax position has a likelihood of greater than 50% of being sustained upon examination based on the technical merits of the position, including resolution of any related appeals or litigation processes. For tax positions that are currently estimated to have a less than 50% likelihood of being sustained, zero tax benefit is recorded. For tax positions that have met the recognition threshold in the first step, the Company performs the second step of measuring the benefit to be recorded. The actual benefits ultimately realized may differ from the Company’s estimates. In future periods, changes in facts and circumstances and new information may require the Company to change the recognition and measurement estimates with regard to individual tax positions. Changes in recognition and measurement estimates are recorded in results of operations and financial position in the period in which such changes occur. As of September 30, 2015, the Company had net liabilities for unrecognized tax benefits pertaining to uncertain tax positions totaling $27.0 million. New Accounting Standards Refer to Note 2 of the Notes to Consolidated Financial Statements for a discussion of the impact of new accounting standards on the Company’s consolidated financial statements. Customers and Backlog Sales to the U.S. government comprised approximately 15% of the Company’s net sales in fiscal 2015. No other single customer accounted for more than 10% of the Company’s net sales for this period. A substantial majority of the Company’s net sales are derived from the fulfillment of customer orders that are received prior to commencing production. The Company’s backlog as of September 30, 2015 increased 37.9% to $2.61 billion compared to $1.89 billion at September 30, 2014 due largely to an increase the defense segment backlog as a result of new contracts in fiscal 2015. Access equipment segment backlog decreased 45.4% to $209.7 million at September 30, 2015 compared to $384.3 million at September 30, 2014, due to the impact of the mid-cycle dip in North American demand for access equipment. Defense segment backlog increased 81.4% to $1,414.0 million at September 30, 2015 compared to $779.7 million at September 30, 2014 due largely to orders under a new FHTV contract, higher international M-ATV orders and $114.7 million in delivery orders under the new JLTV contract. The JLTV orders represent initial delivery orders on this new contract. Fire & emergency segment backlog increased 39.4% to $790.7 million at September 30, 2015 compared to $567.1 million at September 30, 2014 due largely to increased orders for domestic fire apparatus as a result of market growth and share gains. Commercial segment backlog increased 20.7% to $193.0 million at September 30, 2015 compared to $159.9 million at September 30, 2014. Unit backlog for concrete mixers as of September 30, 2015 was flat compared to September 30, 2014. Unit backlog for refuse collection vehicles was up 46.0% at September 30, 2015 compared to September 30, 2014 due to fleet replacement and share growth. Reported backlog excludes purchase options and announced orders for which definitive contracts have not been executed. Backlog information and comparisons thereof as of different dates may not be accurate indicators of future sales or the ratio of the Company’s future sales to the DoD versus its sales to other customers. Approximately 17% of the Company’s September 30, 2015 backlog is not expected to be filled in fiscal 2016. The Company's September 30, 2015 backlog includes $114.7 million in orders under the recently awarded JLTV contract. These orders are on hold until the JLTV contract stop-work-order has been lifted. The Company expects a decision on the JLTV protest in December 2015. Financial Market Risk The Company is exposed to market risk from changes in interest rates, certain commodity prices and foreign currency exchange rates. To reduce the risk from changes in foreign currency exchange and interest rates, the Company selectively uses financial instruments. All hedging transactions are authorized and executed pursuant to clearly defined policies and procedures, which strictly prohibit the use of financial instruments for speculative purposes. Interest Rate Risk. The Company’s earnings exposure related to adverse movements in interest rates is primarily derived from outstanding floating rate debt instruments that are indexed to short-term market interest rates. In this regard, changes in U.S. and off-shore interest rates affect interest payable on the Company’s borrowings under its Credit Agreement. Based on debt outstanding at September 30, 2015, a 100 basis point increase or decrease in the average cost of the Company’s variable rate debt would increase or decrease annual pre-tax interest expense by approximately $4.4 million. The table below provides information about the Company’s debt obligations, which are sensitive to changes in interest rates (dollars in millions): The table presents principal cash flows and related weighted-average interest rates by expected maturity dates. Weighted-average variable rates are based on implied forward rates in the yield curve at the reporting date. Commodity Price Risk. The Company is a purchaser of certain commodities, including steel, aluminum and composites. In addition, the Company is a purchaser of components and parts containing various commodities, including steel, aluminum, rubber and others which are integrated into the Company’s end products. The Company generally buys these commodities and components based upon market prices that are established with the vendor as part of the purchase process. The Company does not use commodity financial instruments to hedge commodity prices. The Company generally obtains firm quotations from its suppliers for a significant portion of its orders under firm, fixed-price contracts in its defense segment. In the Company’s access equipment, fire & emergency and commercial segments, the Company generally attempts to obtain firm pricing from most of its suppliers, consistent with backlog requirements and/or forecasted annual sales. To the extent that commodity prices increase and the Company does not have firm pricing from its suppliers, or its suppliers are not able to honor such prices, then the Company may experience margin declines to the extent it is not able to increase selling prices of its products. Foreign Currency Risk. The Company’s operations consist of manufacturing in the U.S., Belgium, Mexico, Canada, France, Australia, Romania, the United Kingdom and China and sales and limited vehicle body mounting activities on five continents. International sales comprised approximately 21% of overall net sales in fiscal 2015, of which approximately 70% involved exports from the U.S. The majority of export sales in fiscal 2015 were denominated in U.S. dollars. As a result of the manufacture and sale of the Company’s products in foreign markets, the Company’s earnings are affected by fluctuations in the value of foreign currencies in which certain of the Company’s transactions are denominated as compared to the value of the U.S. dollar. The Company’s operating results are principally exposed to changes in exchange rates between the U.S. dollar and the European currencies, primarily the Euro and the U.K. pound sterling, changes between the U.S. dollar and the Australian dollar, changes between the U.S. dollar and the Brazilian real, changes between the U.S. dollar and the Mexican peso and changes between the U.S. dollar and the Chinese renminbi. The Company enters into certain forward foreign currency exchange contracts to mitigate the Company’s foreign currency exchange risk on monetary assets or liabilities. These contracts qualify as derivative instruments under FASB ASC Topic 815, Derivatives and Hedging; however, the Company has not designated all of these instruments as hedge transactions under ASC Topic 815. Accordingly, the mark-to-market impact of these derivatives is recorded each period to current earnings along with the offsetting foreign currency transaction gain/loss recognized on the related balance sheet exposure. At September 30, 2015, the Company was managing $138.5 million (notional) of foreign currency contracts, including $125.8 million (notional) which were not designated as accounting hedges. All outstanding foreign currency contracts as of September 30, 2015 will settle within 365 days. The following table quantifies outstanding forward foreign exchange contracts intended to hedge non-U.S. dollar denominated cash, receivables and payables and the corresponding U.S. dollar impact on the value of these instruments assuming a 10% appreciation/depreciation of the sell currency at September 30, 2015 (dollars in millions): As previously noted, the Company’s policy prohibits the trading of financial instruments for speculative purposes or the use of leveraged instruments. It is important to note that gains and losses indicated in the sensitivity analysis would be offset by gains and losses on the underlying receivables and payables.

<s>[INST] General The Company is a leading designer, manufacturer and marketer of a wide range of specialty vehicles and vehicle bodies, including access equipment, defense trucks and trailers, fire & emergency vehicles, concrete mixers and refuse collection vehicles. The Company is a leading global manufacturer of aerial work platforms under the “JLG” brand name. The Company is among the worldwide leaders in the manufacturing of telehandlers under the “JLG” and “SkyTrak” brand names. Under the “JerrDan” brand name, the Company is a leading domestic manufacturer and marketer of towing and recovery equipment. The Company manufactures defense trucks under the “Oshkosh” brand name and is a leading manufacturer of severeduty, tactical wheeled vehicles for the DoD. Under the “Pierce” brand name, the Company is among the leading global manufacturers of fire apparatus assembled on both custom and commercial chassis. Under the “Frontline” brand name, the Company is a leading domestic manufacturer and marketer of broadcast vehicles. The Company manufactures ARFF and airport snow removal vehicles under the “Oshkosh” brand name. Under the “McNeilus,” “Oshkosh,” “London” and “CONECO” brand names, the Company manufactures rear and frontdischarge concrete mixers and portable and stationary concrete batch plants. Under the “McNeilus” brand name, the Company manufactures a wide range of automated, rear, front, side and top loading refuse collection vehicles. Under the “IMT” brand name, the Company is a leading domestic manufacturer of field service vehicles and truckmounted cranes. Major products manufactured and marketed by each of the Company’s business segments are as follows: Access equipment aerial work platforms and telehandlers used in a wide variety of construction, agricultural, industrial, institutional and general maintenance applications to position workers and materials at elevated heights, as well as wreckers and carriers. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies, home improvement centers and towing companies in the U.S. and abroad. Defense tactical trucks, trailers and supply parts and services sold to the U.S. military and to other militaries around the world. Fire & emergency custom and commercial firefighting vehicles and equipment, ARFF vehicles, snow removal vehicles, simulators and other emergency vehicles primarily sold to fire departments, airports and other governmental units, and broadcast vehicles sold to broadcasters and TV stations in the U.S. and abroad. Commercial concrete mixers, refuse collection vehicles, portable and stationary concrete batch plants and vehicle components sold to readymix companies and commercial and municipal waste haulers in the Americas and other international markets and field service vehicles and truckmounted cranes sold to mining, construction and other companies in the U.S. and abroad. All estimates referred to in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” refer to the Company’s estimates as of November 13, 2015. Executive Overview In fiscal 2015, the Company faced two difficult conditions. First, the multiyear decline in U.S. defense spending caused the Company's defense sales and earnings to reach a trough, marginally profitable levels, consistent with the Company's expectations. However, the Company did not anticipate a broadbased decline in construction equipment sales in North America during a period of improving residential and nonresidential construction spending. The decline in fiscal 2015 was caused by a number of contributing factors including severe weather in the Northeast and rains across the Southern U.S. which shortened the construction season and a decline in oil and gas related construction activity which accelerated into fiscal 2015 a midcycle dip in demand for access equipment as a result of low purchases of access equipment in the 20092010 timeperiod. This led to sales declines in the Company's access equipment and concrete mixer businesses at a time that the Company believed it was in position to achieve its longterm target for fiscal 2015 earnings per share. Despite these difficult conditions, the Company delivered solid results in fiscal 2015, which represented a 9.5% compound annual growth rate of earnings per share on an adjusted basis from fiscal 20 [/INST] Positive. </s>